UNITED STATES
SECURITIES AND EXCHANGE COMMISION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
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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.
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(Exact name of registrant as specified in its charter)
Maryland 81-0559116
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1251 Avenue of the Americas, New York, NY 10020
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(Address of principal executive offices) (Zip Code)
(212) 798-6100
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(Registrant's telephone number, including area code)
______________________________________________________________________________
(Former name, former address and former fiscal year, if changed since last
report)
Securities registered pursuant to Section 12 (b) of the Act:
Common Stock, $0.01 par value per share (New York Stock Exchange (NYSE)
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Title of each class Name of exchange on which registered
Securities registered pursuant to Section 12 (g) of the Act: Not Applicable
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
[X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
form 10-K __
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
[ ] Yes [X] No
State the aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was last sold, or the average bid and asked price of such common equity, as of
the last business day of the Registrant's most recently completed second fiscal
quarter: Not applicable. The Registrant completed its initial public offering in
October 2002. (As of February 14, 2003, the aggregate market value of the
Registrant's common stock, $0.01 par value per share, held by nonaffiliates of
the Registrant, computed by reference to the closing price of $16.20 as reported
on the New York Stock Exchange as of the close of business on February 14, 2003
was $ 109.7 million.)
APPLICABLE ONLY TO CORPORATE REGISTRANTS:
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 par value per share: 23,488,517 outstanding as of
February 14, 2003.
DOCUMENTS INCORPORATED BY REFERENCE:
1. Portions of the Registrant's definitive proxy statement for
the Registrant's 2003 annual meeting, to be filed within 120
days after the close of the Registrant's fiscal year,
incorporated by reference into Part III of this Annual Report
on Form 10-K.
CAUTIONARY STATEMENTS
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.
Specifically,
Risks Relating to our Management
- We are dependent on our manager and may not find a suitable
replacement if our manager terminates the management
agreement.
- There are conflicts of interest in our relationship with our
manager, who manages and invests in other real estate-related
investment vehicles, including Newcastle Investment Holdings.
- We have a limited operating history as a separate business
from Newcastle Investment Holdings and may not operate
successfully as a separate business.
- Our directors have approved very broad investment guidelines
for our manager and do not approve each investment decision
made by our manager.
- We may change our investment strategy without stockholder
consent which may result in riskier investments than our
current investments.
Risks Relating to our Business
- We are subject to significant competition from others, many of
which have greater resources than us, and we may not compete
successfully for investments.
- We leverage our portfolio, which may adversely affect our
return on our investments and may reduce cash available for
distribution.
- The mortgage loans we invest in and the mortgage loans
underlying the mortgage backed securities we invest in are
subject to delinquency, foreclosure and loss, which could
result in losses to us.
- Although we seek to match fund our investments to limit
refinance risk, in particular with respect to our investments
in real estate securities, we do not employ this strategy with
respect to our investments in mortgage loans.
- Our investments in subordinated mortgage backed securities are
subject to losses and in the event of a default, we may not be
able to recover all of our investment in the securities we
purchase.
- Our investments in REIT securities are subject to specific
risks relating to the particular REIT issuer of the securities
and to the general risks of investing in subordinated real
estate securities, which may result in losses to us.
- The B Notes we invest in may be subject to additional risks
relating to the privately negotiated structure and terms of
the transaction, which may result in losses to us.
- Our insurance on our real estate and insurance on our real
estate collateral may not cover all losses.
- Environmental compliance costs and liabilities with respect to
our real estate may affect our results of operations.
- Many of our investments are illiquid and we may not be able to
vary our portfolio in response to changes in economic and
other conditions.
- Interest rate fluctuations may cause losses.
- Our investments in mortgage loans and real estate securities
are subject to changes in credit spreads.
- Our hedging transactions may limit our gains or result in
losses.
- We may not be able to acquire eligible securities for a CBO
issuance, or may not be able to issue CBO securities on
attractive terms, which may require us to seek more costly
financing for our investments or to liquidate assets.
- Prepayment rates can increase, adversely affecting yields on
our investments.
- Our international investments are subject to currency rate
exposure and the uncertainty of foreign laws and markets.
- We are exposed to credit risk from a significant tenant, Bell
Canada.
Risks Relating to our Company
- Our failure to qualify as a REIT would result in higher taxes
and reduced cash available for stockholders.
- REIT distribution requirements could adversely affect our
liquidity.
- Maintenance of our Investment Company Act exemption imposes
limits on our operations.
- The stock ownership limit imposed by the Internal Revenue Code
for REITs and our charter may inhibit market activity in our
stock and may restrict our business combination opportunities.
- The following factors may inhibit or prevent a change of our
control, which could depress our stock price: Maryland
takeover statutes; our authorized but unissued common and
preferred stock; our stockholder rights plan; and our
staggered board and other provisions of our charter and
bylaws.
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 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.
NEWCASTLE INVESTMENT CORP.
FORM 10-K
INDEX
PAGE
PART I
Item 1. Business 1
Item 2. Properties 15
Item 3. Legal Proceedings 16
Item 4. Submission of Matters to a Vote of Security Holders 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 16
Item 6. Selected Financial Data 17
Item 7. Management's Discussion and Analysis of Pro Forma Financial
Condition and Results of Operations 23
Management's Discussion and Analysis of Historical Financial
Condition and Results of Operations 32
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 39
Item 8. Financial Statements and Supplementary Data 43
Independent Auditors' Report 45
Consolidated Balance Sheets as of December 31, 2002 and December 31, 2001 46
Consolidated Statements of Income for the years ended December 31, 2002, 2001
and 2000 47
Consolidated Statements of Stockholders' Equity and Redeemable Preferred Stock
for the years ended December 31, 2002, 2001 and 2000 48
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001
and 2000 50
Notes to Consolidated Financial Statements 52
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 84
PART III
Item 10. Directors and Executive Officers of the Registrant 84
Item 11. Executive Compensation 84
Item 12. Security Ownership of Certain Beneficial Owners and Management 84
Item 13. Certain Relationships and Related Transactions 84
Item 14. Controls and Procedures 84
PART IV
Item 15. Exhibits 84
Signatures 86
Certifications 87
PART I
ITEM 1. BUSINESS.
We invest in real estate securities and other real estate-related
assets. We seek to finance these investments primarily using match-funded
financing structures. Match-funded financing structures match assets and
liabilities with respect to maturities and interest rates. Our objective is to
maximize the difference between the yield on our investments and the cost of
financing these investments while hedging our positions. We are organized and
conduct our operations to qualify as a real estate investment trust (REIT) for
federal income tax purposes.
We were formed in June 2002 for the purpose of separating the real
estate securities and credit leased real estate businesses from Newcastle
Investment Holdings Corp. We completed the initial public offering of our common
stock in October 2002. Newcastle Investment Holdings currently owns
approximately 70% of our outstanding common stock. Newcastle Investment Holdings
was formed in May 1998. Prior to the completion of our initial public offering,
Newcastle Investment Holdings contributed to us certain assets and related
liabilities in exchange for shares of our common stock. However, 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 retained by Newcastle Investment Holdings are accounted for as if they
were distributed at historical book basis through a spin-off to Newcastle
Investment Holdings.
We own a diversified portfolio of credit sensitive real estate
securities, including commercial and multifamily mortgage backed securities
(CMBS) and unsecured REIT debt, rated primarily BBB (BBB-- is the lowest
investment grade rating) and BB (BB+ is the highest non-investment grade
rating). Mortgage backed securities are interests in or obligations secured by
pools of commercial or multifamily mortgage loans. We also own credit leased
real estate in Canada and Belgium. We consider credit leased real estate to be
real estate that is leased primarily to tenants with, or whose major tenant has,
investment grade credit ratings. We also own a pool of mortgage loans. We
describe each of these assets and liabilities below under "-- Our Investments."
We are externally managed and advised by Fortress Investment Group LLC.
Our chairman and chief executive officer and each of our executive officers also
serve as officers of our manager. We have no ownership interest in our manager.
We have chosen to be externally managed by Fortress Investment Group to take
advantage of the existing business relationships, operational and risk
management systems, expertise and economies of scale associated with our
manager's current business operation. At December 31, 2002, our manager and its
principals owned approximately 16.4% of the common equity of Newcastle
Investment Holdings (25.8% upon exercise of outstanding options to purchase
shares of Newcastle Investment Holdings). In addition, we have granted to our
manager an option to purchase 700,000 shares of our common stock, at the
offering price of our shares in our initial public offering. Fortress Investment
Group and its principals beneficially own approximately 20.5% of our common
stock, taking into account interests in Newcastle Investment Holdings and
assuming exercise of all of their options. We pay Fortress Investment Group an
annual base management fee and may pay incentive compensation based on certain
performance criteria. Fortress Investment Group also manages and invests in
other entities, including Newcastle Investment Holdings, that invest in real
estate assets.
OUR STRATEGY
We focus on investing in credit sensitive real estate securities,
including mortgage backed securities and REIT securities, and invest in other
real estate related investments, including credit leased real estate and
mortgage loans. The mortgage backed securities we invest in will generally be
junior in right of payment of interest and principal to one or more senior
classes, but will 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 will reflect a comparable credit position and
rating. We believe 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, in the case of REIT securities,
are designed to bear the first risk of default and loss. We further minimize
credit risk through active surveillance and management of our portfolio.
Returns on these investments can be sensitive to interest rate
volatility. We attempt to minimize exposure to interest rate fluctuation through
the use of match-funded financing structures. In particular, we finance our real
estate secu- rities investments through the issuance of debt securities in the
form of collateralized bond obligations (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.
1
We actively monitor our investment portfolio and the underlying credit
quality of our holdings and, where appropriate, may reposition our investments
to upgrade the credit quality and yield on our investments. We selectively
pursue special investment situations where we believe cash flows have been
mispriced, including discounted securities purchases in sectors or jurisdictions
which have fallen out of favor due to economic pressures, regulatory issues or
illiquidity. We draw on our manager's expertise and significant business
relationships with participants in the real estate securities industry to
enhance our access to these investments, which may not be broadly marketed.
Our investments may be made directly or indirectly, such as in the form
of an investment in a vehicle created to hold such assets. We conduct our
business such that our investments in the securities of other issuers do not
require us to register as an "investment company" under the Investment Company
Act of 1940, as amended, and we would divest securities before any such
registration would be required.
OUR COMPETITIVE STRENGTHS
Asset Quality and Diversification
Our portfolio is diversified by asset type, industry, location and
issuer. We expect that diversification will minimize the risk of capital loss,
and will also enhance the terms of our financing structures.
Our portfolio of real estate securities has an overall weighted average
credit rating of BBB--, and approximately 68% of these securities have an
investment grade rating (BBB-- or higher). As of December 31, 2002, 81% of the
square footage of our credit leased real estate was occupied by tenants having
investment grade credit ratings. For a detailed description of the ratings
assigned by Standard and Poor's and Moody's, see "-- Ratings."
Match-Funding Discipline
Generally, we seek to "match fund" our assets and liabilities with
respect to maturities and interest rates. We attempt to match the maturities of
our investments with the maturities of our financial obligations. In addition,
our objective is to finance our investments with like-kind debt (i.e.,
floating-rate assets are financed with floating-rate debt and fixed-rate assets
are financed with fixed-rate debt), directly or through the use of hedges such
as interest rate swaps, caps and other financial instruments, subject to
limitations on the ability to utilize these instruments pursuant to the tax
rules applicable to REITs. This allows us to reduce interim refinancing risk and
the impact of changing interest rates on our earnings and net asset value. As of
December 31, 2002, a 100 basis point change in short-term interest rates would
affect our earnings by no more than $1.9 million per annum.
Creative Financing Strategies
We seek to enhance returns to stockholders through the use of leverage.
We finance our investments in real estate securities by issuing debt securities,
in particular CBOs, to take advantage of the structural flexibility offered by
CBO transactions. Unlike typical securitization structures, the assets
underlying the CBOs may be sold, subject to certain limitations, without a
corresponding pay-down of the CBO, provided the proceeds are reinvested in
qualifying assets. As a result, CBOs enable us to actively manage, subject to
certain limitations, the pool of assets. We have also employed lease
securitizations to finance certain of our credit leased real estate. We use
short term financing, in the form of repurchase agreements, bridge financings
and bank warehousing facilities, prior to implementing optimal match-funded
financing.
Experienced Management
The principal executives of our manager have an average of more than 17
years of experience in the fields of real estate investing and finance, private
equity investment, capital markets, transaction structuring and risk management
with respect to both dollar and non-dollar denominated investments, providing us
with significant expertise in key areas of our business. Over the last six years
alone, the founders of our manager have managed the acquisition of over $20
billion of real estate-related assets and the issuance of over $11 billion of
real estate securities.
2
OUR INVESTMENT GUIDELINES
Our board of directors has adopted general guidelines for our
investments and borrowings to the effect that:
- no investment shall be made which would cause us to fail to qualify
as a REIT;
- no investment shall be made which would cause us to be regulated as
an investment company;
- no more than 20% of our equity, determined as of the date of such
investment, shall be invested in any single asset;
- our leverage shall not exceed 90% of the value of our assets; and
- we shall not co-invest with the manager or any of its affiliates
unless (i) our co-investment is otherwise in accordance with these
guidelines and (ii) the terms of such co-investment are at least as
favorable to us as to the manager or such affiliate (as applicable)
making such co-investment.
Our manager is required to seek the approval of the independent members
of our board of directors before we engage in a material transaction with
another entity managed by our manager. These investment guidelines may be
changed by our board of directors without the approval of our stockholders.
OUR TARGETED INVESTMENTS
COMMERCIAL MORTGAGE BACKED SECURITIES. We invest in commercial mortgage
backed securities (CMBS), which are secured by or evidence ownership interests
in a single commercial mortgage loan or a pool of mortgage loans secured by
commercial properties. These securities may be senior, subordinate, investment
grade or non-investment grade securities. We expect the majority of our CMBS
investments to be rated by at least one nationally recognized rating agency. The
majority of our investments in CMBS consist of securities that are part of a
capital structure or securitization where the rights of such class to receive
principal and interest are subordinate to senior classes but senior to the
rights of lower rated classes of securities. We seek to invest in CMBS that will
yield high current interest income and where we consider the return of principal
to be likely. We acquire CMBS from private originators of, or investors in,
mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, finance companies, investment banks and other entities.
The yield on CMBS depends, in part, on the timely payment of interest
and principal due on the underlying mortgage loans and defaults by the borrowers
on such loans may ultimately result in deficiencies and defaults on the CMBS. In
the event of a default, the trustee for the benefit of the holders of CMBS has
recourse only to the underlying pool of mortgage loans and, if a loan is in
default, to the mortgaged property securing such mortgage loan. After the
trustee has exercised all of the rights of a lender under a defaulted mortgage
loan and the related mortgaged property has been liquidated, no further remedy
will be available. However, holders of relatively senior classes of CMBS will be
protected to a certain degree by the structural features of the securitization
transaction within which such CMBS were issued, such as the subordination of the
relatively more junior classes of the CMBS.
The credit quality of CMBS depends primarily on the credit quality of
the underlying mortgage loans. Among the factors determining credit quality of a
mortgage loan are (i) the purpose of the mortgage loan (e.g. refinancing or new
purchase), (ii) the principal amount of the mortgage loan relative to the value
of the related mortgaged property at origination and at maturity, (iii) the
mortgage loan terms (e.g. amortization, balloon amounts, reserves, prepayment
terms), (iv) the geographic location of the mortgaged property securing the
mortgage loan, and (v) the creditworthiness of tenants occupying the underlying
properties.
In considering whether to acquire a CMBS, we perform due diligence to
assess the credit quality of the mortgage loans as discussed above, as well as
(i) the capabilities of the master and special servicer servicing the mortgage
loans, (ii) the CMBS structure including subordination levels, (iii) the
prepayment and default history of the other mortgage loans previously originated
by lenders, (iv) cash flow analyses under various prepayment and interest rate
scenarios (including sensitivity analyses), and (v) an analysis of various
default scenarios.
B NOTES. We invest in "B Notes" rated by at least one nationally
recognized rating agency. A "B Note" is typically a privately negotiated loan
(a) secured by a first mortgage on a single large commercial property or group
of related properties and (b) subordinated to an "A Note" secured by the same
first mortgage on the same property. The subordination of a B Note is typically
evidenced by an inter-creditor agreement with the holder of the related A Note.
3
B Notes share certain credit characteristics with subordinated CMBS, in
that both reflect an interest in a first mortgage and are subject to more credit
risk with respect to the underlying mortgage collateral than the corresponding
senior securities or the A Notes, as the case may be. As opposed to a typical
CMBS secured by a large pool of mortgage loans, B Notes typically are secured by
a single property, and the associated credit risk is concentrated in that single
property. B Notes also share certain credit characteristics with second
mortgages, in that both are subject to more credit risk with respect to the
underlying mortgage collateral than the corresponding first mortgage or the A
Note, as the case may be. We acquire B Notes in negotiated transactions with the
originators, as well as in the secondary market.
The yield on a B Note depends on the timely payment by the borrower of
interest and principal. Default by the borrower may, depending on the
transaction structure, result in the immediate interruption of current cash flow
and may ultimately result in the loss of principal of the B Note. In the event
of such a default, the rights of the B Note holders to foreclose on the mortgage
collateral are typically subject to the prior right of the holder of the
corresponding A Note. As a result, the rights of the holder of a B Note to
mitigate losses in the event of a borrower default may be impaired.
The credit quality of a B Note depends on (i) the borrower under the
underlying mortgage, (ii) the value of the underlying collateral and the extent
to which it secures the obligation owed to the B Note holder, (iii) the rights
under the mortgage loan documents (e.g. personal guarantees, additional
collateral, default covenants, remedies), (iv) the B Note holder's rights under
an inter-creditor agreement with the A Note holders, (v) the level and stability
of cash flow from the property available to service the mortgage debt, and (vi)
the availability of capital for refinancing by the borrower if the mortgage loan
does not fully amortize.
We perform extensive due diligence and credit analysis including (i)
borrower credit underwriting, (ii) property review (e.g. appraisal,
environmental, structural), (iii) mortgage loan and B Note documentation review,
(iv) property cash flow analysis, and (v) analysis of the eligibility of each
mortgage loan for inclusion as collateral in a future securitization or
appropriateness for other forms of financing or sale.
REIT SECURITIES. We invest in securities issued by other REITs,
including investment grade and non-investment grade debt and preferred equity
securities issued by other REITs. REIT debt securities are generally unsecured
corporate obligations of REITs. We expect the majority of these REIT securities
to be rated by at least one nationally recognized rating agency. We seek to
invest in REIT securities that will yield high current interest and dividend
income and where we consider the return of principal to be likely. We acquire
REIT securities from companies representing a variety of property types.
The credit quality of REIT securities is directly dependent on the
financial condition and business outlook of the issuer. Factors determining the
financial condition and outlook include (i) portfolio credit quality (e.g.
diversity, type of asset and stability of cash flow), (ii) availability of
capital, (iii) leverage and leverage trends, (iv) size of portfolio, (v)
competition, and (vi) quality of the REIT's management team.
In analyzing these REIT securities, we consider, among other factors,
the credit quality factors described above as well as unencumbered and
encumbered cash flow coverage, capital structure, refinancing risks, and
covenants of the issuer's outstanding debt.
RESIDENTIAL MORTGAGE SECURITIES. We may invest in residential mortgage
backed securities (RMBS), which are secured by or evidence ownership interests
in pools of mortgage loans secured by single family residential properties. We
would invest in securities with credit quality and subordination levels similar
to those described above for our CMBS investments.
We seek to invest in RMBS that will yield high current interest income
and where we consider the return of principal to be likely. We will acquire RMBS
from private originators of, or investors in, mortgage loans, including savings
and loan associations, mortgage bankers, commercial banks, finance companies,
investment banks and other entities.
Like CMBS, the yield on RMBS depends, in part, on the timely payment of
interest and principal due on the underlying mortgage loans by the borrowers
under such mortgage loans and defaults by such borrowers may ultimately result
in deficiencies and defaults on the RMBS. In the event of a default, the trustee
for the benefit of the holders of RMBS has rights similar to corresponding
rights of a CMBS trustee.
4
Like CMBS, the credit quality of RMBS depends on the credit quality of
the underlying mortgage loans, which is a function of factors such as (i) the
purpose of the mortgage loans (e.g. refinancing or new purchase), (ii) the
principal amount of the mortgage loans relative to the value of the related
mortgaged properties, (iii) the mortgage loan terms (e.g. amortization), (iv)
the geographic location of the properties securing the mortgage loans, and (v)
the creditworthiness of the borrowers.
In considering whether to acquire an RMBS, we perform due diligence to
assess the credit quality of the mortgage loans as discussed above for CMBS, as
well as the likelihood of prepayment, which residential borrowers are generally
permitted to do without penalty. For RMBS, credit quality may also depend on the
extent of any government or agency guarantee of the mortgage loans securing the
RMBS.
MORTGAGE LOANS. We invest in portfolios of mortgage loans from various
sellers, including life insurance companies, banks and other owners, generally
secured by commercial or residential properties in the U.S. Among the factors
determining credit quality of a mortgage loan are (i) the purpose of the
mortgage loan (e.g. refinancing or new purchase), (ii) the principal amount of
the mortgage loan relative to the value of the related mortgaged property at
origination and at maturity, (iii) the mortgage loan terms (e.g. amortization,
balloon amounts, reserves, prepayment terms), (iv) the geographic location of
the mortgaged property securing the mortgage loan, and (v) the creditworthiness
of tenants or borrowers occupying the underlying property.
OTHER REAL ESTATE-RELATED INVESTMENTS. We may also make investments in
other types of commercial real estate assets as well as in non-mortgage backed
securities. In particular, we may invest in credit leased real property similar
to our current credit leased real estate portfolio.
Although we invest in the investments described above, our business
decisions will depend on changing market conditions. As a result, we cannot
predict with any certainty the percentage of our assets that will be invested in
each category. We may change our investment strategy and policies without a vote
of stockholders. We may acquire assets from our manager or its affiliates,
including securities issued by our manager or its affiliates. There are no
limitations on such transactions, except that they must comply with our general
investment guidelines and our management agreement with our manager.
OUR FINANCING STRATEGY
We seek to enhance returns to stockholders through the use of leverage.
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), through the use of hedges such as interest rate swaps,
caps, 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 intend to
utilize securitization structures, particularly CBOs, as well as other
match-funded financing structures. CBOs are multiple class debt securities, or
bonds, secured by pools of assets, such as mortgage backed securities, B Notes
and REIT debt. Like typical securitization structures, in a CBO (a) the assets
are pledged to a trustee for the benefit of the holders of the bonds, (b) one or
more classes of the bonds are rated by one or more rating agencies, and (c) one
or more classes of the bonds are marketed to a wide variety of fixed income
investors, which enables the CBO sponsor to achieve a relatively low cost of
long-term financing. Unlike typical securitization structures, we prefer to
structure our CBOs such that the underlying assets may be sold, subject to
certain limitations, without a corresponding pay-down of the CBO, provided the
proceeds are reinvested in qualifying assets. As a result, CBOs enable the
sponsor to actively manage, subject to certain limitations, the pool of assets.
We believe that our CBO financing structures are an appropriate financing
vehicle for our targeted asset classes, because they will enable us to lock in a
long-term cost of funds and minimize the risk that we have to refinance our
liabilities prior to the maturities of our investments while giving us the
flexibility to manage credit risk and, subject to certain limitations, to take
advantage of profit opportunities.
We may also use short term financing, in the form of repurchase
agreements, bridge financings and bank warehousing facilities, as an
intermediary step prior to the implementation of optimal match-funded financing.
We utilize leverage for the sole purpose of financing our portfolio and not for
the purpose of speculating on changes in interest rates.
OUR HEDGING ACTIVITIES
We enter into hedging transactions to protect our positions from
interest rate fluctuations and other changes in
5
market conditions. These transactions may include interest rate swaps, the
purchase or sale of interest rate collars, caps or floors, options, mortgage
derivatives and other hedging instruments. These instruments may be used to
hedge as much of the interest rate risk as our manager determines is in the best
interest of our stockholders, given the cost of such hedges and the need to
maintain our status as a REIT. Our manager may elect to have us bear a level of
interest rate risk that could otherwise be hedged when our manager believes,
based on all relevant facts, that bearing such risks is advisable. Our manager
has extensive experience in hedging real estate positions with these types of
instruments. Our manager engages in hedging for the sole purpose of protecting
against interest rate risk and not for the purpose of speculating on changes in
interest rates.
OUR INVESTMENTS
We own a diversified portfolio of credit sensitive real estate
securities, including commercial mortgage backed securities and unsecured REIT
debt rated primarily BBB (the lowest investment grade rating) and BB (one level
below investment grade). We also own certain credit leased real estate in Canada
and Europe and a pool of mortgage loans.
Information regarding our business segments is provided in "Item 7.
Management's Discussion and Analysis of Pro Forma Financial Condition and
Results of Operations," in "Item 7. Management's Discussion and Analysis of
Historical Financial Condition and Results of Operations," and in Note 3 to our
consolidated financial statements which appear in "Item 8. Financial Statements
and Supplementary Data."
Our equity at December 31, 2002 is invested 75% in our real estate
securities segment, 9% in our credit leased real estate segment, 4% in our real
estate loan segment, and 12% in other investments, primarily cash equivalents.
The following is a description of our investment assets as of December
31, 2002. For an explanation of the ratings assigned by Standard & Poor's and
Moody's Investor Services, see "-- Ratings."
REAL ESTATE SECURITIES
CBO I: In July 1999, Fortress CBO Investments I, Limited and Fortress
CBO Investments I Corp. issued approximately $500 million face amount of CBOs
and other securities in transactions exempt from the registration requirements
of the Securities Act pursuant to Rule 144A and Regulation S thereunder. As of
December 31, 2002, the underlying securities securing CBO I consist of:
- $323.0 million face amount in CMBS with a weighted average coupon of
6.72%, a weighted average rating of approximately BB and a weighted
average term to maturity of 7.11 years. Retail, multifamily and
office properties comprise 48%, 19% and 15%, respectively, of the
underlying collateral.
- $234.6 million face amount in unsecured REIT debt securities with a
weighted average coupon of 7.41%, a weighted average rating of
approximately BBB and a weighted average remaining term to maturity
of 5.48 years. Office, retail, industrial and residential REIT
industries comprise 17%, 29%, 19% and 14%, respectively, of the debt.
