UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2005
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________ to ____________
Commission File Number: 001-31458
NEWCASTLE INVESTMENT CORP.
(Exact name of registrant as specified in its charter)
Maryland 81-0559116
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1251 Avenue of the Americas, New York, NY 10020
(Address of principal executive offices) (Zip Code)
(212) 798-6100
(Registrant's telephone number, including area code)
________________________________________________________________________________
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act). Yes [X] No [ ]
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: 43,765,311 SHARES OUTSTANDING AS OF MAY
6, 2005.
NEWCASTLE INVESTMENT CORP.
FORM 10-Q
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2005 (unaudited)
and December 31, 2004 1
Consolidated Statements of Income (unaudited) for the three
months ended March 31, 2005 and 2004 2
Consolidated Statements of Stockholders' Equity (unaudited) for
the three months ended March 31, 2005 and 2004 3
Consolidated Statements of Cash Flows (unaudited) for the three
months ended March 31, 2005 and 2004 4
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 27
Item 4. Controls and Procedures 32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 33
Item 3. Defaults upon Senior Securities 33
Item 4. Submission of Matters to a Vote of Security Holders 33
Item 5. Other Information 33
Item 6. Exhibits 33
SIGNATURES 34
CAUTIONARY STATEMENTS
The information contained in this quarterly report on Form 10-Q is not a
complete description of our business or the risks associated with an investment
in our company. We urge you to carefully review and consider the various
disclosures made by us in this report and in our other filings with the
Securities and Exchange Commission ("SEC"), including our annual report on Form
10-K for the year ended December 31, 2004, that discuss our business in greater
detail.
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; adverse changes in
the financing markets we access affecting our ability to finance our real estate
securities portfolios in general or particular real estate related assets, or in
a manner that maintains our historic net spreads; changes in interest rates
and/or credit spreads, as well as the success of our hedging strategy in
relation to such changes; the quality and size of the investment pipeline and
the rate at which we can invest our cash, including cash obtained in connection
with CBO financings; impairments in the value of the collateral underlying our
real estate securities, real estate related loans and residential mortgage
loans; the relation of any impairments in the value of our real estate
securities portfolio, loans or operating real estate to our judgments as to
whether changes in the market value of our securities are temporary or not and
whether circumstances bearing on the value of our loans or operating real estate
warrant changes in carrying values; changes in the markets;
legislative/regulatory changes; completion of pending investments; the
availability and cost of capital for future investments; competition within the
finance and real estate industries; and other risks detailed from time to time
in our SEC reports. 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 Financial Condition and Results of Operations - Application of
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.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
MARCH 31,
2005 DECEMBER 31,
(UNAUDITED) 2004
----------- ------------
ASSETS
Real estate securities, available for sale $3,429,088 $3,369,496
Real estate securities portfolio deposit 41,793 25,411
Real estate related loans, net 567,489 591,890
Investments in unconsolidated subsidiaries 37,264 41,230
Operating real estate, net 16,533 57,193
Real estate held for sale 41,365 12,376
Residential mortgage loans, net 888,979 654,784
Cash and cash equivalents 28,789 37,911
Restricted cash 128,763 77,974
Derivative assets 57,321 27,122
Receivables and other assets 36,951 37,333
---------- ----------
$5,274,335 $4,932,720
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
CBO bonds payable $2,656,427 $2,656,510
Other bonds payable 436,509 222,266
Notes payable 586,680 652,000
Repurchase agreements 597,270 490,620
Derivative liabilities 23,718 39,661
Dividends payable 28,365 25,928
Due to affiliates 3,080 8,963
Accrued expenses and other liabilities 40,805 40,057
---------- ----------
4,372,854 4,136,005
---------- ----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 2,500,000
shares of Series B Cumulative Redeemable Preferred Stock, liquidation
preference $25.00 per share, issued and outstanding 62,500 62,500
Common stock, $0.01 par value, 500,000,000 shares authorized, 43,758,911 and