$437.5 million of Senior CBO I securities were sold to third parties
and we own $62.5 million of the Subordinate CBO I securities. The table below
sets forth further information with respect to the CBO I structure.
MOODY'S/S&P Expected
Class RATINGS FACE AMOUNT COUPON MATURITY(1)
--------- ----------- ------------- ----------- -----------
Senior CBO I
Securities...... A Aaa/AAA $ 322,500,000 LIBOR +0.65% July-04
B Aa2/AA $ 20,000,000 LIBOR +0.80% July-04
C A2/NR $ 62,500,000 7.85% July-09
D Baa2/NR $ 32,500,000 8.60% July-09
-------------
TOTAL........ $ 437,500,000
=============
Subordinate CBO I
Securities...... E Ba2 $ 17,500,000 8.00% July-09
Preferred B2 $ 17,500,000 9.00% July-09
Common I $ 26,400,000 N/A N/A
Common II $ 1,100,000 N/A N/A
-------------
TOTAL........ $ 62,500,000
=============
- ------------
(1) Reflects expected maturities upon refinancing. Contractual maturities are
July 2038.
6
We act as collateral manager for CBO I and are paid a monthly fee of
0.5% per annum of the principal balance of the CBO I collateral. We have the
discretion to buy and sell up to 15% of the outstanding face of the collateral
annually, and to sell defaulted and credit risk securities on an unlimited
basis. Until 2004, we are obligated to reinvest principal received from the
collateral. In 2004, we intend to refinance the Class A and B Senior CBO I
securities, provided it would not result in a downgrade of any rated classes of
securities. Failure to so refinance on the scheduled date in 2004 will result in
an additional allocation of cash flows from certain of the Subordinate CBO I
securities to the Class A and B Senior CBO I securities. To better match the
collateral cash flow to the debt service on the CBO I Securities, we entered
into interest rate swap and cap agreements.
CBO II: On April 25, 2002, Newcastle CDO I Limited and Newcastle CDO I
Corp. issued $500 million face amount of collateralized bond obligations and
other securities in our second CBO transaction. As of December 31, 2002 the
second CBO, which we refer to as CBO II, consisted of:
- $299.0 million face amount in CMBS with a weighted average coupon of
6.35%, a weighted average rating of approximately BBB- and a
weighted average term to maturity of 7.17 years. Retail, multifamily
and office properties comprise 35%, 29% and 19%, respectively, of
the underlying collateral.
- $113.4 million face amount in unsecured REIT debt securities with a
weighted average coupon of 7.81%, a weighted average rating of
approximately BBB- and a weighted average remaining term to maturity
of 7.85 years. Office, retail and residential REIT industries
comprise 13%, 41% and 16% respectively, of the debt.
- $58.2 million face amount in asset backed securities with a weighted
average coupon of 7.29% and a weighted average term to maturity of
7.89 years.
$444 million face amount of Senior CBO II securities were sold to third
parties and we own $56 million of the Subordinate CBO II securities. The table
below sets for the further information with respect to the structure of CBO II.
MOODY'S/S&P
Class Ratings Face Amount COUPON MATURITY
-------- ------------- ------------ --------- --------
Senior CBO II Securities.... Class I Aaa/AAA $ 372,000,000 LIBOR+0.55% April-32
Class II A3/A-- $ 38,000,000 7.59% April-37
Class III Baa2/BBB $ 34,000,000 8.37% April-37
-------------
TOTAL.......... $ 444,000,000
=============
Subordinate CBO II
Securities.......... Class IV Ba2/BB $ 19,000,000 7.50% April-37
Preferred NR $ 37,000,000 N/A April-37
-------------
TOTAL........ $ 56,000,000
=============
We act as collateral manager for CBO II and are paid a quarterly fee of
1/4 of 0.35% of the principal balance of the CBO II collateral. We have the
discretion to buy and sell up to 15% of the outstanding face of the collateral
annually, and to sell defaulted and credit risk securities on an unlimited
basis. Until 2007, we are obligated to reinvest principal received from the
collateral. To better match the collateral cash flow to the debt service on the
CBO II securities, we entered into interest rate swap and cap agreements.
CBO III: Pursuant to an agreement entered into in July 2002 Bear,
Stearns International Limited 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 Bear, Stearns International Limited. 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 December 31, 2002, approximately $342.4 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 Bear, Stearns International Limited or pay Bear,
Stearns International Limited the negative 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 Bear, Stearns International
Limited's gross neg
7
ligence or willful misconduct, we would be required to either purchase the CBO
III Collateral from Bear, Stearns International Limited or pay Bear, Stearns
International Limited the lesser of the Collateral Loss and our 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. In November and December 2002, we made deposits aggregating
$37.1 million under such agreement, known as the CBO III deposit. As of December
31, 2002, we estimate that the fair value of the securities purchased by Bear,
Stearns International Limited is in excess of the purchase price paid by them.
CREDIT LEASED REAL ESTATE
We own real estate located in Canada and in Belgium which, in addition
to all the risks inherent in the investment in real estate generally, is also
subject to fluctuations in foreign currency exchange rates, unexpected changes
in regulatory requirements, political and economic instability in certain
geographic locations, difficulties in managing international operations,
potentially adverse tax consequences, enhanced accounting and control expenses
and the burden of complying with a wide variety of foreign laws. A change in
foreign currency exchange rates may adversely impact returns on our non-dollar
denominated investments. Our principal currency exposures are to the Euro and
the Canadian Dollar. Changes in the currency rates can adversely impact the fair
values and earnings streams of our international holdings. We generally do not
directly hedge our foreign currency risk through the use of derivatives, due to,
among other things, REIT qualification issues.
Bell Canada Portfolio. We own four office properties and an industrial
property in Canada leased primarily to Bell Canada. We refer to these properties
as the Bell Canada Portfolio. The total net rentable area is approximately 1.3
million square feet and the current annual rent as of December 31, 2002 is
approximately $5.7 million. We believe that these properties are adequately
covered by insurance against potential loss.
To more effectively monetize lease cash flows and the anticipated value
of the properties in the Bell Canada Portfolio, in April 2002 we issued
approximately $70 million (Canadian dollars) face amount of securities secured
by the lease payments and by the five Bell Canada properties in a transaction
exempt from the registration requirements of both Canadian and U.S. securities
laws. The Series A and B Notes were sold to third parties and the Series C Notes
were retained by us.
The table below sets forth further information on the securities
issued:
FACE
DBRS* (CANADIAN
SERIES RATINGS DOLLARS) COUPON MATURITY
- ------------------------ ------- ------------ ------ ---------
Series A Class I Notes . AAA C$18,000,000 6.150% April-2012
Series A Class II Notes AA C$ 6,000,000 6.150% April-2012
Series A Class III Notes A+ C$30,000,000 6.150% April-2012
Series B Notes.......... A C$ 6,000,000 7.675% April-2012
Series C Notes.......... BBB C$10,000,000 11.000% April-2012
------------
TOTAL................... C$70,000,000
============
- ---------------
* Dominion Bond Rating Service Limited
8
The following table sets forth certain information with respect to the
Bell Canada Portfolio as of December 31, 2002:
BELL CANADA PORTFOLIO
NET
RENTABLE YEAR
STATE/ SQUARE BUILT/ OWNERSHIP
PROPERTY ADDRESS CITY/SUBMARKET(1) PROVINCE FEET RENOVATED % USE
- -------------------- -------------------- --------- --------- --------- ---------- ----------
20-40 Norelco Drive, Toronto/North York ON 624,786 1963/ 100% Industrial/
83 Signet Drive 1971/ Distribution
1979
2 Fieldway Road Etobicoke (Toronto)/ ON 177,214 1972/ 100% Office
Metro West expanded
1978
100 Dundas Street London/CBD ON 325,764 1980 100% Office
449 Princess Street(3) Kingston/CBD ON 45,691 1981 100% Office
66 Bay Street South(3) Hamilton/CBD ON 118,787 1974 100% Office
---------
Total/Average 1,292,242
% OF TENANT CURRENT
TOTAL NET RENT ANNUAL
SQUARE RENTABLE LEASE LEASE TENANT PER REAL LEASE
FOOTAGE SQUARE START EXP CREDIT ANNUAL SQUARE ESTATE RENEWAL
PROPERTY ADDRESS TENANT LEASED FEET DATE DATE RATING RENT(2) FOOT TAXES OPTION
- ---------------- ------------------- -------- ---------- ------- -------- ------ ---------- ------- ---------- -------
20-40 NorelcoDr Bell Canada-Office 98.48% 615,274 3/26/98 3/31/07 A $2,726,588 $ 4.43 $ 924,789 One 5 Yr
83 Signet Drive Bell
Canada-Cafeteria 0.73% 4,559 3/26/98 3/31/07 A $ 28,862 $ 6.33
Bell Canada-Storage 0.47% 2,960 3/26/98 3/31/07 A $ 9,369 $ 3.17
Bell Canada-O&Y 0.32% 1,993 3/26/98 3/31/07 $ 8,832 $ 4.43
2 Fieldway Road Bell Canada-Office 94.1% 166,753 3/26/98 3/31/04 A $ 738,966 $ 4.43 $ 564,715 One 5 Yr
Bell
Canada-Cafeteria 4.25% 7,533 3/26/98 3/31/04 A $ 47,689 $ 6.33
Bell Canada-Storage 0.91% 1,619 3/26/98 3/31/04 A $ 5,125 $ 3.17
Bell Canada-Mgmt 0.65% 1,153 3/26/98 3/31/04 A $ 7,299 $ 6.33
Hosnya Elshaarawy 0.09% 156 4/1/01 3/31/06 $ 691 $ 4.43
100 Dundas Street Bell Canada-Office 89.24% 290,706 3/26/98 3/31/06 A $1,288,264 $ 4.43 $ 951,266 One 5 Yr
Bell Canada-Storage 3.96% 12,890 3/26/98 3/31/06 A $ 40,801 $ 3.17 One 5 Yr
Bell Canada-
Communications 0.52% 1,686 3/26/98 3/31/47 A $ 21,347 $ 12.66 None
Bell Canada-Mgmt 0.45% 1,478 3/26/98 3/31/06 A $ 9,825 $ 6.65
ComTech 0.03% 96 1/01/00 12/31/05 $ 486 $ 5.06
MacTel 0.47% 1,536 6/1/00 5/31/03 $ 7,779 $ 5.06 One 2 Yr
MacTel 0.21% 673 4/1/01 5/31/03 $ 3,408 $ 5.06 One 2 Yr
Tony & Fay Gardner 0.15% 475 9/1/99 8/31/07 $ 2,706 $ 5.70 None
Palmieri's Fine 0.58% 1,884 10/1/00 9/30/10 $ 31,010 $ 16.46 One 5 Yr
Food Inc
449 Princess Street
(3) Bell Canada-Office 99.41% 45,422 3/26/98 3/31/03 A $ 201,288 $ 4.43 $ 55,170 One 5 Yr
Bell Canada-Storage 0.59% 269 3/26/98 3/31/03 A $ 851 $ 3.17 One 5 Yr
66 Bay Street South
(3) Bell Canada-Office 92.94% 110,400 3/26/98 3/31/03 A $ 489,238 $ 4.43 $ 209,414 One 5 Yr
Bell 6.42% 7,621 3/26/98 3/31/03 A $ 48,246 $ 6.33 One 5 Yr
Canada-Cafeteria
Bell Canada-Storage 0.41% 492 3/26/98 3/31/03 A $ 1,557 $ 3.17 One 5 Yr
Bell Canada-Mgmt 0.23% 274 3/26/98 3/31/03 A $ 1,215 $ 4.43
----- --------- ---------- ----------
Total/Average 98.89% 1,277,902 $5,721,442 $2,705,354
- ----------
(1) CBD means central business district.
(2) Certain operating expenses are reimbursed by tenants at rates ranging
up to 15% above actual cost.
(3) Under contract for sale upon lease expiration in April 2003.
All monetary amounts are in U.S. dollars based on the December 31, 2002 Canadian
dollar to U.S. dollar exchange rate of 1.5796.
9
The following schedule represents the leases expiring over the next 10
years for the Bell Canada portfolio as of December 31, 2002.
SCHEDULE OF LEASE EXPIRATIONS
BELL CANADA PORTFOLIO
% OF GROSS ANNUAL
NUMBER OF TENANTS SQUARE FEET OF ANNUAL RENT OF RENT REPRESENTED
YEAR LEASE EXPIRING EXPIRING LEASES* EXPIRING LEASES** BY EXPIRING LEASES
- ----- ------------------ ---------------- ----------------- ------------------
2003 8 166,687 $ 753,584 13.17%
2004 4 177,058 $ 799,080 13.97%
2005 1 96 $ 486 0.01%
2006 4 305,230 $1,339,582 23.41%
2007 5 625,261 $2,776,357 48.53%
2008 0 0 $ 0 0.00%
2009 0 0 $ 0 0.00%
2010 1 1,884 $ 31,010 0.54%
2047 1 1,686 $ 21,343 0.37%
- ----------
* 2003 includes 164,478 square feet expiring in properties which are under
contract to be sold upon lease expiration in April 2003.
** Monetary amount is in U.S. dollars based on a Canadian dollar to U.S. dollar
exchange rate of 1.5796 as of December 31, 2002.
LIV Portfolio. As of December 31, 2002, we own eight office and
industrial properties in Belgium leased primarily to government or
quasi-governmental entities, referred to as the LIV portfolio. The total net
rentable area of the portfolio is approximately 456,000 square feet and the
current annual rent is approximately $6.0 million.
The LIV portfolio is financed with a loan from a commercial bank in
Belgium, $63.0 million of which was outstanding as of December 31, 2002. The
loan bears interest at a rate equal to 5.32% and matures in November 2006.
10
The following table sets forth certain information with respect to the
LIV portfolio as of December 31, 2002:
LIV PORTFOLIO
NET
STATE/ RENTABLE YEAR BUILT/
PROPERTY ADDRESS CITY/ SUBMARKET PROVINCE SQUARE FEET RENOVATED OWNERSHIP % USE
- ------------------ ---------------- --------- ------------ -------------- ----------- ---------
54 Gossetlaan Groot-Bijgaarden Belgium 81,763 1994 100% Office
325 Leuvenses- Zaventum Belgium 65,175 1975/1990 100% Office
teenweg
15-17 Rue Belliard Brussels Belgium 28,180 1974/1996 100% Office
159 Dreve Richelle Waterloo Belgium 46,231 1930/1990 100% Office
4 Rue de la Brussels Belgium 26,651 1952/1993/1998 100% Office
Science
4-6 Rue Belliard Brussels Belgium 32,206 1987/2001 100% Office
5 Hoge Wei Zaventum Belgium 55,606 1986 100% Warehouse
10 Rue Guimard Brussels Belgium 119,781 1973/1995 100% Office
-------
Total/Average 455,593
% OF TOTAL CURRENT ANNUAL
SQUARE TENANT NET LEASE LEASE RENT PER REAL
PROPERTY ADDRESS FOOTAGE RENTABLE START EXP ANNUAL SQUARE ESTATE
- ---------------- TENANT LEASED SQUARE FEET DATE DATE RENT FOOT TAXES
------ --------- ----------- -------- -------- ---------- --------- ---------
54 Gossetlaan Lucent 27.95% 22,852 12/1/98 4/30/11 $ 312,782 $ 13.69 $ 51,724
Wella 14.96% 12,228 1/1/99 12/31/07 $ 173,627 $ 14.20
United Biscuits 13.95% 11,410 3/1/99 2/28/08 $ 167,802 $ 14.71
Job @ 10.02% 8,191 7/1/00 6/30/09 $ 104,160 $ 12.72
325 Leuvenses- Space Applic. 7.27% 4,736 8/15/93 8/14/11 $ 50,419 $ 10.65 $ 30,034
teenwe Services
K & L 4.38% 2,852 10/1/97 9/30/06 $ 29,858 $ 10.47
Integri 14.93% 9,730 4/1/98 3/31/07 $ 106,791 $ 10.98
Euro Business 2.89% 1,884 6/1/99 5/31/08 $ 23,024 $ 12.22
Elsevier 23.32% 15,199 6/1/99 5/31/08 $ 173,868 $ 11.44
Aprico 7.27% 4,736 3/1/00 2/28/09 $ 55,007 $ 11.61
Secproof 1.90% 1,238 1/1/01 12/31/09 $ 13,833 $ 11.18
Quality Infor. 4.57% 2,982 3/1/01 2/28/10 $ 31,589 $ 10.59
15-17 Rue Belliard Foratom 18.87% 5,318 6/1/97 5/31/06 $ 69,413 $ 13.05
Foratom 10.73% 3,025 6/1/99 5/31/08 $ 38,087 $ 12.59 $ 74,619
Alliance for 10.73% 3,025 2/1/00 1/31/09 $ 36,936 $ 12.21
Beverages
Czech Trade 4.39% 1,238 12/1/00 11/30/09 $ 17,071 $ 13.79
Promotion Agency
C.V.N. 10.73% 3,025 9/1/01 8/31/10 $ 35,202 $ 11.64
159 Dreve Richelle CBC Banque 4.66% 2,153 11/1/93 10/31/11 $ 42,383 $ 19.69
Battersby Chung 1.70% 786 7/1/96 6/30/05 $ 10,513 $ 13.38 $ 53,161
Europay 91.01% 42,075 1/1/00 12/31/07 $ 552,051 $ 13.12
Lunch Time 2.63% 1,217 5/1/00 4/30/09 $ 28,997 $ 23.83
4 Rue de la Swedish & 13.81% 3,681 8/15/95 8/14/04 $ 61,352 $ 16.67
Science Finnish Ass.
Vedior Interim 11.03% 2,939 6/1/96 5/31/05 $ 32,772 $ 11.15 $ 54,295
Local Government 19.91% 5,307 1/1/00 12/31/08 $ 73,443 $ 13.84
Denmark
Government of 55.25% 14,724 4/1/01 03/31/10 $ 233,442 $ 15.85
Belgium
4-6 Rue Belliard Nouvelle 28.7% 9,235 04/01/02 03/31/11 $ 105,741 $ 11.45 $ 85,760
Entreprise
Stragier
5 Hoge Wei Noortman/UPS 100% 55,606 7/1/00 6/30/09 $ 282,772 $ 5.09 $ 16,308
Logistics
10 Rue Guimard European 100% 119,781 10/1/95 9/30/07 $3,171,793 $ 26.48 $ 405,456
Commission ----- ------- ---------- ---------
Total/Average 81.47% 371,173 $6,034,728 $ 771,357
- ----------
All monetary amounts are in U.S. dollars based on the December 31, 2002 Euro to
U.S. dollars exchange rate of 0.95202
11
The following schedule represents the leases expiring over the next 10
years for the LIV portfolio as of December 31, 2002.
SCHEDULE OF LEASE EXPIRATIONS
LIV PORTFOLIO
% OF GROSS ANNUAL
NUMBER OF TENANTS SQUARE FEET OF ANNUAL RENT OF RENT REPRESENTED
YEAR LEASE EXPIRING EXPIRING LEASES EXPIRING LEASES* BY EXPIRING LEASES
- ------ ------------------ ---------------- ---------------- ------------------
2003 0 0 $ 0 0.00%
2004 1 3,681 $ 61,352 1.02%
2005 2 3,725 $ 43,286 0.72%
2006 2 8,170 $ 99,270 1.64%
2007 4 183,816 $4,004,261 66.35%
2008 5 36,824 $ 476,224 7.89%
2009 7 75,251 $ 538,777 8.93%
2010 3 20,730 $ 300,233 4.98%
2011 4 38,976 $ 511,325 8.47%
- ----------
* Monetary amount is in U.S. dollars based on Euro to U.S. dollars exchange rate
of 0.95202 as of December 31, 2002.
MORTGAGE LOANS
In November 2002, we purchased a portfolio of approximately 1,200 residential
mortgage loans, secured by first priority liens on properties located primarily
in the central and southeastern regions of the U.S. The purchase price of the
portfolio aggregated approximately $259.7 million plus accrued interest and was
initially 95% financed pursuant to a repurchase agreement. The following table
sets forth certain information with respect to our mortgage loan portfolio and
repurchase agreement at December 31, 2002:
LOAN PORTFOLIO
UNPAID
LOAN PRINCIPAL CARRYING WEIGHTED AVG. RANGE OF STATED
COUNT BALANCE AMOUNT EFFECTIVE RATE MATURITY DATES
------ ---------- --------- -------------- -----------------
Agency eligible loans 914 $ 160,489 $ 163,416 3.31% 9/2027 - 11/2032
Jumbo/Non-agency loans 292 93,712 94,782 3.56% 10/2027 - 11/2032
------ --------- --------- ---- -----------------
1,206 $ 254,201 $ 258,198 3.40%
REPURCHASE AGREEMENT
UNPAID
PRINCIPAL CARRYING WEIGHTED AVG.
BALANCE AMOUNT EFFECTIVE RATE MATURITY DATES
------------ ----------- ---------------- --------------
Agency eligible loans $ 156,615 $ 156,615 1.78% 5/2003
Jumbo/Non-agency loans 90,097 90,097 1.83% 5/2003
--------- --------- ----
$ 246,712 $ 246,712 1.80%
RATINGS
The following are the explanations of the ratings provided by Standard
and Poor's and Moody's. Ratings of BBB-- and Baa3 and above are considered
investment grade.
STANDARD AND POOR'S RATINGS:
AAA: The highest rating assigned by Standard & Poor's. The obligor's
capacity to meet its financial commitment on the obligation is extremely strong.
12
AA: Differs from the highest rated obligations only in small degree.
The obligor's capacity to meet its financial commitment on the obligation is
very strong.
A: Somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than obligations in higher rated
categories. However, the obligor's capacity to meet its financial commitment on
the obligation is still strong.
BBB: Exhibits adequate protection parameters. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation.
BB: Less vulnerable to nonpayment than other speculative issues.
However, it faces major ongoing uncertainties or exposure to adverse business,
financial, or economic conditions which could lead to the obligor's inadequate
capacity to meet its financial commitment on the obligation.
PLUS (+) OR MINUS (--): Shows relative standing within the major rating
categories.
MOODY'S RATINGS:
Aaa: Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edged." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
Aa: Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high-grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risk appear somewhat larger than the Aaa securities.
A: Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper-medium-grade obligations. Factors giving
security to principal and interest are considered adequate, but elements may be
present which suggest a susceptibility to impairment some time in the future.
Baa: Bonds which are rated Baa are considered as medium-grade
obligations (i.e., they are neither highly protected nor poorly secured).
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Ba: Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well-assured. Often the protection of
interest and principal payments may be very moderate, and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
B: Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranging; and the modifier 3 indicates a ranking in the lower end of
that generic rating category.
POLICIES WITH RESPECT TO CERTAIN OTHER ACTIVITIES
If our board of directors determines that additional funding is
required, we may raise such funds through additional equity offerings, debt
financing, retention of cash flow (subject to provisions in the Internal Revenue
Code concerning taxability of undistributed REIT taxable income) or a
combination of these methods.
In the event that our board of directors determines to raise additional
equity capital, it has the authority, without stockholder approval, to issue
additional common stock or preferred stock in any manner and on such terms and
for such consideration it deems appropriate, including in exchange for property.
13
Borrowings may be in the form of bank borrowings, secured or unsecured,
and publicly or privately placed debt instruments, purchase money obligations to
the sellers of assets, long-term, tax-exempt bonds or other publicly or
privately placed debt instruments, financing from banks, institutional investors
or other lenders, securitizations, including CBOs, any of which indebtedness may
be unsecured or may be secured by mortgages or other interests in the asset.
Such indebtedness may be recourse to all or any part of our assets or may be
limited to the particular asset to which the indebtedness relates.
We have authority to offer our common stock or other equity or debt
securities in exchange for property and to repurchase or otherwise reacquire our
shares or any other securities and may engage in such activities in the future.
We also may make loans to our subsidiaries. Although we have no current
intentions of doing so, we may repurchase or otherwise reacquire our shares or
other securities.
Subject to the gross income and asset tests necessary for REIT
qualification, we may invest in securities of other REITs, other entities
engaged in real estate activities or securities of other issuers, including for
the purpose of exercising control over such entities.
We may engage in the purchase and sale of investments. We do not
underwrite the securities of other issuers.
Our officers and directors may change any of these policies without a
vote of our stockholders.
COMPETITION
We are subject to significant competition in seeking investments. We
compete with several other companies for investments, including other REITs,
insurance companies and other investors. Some of our competitors have greater
resources than we do and we may not be able to compete successfully for
investments.
14
COMPLIANCE WITH THE AMERICANS WITH DISABILITIES ACT OF 1990
Our properties are required to meet federal requirements related to
access and use by disabled persons as a result of the Americans with
Disabilities Act of 1990. In addition, a number of additional federal, state and
local laws may require modifications to any properties we purchase, or may
restrict further renovations thereof, with respect to access by disabled
persons. Noncompliance with these laws or regulations could result in the
imposition of fines or an award of damages to private litigants. Additional
legislation could impose additional financial obligations or restrictions with
respect to access by disabled persons. If required changes involve greater
expenditures than we currently anticipate, or if the changes must be made on a
more accelerated basis, our ability to make expected distributions could be
adversely affected.
COMPLIANCE WITH FEDERAL, STATE AND LOCAL ENVIRONMENTAL LAWS
Our properties are subject to various federal, state and local
environmental laws, ordinances and regulations. Under these laws, ordinances and
regulations, a current or previous owner of real estate (including, in certain
circumstances, a secured lender that succeeds to ownership or control of a
property) may become liable for the costs of removal or remediation of certain
hazardous or toxic substances or petroleum product releases at, on, under or in
its property. These laws typically impose cleanup responsibility and liability
without regard to whether the owner or control party knew of or was responsible
for the release or presence of the hazardous or toxic substances. The costs of
investigation, remediation or removal of these substances may be substantial and
could exceed the value of the property. An owner or control party of a site may
be subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from a site. Certain
environmental laws also impose liability in connection with the handling of or
exposure to asbestos-containing materials, pursuant to which third parties may
seek recovery from owners of real properties for personal injuries associated
with asbestos-containing materials. Our operating costs and values of these
assets may be adversely affected by the obligation to pay for the cost of
complying with existing environmental laws, ordinances and regulations, as well
as the cost of complying with future legislation, and our income and ability to
make distributions to our stockholders could be affected adversely by the
existence of an environmental liability with respect to our properties. We will
endeavor to ensure our properties will be in compliance in all material respects
with all Federal, state and local laws, ordinances and regulations regarding
hazardous or toxic substances or petroleum products.
EMPLOYEES
We have entered into a management agreement with Fortress Investment Group LLC
pursuant to which they advise us regarding investments, portfolio management,
and other aspects of our business, and manage our day-to-day operations. As a
result, we have no employees. The employees of Fortress Investment Group LLC are
not a party to any collective bargaining agreement.
INTERNET ADDRESS
Our website is under construction and is expected to be complete in the second
quarter of 2003.
Our internet address will be http://www.newcastleinv.com. We will make
available, free of charge through a link on our site, our annual reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to such reports, if any, as filed with the SEC as soon as reasonably
practicable after such filing.
ITEM 2. PROPERTIES.
Our investments in properties, which comprise our real estate business segment,
are described under "Item 1. Business - Our Investments."
Our manager leases principal executive and administrative offices located at
1251 Avenue of the Americas, New York, NY 10020, 16th floor. Its telephone
number is (212) 798-6100. Our manager and its affiliates also lease office space
in Dallas, London, Toronto, and Rome. We believe that this office space is
suitable for our operations for the foreseeable future.
15
ITEM 3. LEGAL PROCEEDINGS.
We are not a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of our security holders during the fourth
quarter of 2002.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Our common stock has been listed and is traded on the New York Stock Exchange
(NYSE) under the symbol "NCT" since our initial public offering in October 2002.
The following table sets forth, for the periods indicated, the high, low and
last sale prices in dollars on the NYSE for our common stock and the
distributions we declared with respect to the periods indicated.
Last Distributions
2002 High Low Sale Declared
---- ------- ------ ------- -------------
July 12, 2002 through September 30, 2002 N/A N/A N/A $0.40
October 1, 2002 through October 9, 2002 (1) N/A N/A N/A $0.06
October 10, 2002 through December 31, 2002 $ 15.97 $12.38 $ 15.97 $0.39 (2)
2003
First Quarter through February 14, 2003 $ 16.20 $15.65 $ 16.20 $0.45 (3)
(1) Represents the portion of the fourth quarter of 2002 prior to
our initial public offering.
(2) When combined with the $0.06 paid for the period October 1
through October 9, represents a regular quarterly dividend of
$0.45 per share.
(3) For the full quarter.
We intend to continue to declare quarterly distributions on our common stock. No
assurance, however, can be given as to the amounts or timing of future
distributions as such distributions are subject to our earnings, financial
condition, capital requirements and such other factors as our board of directors
deems relevant.
On February 14, 2003, the closing sale price for our common stock, as reported
on the NYSE, was $16.20. As of February 14, 2003, there were approximately five
record holders of our common stock. This figure does not reflect the beneficial
ownership of shares held in nominee name.
The record holders described above include Newcastle Holdings, which held
16,486,339 shares of our common stock as of such date. Newcastle Holdings'
shares of our common stock have not been traded on the NYSE through such date.
Newcastle Holdings has informed us that it may make a distribution to its
stockholders of its holdings of our common stock. However, Newcastle Holdings
has agreed with Bear, Stearns & Co. Inc. not to distribute our common stock to
its stockholders prior to April 10, 2003 without the consent of Bear Stearns.
Equity Compensation Plan Information
Number of securities to be Weighted-average Number of securities remaining
issued upon exercise of exercise price of available for future issuance under
Plan Category outstanding options outstanding options equity compensation plans
-------------- ---------------------------- ------------------------- --------------------------------------
Equity compensation plans
previously approved by
stockholders: Newcastle
Investment Corp.
Nonqualified Stock Option
and Incentive Award Plan 704,000 $ 13.00 (A)
16
Equity compensation plans not approved by stockholders: None
(A) The maximum available for issuance each year is equal to 15% of the number
of outstanding equity interests, subject to a maximum of 10,000,000 shares in
the aggregate over the term of the plan.
ITEM 6. SELECTED FINANCIAL DATA.
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
Our predecessor, Newcastle Holdings, contributed to us certain assets and
related liabilities in exchange for shares of our common stock. However, as
presented in the following table, 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 to be retained by
Newcastle Investment Holdings are accounted for as if they were distributed at
historical book basis through a spin-off to Newcastle Investment Holdings.
As of July 12, 2002, for accounting purposes, we distributed to Newcastle
Investment Holdings assets which represented approximately thirty percent of our
total assets (100% of our real estate loans, our investment in Fortress
Investment Fund LLC, and approximately 75% of our real properties), and related
liabilities. The following assets were retained by us:
- Real estate securities (which serve as collateral for CBO I
and CBO II);
- Credit leased real estate (Bell Canada portfolio and LIV portfolio);
and
- Other assets.
The following table sets forth certain selected operating information on a pro
forma basis.
The selected unaudited pro forma consolidated statements of income are presented
as if the distribution had been consummated on January 1, 2002 or 2001, as
applicable. The historical results of operations of the assets and liabilities
distributed to Newcastle Investment Holdings have been presented as discontinued
operations for those operations that constitute a component of an entity. A
component of an entity must have cash flows that are clearly distinguished
operationally and for financial reporting purposes from the rest of the entity.
Of the assets distributed to Newcastle Investment Holdings, the U.S. real estate
portfolio and the mortgage loans qualify as a component of an entity. The
remaining operations related to the other assets and liabilities distributed to
Newcastle Investment Holdings which are not a component of an entity have been
eliminated.
The selected 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. The selected pro forma
financial information set forth below for the years ended December 31, 2002 and
2001 have been derived from our unaudited pro forma statements of income
included in Note 13 of our consolidated financial statements included in "Item
8. Financial Statements and Supplementary Data."
The information below should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Pro Forma Financial Condition and Results of
Operations" and our consolidated financial statements and notes thereto included
in "Item 8. Financial Statements and Supplementary Data."
17
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED YEAR ENDED
DECEMBER 31, 2002 DECEMBER 31, 2001
OPERATING DATA ------------------- ------------------
Revenues
Interest and dividend income $ 72,856 $ 47,709
Rental and escalation income 19,874 20,053
Gain on settlement of investments 11,446 7,405
Other income 15 43
------------------ ------------------
104,191 75,210
Expenses
Interest expense 47,191 32,659
Property operating expense 8,631 8,695
Loan servicing expense 655 243
General and administrative expense 2,814 1,230
Management fees to affiliate 3,905 3,642
Preferred incentive return to affiliate 2,029 -
Depreciation and amortization 2,769 2,567
------------------ -----------------
67,994 49,036
------------------ -----------------
Income from continuing operations $ 36,197 $ 26,174
================== =================
Income from discontinued operations $ 1,777 $ 5,016
================== =================
Income from continuing operations per share of common stock, basic and diluted $ 1.95 $ 1.54
================== =================
Weighted average number of shares of common stock outstanding, basic 18,560 16,973
================== =================
Weighted average number of shares of common stock outstanding, diluted 18,570 16,973
================== =================
18
YEAR ENDED YEAR ENDED
OTHER DATA 12/31/02 12/31/01
----------- ------------
Cash flow from continuing operations provided by (used in):
Operating activities $ 17,908 $ 17,483
Investing activities $ (741,971) $ (6,973)
Financing activities $ 727,141 $ 16,294
Funds from Operations (FFO) from continuing operations (A) $ 38,828 $ 28,688
- ----------
(A) 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. We also believe that funds from operations (FFO) is an
appropriate supplemental disclosure of operating performance for a REIT due
to its widespread acceptance and use within the REIT and analyst
communities. Funds from operations (FFO), for our purposes, represents net
income available for common stockholders (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 funds from operations (FFO). Adjustments
for unconsolidated subsidiaries, if any, 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 as 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.
YEAR ENDED YEAR ENDED
CALCULATION OF FUNDS FROM OPERATIONS 12/31/02 12/31/01
----------- -----------
Income from continuing operations
Real estate depreciation and amortization $ 36,197 $ 26,174
2,631 2,514
----------- ----------
Funds from Operations (FFO) from continuing operations $ 38,828 $ 28,688
=========== ==========
19
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following table sets forth certain selected operating information on a
historical basis. As such, it includes the historical results of operations of
the assets and liabilities distributed to Newcastle Investment Holdings which
are not part of our continuing operations, and therefore the information set
forth for periods prior to the commencement of our operations in July 2002 is
not indicative of our ongoing operations.
The selected historical consolidated financial information set forth below as of
December 31, 2002, 2001, 2000, 1999 and 1998 and for the years ended December
31, 2002, 2001, 2000 and 1999 and for the period from May 11, 1998 to December
31, 1998 has been derived from our audited historical consolidated financial
statements.
The information below should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Historical Financial Condition and Results of
Operations" and our consolidated financial statements and notes thereto included
in "Item 8. Financial Statements and Supplementary Data."
20
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
(in thousands, except per share data)
YEAR ENDED DECEMBER 31, PERIOD FROM MAY
------------------------------------------------ 11, 1998 TO DEC.
2002 2001 2000 1999 31, 1998
--------- ------------ ---------- ---------- ----------------
OPERATING DATA
Revenues
Interest and dividend income $ 73,082 $ 48,913 $ 50,985 $ 30,288 $ 4,475
Rental and escalation income 19,874 20,053 20,433 14,798 3,885
Gain (loss) on settlement of investments 11,417 8,438 20,836 1,765 (15)
Management fee from affiliates 4,470 8,941 8,941 944 -
Incentive income from affiliates (1,218) 28,709 - - -
Other income 18 68 728 66 (4)
--------- ---------- --------- --------- ----------
107,643 115,122 101,923 47,861 8,341
Expenses
Interest expense 49,527 35,863 36,897 19,741 -
Property operating expense 8,631 8,695 8,957 7,353 1,713
Loan servicing and REO expense 655 254 265 112 -
General and administrative expense 2,914 1,568 3,272 2,938 1,444
Management fees to affiliate 9,250 14,687 15,587 8,331 6,751
Preferred incentive return to affiliate 2,856 17,188 - - -
Depreciation and amortization 3,199 3,574 2,926 1,693 452
--------- ---------- --------- --------- ----------
77,032 81,829 67,904 40,168 10,360
Income (loss) before equity in earnings of unconsolidated
subsidiaries 30,611 33,293 34,019 7,693 (2,019)
Equity in earnings (losses) of unconsolidated subsidiaries 362 2,807 (980) (3,615) 117
--------- ---------- --------- --------- ----------
Income (loss) from continuing operations 30,973 36,100 33,039 4,078 (1,902)
Income from discontinued operations 522 7,571 9,821 8,734 12,542
--------- ---------- --------- --------- ----------
Income before change in accounting principle 31,495 43,671 42,860 12,812 10,640
Cumulative effect of change in accounting principle-
write off of organizational costs - - - (513) -
--------- ---------- --------- --------- ----------
Net Income 31,495 43,671 42,860 12,299 10,640
Preferred dividends and related accretion (1,162) (2,540) (2,084) - -
--------- --------- ------- --------- ----------
Income available for common stockholders $ 30,333 $ 41,131 $ 40,776 $ 12,299 $ 10,640
========= ========== ========= ========= ==========
Net Income per Share of Common Stock, basic and diluted $ 1.68 $ 2.49 $ 2.16 $ 0.59 $ 0.51
========= ========== ========= ========= ==========
Income (loss) from continuing operations per share of
common stock, after preferred dividends and related
accretion, basic and diluted $ 1.65 $ 2.03 $ 1.64 $ 0.19 $ (0.09)
========= ========== ========= ========= ==========
Income from discontinued operations per share of common
stock, basic and diluted $ 0.03 $ 0.46 $ 0.52 $ 0.42 $ 0.60
========= ========== ========= ========= ==========
Effect of change in accounting principle per share of common
stock, basic and diluted $ - $ - $ - $ (0.02) $ -
========= ========== ========= ========= ==========
Weighted average number of shares of common stock
outstanding, basic 18,080 16,493 18,892 20,917 20,862
========= ========== ========= ========= ==========
Weighted average number of shares of common stock
outstanding, diluted 18,090 16,493 18,892 20,917 20,862
========= ========== ========= ========= ==========
Dividends declared per share of common stock $ 2.05 $ 2.00 $ 1.50 $ 2.04 $ 0.55
========= ========== ========= ========= ==========
21
DECEMBER 31,
-------------------------------------------------------------------------
2002 2001 2000 1999 1998
------------ ------------- ------------ --------------- ------------
BALANCE SHEET DATA
Real estate securities, available for sale $ 1,069,892 $ 522,258 $ 509,729 $ 504,669 $ -
Operating real estate, net $ 113,652 $ 524,834 $ 540,539 $ 558,849 $ 383,073
Cash and cash equivalents $ 45,463 $ 31,360 $ 10,575 $ 14,345 $ 75,596
Total assets $ 1,572,567 $ 1,262,119 $1,331,086 $ 1,381,600 $ 765,650
Debt $ 1,217,007 $ 897,390 $ 975,656 $ 971,260 $ 336,845
Stockholders' equity $ 284,241 $ 310,545 $ 300,655 $ 354,673 $ 384,924
YEAR ENDED DECEMBER 31, PERIOD FROM MAY
---------------------------------------------------------- 11, 1998 TO DEC.
2002 2001 2000 1999 31, 1998
------------- ------------- -------------- ------------- ---------------
OTHER DATA
Cash Flow provided by (used in):
Operating activities $ 21,557 $ 34,448 $ 24,823 $ 32,834 $ (7,230)
Investing activities $ (682,691) $ 106,053 $ 151,632 $ (683,420) $ (638,844)
Financing activities $ 675,237 $ (119,716) $ (180,225) $ 589,335 $ 721,670
Funds from Operations (FFO) (A) $ 37,633 $ 48,264 $ 53,523 $ 24,707 $ 14,337
(A) We believe funds from operations (FFO) is one appropriate measure of
the performance of real es investors with an understanding of estate
companies because it provid our ability to incur and service debt and
make capital We also believe that funds from operations (FFO) is an
approp riate supplemental expenditures. disclosure of operating
performance for a REIT due to its widespread acceptance and use within
the REIT and Funds from (FFO), for our purposes, represents analyst
communities. operations net income available for common stockholders
(computed in accordance with 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 exclude accrued incentive inco
me from Fortress Investment Fund (Fund I) and include incentive income
distributed or distributable from Fund I in accordance with the
operating agreement of Fund I since this more accurately reflects cash
distributed or distributable to us from Fund I, while our accrued
incentive income is based upon the fair value of Fund I's net assets,
which is subject to fluctuation in future periods. Adjustments
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 no 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.
YEAR ENDED DECEMBER 31, PERIOD FROM MAY
---------------------------------------------------------- 11, 1998 TO DEC.
2002 2001 2000 1999 31, 1998
------------- ------------- -------------- ------------ ---------------
CALCULATION OF FUNDS FROM OPERATIONS (FFO):
Income available for common stockholders $ 30,333 $ 41,131 $ 40,776 $ 12,299 $ 10,640
Extraordinary item - loss on extinguishment of debt - - - 2,341 -
Real estate depreciation and amortization 7,994 12,909 12,621 9,927 3,697
Accumulated depreciation on real estate sold (2,847) - - - -
Real estate depreciation and amortization-
unconsolidated subsidiaries 1,614 2,564 126 140 -
Incentive (income) loss accrued from Fund I (A) 609 (14,354) - - -
Equity in incentive return accrued by Fund I (70) 1,645 - - -
Distributable incentive income from Fund I (B) - 4,369 - - -
----------- -------- --------- ---------- ----------
Funds from operations (FFO) $ 37,633 $ 48,264 $ 53,523 $ 24,707 $ 14,337
=========== ======== ========= ========== ==========
(A) Represents our predecessor's 50% interest in the incentive income as
follows:
YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31,
2002 2001
------------- -------------
Total incentive income (loss) $ (1,218) $ 28,708
Manager portion 609 (14,354)
--------- ----------
Our predecessor's incentive income (loss) $ (609) $ 14,354
========= ==========
(B) Represents our predecessor's 50% interest in the distributable incntive
income:
Total distributable incentive income $ 8,738
Distributable incentive income due to Manager (4,369)
----------
Our predecessor's distributable incentive income $ 4,369
==========
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PRO FORMA FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following should be read in conjunction with our consolidated financial
statements and notes thereto, and in particular with the unaudited pro forma
consolidated statements of income included in Note 13 to our consolidated
financial statements, included in "Item 8. Financial Statements and
Supplementary Data."
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, prior to our initial public
offering, 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 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 shares of common stock
outstanding.
Newcastle Holdings has informed us that it may make a distribution to its
stockholders of its holdings of our common stock. However, Newcastle Holdings
has agreed with Bear, Stearns & Co. Inc. not to distribute our common stock to
its stockholders earlier than April 2003 without the consent of Bear Stearns.
We conduct our business through three primary segments: (i) real estate
securities, including our first two CBO securitization transactions, which we
refer to as CBO I and CBO II, (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, and (iii)
real estate loans. Revenues attributable to each segment are disclosed below on
a pro forma basis (unaudited) (in thousands).
23
Real Estate Real Estate
Securities Real Estate Loans Unallocated Total
------------- ----------- ------------- ------------ -----------
For the year ended December 31, 2002 $ 83,259 $ 19,384 $ 1,281 $ 267 $ 104,191
TAXATION
We intend to elect to be taxed as a real estate investment trust, or REIT, under
the Internal Revenue Code of 1986, as amended (the "Code"), commencing with our
first tax year which began on July 12, 2002, and we intend to continue to
operate in such a manner. Our current and continuing qualification as a REIT
depends on our ability to meet various tax law requirements, including, among
others, requirements relating to the sources of our income, the nature of our
assets, the composition of our stockholders, and the timing and amount of
distributions that we make.
If we qualify for taxation as a REIT, we will generally not be subject to U.S.
federal corporate income tax on our net income that is currently distributed to
stockholders. This treatment substantially eliminates the "double taxation" (at
the corporate and stockholder levels) that generally results from investment in
a corporation under current law. We may, however, nevertheless be subject to
certain state, local and foreign income and other taxes, and to U.S. federal
income and excise taxes and penalties in certain situations, including taxes on
our undistributed income. In addition, our stockholders may be subject to state,
local or foreign taxation in various jurisdictions, including those in which
they or we transact business or reside. The state, local and foreign tax
treatment of us and our stockholders may not conform to the U.S. federal income
tax treatment.
If, in any taxable year, we fail to satisfy one or more of the various tax law
requirements, we could fail to qualify as a REIT. In addition, if Newcastle
Holdings fails to qualify as a REIT and we are treated as a successor to
Newcastle Holdings, this could cause us to likewise fail to qualify as a REIT.
If we fail to qualify as a REIT for a particular tax year, our income in that
year would be subject to U.S. federal corporate income tax (including any
applicable alternative minimum tax), and we may need to borrow funds or
liquidate certain investments in order to pay the applicable tax, and we would
not be compelled by the Code to make distributions. Unless entitled to relief
under certain statutory provisions, we would also be disqualified from treatment
as a REIT for the four taxable years following the year during which
qualification is lost.
Although we currently intend to operate in a manner designed to qualify as a
REIT, it is possible that future economic, market, legal, tax or other
developments may cause us to fail to qualify as a REIT, or may cause our Board
of Directors to revoke the REIT election.
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 following is a summary of our accounting
policies that are most effected by judgments, estimates and assumptions.
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. We
must also assess whether unrealized losses on securities, if any, reflect a
decline in value which is other than temporary and, accordingly, write the
impaired security down to its value through earnings. Significant judgment is
required in this analysis. To date, no such write-downs have been made.
Income on these securities is recognized using a level yield methodology based
upon a number of assumptions that are subject to uncertainties and
contingencies. Such assumptions include the expected disposal date of such
security
24
(which generally corresponds to the expected maturity of any related
securitization financing) and the rate and timing of principal and interest
receipts (which may be subject to prepayments, delinquencies and defaults).
These uncertainties and contingencies are difficult to predict and are subject
to future events, and economic and market conditions, which may alter the
assumptions.
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.
We purchase mortgage loans to be held as long-term investments. We must
periodically evaluate each of these loans for possible impairment. Impairment is
indicated when it is deemed probable that we will be unable to collect all
amounts due according to the contractual terms of the loan. Upon determination
of impairment, we would establish a specific valuation allowance with a
corresponding charge to earnings. Significant judgment is required both in
determining impairment and in estimating the resulting loss allowance. To date,
we have determined that no loss allowances have been necessary on the loans in
our portfolio.
RESULTS OF OPERATIONS
Our independent operations commenced in July 2002 and our initial public
offering was completed in October 2002. These events resulted in additional
capital being deployed to our investments which, in turn, resulted in changes to
our results of operations.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2002 TO THE YEAR ENDED DECEMBER 31,
2001 ON A PRO FORMA BASIS
Interest and dividend income is derived primarily from our investments in real
estate securities and increased by $25.2 million or 53%, from $47.7 million to
$72.9 million. This increase is primarily the result of interest earned on the
real estate securities purchased in connection with our CBO II transaction.
Rental and escalation income is derived from our Bell Canada and LIV portfolios
and decreased by $0.2 million or 1%, from $20.1 million to $19.9 million. This
decrease is primarily the result of foreign currency fluctuations with respect
to our Bell Canada portfolio. 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 $4.0 million, from $7.4 million
to $11.4 million, primarily as a result of an increase in the volume of sales of
real estate securities. Sales of real estate 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 $14.5 million or 44%, from $32.7 million to $47.2
million. This increase is primarily the result of interest on the CBO II
securitization ($18.6 million), partially offset by lower interest rates being
paid on the variable rate CBO I securities classes ($4.6 million).
Property operating expense on our Bell Canada and LIV portfolios decreased by
$0.1 million or 1%, from $8.7 million to $8.6 million, primarily as the result
of the same factors which effected rental and escalation income.
Loan servicing expense, primarily trustee fees on our securitizations, increased
by $0.5 million or 170%, from $0.2 million to $0.7 million, primarily as a
result of the acquisition of the real estate securities purchased in connection
with our CBO II transaction.
General and administrative expense increased by $1.6 million, from $1.2 million
to $2.8 million, primarily as a result of our increased size.
25
Management fee expense increased by $0.3 million, from $3.6 million to $3.9
million, based on our increased equity.
Preferred incentive return increased by $2.0 million, to $2.0 million, due to
the commencement of our operations and our management agreement.
Depreciation and amortization, primarily of our real estate assets, increased by
$0.2 million or 8%, from $2.6 million to $2.8 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 December 31, 2002, our real estate securities purchased
in connection with our CBO I and CBO II transactions as well as our Bell Canada
portfolio were securitized, while our LIV portfolio, one of our marketable real
estate securities and our mortgage loan portfolio 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. In
addition, at December 31, 2002 we had an unrestricted cash balance of $45.5
million. Our cash flow provided by operations differs from our net income due to
four primary factors: (i) depreciation of our real estate, (ii) accretion of
discounts on our real estate securities, discounts on our debt, and deferred
hedge gains and losses, (iii) straight-lined rental income, and (iv) gains and
losses. Proceeds from the sale of real estate securities which serve as
collateral for our CBO securitizations, including gains thereon, are required to
be retained in the CBO structure until the related bonds are retired and are
therefore not available to fund current cash needs.
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 7A. 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. Our ability to meet our long-term liquidity requirements is
subject to obtaining additional equity and debt financing. Decisions by
investors and lenders to enter into such transactions with us will depend upon a
number of factors, such as our historical and projected financial performance,
compliance with the terms of our current credit arrangements, industry and
market trends, the availability of capital and our investors' and lenders'
policies and rates applicable thereto, and the relative attractiveness of
alternative investment or lending opportunities.
We expect that our cash on hand, our cash flow provided by operations, 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 over the next
twelve months. However, we currently expect to seek additional capital in order
to grow our investment portfolio.
26
With respect to our real estate assets, we expect to incur approximately $1.8
million of tenant improvements in connection with the inception of leases and
capital expenditures during the year ending December 31, 2003.
Our long-term debt existing at December 31, 2002 (gross of $13.8 million of
discounts) is expected to mature as follows (in millions):
2003 $ 251.8
2004 2.0
2005 1.7
2006 58.4
2007 0.0
Thereafter 916.9
--------
Total $1,230.8
========
In July 1999, we completed our first CBO securitization, CBO I, whereby a
portfolio of real estate securities 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 December 31, 2002, the subordinated securities were
retained by us, and the $429.4 million carrying amount of senior securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of approximately 3.99%, had an expected weighted average life
of approximately 5.26 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. CBO I's
weighted average effective interest rate, including the effect of such hedges,
was 5.63% at December 31, 2002. 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 April 2002, we refinanced the Bell Canada portfolio through a securitization
transaction. At December 31, 2002, the CAD 58.8 million or approximately $37.4
million carrying amount of outstanding securities, which bore interest at a
weighted average effective rate, including discount and cost amortization, of
approximately 7.07%, had an expected weighted average life of approximately 2.75
years. We have retained one class of the issued securities. In connection with
this securitization, we guaranteed certain payments under an interest rate swap
to be entered into in 2007 if the securitization is not fully repaid by such
date. We believe the fair value of this guarantee is negligible at December 31,
2002.
In April 2002, we completed our second CBO securitization, CBO II, whereby a
portfolio of real estate securities 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. At December 31, 2002, the subordinated securities were
retained by us, and the $439.1 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 7.36 years. One class of the senior securities bears a floating
interest rate. 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
this security, at an initial cost of $1.2 million. CBO II's weighted average
effective interest rate, including the effect of such hedges, was 6.16% at
December 31, 2002.
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 represented a
repayment of debt and was recorded as a reduction of CBO bonds payable. The
Class E Note is included in the collateral for CBO II. 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, 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; a mark of $0.7 million has been booked to income through
December 31, 2002. These securities are 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 December 31, 2002,
approximately $342.4 million of the $450 million had been accumulated.
27
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 such securities from
BSIL or pay BSIL the difference between the price it paid for such securities
and the price at which it sold such securities 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 such securities from BSIL or pay BSIL the lesser of
the collateral loss and our 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 December 31, 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 and December 2002, we made deposits
aggregating $37.1 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 shares of common stock outstanding.
In November 2002, we utilized $13.5 million of our offering proceeds to purchase
a $260.2 million portfolio of variable rate mortgage loans subject to $246.7
million of variable rate financing. At December 31, 2002, the $258.2 million
carrying amount of mortgage loans bore interest at a net weighted average
effective rate of approximately 3.40%, and the $246.7 million carrying amount of
financing bore interest at a weighted average effective rate of approximately
1.80%.
In November 2002, we refinanced the LIV portfolio. At December 31, 2002, the EUR
60.0 million or approximately $63.0 million carrying amount of debt bore
interest at a rate of 5.32% and matures in November 2006.
We declared a distribution of $0.40 per share of common stock to 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 share
of common stock 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 distributions were paid in October 2002. In December 2002, we declared a
distribution of $0.39 per share of common stock to our stockholders of record at
the close of business on December 27, 2002, which included Newcastle Holdings
and Fortress Principal Investment Holdings LLC, which was paid in January 2003.
In February 2003, we sold our entire position in agency eligible residential
mortgage loans (a portion of our mortgage loan portfolio) with an aggregate
unpaid principal balance of approximately $159.0 million for gross proceeds of
approximately $162.6 million at a gain of approximately $0.7 million. As a
result of the sale, the existing repurchase agreement allocated to the agency
eligible loans was satisfied for approximately $153.9 million. Simultaneously,
approximately $207.4 million of non-agency/jumbo residential mortgage loans were
purchased for a price of approximately $210.2 million. In connection with this
purchase, the outstanding balance of the existing repurchase agreement was
increased by a net of $45.9 million, after the repayment described above.
CREDIT, SPREAD 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.
28
Our portfolio is diversified by asset type, industry, location and issuer. We
expect that diversification will also minimize the risk of capital loss.
At December 31, 2002, our real estate securities which serve as collateral for
our CBO transactions have an overall weighted average credit rating of
approximately Baa3, and approximately 68% of these securities have an investment
grade rating (Baa3 or higher).
Our real estate securities are also subject to spread risk. The majority of such
securities are fixed rate securities valued based on a market credit spread to
U.S. Treasuries. In other words, their value is dependent on the yield demanded
on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our securities portfolio would tend to
decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our securities would tend to increase.
Such changes in the market value of our portfolio may effect our net equity, net
income or cash flow directly through their impact on unrealized gains or losses
on available-for-sale securities, and therefore our ability to realize gains on
such securities, or indirectly through their impact on our ability to borrow and
access capital. See "Item 7A. Quantitative and Qualitative Disclosures About
Market Risk-Credit Spread Curve Exposure" below.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also effect the yield
required on our securities and therefore their value. This would have similar
effects on our portfolio and our financial position and operations to a change
in spreads.
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 December 31, 2002, a 100 basis point
change in short term interest rates would affect our earnings by no more than
$1.9 million per annum. See "Item 7A. Quantitative and Qualitative Disclosures
About Market Risk - Interest Rate Exposure" below.
Interest rate changes may also impact our net book value as our securities and
related hedge derivatives are marked -to-market each quarter. Generally, as
interest rates increase, the value of our fixed income securities, such as
commercial mortgage backed securities, decreases and as interest rates decrease,
the value of such securities will increase. We seek to hedge changes in value
attributable to changes in interest rates by entering into interest rate swaps
and other derivative instruments. In general, we would expect that over time,
decreases in value of our securities portfolio attributable to interest rate
changes will be offset to some degree by increases in value of our swaps, and
vice versa. However, the relationship between spreads on securities and spreads
on swaps may vary from time to time, resulting in a net aggregate book value
increase or decline. Our securities portfolio is largely financed to maturity
through long term, collateralized debt obligations that are not callable as a
result of book value changes. Accordingly, unless there is a material impairment
in value that would result in a payment not being received on a security,
changes in the book value of our portfolio will not directly affect our
recurring earnings or our ability to pay a dividend.
Furthermore, 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.
Similar to our real estate securities portfolio, we are subject to credit and
spread risk with respect to our mortgage loan portfolio.
Credit risk refers to each individual borrower's ability to make their required
interest and principal payments on the scheduled due dates. Unlike our real
estate securities portfolio, our mortgage loan portfolio does not benefit from
the support of junior classes of securities, but rather bears the first risk of
default and loss. We believe that this credit risk is mitigated through our
extensive due diligence process, periodic reviews of the borrower's payment
history, delinquency status, and the relationship of the loan balance to the
underlying property value.
Our portfolio is diversified by geographic location and by borrower. We believe
that this diversification also helps to minimize the risk of capital loss.
29
Our mortgage loan portfolio is also subject to spread risk. The majority of such
loans are floating rate securities valued based on a market credit spread to
LIBOR. The value of the loans is dependent upon the yield demanded by the market
based on their credit. The value of our portfolio would tend to decline should
the market require a higher yield on such loans, resulting in the use of a
higher spread over the benchmark rate (usually the applicable LIBOR yield). If
the value of our mortgage loan portfolio were to decline, it could affect our
ability to refinance such portfolio upon the maturity of the related repurchase
agreement.
Any credit or spread losses incurred with respect to our mortgage loan portfolio
would affect us in the same way as similar losses on our real estate securities
portfolio as described above.
OFF-BALANCE SHEET ARRANGEMENTS
As of December 31, 2002, we had the following material off-balance sheet
arrangements:
- -The $37.8 million CBO III deposit, as described above under "-Liquidity and
Capital Resources."
- -A $3.3 million equity interest in a securitization,
described in Note 7 to our consolidated financial statements which appear in
"Item 8. Financial Statements and Supplementary Data."
- -A guarantee of certain payments under an interest rate swap which may be
entered into in 2007 in connection with the securitization of the Bell portolio.
In the first two cases, our potential loss is limited to the amounts shown above
which are included in our consolidated balance sheet. At this time, we do not
anticipate a substantial risk of incurring a loss with respect to any of the
arrangements.
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 Belgian Sante Index. 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 7A.
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. We also believe that funds from operations (FFO) is an appropriate
supplemental disclosure of operating performance for a REIT due to its
widespread acceptance and use within the REIT and analyst communities. 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.
30
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 Year
Ended
December 31,
2002
------------
Income from continuing operations $ 36,197
Real estate depreciation and amortization 2,631
---------
Funds from Operations (FFO) from continuing operations $ 38,828
=========
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 Year Ended continuing Equity
12/31/02 (1) 12/31/02 (1) operations (ROE) (2)
------------ -------------- ---------- ---------
Real estate securities $ 201,498 $ 152,316 $ 41,868 27.5%
Revenue-producing real estate 39,129 50,585 4,273 8.4%
Real estate loans 12,278 2,168 482 22.2%
Unallocated 33,759 7,200 (7,795) N/A
---------- ---------- --------- ----
Total 286,664 $ 212,269 $ 38,828 18.3%
Accumulated depreciation (9,460) ========== ========= ====
Accumulated other comprehensive income 7,037
----------
Net $ 284,241
==========
(1) Gross of accumulated depreciation and accumulated other comprehensive
income.
(2) FFO divided by average book equity.
31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF HISTORICAL FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following should be read in conjunction with our consolidated financial
statements and notes thereto included in "Item 8. Financial Statements and
Supplementary Data."
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, prior to our initial public
offering, 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.
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 it 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. 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." Revenues attributable to each segment are disclosed below
(in thousands).
32
Real Fortress
Real Estate Esate Investment
Securities Real Estate Loans Fund Unallocated Totals
----------- ----------- ----- ---------- ----------- ------
For the year ended December 31, 2002:
Revenues $ 83,259 $ 19,384 $ 1,281 $ 3,287 $ 432 $ 107,643
For the year ended December 31, 2001:
Revenues $ 54,961 $ 20,249 $ - $ 38,297 $ 1,615 $ 115,122
For the year ended December 31, 2000:
Revenues $ 46,893 $ 20,640 $ - $ 8,941 $ 25,449 $ 101,923
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 following is a summary of our
predecessor's accounting policies that were most effected by judgments,
estimates and assumptions.
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
Fund I 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.
33
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
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
Our independent operations commenced in July 2002 and our initial public
offering was completed in October 2002. These events resulted in additional
capital being deployed to our investments which, in turn, resulted in changes to
our results of operations. Furthermore, the historical results of operations
described below include the operations of our predecessor through the date of
the commencement of our operations. Therefore, many items discussed below will
not have a continuing impact on our operations.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2002 TO THE YEAR ENDED DECEMBER 31,
2001
Interest and dividend income increased by $24.2 million or 49%, from $48.9
million to $73.1 million. This increase is primarily the result of interest
earned on the real estate securities purchased in connection with our CBO II
transaction.
Rental and escalation income decreased by $0.2 million or 1%, from $20.1 million
to $19.9 million. This decrease is primarily the result of foreign currency
fluctuations with respect to our Bell Canada portfolio.
Gain on settlement of investments increased by $3.0 million, from $8.4 million
to $11.4 million, primarily as a result of an increase in the volume of sales of
certain real estate securities. Sales of real estate 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 $2.4 million or
87%, from $2.8 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.
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.
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.
Interest expense increased by $13.6 million or 38%, from $35.9 million to $49.5
million. This increase is primarily the result of interest on the CBO II
securitization ($18.6 million), partially offset by lower interest rates being
paid on the variable rate CBO securities classes ($4.6 million).
Property operating expense decreased by $0.1 million or 1%, from $8.7 million to
$8.6 million, primarily as the result of the same factors which effected rental
and escalation income.
Loan servicing and REO expense increased by $0.4 million or 158%, from $0.3
million to $0.7 million, primarily as a result of the acquisition of the real
estate securities purchased in connection with our CBO II transaction.
34
General and administrative expense increased by $1.3 million, from $1.6 million
to $2.9 million, primarily as a result of increased insurance costs.
Management fee expense decreased by $5.4 million, from $14.7 million to $9.3
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 through the date of the distribution of such investment to
Newcastle Holdings, that decreased by $4.5 million, which are directly offset by
management fee income.
Preferred incentive return decreased by $14.3 million, from $17.2 million to
$2.9 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 $0.4 million or 10%, from $3.6
million to $3.2 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 $1.3 million, from $2.5
million to $1.2 million, as a result of the redemption of such stock in June
2002.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2001 TO THE YEAR ENDED DECEMBER 31,
2000
Interest and dividend income decreased by $2.1 million or 4.1%, from $51.0
million to $48.9 million. This decrease is primarily the result of a decrease in
dividend income from our ICH stock subsequent to our acquisition of ICH ($1.5
million) and a decrease in bank interest due to lower cash balances ($1.3
million), offset by an increase related to the securities acquired from ICH in
November 2000 ($1.1 million).
Rental and escalation income decreased by $0.3 million or 1.9%, from $20.4
million to $20.1 million. This decrease is primarily the result of foreign
currency fluctuations related to our Bell Canada and LIV portfolios.
Gain on settlement of investments decreased by $12.4 million, from $20.8 million
to $8.4 million, primarily as a result of gains taken on assets acquired from
ICH in 2000 ($19.8 million) offset by gains on sales of certain real estate
securities in 2001 ($7.4 million). Sales of real estate 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 increased by $3.8 million,
primarily as a result of income from our predecessor's investment in Fund I.
Fund I was more fully invested in 2001 and therefore generated more income.
Incentive Income from our predecessor's investment in Fund I increased by $28.7
million as a result of the incentive threshold being reached in 2001.
Interest expense decreased by $1.0 million or 2.8%, from $36.9 million to $35.9
million. This decrease is primarily the result of lower interest rates being
paid on the variable rate CBO I securities classes ($2.9 million), offset by
increased interest on our predecessor's credit facility due to a higher average
outstanding balance ($1.4 million).
Property operating expense decreased by $0.3 million or 2.9%, from $9.0 million
to $8.7 million, primarily as the result of foreign currency fluctuations
related to our Bell Canada and LIV portfolios.
Loan servicing expense remained approximately the same at $0.3 million.
General and administrative expense decreased by $1.7 million, from $3.3 million
to $1.6 million, primarily as a result of decreased professional fee expenses.
Management fee expense decreased by $0.9 million, from $15.6 million to $14.7
million, based on the reduction in our equity resulting from the repurchase of
4.4 million shares of our common stock in late 2000.
35
Preferred incentive return increased by $17.2 million primarily as a result of
reaching the incentive return thresholds in both our management agreement and in
Fund I's agreement in 2001.
Depreciation and amortization increased by $0.7 million or 22%, from $2.9
million to $3.6 million, primarily as the result of the amortization of certain
costs related to our predecessor's, investment in Fund I.
Preferred dividends and related accretion increased by $0.5 million as a result
of the issuance of such stock in 2000.
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.
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 Fund I,
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 for the
reasons described below. 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 95% income
test that applies to REITs. Newcastle Holdings held non-voting preferred stock
of Austin. Newcastle Holdings' preferred stock in Austin represented a 95%
economic ownership interest in Austin and had a liquidation preference over the
common stockholders. Newcastle Holdings' interest in Austin was 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 was the holder of all of the common
stock, which represented 100% of the vote and 5% of the economic ownership
interest in Austin. Austin also owned 100% of the common stock of Ascend
Residential Holdings, Inc. ("Ascend"). Ascend's primary business was the
acquisition, rehabilitation and sale of single-family residential properties.
In May 1999, Newcastle Holdings closed on 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.
36
Net cash flow provided by operating activities decreased from $34.4 million for
the year ended December 31, 2001 to $21.6 million for the year ended December
31, 2002. It increased from $24.8 million for the year ended December 31, 2000
to $34.4 million for the year ended December 31, 2001. These changes 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) ($682.7 million), $106.1 million and $151.6
million during the years ended December 31, 2002, 2001 and 2000, 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) $675.2 million, ($119.7 million) and
($180.2 million) during the years ended December 31, 2002, 2001 and 2000,
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 (including the purchase of
hedging instruments), the payment of dividends, the redemption of common and
preferred stock and the repayment of debt as described above.
See the consolidated statements of cash flows in our consolidated financial
statements included in "Item 8. Financial Statements and Supplementary Data" 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. We also believe that funds from operations (FFO) is an appropriate
supplemental disclosure of operating performance for a REIT due to its
widespread acceptance and use within the REIT and analyst communities. 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.
37
Funds from Operations is calculated as follows (unaudited) (in thousands):
For the Year Ended December 31,
2002 2001 2000
---- ---- ----
Income available for common stockholders $ 30,333 $ 41,131 $ 40,776
Real estate depreciation and amortization 7,994 12,909 12,621
Accumulated depreciation on real estate sold (2,847) - -
Real estate depreciation and amortization-unconsolidated subsidiaries 1,614 2,564 126
Incentive income accrued from Fund I (A) 609 (14,354) -
Equity in incentive return accrued by Fund I (70) 1,645 -
Distributable incentive income from Fund I (B) - 4,369 -
--------- --------- ---------
Funds from Operations (FFO) $ 37,633 $ 48,264 $ 53,523
========= ========= =========
(A) Represents our predecessor's 50% interest in the incentive income as follows:
Total incentive income $ (1,218) $ 28,708
Manager portion 609 (14,354)
--------- ---------
Our predecessor's incentive income $ (609) $ 14,354
========= =========
(B) Represent our predecessor's 50% interest in the distributable incentive income:
Total distributable incentive income $ 8,738
Distributable incentive income due to Manager (4,369)
---------
Our predecessor's distributable incentive income $ 4,369
=========
38
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates,
credit spreads, 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 securities, and our ability to realize
gains from the settlement of such assets.
While we have not experienced any significant credit losses, in the event of a
significant rising interest rate environment and/or economic downturn, mortgage
and loan defaults may increase and result in credit losses that would adversely
affect our liquidity and operating results.
Interest rates are highly sensitive to many factors, including governmental
monetary and tax policies, domestic and international economic and political
conditions, and other factors beyond our control. Our general 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 interest rate swaps, caps, or other financial instruments, or through
a combination of these strategies.
Interest rate swaps are agreements in which a series of interest rate flows are
exchanged with a third party (counterparty) over a prescribed period. The
notional amount on which swaps are based is not exchanged. In general, our swaps
are "pay fixed" swaps involving the exchange of variable-rate interest payments
from the counterparty for fixed interest payments from us. This can effectively
convert a variable-rate obligation into a fixed-rate obligation.
Similarly, an interest rate cap or floor agreement is a contract in which we
purchase a cap or floor contract on a notional face amount. We will make an
up-front payment to the counterparty for which the counterparty agrees to make
future payments to us should the reference rate (typically one- or three-month
LIBOR) rise above (cap agreements) or fall below (floor agreements) the "strike"
rate specified in the contract. Should the reference rate rise above the
contractual strike rate in a cap, we will earn cap income; should the reference
rate fall below the contractual strike rate in a floor, we will earn floor
income. Payments on an annualized basis will equal the contractual notional face
amount multiplied by the difference between the actual reference rate and the
contracted strike rate.
While a REIT may utilize these types of derivative instruments to hedge interest
rate risk on its liabilities or for other purposes, such derivative instruments
could generate income that is not qualified income for purposes of maintaining
REIT status. As a consequence, we may only engage in such instruments to hedge
such risks within the constraints of maintaining our standing as a REIT. We do
not enter into derivative contracts for speculative purposes nor as a hedge
against changes in credit risk.
The above strategies are specifically designed to reduce our exposure, on
specific transactions or on a portfolio basis, to changes in cash flows as a
result of interest rate movements in the market. In this regard, we utilize
securitization structures, particularly CBOs, as well as other match-funded
financing structures. Our financing strategy is dependent on 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.
39
While our strategy is to utilize interest rate swaps, caps and match-funded
financings in order to limit the effects of changes in interest rates on our
operations, there can be no assurance that our profitability will not be
adversely affected during any period as a result of changing interest rates. As
of December 31, 2002, a 100 basis point change in short term interest rates
would effect our earnings by no more than $1.9 million per annum.
Our hedging transactions using derivative instruments also involve certain
additional risks such as counterparty credit risk, the enforceability of hedging
contracts and the risk that unanticipated and significant changes in interest
rates will cause a significant loss of basis in the contract. The counterparties
to our derivative arrangements are major financial institutions with high credit
ratings with which we and our affiliates may also have other financial
relationships. As a result, we do not anticipate that any of these
counterparties will fail to meet their obligations. There can be no assurance
that we will be able to adequately protect against the foregoing risks and will
ultimately realize an economic benefit that exceeds the related amounts incurred
in connection with engaging in such hedging strategies.
Interest rate changes may also impact our net book value as our securities and
related hedge derivatives are marked-to-market each quarter. Generally, as
interest rates increase, the value of our fixed income securities, such as
commercial mortgage backed securities, decreases and as interest rates decrease,
the value of such securities will increase. We seek to hedge changes in value
attributable to changes in interest rates by entering into interest rate swaps
and other derivative instruments. In general, we would expect that over time,
decreases in value of our securities portfolio attributable to interest rate
changes will be offset to some degree by increases in value of our swaps, and
vice versa. However, the relationship between spreads on securities and spreads
on swaps may vary from time to time, resulting in a net aggregate book value
increase or decline. Our securities portfolio is largely financed to maturity
through long term, collateralized debt obligations that are not callable as a
result of book value changes. Accordingly, unless there is a material impairment
in value that would result in a payment not being received on a security,
changes in the book value of our portfolio will not directly affect our
recurring earnings or our ability to pay a dividend.
Credit Spread Curve Exposure
Our real estate securities are also subject to spread risk. The majority of such
securities are fixed rate securities valued based on a market credit spread to
U.S. Treasuries. In other words, their value is dependent on the yield demanded
on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our securities portfolio would tend to
decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our securities portfolio would tend to
increase. Such changes in the market value of our portfolio may effect our net
equity, net income or cash flow directly through their impact on unrealized
gains or losses on available-for-sale securities, and therefore our ability to
realize gains on such securities, or indirectly through their impact on our
ability to borrow and access capital.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rtes, would also effect the yield
required on our securities and therefore their value. This would have similar
effects on our portfolio and our financial position and operations as a change
in spreads would.
As of December 31, 2002, a 25 basis point movement in credit spreads would
impact our net book value by approximately $13.2 million.
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 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 $8.1 million and $18.3 million,
respectively, at December 31, 2002, is exposed to foreign currency exchange
risk.
40
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
December 31, 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, 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.
41
We held the following interest rate risk sensitive instruments at December 31,
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
Assets: floating and fixed
Real estate securities, rates, amortizing
available for sale (A) $ 1,069,892 $ 1,028,150 8.14% Various and interest only) $ 1,069,892
CBO III deposit (B) 37,777 (B) (B) (B) (B) 37,777
Marketable securities,
available for sale (C) 11,209 23,953 16.34% (C) (C) 11,209
Various
Mortgage loans (D) 258,198 254,201 3.40% Various (all floating rate) 258,198
Interest rate caps, treated
as hedges, net (E) 4,638 213,035 N/A (E) (E) 4,638
Amortizes princi-
pal based on col-
lateral payments,
Liabilities: subject to
CBO bonds payable (F) 868,497 881,500 3.73% (F) reinvestment 892,117
Amortizes princi-
pal with a balloon
payment at
Other bonds payable (G) 37,389 38,173 7.07% Apr-12 maturity 36,784
Amortizes princi-
pal with a balloon
payment at
Notes payable(G) 62,952 62,952 5.32% Nov-06 maturity 58,970
Repurchase agree- Short-
ments (H) 248,169 248,169 1.81% term Interest only 248,169
Interest rate swaps,
treated as hedges,
net (I) 51,110 437,465 N/A (I) (I) 51,110
Non-hedge derivative
obligations (J) 745 (J) N/A (J) (J) 745
- ---------------
(A) These securities serve as collateral for our CBO transactions. The fair
value of these securities is estimated by obtaining third party
independent broker quotations, if available and practicable, or
counterparty quotations.
(B) The CBO III deposit was valued based on a counterparty quotation. See
"Item 7. Management's Discussion and Analysis of Pro Forma Financial
Condition and Results of Operations-Liquidity and Capital Resources"
for a further discussion of the CBO III deposit.
(C) These three securities with carrying amounts of $3.9 million, $3.3
million and $4.0 million, respectively, mature in November 2007, August
2030 and November 2017, respectively. The former two represent
subordinate and residual interests in securitizations; the latter
represents a CMBS security. The fair values of the former two
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. The fair value of the latter
security was obtained from independent third party broker quotations.
(D) This portfolio of mortgage loans bears a floating rate of interest. We
believe that for similar financial investments with comparable credit
risks, the effective rate on this portfolio approximates the market
rate. Accordingly, the carrying amount of this portfolio is believed to
approximate fair value.
42
(E) These two agreements have notional balances of $195.0 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.
(F) For those bonds bearing floating rates at spreads over market indices,
representing approximately $710.7 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.
(G) The Bell Canada Securitization and Belgian Mortgage were valued by
discounting expected future payments by a rate calculated by imputing a
spread over a market index on the date of borrowing.
(H) These agreements bear floating rates of interest and we believe that
for similar financial instruments with comparable credit risks, the
effective rates approximate market rates. Accordingly, the carrying
amounts outstanding are believed to approximate fair value.
(I) These two agreements have notional balances of $147.5 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.
(J) 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 $61.6 million. 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
$61.6 million cap is August 2004. They have been valued by reference to
counterparty quotations.
We held the following currency rate risk sensitive balances at December 31, 2002
(unaudited):
CURRENT EFFECT OF A 5% EFFCT OF A 5%
CARRYING EXCHANGE NEGATIVE NEGATIVE
AMOUNT LOCAL RATE TO CHANGE IN CHANGE IN
(USD) CURRENCY USD EURO RATE CAD RATE
----- -------- --- --------- --------
(DOLLARS IN THOUSANDS, EXCEPT EXCHANGE RATES)
Assets:
LIV portfolio.................... $67,852 Euro 0.95311 $(3,392) N/A
Bell Canada portfolio............ 49,271 CAD 1.57180 N/A $(2,464)
LIV other, net................... 3,157 Euro 0.95311 (158) N/A
Bell Canada other, net........... 6,456 CAD 1.57180 N/A (323)
Liabilities:
LIV mortgage..................... 62,952 Euro 0.95311 3,148 N/A
Bell Canada bonds................ 37,389 CAD 1.57180 N/A 1,869
------- -------
Total............................ $ (402) $ (918)
======= =======
- ---------------
USD refers to U.S. dollars; CAD refers to Canadian dollars
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 2002 and December 31, 2001
43
Consolidated Statements of Income for the years ended December 31, 2002, 2001
and 2000
Consolidated Statements of Stockholders' Equity and Redeemable Preferred
Stock for the years ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the years ended December 31, 2002,
2001 and 2000
Notes to Consolidated Financial Statements
All schedules have been omitted because either the required information is
included in our consolidated financial statements and notes thereto or it is not
applicable.
44
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
Newcastle Investment Corp.
We have audited the accompanying consolidated balance sheets of Newcastle
Investment Corp. and subsidiaries (the "Company") as of December 31, 2002 and
2001, and the related consolidated statements of income, stockholders' equity
and redeemable preferred stock, and cash flows for each of the three years in
the period ended December 31, 2002. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of the Newcastle
Investment Corp. and subsidiaries at December 31, 2002 and 2001, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2002 in conformity with accounting
principles general accepted in the United States.
As discussed in Note 2 to the consolidated financial statements, in 2001 the
Company adopted Statement of Financial Accounting Standards No. 133, "Accounting
for Derivative Instruments and Hedging Activities," as amended by Statement of
Financial Accounting Standards No. 138, "Accounting for Derivative Instruments
and Certain Hedging Activities."
/s/ Ernst & Young LLP
February 11, 2003, except for note 12 as to
which the date is February 28, 2003
45
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
DECEMBER 31, 2002 DECEMBER 31, 2001
----------------- -----------------
ASSETS
Real estate securities, available for sale - Note 4 $ 1,069,892 $ 522,258
CBO III deposit - Note 4 37,777 -
Operating real estate, net - Note 5 113,652 524,834
Real estate held for sale - Note 5 3,471 -
Marketable securities, available for sale -Note 4 11,209 14,467
Loans and mortgage pools receivable, net - Note 6 258,198 10,675
Investments in unconsolidated subsidiaries - Note 3 - 73,208
Cash and cash equivalents 45,463 31,360
Restricted cash 10,380 34,508
Due from affiliates - Note 10 - 11,334
Deferred costs, net 6,489 17,988
Receivables and other assets 16,036 21,487
----------- -----------
TOTAL ASSETS $ 1,572,567 $ 1,262,119
=========== ===========
LIABILITIES, MINORITY INTEREST, REDEEMABLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY
LIABILITIES
CBO bonds payable - Note 8 $ 868,497 $ 445,514
Other bonds payable - Note 8 37,389 319,303
Notes payable - Note 8 62,952 111,116
Repurchase agreements - Note 8 248,169 1,457
Credit facility - Note 8 - 20,000
Derivative liabilities - Note 7 54,095 11,732
Dividends payable 9,161 8,882
Due to affiliates - Note 10 1,335 -
Accrued expenses and other liabilities 6,728 10,633
----------- -----------
TOTAL LIABILITIES 1,288,326 928,637
----------- -----------
Commitments and contingencies - Notes 9,10 and 11 - -
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, 23,488,517
and 16,488,517 shares issued and outstanding at
December 31, 2002 and 2001, respectively 235 165
Additional paid-in capital 290,935 309,356
Dividends in excess of earnings (13,966) (7,767)
Accumulated other comprehensive income - Note 2 7,037 8,791
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 284,241 310,545
----------- -----------
TOTAL LIABILITIES, MINORITY INTEREST, REDEEMABLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY $ 1,572,567 $ 1,262,119
=========== ===========
See notes to consolidated financial statements.
46
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands, except share data)
YEAR ENDED YEAR ENDED YEAR ENDED
12/31/02 12/31/01 12/31/00
-------- -------- --------
REVENUES:
Interest and dividend income $ 73,082 $ 48,913 $ 50,985
Rental and escalation income 19,874 20,053 20,433
Gain on settlement of investments 11,417 8,438 20,836
Management fee from affiliate - Note 3 4,470 8,941 8,941
Incentive income from affiliate - Note 3 (1,218) 28,709 -
Other income 18 68 728
------------ ------------ ------------
107,643 115,122 101,923
------------ ------------ ------------
EXPENSES:
Interest expense 49,527 35,863 36,897
Property operating expense 8,631 8,695 8,957
Loan servicing expense 655 254 265
General and administrative expense 2,914 1,568 3,272
Management fees to affiliate - Notes 3 and 10 9,250 14,687 15,587
Preferred incentive return to affiliate - Notes 3 and 10 2,856 17,188 -
Depreciation and amortization 3,199 3,574 2,926
------------ ------------ ------------
77,032 81,829 67,904
------------ ------------ ------------
Income before equity in earnings of
unconsolidated subsidiaries 30,611 33,293 34,019
Equity in earnings of unconsolidated subsidiaries - Note 3 362 2,807 (980)
------------ ------------ ------------
Income from continuing operations 30,973 36,100 33,039
Income (loss) from discontinued operations - Note 5 522 7,571 9,821
------------ ------------ ------------
NET INCOME 31,495 43,671 42,860
Preferred dividends and related accretion (1,162) (2,540) (2,084)
------------ ------------ ------------
INCOME AVAILABLE FOR COMMON STOCKHOLDERS $ 30,333 $ 41,131 $ 40,776
============ ============ ============
NET INCOME PER SHARE OF COMMON STOCK, BASIC AND DILUTED $ 1.68 $ 2.49 $ 2.16
============ ============ ============
Income from continuing operations per share of common
stock, after preferred dividends and related
accretion, basic and diluted $ 1.65 $ 2.03 $ 1.64
============ ============ ============
Income (loss) from discontinued operations per share of common
stock, basic and diluted $ 0.03 $ 0.46 $ 0.52
============ ============ ============
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON STOCK
OUTSTANDING, BASIC 18,080,298 16,492,708 18,892,232
============ ============ ============
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON STOCK
OUTSTANDING, DILUTED 18,090,052 16,492,708 18,892,232
============ ============ ============
DIVIDENDS DECLARED PER SHARE OF COMMON STOCK $ 2.05 $ 2.00 $ 1.50
============ ============ ============
See notes to consolidated financial statements.
47
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(dollars in thousands)
REEDEEMABLE PREFERRED ACCUM.
STOCK COMMON STOCK ADDITIONAL DIVIDENDS OTHER TOTAL STOCK-
--------------------- ------------------ PD. IN IN EXCESS COMP. HOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL OF EARNINGS INCOME EQUITY
------ ------ ------ ------ ------- ----------- ------ ------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 1,020,517 $ 20,410 16,488,517 $165 $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 - - - - - (7,584) - (7,584)
Redemption of redeemable preferred stock (1,020,517) (20,410) - - - - - -
Initial public offering of shares of
common stock - - 7,000,000 70 79,957 - - 80,027
Dividends declared subsequent to our
initial public offering - - - - - (9,161) - (9,161)
Comprehensive income:
Net income - - - - - 31,495 - 31,495
Unrealized gain on securities - - - - - - 62,170 62,170
Realized (gain) on securities:
reclassification adjustment - - - - - - (4,364) (4,364)
Foreign currency translation - - - - - - 4,387 4,387
Foreign currency translation:
reclassification adjustment - - - - - - (496) (496)
Unrealized (loss) on derivatives
designated as cash flow hedges - - - - - - (52,102) (52,102)
Realized (gain) on derivatives
designated as cash flow hedges:
reclassification adjustment - - - - - - (274) (274)
---------
Total comprehensive income 40,816
---------- -------- ---------- ---- -------- -------- -------- ---------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2002 - $ - 23,488,517 $235 $290,935 $(13,966) $ 7,037 $ 284,241
========== ======== ========== ==== ======== ======== ======== =========
STOCKHOLDERS' EQUITY - DECEMBER 31, 2000 1,020,517 $ 20,167 16,499,765 $165 $309,551 $ (7,666) $ (1,395) $ 300,655
Dividends declared - - - - - (43,529) - (43,529)
Redemption of common stock - - (11,248) - (195) - - (195)
Accretion of redeemable preferred stock - 243 - - - (243) - (243)
Transition adjustment - deferred hedge
gains and losses - - - - - - 4,064 4,064
Comprehensive income:
Net income - - - - - 43,671 - 43,671
Unrealized gain on securities - - - - - - 19,695 19,695
Unrealized loss on securities:
reclassification adjustment - - - - - - 954 954
Foreign currency translation - - - - - - (3,198) (3,198)
Foreign currency translation:
reclassification adjustment - - - - - - 29 29
Unrealized (loss) on derivatives
designated as cash flow hedges - - - - - - (11,563) (11,563)
Unrealized loss derivatives designated
as cash flow hedges: reclassification
adjustment - - - - - - 205 205
---------
Total comprehensive income 49,793
---------- -------- ---------- ---- -------- -------- -------- ---------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 1,020,517 $ 20,410 16,488,517 $165 $309,356 $ (7,767) $ 8,791 $ 310,545
========== ======== ========== ==== ======== ======== ======== =========
Continued on next page.
48
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(dollars in thousands)
REEDEEMABLE PREFERRED ACCUM.
STOCK COMMON STOCK ADDITIONAL DIVIDENDS OTHER TOTAL STOCK-
--------------------- ----------------- PD. IN IN EXCESS COMP. HOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL OF EARNINGS INCOME EQUITY
------ ------ ------- ------ ------- ----------- ------ ---------
STOCKHOLDERS' EQUITY - DECEMBER 31, 1999 - $ - 20,916,739 $209 $388,045 $(31,236) $ (2,345) $354,673
Dividends declared - - - - - (18,436) - (18,436)
Redemption of common stock - - (2,210,540) (22) (32,204) - - (32,226)
Exchange of redeemable preferred stock
for common stock 2,370,516 46,312 (2,206,434) (22) (46,290) - - (46,312)
Redemption of redeemable preferred stock (1,349,999) (26,999) - - - - - -
Accretion of redeemable preferred stock - 854 - - - (854) - (854)
Comprehensive income:
Net income - - - - - 42,860 - 42,860
Unrealized gain on securities - - - - - - 2,828 2,828
Unrealized loss on securities:
reclassification adjustment - - - - - - 509 509
Foreign currency translation - - - - - - (2,644) (2,644)
Foreign currency translation:
reclassificantion adjustment - - - - - - 257 257
---------
Total comprehensive income 43,810
---------- -------- ---------- ---- -------- -------- -------- ---------
Stockholders' equity - December 31, 2000 1,020,517 $ 20,167 16,499,765 $165 $309,551 $ (7,666) $ (1,395) $300,655
========== ======== ========== ==== ======== ======== ======== =========
See notes to consolidated financial statements.
49
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2002 2001 2000
----------- ---------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 31,495 $ 43,671 $ 42,860
Adjustments to reconcile net income to net cash provided by
operating activities
(inclusive of amounts related to discontinued operations):
Depreciation and amortization 8,603 13,996 13,183
Accretion of discount and other amortization (4,767) (3,284) (2,739)
Equity in earnings of unconsolidated subsidiaries (362) (2,807) 980
Accrued incentive income from affiliate 1,218 (11,715) -
Minority interest 14 (83) 748
Deferred rent (1,353) (1,964) (2,544)
Gain on settlement of investments (9,619) (10,386) (21,763)
Change in:
Restricted cash (3,186) 1,308 537
Receivables and other assets (4,449) 2,687 (627)
Accrued expenses and other liabilities 5,469 (555) (5,582)
Due from affiliates (1,506) 3,580 (230)
--------- -------- ---------
Net cash provided by operating activities: 21,557 34,448 24,823
--------- -------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase and improvement of operating real estate (2,250) (4,495) (1,520)
Proceeds from sale of operating real estate 42,492 - -
Acquisitions of and advances on loans (259,697) - (33,770)
Repayments of loan and security principal 15,217 75,324 62,891
Proceeds from settlement of loans and foreclosed real estate 372 29,069 22,239
Contributions to unconsolidated subsidiaries (19,991) (25,829) (57,042)
Distributions from unconsolidated subsidiaries 8,265 25,814 11,170
Purchase of real estate securities (695,354) (73,365) (10,799)
Proceeds from sale of real estate securities 276,704 105,722 10,543
Deposit on real estate securities (37,125) (23,631) -
Payment of deferred transaction costs (508) (5,150) (1,319)
Settlement of foreign exchange future contracts - - (137)
Purchase of marketable securities (10,816) (7,680) (29,935)
Proceeds from sale of marketable securities - 10,274 179,311
--------- -------- ---------
Net cash provided by (used in) investing activities: (682,691) 106,053 151,632
--------- -------- ---------
Continued on next page.
50
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2002 2001 2000
----------- ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under repurchase agreements 246,712 10,000 -
Repayments of repurchase agreements - (24,837) (104,314)
Borrowings under notes payable 62,952 - -
Repayments of notes payable (119,670) (4,157) (541)
Issuance of CBO bonds payable 438,787 18,418 -
Repayments of CBO bonds payable (17,742) - -
Issuance of other bonds payable 37,001 - -
Repayments of other bonds payable (8,151) (64,175) (17,899)
Draws under credit facility 20,000 21,000 74,000
Repayments of credit facility (1,750) (34,000) (41,000)
Minority interest distributions - (5,090) (1,485)
Proceeds from initial public offering 91,000 - -
Costs related to initial public offering (10,185) - -
Redemption of common stock - (195) (32,226)
Redemption of redeemable preferred stock (20,410) - (27,000)
Dividends paid (27,522) (34,796) (28,893)
Distribution of cash to predecessor (12,423) - -
Payment of deferred financing costs (3,362) (1,884) (867)
--------- -------- --------
Net cash provided by (used in) financing activities 675,237 (119,716) (180,225)
--------- -------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 14,103 20,785 (3,770)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 31,360 10,575 14,345
--------- -------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 45,463 $ 31,360 $ 10,575
========= ======== =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for interest expense $ 56,365 $ 61,640 $ 66,141
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:
Common stock dividends declared but not paid $ 9,161 $ 8,244 $ -
Redeemable preferred stock dividends declared but not paid $ - $ 638 $ 149
Issuance of redeemable preferred stock in exchange for
common stock $ - $ - $ (46,312)
Repurchase agreements assumed $ - $ - $ 94,776
Transfer of interest in unconsolidated subsidiary $ - $ - $ 5,169
Loan foreclosures $ - $ - $ (5,169)
Contribution of assets to unconsolidated subsidiary $ (1,454) $ - $ -
Deposit used in acquisiton of CBO collateral $ 23,631 $ - $ -
Distribution of non-cash assets and liabilities to
predecessor $ (97,030) $ - $ -
*
See notes to consolidated financial statements.
51
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
1. ORGANIZATION
Newcastle Investment Corp. and subsidiaries ("Newcastle") is a Maryland
corporation that 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. Newcastle conducts its
business through three primary segments: (i) real estate securities, (ii)
revenue producing real estate, primarily credit leased real estate, and (iii)
real estate loans.
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. At December 31, 2002
Newcastle Holdings held approximately 70% of Newcastle's outstanding shares
of common stock.
In October 2002, Newcastle sold 7 million shares of its common stock in a
public offering (the "IPO") 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, including a deposit on a portfolio of real estate
securities. Subsequent to this offering, Newcastle has 23,488,517 shares of
common stock outstanding.
Newcastle is organized and conducts its operations to qualify as a real
estate investment trust ("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 stockholders if it distributes at least
90% of its REIT taxable income to its stockholders by prescribed dates and
complies with various other requirements.
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. For a
further discussion of the Management Agreement, see Note 10.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
BASIS OF ACCOUNTING - The accompanying consolidated financial statements are
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP") and include the accounts of Newcastle and its
consolidated subsidiaries. All significant intercompany transactions and
balances have been eliminated. Newcastle consolidates those entities in which
it has an investment of 50% or more and has control over significant
operating, financial and investing decisions of the entity.
In January 2003, the Financial Accounting Standards Board issued
Interpretation No. 46 "Consolidation of Variable Interest Entities" which
explains how to identify variable interest entities and how to assess whether
to consolidate such entities. This interpretation becomes effective in June
2003. Newcastle has not yet determined whether any of its consolidated or
unconsolidated subsidiaries represent variable interest entities pursuant to
such interpretation. Such a determination could result in a change in
Newcastle's consolidation policy related to such subsidiaries and the impact
of such a change could be material to Newcastle's financial condition and
results of operations on a gross basis; no material effect on net assets or
net income would be expected.
The consolidated financial statements include the accounts of Newcastle and
its consolidated subsidiaries, subsequent to the date of commencement of its
operations, and also include the accounts of its predecessor, Newcastle
Holdings, prior to such date.
52
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
Newcastle Holdings is a Maryland corporation that invested in real
estate-related assets on a global basis. Its primary businesses were (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.
Newcastle Holdings' investments in real estate securities and a portion of
its investments in revenue-producing real estate were transferred to
Newcastle; its other investments are treated as having been distributed to
Newcastle Holdings from Newcastle in July 2002 pursuant to the reverse
spin-off presentation. The real estate (GSA Portfolio-see Note 5) 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 Statement of Financial Accounting Standards
("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets."
For entities over which Newcastle Holdings exercised significant influence,
but which did not meet the requirements for consolidation, Newcastle Holdings
used the equity method of accounting whereby it recorded its share of the
underlying income of such entities. Minority interest represented the
ownership in certain consolidated subsidiaries held by entities other than
Newcastle Holdings. Newcastle does not have any subsidiaries that qualify for
the equity method of accounting, nor does it have any minority interest
ownership.
RISKS AND UNCERTAINTIES -- In the normal course of business, Newcastle
encounters primarily two significant types of economic risk: credit and
market. Credit risk is the risk of default on Newcastle's securities, loans,
leases, and derivatives that results from a borrower's, lessee's or
derivative counterparty's inability or unwillingness to make contractually
required payments. Market risk reflects changes in the value of investments
in securities, loans and real estate or in derivatives due to changes in
interest rates, spreads or other market factors, including the value of the
collateral underlying loans and securities and the valuation of real estate
held by Newcastle. Concentrations of risks include the leasing of a
substantial portion of Newcastle's operating real estate to two tenants as
described in Note 5. Management believes that the carrying values of its
investments are reasonable taking into consideration these risks along with
estimated collateral values, payment histories, and other borrower
information.
Newcastle invests in real estate located outside of the United States.
Newcastle's international operations are subject to the same risks associated
with its United States operations as well as additional risks, such as
fluctuations in foreign currency exchange rates, unexpected changes in
regulatory requirements, heightened risk of political and economic
instability, potential adverse tax consequences and the burden of complying
with a wide variety of foreign laws.
Additionally, Newcastle is subject to significant tax risks. If Newcastle
were to fail to qualify as a REIT in any taxable year, Newcastle would be
subject to federal income tax on its taxable income at regular corporate
rates, which could be material. In addition, if Newcastle Holdings fails to
qualify as a REIT and Newcastle is treated as a successor to Newcastle
Holdings, this could cause Newcastle to likewise fail to qualify as a REIT.
Unless entitled to relief under certain provisions of the Internal Revenue
Code (the "Code"), Newcastle could also be disqualified from taxation as a
REIT for the four taxable years following any year during which it may have
failed to qualify as a REIT.
USE OF ESTIMATES -- The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, the disclosure of contingent
assets and liabilities at the date of the financial statements and the
reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates.
FEDERAL INCOME TAXES -- Newcastle expects to qualify as a REIT under the
Code. A REIT will generally not be subject to federal income taxation on that
portion of its income that is distributed to stockholders if it distributes
at least 90% of its REIT taxable income by prescribed dates and complies with
certain
53
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
other requirements. Since Newcastle distributed 100% of its 2002 taxable
income, no provision has been made for federal income taxes in the
accompanying consolidated financial statements.
Distributions relating to 2002 amounted to $0.85 per share of common stock.
Of this amount, approximately $0.577 was taxable in 2002 and $0.273 relates
to 2003 for tax purposes. Distributions relating to 2002 were taxable as
follows:
Dividends Ordinary Capital Return of
Per Share Income Gains Capital
2002 $ 0.577 100% -% -%
The distributions disclosed above do not include the distributions made by
our predecessor, Newcastle Holdings. Newcastle Holdings made per share
distributions of $1.50 in 2000, $2.00 in 2001, and $1.20 in 2002 prior to the
commencement of our operations. Newcastle Holdings also elected to be taxed
as a REIT.
EARNINGS PER SHARE -- Newcastle is required to present both basic and diluted
earnings per share ("EPS"). Basic EPS is calculated by dividing net income
available for common stockholders by the weighted average number of shares of
common stock outstanding during each period. Diluted EPS is calculated by
dividing net income available for common stockholders by the weighted average
number of shares of common stock outstanding plus the additional dilutive
effect of common stock equivalents during each period. Newcastle's common
stock equivalents are its stock options (Note 9). Based upon the treasury
stock method, Newcastle did not have any dilutive common stock equivalents
during 2001 or 2000. During 2002, based on the treasury stock method,
Newcastle had 9,754 dilutive common stock equivalents resulting from its
outstanding options. Net income available for common stockholders is equal to
net income less preferred dividends and accretion of the discount on the
Series A Preferred, which was fully redeemed in June 2002.
COMPREHENSIVE INCOME - Comprehensive income is defined as the change in
equity of a business enterprise during a period from transactions and other
events and circumstances, excluding those resulting from investments by and
distributions to owners. For Newcastle's purposes, comprehensive income
represents net income, as presented in the statements of operations, adjusted
for net foreign currency translation adjustments and unrealized gains or
losses on marketable securities held for sale and derivatives designated as
cash flow hedges. Accumulated other comprehensive income at December 31, 2002
and 2001 represented $1.8 million and $5.6 million of net foreign currency
translation loss adjustments, respectively, $69.8 million and $21.7 million
of net unrealized gains on marketable securities, respectively, and $61.0
million and $7.3 million of net unrealized losses on derivatives designated
as cash flow hedges, respectively.
REVENUE RECOGNITION
MORTGAGE LOANS RECEIVABLE AND REAL ESTATE SECURITIES -- Newcastle invests in
mortgage loans and securities secured by loans or loan portfolios.
Furthermore, Newcastle Holdings invested in sub- and non-performing loans and
loan portfolios. Mortgage loans receivable are presented in the consolidated
balance sheet net of any unamortized discount (or gross of any unamortized
premium) and an allowance for loan losses. Discounts or premiums are accreted
into interest income on an effective yield or "interest" method, based upon a
comparison of actual collections and expected collections, through the
expected maturity date of the loan or security. Income is not accrued on
non-performing loans; cash received on such loans is treated as income to the
extent of interest previously accrued. Interest income with respect to
non-discounted loans is recognized on an accrual basis. Deferred fees and
costs are recognized as interest income over the terms of the loans using the
interest method. Upon settlement of loans and securities, the excess (or
deficiency) of net proceeds over the net carrying value of the loan or
security is recognized as a gain (or loss) in the period of settlement.
ALLOWANCE FOR MORTGAGE LOAN LOSSES -- Newcastle periodically evaluates loans
for impairment. Mortgage loans are considered to be impaired, for financial
reporting purposes, when it is probable that Newcastle will be unable to
collect all principal or interest when due according to the contractual terms
of the original loan agreements, or, for loans purchased at a discount for
credit losses, when Newcastle determines that it is probable that it would be
54
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
unable to collect as anticipated. Upon determination of impairment, Newcastle
establishes specific valuation allowances, through provisions for losses,
based on the estimated fair value of the underlying real estate collateral
using a discounted cash flow analysis. The allowance for each loan is
maintained at a level believed adequate by management to absorb probable
losses. It is Newcastle's policy to establish an allowance for uncollectible
interest on performing loans that are past due more than 90 days or sooner
when, in the judgment of management, the probability of collection of
interest is deemed to be insufficient to warrant further accrual. Upon such a
determination, those loans are placed on non-accrual status and deemed to be
non-performing. Actual losses may differ from Newcastle's estimates.
RENTAL AND ESCALATION INCOME -- Contractual minimum rental income is
recognized on a straight-line basis over the terms of the related operating
leases. The excess of straight-line rents above contractual amounts was $1.4
million, $2.0 million and $2.5 million during 2002, 2001 and 2000,
respectively. Expense recoveries are included in rental and escalation
income.
MANAGEMENT FEE AND INCENTIVE INCOME FROM AFFILIATE -- These income items
relate to Newcastle Holdings' investment in Fund I which was not transferred
to Newcastle and is not part of our ongoing operations. For a further
discussion of this income, see Note 3.
EXPENSE RECOGNITION
INTEREST EXPENSE -- Newcastle finances its investments using both fixed-and
floating-rate financing structures, including repurchase agreements,
mortgages, securitizations, and other financing vehicles. Certain of this
debt has been issued at discounts. Discounts are accreted into interest
expense on the interest method through the expected maturity date of the
financing.
DEFERRED COSTS -- Deferred costs consist primarily of costs incurred in
obtaining financing (amortized over the term of such financing using the
interest method). During 2002, 2001 and 2000, approximately $1.4 million,
$1.9 million and $2.5 million of financing costs were amortized into interest
expense, respectively.
DERIVATIVES AND HEDGING ACTIVITIES -- In January 2001, Newcastle adopted SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities" as
amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and
Certain Hedging Activities." SFAS No. 133, as amended, establishes accounting
and reporting standards for derivative instruments. Specifically, SFAS No.
133 requires an entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and to measure those
instruments at fair value. Additionally, the fair value adjustments will
affect either stockholders' equity or net income depending on whether the
derivative instrument qualifies as a hedge for accounting purposes and, if
so, the nature of the hedging activity.
For those derivative instruments that are designated and qualify as hedging
instruments, a company must designate the hedging instrument, based upon the
exposure being hedged, as either a cash flow hedge, a fair value hedge or a
hedge of a net investment in a foreign operation.
Derivative transactions are entered into by Newcastle solely for
risk-management purposes, except for the CBO III deposit as described in Note
4. The decision of whether or not a given transaction/position (or portion
thereof) is hedged is made on a case-by-case basis, based on the risks
involved and other factors as determined by senior management, including
restrictions imposed by the Internal Revenue Code among others. In
determining whether to hedge a risk, Newcastle may consider whether other
assets, liabilities, firm commitments and anticipated transactions already
offset or reduce the risk. All transactions undertaken as hedges are entered
into with a view towards minimizing the potential for economic losses that
could be incurred by Newcastle. Generally, all derivatives entered into are
intended to qualify as hedges under GAAP, unless specifically stated
otherwise. To this end, terms of hedges are matched closely to the terms of
hedged items.
55
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
Description of the risks being hedged:
1) Interest rate risk, existing positions - Newcastle generally hedges
the aggregate risk of interest rate fluctuations with respect to
its borrowings, regardless of the form of such borrowings, which
require payments based on a variable interest rate index. Newcastle
generally intends to hedge only the risk related to changes in the
benchmark interest rate (LIBOR or a Treasury rate).
In order to reduce such risks, Newcastle may enter into swap
agreements whereby Newcastle would receive floating rate payments
in exchange for fixed rate payments, effectively converting the
borrowing to fixed rate. Newcastle may also enter into cap
agreements whereby, in exchange for a fee, Newcastle would be
reimbursed for interest paid in excess of a certain cap rate.
2) Interest rate risk, anticipated transactions - Newcastle may hedge
the aggregate risk of interest rate fluctuations with respect to
anticipated transactions, primarily anticipated borrowings. The
primary risk involved in an anticipated borrowing is that interest
rates may increase between the date the transaction becomes
probable and the date of consummation. Newcastle generally intends
to hedge only the risk related to changes in the benchmark interest
rate (LIBOR or a Treasury rate).
In order to "lock in" the rate on the date of forecast, Newcastle
may enter into swap agreements whereby Newcastle would receive
fixed rate payments in exchange for floating rate payments. The
value of such a swap should vary inversely with the expected
proceeds of a given fixed rate borrowing in the future, assuming
the terms of the swap and borrowing are properly matched. At the
date the borrowing occurs, the swap is unwound at a gain or loss
which should equal the change in expected proceeds between the date
of forecast and the date of consummation which result from changes
in market interest rates, effectively hedging such changes. At
December 31, 2002, no such derivative transactions were
outstanding.
3) Foreign currency rate risk, net investments - Newcastle may hedge
the aggregate risk of fluctuations in the exchange rate between a
foreign currency, in which Newcastle has made a net investment, and
the U.S. dollar.
In order to reduce the risk, Newcastle may maintain a short
position in the applicable foreign currency. The amount of the
position would be equal to the anticipated net equity in the
foreign investment at a forward date, as denominated in the foreign
currency. This effectively locks in the current exchange rate on
Newcastle's net equity position for the period of such position. At
December 31, 2002, no such derivative transactions were
outstanding.
Newcastle, including its predecessor Newcastle Holdings, has employed
interest rate swaps primarily in four ways: (i) to hedge fluctuations in the
fair value of the fixed lease payments underlying its revenue-producing real
estate in Canada, (ii) to hedge the anticipated GSA Securitization (Note 8),
which occurred in May 1999, (iii) to hedge the anticipated securitization
known as the CBO I transaction (Note 8), which occurred in July 1999, and
(iv) to hedge its exposure to changes in market interest rates with respect
to its floating rate debt. Approximately, $437.5 million and $195.0 million
in principal amount of Newcastle's floating rate debt were designated as the
hedged items to interest rate swap and cap agreements at December 31, 2002,
respectively.
To qualify for cash flow hedge accounting, interest rate swaps and caps must
meet certain criteria, including (1) the items to be hedged expose Newcastle
to interest rate risk, (2) the interest rate swaps or caps are highly
effective in reducing Newcastle's exposure to interest rate risk, and (3)
with respect to an anticipated transaction, such transaction is probable.
Correlation and effectiveness are periodically assessed based upon a
comparison of the relative changes in the fair values or cash flows of the
interest rate swaps and caps and the items being hedged.
For derivative instruments that are designated and qualify as a cash flow
hedge (i.e. hedging the exposure to variability in expected future cash flows
that is attributable to a particular risk), the effective portion of the gain
or loss, and net payments received or made, on the derivative instrument is
reported as a component of other
56
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
comprehensive income and reclassified into earnings in the same period or
periods during which the hedged transaction affects earnings. The remaining
gain or loss on the derivative instrument in excess of the cumulative change
in the present value of future cash flows of the hedged item, if any, is
recognized in current earnings during the period of change. No material
ineffectiveness was recorded during the years ended December 31, 2002 and
2001. Prior to the adoption of SFAS No. 133, these hedges were measured at
historical cost which was amortized into interest expense on the interest
method. Periodic net payments received or made on such hedges were also
included in interest expense at such time.
With respect to interest rate swaps which were designated as hedges of the
fair value of lease payments, periodic net payments and any gain or loss from
fluctuations in the fair value of the interest rate swaps were capitalized as
adjustments to deferred rent and are being recognized over the term of the
leases as adjustments to rental income. Pursuant to SFAS No. 133, such net
amounts were reclassified to accumulated other comprehensive income at
January 1, 2001. Newcastle's hedge of such payments was terminated in 1999.
As of December 31, 2002 and 2001, $1.5 million and $1.6 million of such
losses were deferred, net of amortization, respectively.
With respect to interest rate swaps which have been designated as hedges of
anticipated refinancings, periodic net payments were recognized currently as
adjustments to interest expense; any gain or loss from fluctuations in the
fair value of the interest rate swaps was recorded as a deferred hedging gain
or loss and treated as a component of the anticipated transaction at the time
of such transaction. Pursuant to SFAS No. 133, such net amounts were
reclassified to accumulated other comprehensive income at January 1, 2001. In
the event the anticipated refinancing failed to occur as expected, the
deferred hedging credit or charge was recognized currently in income.
Newcastle's hedges of such refinancings were terminated upon the consummation
of such refinancings. As of December 31, 2002 and 2001, $1.4 million and $9.1
million of such gains were deferred, net of amortization, respectively.
SFAS No. 133 has resulted in a change in Newcastle's method of accounting for
interest rate caps and swaps used as hedges. As a result of this change,
Newcastle recorded a transition gain adjustment to other comprehensive income
of approximately $4.1 million on January 1, 2001. During the years ended
December 31, 2002 and 2001, Newcastle recorded an aggregate $52.4 million and
$11.4 million of loss to other comprehensive income and an aggregate of $4.6
million and $4.7 million of gain to earnings, as an adjustment to interest
expense, resepctively, related to such hedges. Newcastle expects to
reclassify approximately $3.9 million of net loss on derivative instruments
from accumulated other comprehensive income to earnings during the next
twelve months due to differences in the present value of net interest
payments associated with interest rate swaps and to changes in fair value
associated with interest rate caps.
With respect to interest rate swaps and caps that have not been designated as
hedges, any net payments under, or fluctuations in the fair value of, such
swaps and caps has been recognized currently in income.
Newcastle's derivative financial instruments contain credit risk to the
extent that its bank counterparties may be unable to meet the terms of the
agreements. Newcastle minimizes such risk by limiting its counterparties to
major financial institutions with good credit ratings. In addition, the
potential risk of loss with any one party resulting from this type of credit
risk is monitored. Management does not expect any material losses as a result
of default by other parties. Newcastle does not require collateral.
MANAGEMENT FEES AND PREFERRED INCENTIVE RETURN TO AFFILIATE -- These
represent amounts due to the Manager pursuant to the Management Agreement as
well as amounts due to the Manager related to Newcastle Holdings' investment
in Fund I, which were passed through Newcastle Holdings' income statement on
a gross basis through the date of the commencement of our operations. For
further information on the Management Agreement, see Note 10. For further
information the Fund I related expenses, see Note 3.
BALANCE SHEET MEASUREMENT
INVESTMENT IN MARKETABLE SECURITIES - Newcastle has classified its investment
in marketable securities, including the real estate securities which serve as
collateral for its CBO transactions, as available for sale. Securities
57
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
available for sale are carried at market value with the net unrealized gains
or losses reported as a separate component of accumulated other comprehensive
income. At disposition, the net realized gain or loss is determined on the
basis of the cost of the specific investments and is included in earnings.
Unrealized losses on securities are charged to earnings if they reflect a
decline in value that is other than temporary.
INVESTMENT IN REAL ESTATE -- Investment in real estate is recorded at cost
less accumulated depreciation. Depreciation is computed on a straight-line
basis. Buildings are depreciated over 40 years. Major improvements are
capitalized and depreciated over their estimated useful lives. Fees and costs
incurred in the successful negotiation of leases are deferred and amortized
on a straight-line basis over the terms of the respective leases.
Expenditures for repairs and maintenance are expensed as incurred. Foreclosed
real estate, held for sale, is recorded in Receivables and Other Assets at
the lower of its cost or fair value less cost to sell and is not depreciated.
Newcastle adopted SFAS No. 144 "Accounting for the Impairment or Disposal of
Long-Lived Assets" in 2002. Pursuant to such pronouncement, Newcastle reviews
its real estate assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. No material impairment was recorded during 2002, 2001 or 2000.
SFAS No. 144 also specifies that long-lived assets to be disposed of by sale,
which meet certain criteria, should be reclassified to Real Estate Held for
Sale and measured at the lower of its carrying amount or fair value. The
results of operations for such an asset, assuming such asset qualifies as a
"component of an entity" as defined in SFAS No. 144, are retroactively
reclassified to Income (Loss) from Discontinued Operations for all periods
presented.
FOREIGN CURRENCY OPERATIONS - Assets and liabilities relating to foreign
operations are translated using exchange rates as of the end of each
reporting period. The results of Newcastle's foreign operations are
translated at the weighted average exchange rate for each reporting period.
Translation adjustments are included as a component of accumulated other
comprehensive income.
Foreign exchange contracts may, from time to time, be used to hedge
Newcastle's net investments in its foreign operations. Gains and losses on
foreign exchange contracts which qualify as hedges of net investments in
foreign operations as well as changes in the market value of these
instruments are included in accumulated other comprehensive income. Upon sale
or liquidation of its investment in a foreign operation, the related amount
in accumulated other comprehensive income is reclassified to transaction gain
or loss in the period of such liquidation.
Transaction gains and losses that arise from exchange rate fluctuations on
transactions denominated in a currency other than the functional currency,
except those transactions which qualify as a hedge, are included currently in
income.
CASH AND CASH EQUIVALENTS AND RESTRICTED CASH - Newcastle considers all
highly liquid short-term investments with maturities of 90 days or less when
purchased to be cash equivalents. Restricted cash consisted of amounts held
by third parties in margin accounts of $1.6 million and $1.6 million at
December 31, 2002 and 2001, respectively, related to certain derivative hedge
agreements, restricted property operating accounts of $1.6 million and $8.4
million at December 31, 2002 and 2001, respectively, cash held by trustees
related to certain of Newcastle's investments of $7.2 million and $0.9
million at December 31, 2002 and 2001, respectively, and cash held as a
deposit on the real estate securities used as collateral for the CBO II
transaction (Note 4) of $23.6 million at December 31, 2001. Substantially all
amounts on deposit with major financial institutions exceed insured limits.
STOCK OPTIONS -- Newcastle accounts for stock options granted to
non-employees in accordance with SFAS No. 123, "Accounting for Stock-Based
Compensation." The fair value of the options issued as compensation to the
Manager for its efforts in raising capital for Newcastle Holdings was
recorded in 1998 as an increase in stockholders' equity with an offsetting
reduction of capital proceeds received. No options were issued in 2001, 2000
or 1999. The fair value of the options issued as compensation to the Manager
for its efforts in raising capital for Newcastle was recorded in 2002 as an
increase in stockholders' equity with an offsetting reduction of capital
proceeds received.
58
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
3. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through three primary segments: real estate
securities, revenue-producing real estate and real estate loans. Details of
Newcastle's investments in such segments can be found in Notes 4, 5 and 6,
respectively.
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 Canada (Canadian) and LIV
(Belgian) portfolios were retained by Newcastle while the GSA (U.S.)
portfolio was 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.
The unallocated portion consists primarily of interest on short-term
investments, general and administrative expenses, management fees and
preferred incentive return pursuant to the Management Agreement, and interest
on Newcastle Holdings' credit facility.
59
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
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, through the date of the commencement of our
operations, as described in Note 1) (in thousands):
Real Estate Real Estate
Securities Real Estate Loans Fund I Unallocated Total
----------- ----------- ----------- --------- ----------- -----
December 31 2002 and the Year then Ended
Gross revenues $ 83,259 $ 19,384 $ 1,281 $ 3,287 $ 432 $ 107,643
Operating expenses (586) (9,245) (141) (3,861) (10,473) (24,306)
---------- -------- -------- -------- --------- ----------
Operating income (loss) 82,673 10,139 1,140 (574) (10,041) 83,337
Interest expense (40,805) (5,728) (658) - (2,336) (49,527)
Depreciation and amortization - (2,769) - (329) (101) (3,199)
Equity in earnings of unconsolidated subsidiaries - - - 303 59 362
---------- -------- -------- -------- --------- ----------
Income (loss) from continuing operations 41,868 1,642 482 (600) (12,419) 30,973
Income (loss) from discontinued operations - 1,021 (499) - - 522
---------- -------- -------- -------- --------- ----------
Net Income (Loss) $ 41,868 $ 2,663 $ (17) $ (600) $ (12,419) $ 31,495
========== ======== ======== ======== ========= ==========
Revenue derived from non-US sources:
Canada $ - $ 14,015 $ - $ - $ - $ 14,015
========== ======== ======== ======== ========= ==========
Belgium $ - $ 5,402 $ - $ - $ - $ 5,402
========== ======== ======== ======== ========= ==========
Italy $ - $ - $ 180 $ - $ - $ 180
========== ======== ======== ======== ========= ==========
Total assets $1,138,767 $128,831 $259,381 $ - $ 45,588 $1,572,567
========== ======== ======== ======== ========= ==========
Long-lived assets outside the US:
Canada $ - $ 56,939 $ - $ - $ - $ 56,939
========== ======== ======== ======== ========= ==========
Belgium $ - $ 71,892 $ - $ - $ - $ 71,892
========== ======== ======== ======== ========= ==========
December 31, 2001 and the Year then Ended
Gross revenues $ 54,961 $ 20,249 $ - $ 38,297 $ 1,615 $ 115,122
Operating expenses (253) (9,352) - (23,295) (9,492) (42,392)
---------- -------- -------- -------- --------- ----------
Operating income (loss) 54,708 10,897 - 15,002 (7,877) 72,730
Interest expense (26,880) (5,779) - - (3,204) (35,863)
Depreciation and amortization - (2,567) - (560) (447) (3,574)
Equity in earnings (losses) of unconsolidated
subsidiaries - - - 5,360 (2,553) 2,807
---------- -------- -------- -------- --------- ----------
Income (loss) from continuing operations 27,828 2,551 - 19,802 (14,081) 36,100
Income (loss) from discontinued operations - 5,380 2,191 - - 7,571
---------- -------- -------- -------- --------- ----------
Net Income (Loss) $ 27,828 $ 7,931 $ 2,191 $ 19,802 $ (14,081) $ 43,671
========== ======== ======== ======== ========= ==========
Revenue derived from non-US sources:
Canada $ - $ 16,092 $ (17) $ - $ - 16,075
========== ======== ======== ======== ========= ==========
Belgium $ - $ 7,219 $ - $ - $ - 7,219
========== ======== ======== ======== ========= ==========
Italy $ - $ - $ 764 - $ - 764
========== ======== ======== ======== ========= ==========
Total assets $ 567,492 $565,481 $ 12,920 $ 97,562 $ 18,664 $1,262,119
========== ======== ======== ======== ========= ==========
Long-lived assets outside the US:
Canada $ - $ 51,060 $ - $ - $ - $ 51,060
========== ======== ======== ======== ========= ==========
Belgium $ - $ 68,399 $ - $ - $ - $ 68,399
========== ======== ======== ======== ========= ==========
60
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
Real Estate Real Estate
Securities Real Estate Loans Fund I Unallocated Total
----------- ----------- ----------- --------- ----------- -----
December 31, 2000 and the Year then Ended
Gross revenues $ 46,893 $ 20,640 $ - $ 8,941 $ 25,449 $ 101,923
Operating expenses (361) (9,669) - (8,941) (9,110) (28,081)
---------- -------- -------- -------- --------- ----------
Operating income 46,532 10,971 - - 16,339 73,842
Interest expense (29,671) (5,470) - - (1,756) (36,897)
Depreciation and amortization - (2,411) - - (515) (2,926)
Equity in earnings (losses) of unconsolidated
subsidiaries - - - 1,044 (2,024) (980)
---------- -------- -------- -------- --------- ----------
Income from continuing operations 16,861 3,090 - 1,044 12,044 33,039
Income from discontinued operations - 4,186 5,635 - - 9,821
---------- -------- -------- -------- --------- ----------
Net Income $ 16,861 $ 7,276 $ 5,635 $ 1,044 $ 12,044 $ 42,860
========== ======== ======== ======== ========= ==========
Revenue derived from non-US sources:
Canada $ - $ 16,742 $ (103) $ - $ - $ 16,639
========== ======== ======== ======== ========= ==========
Belgium $ - $ 7,022 $ - $ - $ - $ 7,022
========== ======== ======== ======== ========= ==========
Italy $ - $ - $ 2,171 $ - $ - $ 2,171
========== ======== ======== ======== ========= ==========
Total assets $ 560,929 $576,728 $112,507 $ 50,694 $ 30,228 $1,331,086
========== ======== ======== ======== ========= ==========
Long lived assets outside the U.S.:
Canada $ - $ 55,404 $ - $ - $ - $ 55,404
========== ======== ======== ======== ========= ==========
Belgium $ - $ 72,615 $ - $ - $ - $ 72,615
========== ======== ======== ======== ========= ==========
Unconsolidated Subsidiaries
Newcastle does not have any unconsolidated subsidiaries which it accounts for
under the equity method. Newcastle Holdings held three such investments, none of
which were transferred to Newcastle, which are described below. Such investments
are included in Newcasstle's financial statements through the date of the
commencements of Newcastle's operations.
61
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
The following table summarizes the activity affecting the equity held by
Newcastle in unconsolidated subsidiaries:
Fortress Investment
Austin Holdings Fund LLC Total
--------------- ------------------- --------
Balance 12/31/00 $ 12,733 $ 50,694 $ 63,427
Contributions to unconsolidated subsidiaries 5,413 20,416 25,829
Distributions from unconsolidated subsidiaries (10,616) (15,198) (25,814)
Equity in earnings of unconsolidated subsidiaries (2,553) 5,360 2,807
Equity in OCI of unconsolidated subsidiaries - 7,074 7,074
Transfer of investment in exchange for notes
from Fund I co-investors - (3,555) (3,555)
Costs incurred related to investment in the
venture - 3,440 3,440
--------- --------- --------
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 12/31/02 $ - $ - $ -
========= ========= ========
Summarized financial information related to Newcastle's unconsolidated
subsidiaries through the date of their distribution to Newcastle Holdings was as
follows (in thousands):
Included in Unallocated Segment
---------------------------------------------------------------
Austin Holdings FIC Management Inc. Fortress Investment Fund LLC (A)
------------------------------- ----------------------------- ----------------------------------
12/31/02 12/31/01 12/31/00 2/31/02 12/31/01 12/31/00 12/31/02 12/31/01 12/31/00
-------- -------- -------- ------- -------- -------- -------- --------- ----------
Assets $ 7,947 $ 21,259 $ - $ - $612,083 $ 434,009
Liabilities (2,353) (7,207) - - - -
Minority interest (352) (590) - - - -
-------- --------- -------- -------- --------- ---------
Equity $ 5,242 $ 13,462 $ - $ - $612,083 $ 434,009
======== ========= ======== ======== ========= =========
Equity held by
Newcastle(B) $ 4,977 $ 12,733 $ - $ - $ 68,231 $ 50,694
======== ========= ======== ======== ========= =========
2002 2001 2000 2002 2001 2000 2002 2001 2000
-------- -------- --------- ------- -------- -------- -------- --------- ---------
Revenues $ 585 $ (1,370) $ 2,675 $ - $ - $ 234 $ 9,740 $ 141,475 $ 21,894
Expenses (477) (1,302) (5,001) - - (523) (4,470) (9,941) (8,941)
Minority interest (45) (16) 484 - - - - - -
-------- -------- --------- ------- -------- -------- -------- --------- ---------
Net income (loss) $ 63 $ (2,688) $ (1,842) $ - $ - $ (289) $ 5,270 $ 131,534 $ 12,953
======== ======== ========= ======= ======== ======== ======== ========= =========
Newcastle's
equity in net
income (loss) $ 59 $ (2,553) $ (1,749) $ - $ - $ (275) $ 303 $ 5,360 $ 1,044
======== ======== ========= ======= ======== ======== ======== ========= =========
(A) Fortress Investment Fund LLC's summary financial information is presented on
a fair value basis, consistent with
62
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
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.
FUND I
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%, in each case through Class A membership interests. A separate class
of membership interests in the Fund I Managing Member, designated as
Class B, reflects the entitlement to the incentive return payable by
Fund I, as described below, which is owned 50% by the Manager and 50%
by Newcastle Holdings. Newcastle Holdings and its affiliates, including
the Fund I Managing Member, have committed to contribute an aggregate
of $100 million, or approximately 11.5% of Fund I's total committed
capital, to Fund I; in the aggregate, Newcastle Holdings and 21
unaffiliated investors (collectively, the "Fund I Investors") have
committed approximately $872.8 million (the "Capital Commitment") to
Fund I over the three years ending April 28, 2003. Newcastle Holdings
has committed to fund 100% of the capital commitments of its
affiliates, including the Fund I Managing Member (which has committed
$8.7 million or approximately 1% of Fund I's total committed capital),
to Fund I. Fund I, which is a Delaware limited liability company, is
owned through membership interests issued in direct proportion to
capital committed.
The Fund I Managing Member is entitled to receive an annual management
fee of up to 1.5% (inclusive of an administrative fee of up to 0.5%) of
Fund I's invested capital or total equity commitments. Newcastle
Holdings is not charged management and administrative fees for its
investment in Fund I. Pursuant to an agreement with the Fund I Managing
Member and the Manager, the Manager is entitled to 100% of the
management fee paid by Fund I to the Fund I Managing Member. Since the
management fees paid to the Manager flow through Newcastle Holdings
through its ownership of the Fund I Managing Member, they are reflected
as gross amounts in both Management Fee from Affiliate and Management
Fee to Affiliate, although they have no effect on net income.
The Fund I Managing Member is entitled to an incentive return (the
"Incentive Return") generally equal to 20% of Fund I's returns, as
defined, subject to: 1) a 10% preferred return payable to the Fund I
Investors and 2) a clawback provision which requires amounts previously
distributed as Incentive Return to be returned to Fund I if, upon
liquidation of Fund I, the amounts ultimately distributed to each Fund
I Investor do not meet a 10% preferred return to the Fund I 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, (a) the Manager is entitled to 100% of the management fee
payable by Fund I, (b) the Manager is entitled to 50% of the Incentive
Return payable by Fund I, (c) Newcastle Holdings is entitled to 50% of
the Incentive Return payable by Fund I, and (d) 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.
Newcastle Holdings consolidated the financial results of the Fund I
Managing Member because Newcastle Holdings owned substantially all of
the voting interest in the Fund I Managing Member. As a result,
Newcastle's consolidated financial statements reflect all of the
Incentive Return payable to the Fund I Managing Member, including the
50% portion payable to the Manager which was treated as Preferred
Incentive Return to Affiliates.
In January 2000, Newcastle Holdings transferred, in exchange for cash,
approximately $51.2 million of preferred equity securities, acquired in
December 1999, to Fund I at their market value, which approximated
their book value, resulting in no gain or loss being recorded. During
2002 (through the date of commencement of Newcastle's operations), 2001
and 2000, Newcastle Holdings invested approximately $18.0 million,
$21.5 million and $47.2 million, respectively, in Fund I. During 2002
(through the date of commencement of Newcastle's operations) and 2001,
Newcastle Holdings received $7.8 million and $16.3 million of
distributions from Fund I, respectively, excluding Incentive Return.
Newcastle Holdings accounted for its investment in Fund I under the
equity method. During 2002, 2001 and 2000, the Manager earned $4.5
million, $8.9 million and $9.2 million of management and administrative
fees from Fund I, respectively, through its agreement with the Fund I
Managing Member.
The Incentive Return is payable on an asset-by-asset basis, as
realized. Accordingly, an Incentive Return may be paid to the Fund I
Managing Member in connection with a particular Fund I investment if
and when such invest-
63
ment 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 Incentive Return exceeds the amount actually due to
the Fund I Managing Member (that is, amounts that should instead have
been paid to Fund I Investors) after taking into account the aggregate
return to Fund I Investors, the excess is required to be returned by
the Fund I Managing Member (that is "clawed back") to Fund I. Newcastle
Holdings is responsible to pay to Fund I the amount of any excess
return to be clawed back to the extent not funded by the Fund I
Managing Member. The Manager, in turn, is responsible for the clawback
of any excess return received by it. Newcastle Holdings believes that
the Manager has the ability to meet this obligation. Newcastle Holdings
received a credit against management fees otherwise payable by it under
its management agreement with the Manager for management fees and any
Incentive Return paid to the Manager by Fund I allocable to Newcastle
Holdings' investment in Fund I. This credit was reflected as increased
return to Newcastle Holdings from Fund I, in Equity in Earnings
(Losses) from Unconsolidated Subsidiaries, because: (a) Newcastle
Holdings, unlike the other Fund I Investors, did not pay a management
fee to Fund I and its allocation of income from Fund I was calculated
gross of any management fees, and (b) Newcastle Holdings received
payments from the Manager of amounts paid to the Manager by Fund I
representing the Incentive Return allocable to Newcastle Holdings'
investment in Fund I, of which $0.5 million was received in January
2002.
Newcastle Holdings 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.
Newcastle Holdings 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,
Newcastle Holdings' net income in each reporting period reflected
changes in the fair value of the assets in Fund I. As such, Newcastle
Holdings accrued $27.5 million of Incentive Return through the date of
the commencement of Newcastle's operations. This amount was recorded in
Incentive Income from Affiliate. The Manager was entitled to 50% of
this income which Newcastle Holdings recorded as Incentive Return to
Affiliates. The Fund I Managing Member has received $8.8 million of
such income, all of which is subject to clawback. Newcastle Holdings
received $4.4 million of such income in cash pertaining to the year
ended December 31, 2001, representing its 50% interest in the Incentive
Return paid by Fund I.
AUSTIN
In 1998, Newcastle Holdings and Fortress Principal Investment Group LLC
("FPIG"), an affiliate of the Manager, formed Austin Holdings
Corporation ("Austin"). FPIG contributed cash, and Newcastle Holdings
contributed its interest in entities that owned certain assets,
primarily non-performing loans and foreclosed real estate intended for
sale, which were originally acquired as part of loan pool acquisitions.
The assets Newcastle Holdings contributed, and any income generated
from them, were not well suited to be held by a REIT for the reasons
described below. 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 95% income test that
applies to REITs. Newcastle Holdings held non-voting preferred stock of
Austin. Newcastle Holdings' preferred stock in Austin represented a 95%
economic ownership interest in Austin, and had a liquidation preference
over the common stockholders. Newcastle Holdings' interest in Austin
was accounted for under the equity method. Newcastle Holdings and
Austin elected to treat Austin as a taxable REIT subsidiary ("TRS") as
of January 1, 2001 in order to comply with the rule that REITs
generally may not hold more than 10% of the voting securities or 10% of
the value of securities of any corporation that is not a TRS. FPIG was
the holder of all of the common stock which represents 100% of the vote
and 5% of the economic ownership interest of Austin. FPIG's ownership
interest was funded in part by a $0.7 million loan from Austin in 2001.
Austin also owned 100% of the common stock of Ascend Residential
Holdings, Inc. ("Ascend "). Ascend's primary business was the
acquisition, rehabilitation and sale of single-family residential
properties.
FICMI
In May 1999, Newcastle Holdings purchased from Impac Commercial
Holdings, Inc. ("ICH"), a publicly traded mortgage REIT, approximately
$12 million of non-voting Series B Convertible Preferred Stock with a
coupon of 8.5%. The preferred stock was initially convertible into
1,683,635 shares of common stock of ICH. Subsequently, during 1999 and
2000, Newcastle Holdings purchased 832,400 shares of common stock of
ICH. Additionally, FIC Management Inc. ("FICMI"), an unconsolidated
subsidiary of Newcastle Holdings created for this purpose, purchased
the management contract for ICH for $6 million and subcontracted the
management of ICH to the
64
Manager. FICMI was entitled to an incentive fee under the management
agreement, as defined, if certain minimum returns were achieved. During
the third quarter of 2000, FICMI recognized incentive fee income of
$0.2 million based on ICH's achievement of such returns. During 2000,
ICH reimbursed the Manager for approximately $0.7 million of expenses
pursuant to such contract, and reimbursed Newcastle Holdings for $0.4
million of such expenses. FICMI had substantially the same legal
structure as Austin. Newcastle Holdings and FICMI and Fortress Fund MM,
Inc. ("FFMMI") have made elections to treat FICMI and FFMMI as TRS's as
of January 1, 2001.
In November 2000 a wholly-owned subsidiary of Newcastle Holdings
completed a tender offer for all of the remaining outstanding common
shares of ICH. Newcastle Holdings' basis in its investment in ICH was
approximately $22.1 million at the date of acquisition. In addition,
Newcastle Holdings incurred approximately $44.3 million in connection
with its tender offer and assumed approximately $95.7 million of ICH's
liabilities, resulting in total assets acquired of $162.1 million
(including $12.1 million of cash), based on the "purchase" method of
accounting. Subsequent to the acquisition, Newcastle Holdings sold
$108.9 million of the former ICH assets during 2000 for net proceeds of
approximately $130.2 million at a gain of approximately $21.3 million,
and repaid approximately $92.8 million of the former ICH liabilities.
The remaining, non-cash ICH assets at December 31, 2002 and 2001 were
primarily included in Marketable Securities Available for Sale (Note
2). Newcastle's consolidated financial statements include ICH's results
of operations for the period subsequent to the completion of the tender
offer.
65
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
4. REAL ESTATE SECURITIES
The following is a summary of Newcastle's real estate securities at
December 31, 2002 and 2001, 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 through December 31, 2002. None of the securities
is delinquent.
DECEMBER 31, 2002
Gross Unrealized Weighted Average
-------------------- ----------------------------------
Term to
Principal Amortized Moody's Maturity
CBO I Balance Cost Basis Gains Losses Carrying Value Rating Coupon Yield (Years)
- ----- ----------- ---------- --------- -------- -------------- ------- ------ ----- -------
CMBS $ 323,025 $ 283,991 $ 26,999 $ (3,686) $ 307,304 BB 6.72% 9.50% 7.11
Unsecured REIT debt 234,562 232,892 21,726 (100) 254,518 BBB 7.41% 7.64% 5.48
----------- ---------- --------- -------- ------------ ------- ----- ----- ------
Subtotal - CBO I 557,587 516,883 48,725 (3,786) 561,822 BB+ 7.01% 8.67% 6.43
----------- ---------- --------- -------- ------------ ------- ----- ----- ------
CBO II
CMBS 299,051 285,035 17,055 (238) 301,852 BBB- 6.35% 7.26% 7.17
Unsecured REIT debt 113,357 112,475 8,678 - 121,153 BBB- 7.81% 7.87% 7.85
Other 58,155 56,086 1,172 (1,867) 55,391 AA 7.29% 8.23% 7.89
----------- ---------- --------- -------- ------------ ------- ----- ----- ------
Subtotal - CBO II 470,563 453,596 26,905 (2,105) 478,396 BBB 6.28% 7.53% 7.41
----------- ---------- --------- -------- ------------ ------- ----- ----- ------
Total Real Estate
Securities* $ 1,028,150 $ 970,479 $ 75,630 $ (5,891) $ 1,040,218 BBB- 6.67% 8.14% 6.88
=========== ========== ========= ======== ============ ======= ===== ==== ======
Non-CBO Securities-
Rated 5,000 3,888 137 - 4,025 AAA 7.39% 12.11% 8.49
Non-CBO Securities -
Unrated 18,953 7,184 - - 7,184 N/A 7.40% 18.63% 7.50
----------- ---------- --------- -------- ------------ ----- ----- ------
Total Marketable
Securities $ 23,953 $ 11,072 $ 137 $ - $ 11,209 7.40% 16.34% 7.71
=========== ========== ========= ======== ============ ===== ===== ======
DECEMBER 31, 2001
Gross Unrealized
--------------------
Principal Amortized Cost
CBO I Balance Basis Gains Losses Carrying Value
- ----- -------- -------------- ----- ------ --------------
CMBS $ 316,057 $ 268,209 $ 9,110 $ (5,683) $ 271,636
Unsecured REIT debt 219,515 216,411 9,238 (258) 225,391
--------- ---------- -------- -------- ----------
Subtotal - CBO I* $ 535,572 $ 484,620 $ 18,348 $ (5,941) $ 497,027
========= ========== ======== ======== ==========
Non-CBO securities $ 19,326 $ 14,507 $ - $ (40) $ 14,467
========= ========== ======== ======== ==========
*Carrying value excludes restricted cash of $29.7 million and $25.2
million at December 31, 2002 and 2001, respectively, included in Real
Estate Securities pending its reinvestment in securities. The total
carrying value of
66
fixed rate real estate securities was $961.4 million and $497.0
million, and of variable rate real estate securities was $78.8 million
and $0.0 million, at December 31, 2002 and 2001, respectively.
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, REIT debt, real estate loans and
asset backed securities, 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; a mark of $0.7 million has been booked to
income through December 31, 2002. These securities are expected to be
included in a securitization transaction in which Newcastle would
acquire the equity interest (the "CBO III Transaction"). As of December
31, 2002, approximately $342.4 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 such securities or pay the
difference between the original purchase price of such securities and
the price at which such securities 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 such
securities or pay the lesser of the Collateral Loss and its 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 December 31,
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 and December 2002, Newcastle made deposits
aggregating $37.1 million under such agreement (the "CBO III Deposit").
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 the collateral for the CBO I and CBO II
transactions, were retained by Newcastle. These bonds were sold by
Newcastle at a loss of $0.3 million in September 2002.
The securities denoted "CBO I" and "CBO II" are encumbered by the CBO I
and CBO II securitizations (Note 8), respectively. One of the non-CBO
securities was encumbered by a $1.5 million repurchase agreement at
December 31, 2002.
67
5. OPERATING REAL ESTATE
The following is a reconciliation of real estate assets and accumulated
depreciation:
Accumulated
Operating Real Estate Gross Depreciation Net
- ----------------------------------------- ---------- ------------------ ---------------
Balance at December 31, 2000 $ 566,923 $ (26,384) $ 540,539
Improvements 4,495 - 4,495
Foreign currency translation (7,636) 345 (7,291)
Depreciation - (12,909) (12,909)
---------- ------------ ----------
Balance at December 31, 2001 563,782 (38,948) 524,834
Improvements 2,166 - 2,166
Foreign currency translation 11,998 (737) 11,261
Depreciation - (7,994) (7,994)
Cost of real estate sold (44,548) 2,425 (42,123)
Distribution to Newcastle Holdings (404,715) 35,320 (369,395)
Transferred to Real Estate Held for Sale (5,571) 474 (5,097)
---------- ------------ ----------
Balance at December 31, 2002 $ 123,112 $ (9,460) $ 113,652
========== ============ ==========
U.S. Properties $ - $ - $ -
Canadian Properties 50,186 (4,386) 45,800
Belgian Properties 72,926 (5,074) 67,852
---------- ------------ ----------
Total $ 123,112 $ (9,460) $ 113,652
========== ============ ==========
Real Estate Held for Sale
- -----------------------------------------
Balance at December 31, 2001 $ -
Transferred from Operating Real Estate 5,097
Mark-to-market (1,626)
----------
Balance at December 31, 2002 3,471
==========
U.S. Properties $ -
Canadian Properties 3,471
Belgian Properties -
----------
Total $ 3,471
==========
All of Newcastle's U.S. properties (the "GSA Properties") were
distributed to Newcastle Holdings prior to the commencement of
Newcastle's operations. Such properties were primarily leased to the
General Services Administration of the U.S. Government.
The Canadian properties are primarily leased to Bell Canada, a
wholly-owned subsidiary of BCE, Inc. and are referred to as the "Bell
Canada Portfolio." For 2002, 2001 and 2000, approximately 66.6%, 68.0%
and 69.7% of Newcastle's consolidated rental and escalation income from
continuing operations was attributable to Bell Canada. The Bell Canada
leases expire over various dates through 2007. Each Bell Canada lease
contains one five-year lease renewal option and provides for a
significant payment due upon expiration of the lease. These terminal
payments have been included in the calculation of straight-line rental
income assuming that each lease is renewed once. The Bell Canada leases
also provide for the reimbursement of substantially all operating
expenses and property taxes plus an administrative fee. The Bell Canada
Portfolio is encumbered by the Bell Canada Securitization (Note 8).
The Belgian properties are referred to as the "LIV Portfolio" and are
leased to a variety of tenants, including the European Commission
("EC"). For 2002, 2001 and 2000, approximately 14.2%, 13.0% and 14.9%
of Newcastle's consolidated rental and escalation income from
continuing operations was attributable to the EC. The leases on the
Belgian properties provide for annual increases in base rent based on
the change in the Sante Index, as well as payment of increases in
operating expenses and real estate taxes over base year amounts. The
LIV Portfolio is encumbered by the Belgian Mortgage (Note 8).
68
The following is a schedule of the future minimum rental payments to be
received under non-cancelable operating leases:
2003 $10,476
2004 9,405
2005 8,396
2006 6,602
2007 3,299
Thereafter 92
-------
$38,270
=======
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 Belgian
property for gross proceeds of approximately $8.9 million, at a loss of
approximately $1.1 million. Pursuant to SFAS No. 144, Newcastle has
retroactively recorded the operations of such properties in Income from
Discontinued Operations for all periods presented.
In August and November 2002, Newcastle entered into contracts to sell
two commercial properties located in Canada for gross proceeds of
approximately $2.6 million, at a loss of approximately $1.6 million
including the write off of accumulated other comprehensive income
related to foreign currency translation. The sales are contracted to
occur in April 2003. Pursuant to SFAS No. 144, Newcastle has
reclassified the net carrying value of these properties to Real Estate
Held for Sale and has retroactively recorded the operations of such
properties in Income from Discontinued Operations for all periods
presented.
Gross revenues from discontinued operations, which include those
investments distributed to Newcastle Holdings as discussed in Note 2,
were approximately $29.2 million, $67.9 million and $75.8 million in
2002, 2001 and 2000, respectively.
69
The following table sets forth certain information concerning the real
estate portfolio:
COSTS
CAPITALIZED
TYPE OF INITIAL COST SUBSEQ. TO
PROPERTY LOCATION (A) ACQ'N (A)
- ------------- --------- ------------ -----------
Off. Bldg. Etobicoke, ON $ 8,937 $ 654
Off. Bldg. London, ON 14,630 235
Industrial Toronto, ON 25,521 209
--------- -------
Subtotal - Canada 49,088 1,098
--------- -------
Off. Bldg. G. Bijgaarden, BEL 9,906 212
Off. Bldg. Brussels, BEL 27,288 22
Off. Bldg. Brussels, BEL 4,589 376
Off. Bldg. Waterloo, BEL 7,518 13
Off. Bldg. Zaventem, BEL 6,725 75
Off. Bldg. Brussels, BEL 5,477 97
Warehouse Zaventem, BEL 3,719 5
Off. Bldg. Brussels, BEL 5,079 1,825
--------- -------
Subtotal - Belgium 70,301 2,625
--------- -------
Subtotal - Operating Real Eastate 119,389 3,723
--------- -------
Off. Bldg. Hamilton, ON N/A N/A
Off. Bldg. Kingston, ON N/A N/A
--------- -------
Subtotal - Real Estate Held for Sale - -
--------- -------
TOTALS: $ 119,389 $ 3,723
========= =======
UNAUDITED
12/31/2002 -----------------------------------------------
-------------------------------------------------
GROSS YEAR
TYPE OF CARRYING ACCUM. NET CARRYING NET RENTABLE ACQ. BUILT/REN-
PROPERTY LOCATION AMOUNT DEPR. AMOUNT (B) ENCUMB. OCC. SQ. FT. DATE OVATED
- ---------- -------------- -------- ------ ------------ ------- ------ ------------ ------ ------------
Off. Bldg. Etobicoke, ON $ 9,591 $ 932 $ 8,659 $ 8,793 100% 177,214 10/98 1972/1978
Off. Bldg. London, ON 14,865 1,485 13,380 7,686 96% 325,764 10/98 1980
Industrial Toronto, ON 25,730 1,969 23,761 18,635 100% 624,786 10/98 1963/'71/'79
-------- ------- -------- -------- --- ---------
Subtotal - Canada 50,186 4,386 45,800 35,114 99% 1,127,764
-------- ------- -------- -------- --- ---------
Off. Bldg. G. Bijgaarden, BEL 10,118 696 9,422 9,701 67% 81,763 11/99 1994
Off. Bldg. Brussels, BEL 27,310 1,810 25,500 29,863 100% 119,781 11/99 1973/1995
Off. Bldg. Brussels, BEL 4,965 444 4,521 4,210 100% 26,651 11/99 1952/'93/'98
Off. Bldg. Waterloo, BEL 7,531 505 7,026 6,235 100% 46,231 11/99 1930/1990
Off. Bldg. Zaventem, BEL 6,800 489 6,311 4,874 67% 65,175 11/99 1975/1990
Off. Bldg. Brussels, BEL 5,574 401 5,173 2,992 55% 28,180 11/99 1974/1996
Warehouse Zaventem, BEL 3,724 247 3,477 2,096 100% 55,606 11/99 1986
Off. Bldg. Brussels, BEL 6,904 482 6,422 2,981 29% 32,206 11/99 1987/2001
-------- ------- -------- -------- --- ---------
Subtotal - Belgium 72,926 5,074 67,852 62,952 81% 455,593
-------- ------- -------- -------- --- -------
Subtotal - Operating Real Eastate 123,112 9,460 113,652 98,066 94% 1,583,357
-------- ------- -------- -------- --- ---------
Off. Bldg. Hamilton, ON 2,057 N/A 2,057 1,645 100% 118,787 10/98 1974
Off. Bldg. Kingston, ON 1,414 N/A 1,414 630 100% 45,691 10/98 1981
-------- ------- -------- -------- --- ----------
Subtotal - Real Estate Held for Sale 3,471 - 3,471 2,275 100% 164,478
-------- ------- -------- -------- --- ----------
TOTALS: $126,583 $ 9,460 $117,123 $100,341 94% 1,747,835
======== ======= ======== ======== === =========
(A) Adjusted for changes in foreign currency exchange rates, which
aggregated $12.0 million of gain and $7.6 million of loss between land,
building and improvements in 2002 and 2001, respectively.
(B) The federal income tax basis for such assets at December 31, 2002
was approximately equal to their book basis.
70
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
6. REAL ESTATE LOANS
Loans and mortgage pools receivable consisted of the following at
December 31, 2002 and 2001.
Wtd. Avg. Range of
Effective Stated Delinquent
Interest Maturity Payment Carrying
Rate Dates Terms Amount Encumbrance
Description 12/31/02 12/31/02 12/31/02 Carrying Amount Face Amount 12/31/02 12/31/02
----------- ---------- --------- --------- ---------------------- ------------------- -------- -----------
12/31/02 12/31/01 12/31/02 12/31/01
-------- -------- -------- --------
Whole Loan Portfolio 3.40% 9/27-11/32 Various $ 258,198 $ - $ 254,201 $ - $ - $ 246,712
Loan on Retail Stores N/A N/A N/A - 6,560 - 6,560 - -
Italian Mortgage Portfolio N/A N/A N/A - 4,073 - 17,002 - -
Other N/A N/A N/A - 42 - 1,833 - -
--------- -------- -------- -------- -------- ---------
Total $ 258,198 $ 10,675 $254,201 $ 25,395 $ - $ 246,712
========= ======== ======== ======== ======== =========
The following is a reconciliation of loans and mortgage pools
receivable.
Market
Discount)/ Loss Carrying
Face Amount Premium Allowance Amount
----------- ---------- --------- --------
Balance 12/31/00 $129,621 $(1,095) $(21,569) $ 106,957
Collections of principal (70,801) - - (70,801)
Cost of loans sold (32,986) 1,095 6,741 (25,150)
Foreign currency translation (439) - 108 (331)
-------- ------- -------- ---------
Balance 12/31/01 25,395 - (14,720) 10,675
Purchases/advances 255,550 4,147 - 259,697
Collections of principal (7,909) - - (7,909)
Cost of loans sold - - (267) (267)
Accretion - (150) - (150)
Foreign currency translation 432 - (210) 222
Transfer to unconsolidated subsidiary (17,355) - 13,329 (4,026)
Distribution to Newcastle Holdings (1,912) - 1,868 (44)
-------- ------- -------- ---------
Balance 12/31/02 $254,201 $ 3,997 $ - $ 258,198
======== ======= ======== =========
The average carrying amount of Newcastle Holdings' real estate loans
was approximately $54.5 million and $11.8 million during 2002 and 2001,
respectively, on which Newcastle Holdings earned approximately $1.4
million and $1.6 million of gross revenues, respectively.
All of Newcastle's real estate loans and loan portfolios owned at such
time were transferred to Newcastle Holdings prior to the commencement
of Newcastle's operations.
In November 2002, Newcastle invested $13.5 million of equity in a
portfolio of mortgage loans. This portfolio is encumbered by a
repurchase agreement (Note 8).
71
7. FAIR VALUE OF FINANCIAL INSTRUMENTS
For certain of Newcastle's financial instruments, principally loans
receivable and debt, 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 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. It
should be noted 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 environments as of December 31, 2002 and do not take
into consideration the effects of subsequent interest rate
fluctuations.
The carrying amounts and estimated fair values of Newcastle's financial
instruments at December 31, 2002 are as follows:
Carrying Principal Balance or Estimated Fair
Amount Notional Amount Value
Assets:
Real estate securities, available for sale $1,069,892 $ 1,028,150 $ 1,069,892
CBO III deposit 37,777 See below 37,777
Marketable securities, available for sale 11,209 23,953 11,209
Mortgage loans 258,198 254,201 258,198
Interest rate caps, treated as hedges, net(A) 4,638 213,035 4,638
Liabilities:
CBO bonds payable 868,497 881,500 868,497
Other bonds payable 37,389 38,173 36,784
Notes payable 62,952 62,952 58,970
Repurchase agreements 248,169 248,169 248,169
Interest rate swaps, treated as hedges, net(B) 51,110 437,465 51,110
Non-hedge derivative obligations(C) 745 See below 745
(A) Included in Deferred Costs, Net. The longest cap maturity is October 2015.
(B) Included in Derivative Liabilities. The longest swap maturity is April 2011.
(C) Included in Derivative Liabilities. The longest maturity is July 2038.
The methodologies used and key assumptions made to estimate fair value
are as follows:
REAL ESTATE SECURITIES, AVAILABLE FOR SALE -- The fair value of the
REIT unsecured loans and CMBS is estimated by obtaining third party
independent broker quotations, if available and practicable, or
counterparty quotations.
CBO III DEPOSIT -- The fair value of the CBO III Deposit is based on a
counterparty quotation. The CBO III deposits is more fully described in
Note 4.
MARKETABLE SECURITIES, AVAILABLE FOR SALE -- The fair value of these
securities is generally based upon broker quotations. The fair value of
two securities acquired from ICH, for which quoted market prices are
not readily available, is estimated by means of price/yield analyses
based on Newcastle's expected disposition strategies for such assets.
Such assets include Newcastle's interest in a securitization executed
by ICH (the "CMO Asset"). The CMO Asset has an estimated value of $3.3
million at December 31, 2002 based on a discount rate of 20% and
estimated credit losses of $4.9 million. Increasing such estimated
discount rate and credit losses to 25% and $6.5 million, respectively,
would decrease the estimated value by $0.6 million and $0.5 million,
respectively. The gross securitized assets underlying the CMO Asset
aggregate $262.5 million (of which $2.8 million was delinquent) at
December 31, 2002, subject to $251.3 million of debt.
MORTGAGE LOANS -- This portfolio of mortgage loans bears a floating
rate of interest. We believe that for similar financial instruments
with comparable credit risks, the effective rate on this portfolio
approximates the market rate. Accordingly, the carrying amount of this
portfolio is believed to approximate fair value.
INTEREST RATE CAP AND SWAP AGREEMENTS -- The fair value of these
agreements is estimated by obtaining counterparty quotations.
CBO AND OTHER BONDS PAYABLE -- For those bonds bearing floating rates
at spreads over market indices, representing approximately $710.7
million of the carrying amount of the CBO Bonds Payable, management
believes that for similar financial instruments with comparable credit
risks, the effective rates approximate market rates.
72
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 inputing a spread over a market index on the date
of borrowing.
NOTES PAYABLE -- The Belgian Mortgage was valued by discounting
expected future payments by a rate calculated by imputing a spread over
a market index on the date of borrowing.
REPURCHASE AGREEMENTS -- These agreements bear floating rates of
interest and management believes that for similar financial instruments
with comparable credit risks, the effective rates approximate market
rates. Accordingly, the carrying amounts outstanding are believed to
approximate fair value.
NON-HEDGE DERIVATIVE OBLIGATIONS -- These obligations are valued by
reference to current counterparty quotations. These obligations
represent 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 $61.6 million.
8. DEBT OBLIGATIONS
The following table presents certain information regarding Newcastle's
debt obligations:
Carrying Amount Face Amount
----------------------------- ------------------------
12/31/02 Stated
Issue 12/31/02 12/31/01 12/31/02 12/31/01 Interest Rate Maturity
- ----- -------- -------- -------- -------- ------------- ----------
CBO I Bonds $ 429,363 $ 445,514 $ 437,500 $ 455,000 See Below July 2038
CBO II Bonds 439,134 - 444,000 - See Below April 2037
---------- ---------- ---------- ---------
Total CBO bonds 868,497 445,514 881,500 455,000
---------- ---------- ---------- ---------
Bell Canada Securitization 37,389 - 38,173 - See Below April 2012
GSA Securitization - 319,303 - 360,029 (B) (B)
---------- ---------- ---------- ---------
Total other bonds 37,389 319,303 38,173 360,029
---------- ---------- ---------- ---------
Bell Canada Mortgage - 31,412 - 31,412 Repaid Repaid
Belgian Mortgage 62,952 55,149 62,952 55,149 5.32% Nov. 2006
GSA KC Mortgage - 24,555 - 24,555 Repaid Repaid
---------- ---------- ---------- ---------
Total notes payable 62,952 111,116 62,952 111,116
---------- ---------- ---------- ---------
CMBS Repo 1,457 1,457 1,457 1,457 LIBOR+1.35% (2.77%) One Month
Mortgage Loan Repo (A) 246,712 - 246,712 - LIBOR+0.37% (1.80%) May 2003
---------- ---------- ---------- ---------
Total repurchase agreements 248,169 1,457 248,169 1,457
---------- ---------- ---------- ---------
Credit facility - 20,000 - 20,000 (B) (B)
---------- ---------- ---------- ---------
Total debt obligations $1,217,007 $ 897,390 $1,230,794 $ 947,602
========== ========== ========== =========
(A) The counterparty on this repo is Bear Stearns Mortgage Capital
Corporation.
(B) Distributed to Newcastle Holdings prior to the commencement of
Newcastle's operations.
In July 1999, Newcastle completed a transaction ("CBO I") whereby a
portfolio of real estate securities (Note 4) was contributed to a
consolidated subsidiary which issued $437.5 million fare amount of
investment grade senior securities and $62.5 million face amount of
non- investment grade subordinated securities in a private placement.
As a result of CBO I, the existing repurchase agreement on such real
estate securities was repaid. At December 31, 2002, the subordinated
securities were retained by Newcastle and the senior securities, which
bore interest at a weighted average effective rate, including discount
and cost amortization, of 3.99%, had an expected weighted average life
of approximately 5.26 years. Two classes of the senior securities bear
floating interest rates. Newcastle has obtained an interest rate swap
and cap in order to hedge its exposure to the risk of changes in market
interest rates with respect to these securities, at an initial cost of
approximately $14.3 million. CBO I's weighted average effective
interest rate, including the effect of such hedges, was 5.63% at
December 31, 2002. In addition, in connection with the sale of two
classes of securities, Newcastle entered into two interest rate swaps
and three interest rate cap agreements that do not qualify for hedge
accounting. Changes in the values of these instruments have been
recorded currently in income.
In November 2001, Newcastle sold the retained subordinated $17.5
million Class E Note from CBO I 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 represents an
issuance of debt and was recorded as additional CBO Bonds Payable. In
April 2002, a wholly-owned subsidiary of Newcastle repurchased the
Class E Note. The
73
re-purchase of the Class E Note represented a repayment of debt and was
recorded as a reduction of CBO Bonds Payable. The Class E Note is
included in the collateral for CBO II. The Class E Note is eliminated
in consolidation.
In April 2002, Newcastle completed its second CBO securitization ("CBO
II") whereby a portfolio of real estate securities (Note 4) 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. At December 31, 2002, the subordinated securities
were retained by Newcastle and the 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 7.36 years. One class of the senior
securities bears a floating interest rate. Newcastle has obtained an
interest rate swap and cap in order to hedge its exposure to the risk
of changes in market interest rates with respect to this security, at
an initial cost of $1.2 million. CBO II's weighted average effective
interest rate, including the effect of such hedges, was 6.16% at
December 31, 2002.
In April 2002, Newcastle refinanced the existing debt on the Bell
Canada Portfolio (the "Bell Canada Mortgage") through a securitization
transaction (the "Bell Canada Securitization"). At December 31, 2002,
the outstanding securities, which bore interest at a weighted average
effective rate, including discount and cost amortization, of
approximately 7.07%, had an expected weighted average life of
approximately 2.75 years. In connection with this securitization,
Newcastle guaranteed certain payments under an interest rate swap to be
entered into in 2007, if the Bell Canada Securitization is not fully
repaid by such date. Newcastle believes the fair value of this
guarantee is negligible at December 31, 2002.
In May 1999, Newcastle Holdings financed the GSA Properties (Note 5)
through a secruitization (the "GSA Securitization") which bore interest
at a weighted average effective rate of 7.04%. The GSA Securitization
was distributed to Newcastle Holdings prior to the commencement of
Newcastle's operations.
In November 1999, Newcastle financed the LIV Portfolio (Note 5) with a
mortgage and a related interest rate cap. In November 2001, Newcastle
extended the term of this mortgage, modified the rate, and obtained a
new interest rate cap related thereto. In November 2002, Newcastle
refinanced the LIV Portfolio with a new mortgage (the "Belgian
Mortgage") which bears a fixed rate of interest.
One of the GSA Properties was financed with a mortgage (the "GSA KC
Mortgage") which was repaid in May 2002 upon sale of the related asset.
In November 2002, Newcastle purchased a portfolio of mortgage loans
(Note 6) subject to a repurchase agreement (the "Mortgage Loan Repo").
In July 2000, Newcastle Holdings entered into a $40 million revolving
credit agreement (the "Credit Facility"). Newcastle Holdings hedged its
exposure to the risk of changes in market interest rates with respect
to the Credit Facility by entering into an interest rate swap. The
credit facility and related swap were distributed to Newcastle Holdings
prior to the commencement of Newcastle's operations.
74
Newcastle's debt obligations, including its repurchase agreements,
notes payable, credit facility, CBO and other bonds payable, matures as
follows (gross of discounts of $13.8 million):
2003 $ 251.8 million
2004 2.0 million
2005 1.7 million
2006 58.4 million
2007 0.0 million
Thereafter 916.9 million
-----------------
$ 1,230.8 million
=================
9. STOCK OPTION PLAN
In October 2002, Newcastle (with the approval of the board of
directors) adopted a nonqualified stock option plan (the "Newcastle
Option Plan") for non-employee directors and the Manager. The
non-employee directors were granted options in 2002 to acquire an
aggregate of 4,000 shares of common stock at a price of $13 per share,
which were fully exercisable upon issuance. The fair value of such
options was not material at the date of grant. For the purpose of
compensating the Manager for its successful efforts in raising capital
for Newcastle, the Manager was granted options in 2002 representing the
right to acquire 700,000 shares of common stock at an exercise price
per share of common stock equal to $13, with such price subject to
adjustment as necessary to preserve the value of such options in
connection with the occurrence of certain events (including capital
dividends and capital distributions made by Newcastle). The 700,000
shares represented an amount equal to 10% of the shares of common stock
of Newcastle sold in its initial public offering in 2002.
The options granted to the Manager were fully vested on the date of
grant and one thirtieth of the options become exercisable on the first
day of each of the following thirty calendar months, or earlier upon
the occurrence of certain events, such as a change in control of
Newcastle Holdings or the termination of the Management Agreement. The
options expire in 2012.
The fair value of the options granted to the Manager at the date of
grant was approximately $0.4 million. Newcastle estimated this value by
reference to a volatility estimate of 15%, based on a range of
volatilities for our competition provided by an investment bank, along
with management's best judgement, together with a dividend yield of
13.85%, an expected life assumption of 10 years, and a risk-free rate
assumption of 4.05%. Since the Newcastle Option Plan has
characteristics significantly different from those of traded options,
and since the volatility assumption is subject to significant judgment
and variability, the actual value of the options could vary materially
from management's estimate.
In June 1998, Newcastle Holdings (with the approval of the board of
directors) adopted a nonqualified stock option plan (the "Newcastle
Holdings Option Plan") for non-employee directors and the Manager. The
non-employee directors were granted options in 1998 to acquire an
aggregate of 6,000 shares of common stock at a price of $20 per share,
which were fully exercisable upon issuance. The fair value of such
options was not material at the date of grant. For the purpose of
compensating the Manager for its successful efforts in raising capital
for Newcastle Holdings, the Manager was granted options in 1998
representing the right to acquire 2,091,673 shares of common stock at
an exercise price per share of common stock equal to $20, with such
price subject to adjustment as necessary to preserve the value of such
options in connection with the occurrence of certain events (including
capital dividends and capital distributions made by Newcastle
Holdings). The 2,091,673 shares represented an amount equal to 10% of
the shares of common stock and units of Newcastle Holdings outstanding
after Newcastle Holdings' stock issuances in 1998. All of the options
granted in 1998 represent options in Newcastle Holdings and not in
Newcastle.
The options granted to the Manager in 1998 were fully vested upon
issuance and were exercisable beginning on June 5, 1999. From and after
such date, one thirtieth of the options became exercisable on the first
day of each of the following thirty calendar months. The options expire
on June 5, 2008.
75
The fair value of the 1998 options granted to the Manager at the date
of grant was approximately $3.6 million. Newcastle Holdings estimated
this value by reference to the volatility and dividend yields of the
Morgan Stanley REIT Index that were approximately 15.4% and 7.1%,
respectively, together with an expected life assumption of 5 years, and
a risk-free rate assumption of 4.88%. Since Newcastle Holdings' common
stock is not publicly traded and the Newcastle Holdings Option Plan has
characteristics significantly different from those of traded options,
the actual value of the options could vary materially from management's
estimate.
10. MANAGEMENT AGREEMENT AND RELATED PARTY TRANSACTIONS
Newcastle entered into the Management Agreement with the Manager in
June 2002, which provides for an initial term of one year with
automatic one-year extensions, subject to certain termination rights.
After the initial one year term, the Manager's performance will be
reviewed annually and the Management Agreement may be terminated by
Newcastle by payment of a termination fee, as defined in the Management
Agreement, equal to the amount of management fees earned by the Manager
during the twelve consecutive calendar months immediately preceding the
termination, upon the affirmative vote of at least two-thirds of the
independent directors, or by a majority vote of the holders of common
stock. Pursuant to the Management Agreement, the Manager, under the
supervision of Newcastle's board of directors, will formulate
investment strategies, arrange for the acquisition of assets, arrange
for financing, monitor the performance of Newcastle's assets and
provide certain advisory, administrative and managerial services in
connection with the operations of Newcastle. For performing these
services, Newcastle will pay the Manager an annual management fee equal
to 1.5% of the gross equity of Newcastle, as defined. Newcastle
Holdings' management agreement with the Manager contained substantially
the same terms.
The Management Agreement provides that Newcastle will reimburse the
Manager for various expenses incurred by the Manager or its officers,
employees and agents on Newcastle's behalf, including costs of legal,
accounting, tax, auditing, administrative and other similar services
rendered for Newcastle by providers retained by the Manager or, if
provided by the Manager's employees, in amounts which are no greater
than those which would be payable to outside professionals or
consultants engaged to perform such services pursuant to agreements
negotiated on an arm's-length basis.
To provide an incentive for the Manager to enhance the value of the
common stock, the Manager is entitled to receive a quarterly incentive
return (the "Preferred Incentive Return") on a cumulative, but not
compounding, basis in an amount equal to the product of (A) 25% of the
dollar amount by which (1) (a) the Funds from Operations, as defined
(before the Preferred Incentive Return) of Newcastle per share of
common stock (based on the weighted average number of shares of common
stock outstanding) plus (b) gains (or losses) from debt restructuring
and from sales of property and other assets per share of common stock
(based on the weighted average number of shares of common stock
outstanding), exceed (2) an amount equal to (a) the weighted average of
the price per share of common stock in the IPO and the value attributed
to the net assets transferred by Newcastle Holdings, and in any
subsequent offerings by Newcastle (adjusted for prior capital dividends
or capital distributions) multiplied by (b) a simple interest rate of
10% per annum (divided by four to adjust for quarterly calculations)
multiplied by (B) the weighted average number of shares of common stock
outstanding. An affiliate of the Manager was entitled to a similar
incentive return from Newcastle Holdings.
AMOUNTS EARNED (INCURRED)
----------------------------------------------------
2002 2001 1999
-------------- -------------- --------------
Management Fee to Manager......................... ($4.3 million) ($4.8 million) ($5.1 million)
Expense Reimbursements to Manager ................ ($0.5 million) ($0.9 million) ($1.6 million)
Preferred Incentive Return to Manager ............ ($3.5 million) ($2.8 million) -
Management Fee from Fund to Managing
Member ....................................... $4.5 million $8.9 million $8.9 million
Management Fee from Managing Member
to Manager ................................... ($4.5 million) ($8.9 million) ($8.9 million)
Incentive Return from Fund to Managing
Member ....................................... ($1.2 million) $28.8 million -
Incentive Return from Managing Member
to Manager ................................... $0.6 million ($14.4 million) -
Newcastle Holdings had an investment in Fund I and an investment in
Austin, which were accounted for under the equity method. Newcastle
Holdings also owned an investment in the Managing Member of Fund I,
which was consolidated. As a result of this investment, Newcastle
Holdings was entitled to an Incentive Return from Fund I. The Manager
of Newcastle and Newcastle Holdings also manages Fund I. Newcastle
Holdings received a credit
76
against management fees otherwise payable under its management
agreement with the Manager for management fees and any Incentive Return
paid to the Manager by Fund I in connection with Newcastle Holdings'
investment in Fund I. This credit was reflected as increased return
from Fund I, in Equity in Earnings (Losses) from Unconsolidated
Subsidiaries, because it was structured as a reduced burden on
Newcastle Holdings' return from Fund I as follows: (a) Newcastle
Holdings, unlike the other Fund I Investors, did not pay a management
fee to Fund I and its allocation of income from Fund I was calculated
gross of any management fees, and (b) Newcastle Holdings received
payments from the Manager to reimburse it for its share of Incentive
Return paid to the Manager by Fund I, of which $0.5 million was
received in January 2002. For a more complete discussion of these
relationships, see Note 3.
In January 2001, an employee co-investment program was adopted whereby
certain employees of the Manager and of Fortress Registered Investment
Trust's ("FRIT") operating subsidiary would have the opportunity to
invest in Fund I by purchasing part of Newcastle Holdings' investment.
FRIT is Fund I's investment vehicle. The purpose of the program was to
align the interests of FRIT's employees and the employees of the
Manager with those of Fund I's Investors, including Newcastle Holdings,
and to enable the Manager and FRIT to retain such employees and provide
them with appropriate incentives and rewards for their performance.
These employees were integral to the success of Newcastle Holdings and
Fund I. Certain of the employees of the Manager were officers of
Newcastle Holdings and Fund I and/or provided management services to
Newcastle Holdings and Fund I. No employees of Fund I were officers of
Newcastle Holdings or provided management services to Newcastle
Holdings. Newcastle Holdings set aside $10.0 million of its commitment
to Fund I for this program, of which $6.9 million was allocated, prior
to the distribution of this investment to Newcastle Holdings, and
financed approximately 80% of the employee investments via non-recourse
loans through Austin, which were secured by such employees' interest in
Fund I. The remaining 20% was funded by cash payments from each of the
employees. The loans, which were included in Due from Affiliates, bore
interest at 10%, which was payable currently from distributions from
Fund I, and matured upon liquidation of Fund I. The principal balance
of, and any unpaid interest on, these loans was payable at maturity. At
December 31, 2001, Austin was owed $3.2 million of principal and less
than $0.1 million of interest in connection with this financing. The
Manager would fund up to $0.1 million of the purchase price of these
commitments on behalf of employees.
At December 31, 2002, Due To Affiliates is comprised $1.0 million of
Incentive Return payable and $0.3 million of management fees and
expense reimbursements payable.
11. COMMITMENTS AND CONTINGENCIES
CBO III DEPOSIT -- Newcastle has the option to purchase certain real
estate securities from an investment bank. To the extent that such
securities decline in value, Newcastle must either purchase such
securities or lose an amount equal to the lesser of such decline or its
deposit. See Note 4.
GUARANTEE OF SWAP PAYMENTS -- In connection with the Bell Canada
Securitization, Newcastle has guaranteed certain payments under an
interest rate swap to be entered into in 2007, if the Bell Canada
Securitization is not fully repaid by such date. Newcastle believes the
fair value of this guarantee is negligible at December 31, 2002.
STOCKHOLDER RIGHTS AGREEMENT -- Newcastle has adopted a stockholder
rights agreement (the "Rights Agreement"). Pursuant to the terms of the
Rights Agreement, Newcastle will attach to each share of common stock
one preferred stock purchase right (a "Right"). Each Right entitles the
registered holder to purchase from Newcastle a unit consisting of one
one-hundredth of a share of Series A Junior Participation Preferred
Stock, par value $0.01 per share, at a purchase price of $70 per unit.
Initially, the Rights are not exercisable and are attached to and
transfer and trade with the outstanding shares of common stock. The
Rights will separate from the common stock and will become exercisable
upon the acquisition or tender offer to acquire a 15% beneficial
ownership interest by an acquiring person, as defined. The effect of
the Rights Agreement will be to dilute the acquiring party's beneficial
interest. Until a Right is exercised, the holder thereof, as such, will
have no rights as a stockholder of Newcastle.
LITIGATION -- Newcastle is a defendant in legal actions from
transactions conducted in the ordinary course of business. Management,
after consultation with legal counsel, believes the ultimate liability,
if any, arising from such actions which existed at December 31, 2002
will not materially affect Newcastle's consolidated results of
operations or financial position.
ENVIRONMENTAL COSTS -- As a commercial real estate owner, Newcastle is
subject to potential environmental costs. At December 31, 2002,
management of Newcastle is not aware of any environmental concerns that
would have a material adverse effect on Newcastle's consolidated
financial position or results of operations.
77
DEBT COVENANTS -- Newcastle's debt obligations contain various
customary loan covenants. Such covenants do not, in management's
opinion, materially restrict Newcastle's investment strategy or ability
to raise capital. Newcastle is in compliance with all of its loan
covenants at December 31, 2002.
12. SUBSEQUENT EVENTS
In February 2003, Newcastle sold its entire position in agency eligible
residential mortgage loans (a portion of its mortgage loan portfolio)
with an aggregate unpaid principal balance of approximately $159.0
million for gross proceeds of approximately $162.6 million at a gain of
approximately $0.7 million. As a result of the sale, the existing
repurchase agreement allocated to the agency eligible loans was
satisfied for approximately $153.9 million. Simultaneously,
approximately $207.4 million of non-agency/jumbo residential mortgage
loans were purchased for a price of approximately $210.2 million. In
connection with this purchase, the outstanding balance of the existing
repurchase agreement was increased by a net of $45.9 million, after the
repayment described above.
13. SUMMARY PRO FORMA CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
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.
78
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
For the Year Ended December 31, 2002
Distributed to
Newcastle
Holdings
---------------
Eliminated
Historical (A) Operations Pro Forma
-------------- --------------- ------------
REVENUES
Interest and dividend income $ 73,082 $ (226) (B) $ 72,856
Rental and escalation income 19,874 - 19,874
Gain (loss) on settlement of investments 11,417 29 (B) 11,446
Management fee from affiliate 4,470 (4,470) (B) -
Incentive income from affiliate (1,218) 1,218 (B) -
Other income 18 (3) (B) 15
---------- --------- ---------
107,643 (3,452) 104,191
---------- --------- ---------
EXPENSES
Interest expense 49,527 (2,336) (B) 47,191
Property operating expense 8,631 - 8,631
Loan servicing expense 655 - 655
General and administrative expense 2,914 (100) (B) 2,814
Management fees to affiliate 9,250 (5,345) (C) 3,905
Preferred incentive return to affiliate 2,856 (827) (C) 2,029
Depreciation and amortization 3,199 (430) (B) 2,769
---------- --------- ---------
77,032 (9,038) 67,994
---------- --------- ---------
INCOME BEFORE EQUITY IN EARNINGS
OF UNCONSOLIDATED SUBSIDIARIES 30,611 5,586 36,197
Equity in earnings (losses) of unconsolidated subsidiaries 362 (362) (B) -
---------- --------- ---------
INCOME FROM CONTINUING OPERATIONS $ 30,973 $ 5,224 $ 36,197
========== ========= =========
Income from continuing operations per share of
common stock, basic and diluted $ 1.71 $ 1.95
========== =========
Weighted average number of shares of common stock
outstanding, basic 18,080 18,560 (D)
========== =========
Weighted average number of shares of common stock
outstanding, diluted 18,090 18,570 (D)
========== =========
79
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
(A) Historical amounts were derived from Newcastle's consolidated
financial statements as of and for the year ended December 31,
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) - - (4,470)
Incentive income from affiliate - 1,218 - - 1,218
Other income - - - (3) (3)
Interest expense - - - (2,336) (ii) (2,336)
General and adminstrative expense - - - (100) (iii) (100)
Depreciation and amortization - (329) - (101) (iv) (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 interest on Newcastle Holdings' line of
credit.
(iii) Represents data processing expenses, state and local
taxes, and professional fees related directly to
entities and assets treated as being distributed to
Newcastle Holdings.
(iv) 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 approximately 0.5 million shares of common stock
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.
80
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
For the Year Ended December 31, 2001
Distributed to
Newcastle
Holdings
---------------
Eliminated
Historical (A) Operations Pro Forma
-------------- --------------- -----------
REVENUES
Interest and dividend income $ 48,913 $ (1,204) (B) $ 47,709
Rental and escalation income 20,053 - 20,053
Gain (loss) on settlement of investments 8,438 (1,033) (B) 7,405
Management fee from affiliate 8,941 (8,941) (B) -
Incentive income from affiliate 28,709 (28,709) (B) -
Other income 68 (25) (B) 43
-------- -------------- ---------
115,122 (39,912) 75,210
-------- -------------- ---------
EXPENSES
Interest expense 35,863 (3,204) (B) 32,659
Property operating expense 8,695 - 8,695
Loan servicing expense 254 (11) 243
General and administrative expense 1,568 (338) (B) 1,230
Management fees to affiliate 14,687 (11,045) (C) 3,642
Preferred incentive return to affiliate 17,188 (17,188) (C) -
Depreciation and amortization 3,574 (1,007) (B) 2,567
-------- -------------- ---------
81,829 (32,793) 49,036
-------- -------------- ---------
INCOME BEFORE EQUITY IN EARNINGS
OF UNCONSOLIDATED SUBSIDIARIES 33,293 (7,119) 26,174
Equity in earnings (losses) of unconsolidated subsidiaries 2,807 (2,807) (B) -
-------- -------------- ---------
INCOME FROM CONTINUING OPERATIONS $ 36,100 $ (9,926) $ 26,174
======== ============== =========
Income from continuing operations per share of
common stock, basic and diluted $ 2.19 $ 1.54
======== =========
Weighted average number of shares of common stock
outstanding, basic and diluted 16,493 16,973 (D)
======== =========
81
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(tables in thousands, except per share data)
(A) Historical amounts were derived from Newcastle's consolidated
financial statements as of and for the year ended December 31,
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 $ - $ (647) $ - $ (557) (ii) $ (1,204)
Gain on settlement of investments - - (1,984) 951 (iii) (1,033)
Management fee from affiliate - (8,941) - - (8,941)
Incentive income from affiliate - (28,709) - - (28,709)
Other income - - - (25) (25)
Interest expense - - - (3,204) (vi) (3,204)
General and adminstrative expense - - - (338) (v) (338)
Depreciation and amortization - (560) - (447) (vi) (1,007)
Equity in earnings of unconsolidated subsidiaries 2,553 (5,360) - - (2,807)
(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 interest on Newcastle Holdings' line of
credit.
(v) Represents data processing expenses, state and local
taxes, and professional fees related directly to
entities and assets treated as being distributed to
Newcastle Holdings.
(vi) 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 ($8.9 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 approximately 0.5 million shares of common stock
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.
82
14. SUMMARY QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED)
The following is unaudited summary information on Newcastle's quarterly
operations. The distribution of investments, and related liabilities, to
Newcastle Holdings and the commencement of Newcastle's independent operations
occurred at the beginning of the quarter ended September 30, 2002. Therefore,
periods prior to this quarter are not reflective of Newcastle's ongoing
operations nor are they comparable to subsequent quarters.
Quarter Ended Quarter Ended Quarter Ended Quarter Ended Year Ended
3/31/02 (A) 6/30/02 (A) 9/30/02 (A) 12/31/02 12/31/02
------------- ------------- ------------- ------------- ----------
Gross Revenues $ 9,951 $ 39,086 $ 27,841 $ 30,765 $ 107,643
Operating expenses (868) (13,115) (4,447) (5,876) (24,306)
-------- --------- --------- -------- ---------
Operating income 9,083 25,971 23,394 24,889 83,337
Interest expense (8,069) (13,440) (13,483) (14,535) (49,527)
Depreciation and amortization (850) (938) (695) (716) (3,199)
Equity in earnings of unconsolidated subsidiaries (452) 814 - - 362
-------- --------- --------- -------- ---------
Income (loss) from continuing operations (288) 12,407 9,216 9,638 30,973
Income (loss) from discontinued operations 1,159 981 (1,712) 94 522
Preferred dividends and related accretion (638) (524) - - (1,162)
-------- --------- --------- -------- ---------
Income available for common stockholders $ 233 $ 12,864 $ 7,504 $ 9,732 $ 30,333
======== ========= ========= ======== =========
Net Income per share of common stock, basic and diluted $ 0.01 $ 0.78 $ 0.46 $ 0.43 $ 1.68
======== ========= ========= ======== =========
Income (loss) from continuing operations per share of
common stock, after preferred dividends and
related accretion, basic and diluted $ (0.06) $ 0.73 $ 0.56 $ 0.42 $ 1.65
======== ========= ========= ======== =========
Income (loss) from discontinued operations per share of
common stock, basic and diluted $ 0.07 $ 0.05 $ (0.10) $ 0.01 $ 0.03
======== ========= ========= ======== =========
Weighted average number of shares of common stock
outstanding, basic 16,489 16,489 16,489 22,804 18,080
======== ========= ========= ======== =========
Weighted average number of shares of common stock
outstanding, diluted 16,489 16,489 16,489 22,843 18,090
======== ========= ========= ======== =========
Quarter Ended Quarter Ended Quarter Ended Quarter Ended Year Ended
3/31/01 (A) 6/30/01 (A) 9/30/01 (A) 12/31/01 12/31/01
------------- ------------- ------------- ------------- ----------
Gross Revenues $ 26,531 $ 20,828 $ 47,622 $20,141 $115,122
Operating expenses (6,737) (5,827) (22,243) (7,585) (42,392)
-------- --------- -------- ------- --------
Operating income 19,794 15,001 25,379 12,556 72,730
Interest expense (9,823) (8,691) (8,546) (8,803) (35,863)
Depreciation and amortization (831) (887) (910) (946) (3,574)
Equity in earnings of unconsolidated subsidiaries (346) 1,471 760 922 2,807
-------- --------- -------- ------- --------
Income from continuing operations 8,794 6,894 16,683 3,729 36,100
Income (loss) from discontinued operations 2,902 1,647 1,513 1,509 7,571
Preferred dividends and related accretion (630) (634) (638) (638) (2,540)
-------- --------- -------- ------- --------
Income available for common stockholders $ 11,066 $ 7,907 $ 17,558 $ 4,600 $ 41,131
======== ========= ======== ======= ========
Net Income per share of common stock, basic and diluted $ 0.67 $ 0.48 $ 1.06 $ 0.28 $ 2.49
======== ========= ======== ======= ========
Income from continuing operations per share of common
stock, after preferred dividends and related accretion,
basic and diluted $ 0.49 $ 0.38 $ 0.97 $ 0.19 $ 2.03
======== ========= ======== ======= ========
Income (loss) from discontinued operations per share of
common stock, basic and diluted $ 0.18 $ 0.10 $ 0.09 $ 0.09 $ 0.46
======== ========= ======== ======= ========
Weighted average number of shares of common stock
outstanding, basic and diluted 16,500 16,494 16,489 16,489 16,493
======== ========= ======== ======= ========
(A) The Income Available for Common Stockholders shown agrees with
Newcastle's quarterly report(s) on Form 10-Q as filed with the
Securities and Exchange Commission. However, individual line items vary
from such report(s) due to the operations of properties sold, or
classified as held for sale, during the current period being
retroactively reclassified to Income from Discontinued Operations for
all periods presented (see Note 5).
83
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Incorporated by reference to our definitive proxy statement for the 2003 annual
meeting of stockholders to be filed within 120 days after year-end.
Section 16 (a) of the Securities Exchange Act of 1934 requires the Company's
directors and officers, and persons who own more than 10% of a registered class
of the Company's equity securities, to file initial reports of ownership and
reports of changes in ownership with the Securities and Exchange Commission and
the New York Stock Exchange. These persons are required by the Securities and
Exchange Commission to furnish us with copies of all Section 16 (a) reports that
they file. We believe that in 2002, all transactions by executive officers and
directors have been reported on a timely basis, except that Mr. McKown's initial
report on Form 3, relating to his becoming a director in November 2002, was
filed on February 19, 2003.
ITEM 11. EXECUTIVE COMPENSATION.
Incorporated by reference to our definitive proxy statement for the 2003 annual
meeting of stockholders to be filed within 120 days after year-end.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Incorporated by reference to our definitive proxy statement for the 2003 annual
meeting of stockholders to be filed within 120 days after year-end.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Incorporated by reference to our definitive proxy statement for the 2003 annual
meeting of stockholders to be filed within 120 days after year-end.
ITEM 14. 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 IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) and (d) Financial statements and schedules:
See "Item 8. Financial Statements and Supplementary Data."
(b) Reports on Form 8-K filed by the registrant during its fiscal
quarter ended December 31, 2002: None.
84
(c) Exhibits filed with this Form 10-K:
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 (incorporated by reference to
the Registrant's Quarterly Report on Form 10-Q for
the period ended September 30, 2002, Exhibit 4.1).
10.1 Management and Advisory Agreement by and among the
Registrant and Fortress Investment Group LLC, dated
June 6, 2002 (incorporated by reference to the
Registrant's Quarterly Report on Form 10-Q for the
period ended September 30, 2002, Exhibit 10.1).
21.1 Subsidiaries of the Registrant.
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.
85
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized:
NEWCASTLE INVESTMENT CORP.
February 28, 2003
By: /s/ Wesley R. Edens
--------------------
Wesley R. Edens
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this report has been signed below by the following person on behalf of the
Registrant and in the capacities and on the dates indicated.
February 28, 2003
By: /s/ Wesley R. Edens
--------------------
Wesley R. Edens
Chief Executive Officer
February 28, 2003
By: /s/ Michael I. Wirth
---------------------
Michael I. Wirth
Chief Financial Officer
February 28, 2003
By: /s/ Stuart A. McFarland
------------------------
Stuart A. McFarland
Director
February 28, 2003
By: /s/ David J. Grain
-------------------
David J. Grain
Director
By:
--------------------
David K. McKown
Director
February 28, 2003
By: /s/ Peter M. Miller
--------------------
Peter M. Miller
Director
86
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
I, Wesley R. Edens, certify that:
1. I have reviewed this annual report on Form 10-K of Newcastle Investment
Corp.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 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 annual 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 annual report (the "Evaluation Date");
and
c) presented in this annual 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 functions):
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
annual report whether 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.
February 28, 2003 /s/ Wesley R. Edens
----------------- -------------------
(Date) Wesley R. Edens, Chief Executive Officer
87
CERTIFICATION OF CHIEF FINANCIAL OFFICER
I, Michael I. Wirth, certify that:
1. I have reviewed this annual report on Form 10-K of Newcastle Investment
Corp.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 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 annual 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 annual report (the "Evaluation Date");
and
c) presented in this annual 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 functions):
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
annual report whether 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.
February 28, 2003 /s/ Michael I. Wirth
----------------- --------------------
(Date) Michael I. Wirth, Chief Financial Officer
88
EXHIBIT INDEX
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 (incorporated by reference to
the Registrant's Quarterly Report on Form 10-Q for
the period ended September 30, 2002, Exhibit 4.1).
10.1 Management and Advisory Agreement by and among the
Registrant and Fortress Investment Group LLC, dated
June 6, 2002 (incorporated by reference to the
Registrant's Quarterly Report on Form 10-Q for the
period ended September 30, 2002, Exhibit 10.1).
21.1 Subsidiaries of the Registrant.
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.
89