39,859,481 shares issued and outstanding at March 31, 2005 and
December 31, 2004, respectively 438 399
Additional paid-in capital 781,659 676,015
Dividends in excess of earnings (14,158) (13,969)
Accumulated other comprehensive income 71,042 71,770
---------- ----------
901,481 796,715
---------- ----------
$5,274,335 $4,932,720
========== ==========
1
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except share data)
THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
----------- -----------
REVENUES
Interest income $ 79,711 $ 49,026
Rental and escalation income 1,264 1,147
Gain on settlement of investments, net 2,688 5,136
----------- -----------
83,663 55,309
----------- -----------
EXPENSES
Interest expense 48,766 28,091
Property operating expense 693 640
Loan and security servicing expense 1,583 782
Provision for credit losses 712 --
General and administrative expense 891 1,140
Management fee to affiliate 3,263 2,397
Incentive compensation to affiliate 1,972 2,374
Depreciation and amortization 136 113
----------- -----------
58,016 35,537
----------- -----------
Income before equity in earnings of unconsolidated subsidiaries 25,647 19,772
Equity in earnings of unconsolidated subsidiaries 2,086 1,223
Income taxes on related taxable subsidiaries (233) --
----------- -----------
Income from continuing operations 27,500 20,995
Income from discontinued operations 1,184 856
----------- -----------
NET INCOME 28,684 21,851
Preferred dividends (1,523) (1,523)
----------- -----------
INCOME AVAILABLE FOR COMMON STOCKHOLDERS $ 27,161 $ 20,328
=========== ===========
NET INCOME PER SHARE OF COMMON STOCK
BASIC $ 0.63 $ 0.59
=========== ===========
DILUTED $ 0.62 $ 0.58
=========== ===========
Income from continuing operations per share of common stock, after
preferred dividends
Basic $ 0.60 $ 0.57
=========== ===========
Diluted $ 0.59 $ 0.56
=========== ===========
Income from discontinued operations per share of common stock
Basic $ 0.03 $ 0.02
=========== ===========
Diluted $ 0.03 $ 0.02
=========== ===========
WEIGHTED AVERAGE NUMBER OF SHARES OF
COMMON STOCK OUTSTANDING
BASIC 43,221,792 34,401,800
=========== ===========
DILUTED 43,629,078 34,976,378
=========== ===========
DIVIDENDS DECLARED PER SHARE OF COMMON STOCK $ 0.625 $ 0.600
=========== ===========
2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(dollars in thousands)
DIVIDENDS ACCUM. TOTAL
PREFERRED STOCK COMMON STOCK ADDITIONAL IN EXCESS OTHER STOCK-
------------------ ------------------ PAID-IN OF COMP. HOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL EARNINGS INCOME EQUITY
--------- ------- ---------- ------ ---------- --------- -------- ---------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2004 2,500,000 $62,500 39,859,481 $399 $676,015 $(13,969) $ 71,770 $796,715
Dividends declared -- -- -- -- -- (28,873) -- (28,873)
Issuance of common stock -- -- 3,300,000 33 96,567 -- -- 96,600
Exercise of common stock options -- -- 599,430 6 9,077 -- -- 9,083
Comprehensive income:
Net income -- -- -- -- -- 28,684 28,684
Unrealized (loss) on securities -- -- -- -- -- -- (42,353) (42,353)
Reclassification of realized (gain)
on securities into earnings -- -- -- -- -- -- (1,409) (1,409)
Foreign currency translation -- -- -- -- -- -- (719) (719)
Reclassification of realized foreign
currency translation into earnings -- -- -- -- -- -- (542) (542)
Unrealized gain on derivatives
designated as cash flow hedges -- -- -- -- -- -- 44,637 44,637
Reclassification of realized (gain) on
derivatives designated as cash flow
hedges into earnings -- -- -- -- -- -- (342) (342)
--------
Total comprehensive income 27,956
--------- ------- ---------- ---- -------- -------- -------- --------
STOCKHOLDERS' EQUITY - MARCH 31, 2005 2,500,000 $62,500 43,758,911 $438 $781,659 $(14,158) $ 71,042 $901,481
========= ======= ========== ==== ======== ======== ======== ========
STOCKHOLDERS' EQUITY - DECEMBER 31, 2003 2,500,000 $62,500 31,374,833 $314 $451,806 $(14,670) $ 39,413 $539,363
Dividends declared -- -- -- -- -- (22,350) -- (22,350)
Issuance of common stock -- -- 3,300,000 33 85,770 -- -- 85,803
Exercise of common stock options -- -- 37,000 -- 481 -- -- 481
Comprehensive income:
Net income -- -- -- -- -- 21,851 -- 21,851
Unrealized gain on securities -- -- -- -- -- -- 56,386 56,386
Reclassification of realized (gain) on
securities into earnings -- -- -- -- -- -- (4,151) (4,151)
Foreign currency translation -- -- -- -- -- -- (305) (305)
Unrealized (loss) on derivatives
designated as cash flow hedges -- -- -- -- -- -- (33,577) (33,577)
--------
Total comprehensive income 40,204
--------- ------- ---------- ---- -------- -------- -------- --------
STOCKHOLDERS' EQUITY - MARCH 31, 2004 2,500,000 $62,500 34,711,833 $347 $538,057 $(15,169) $ 57,766 $643,501
========= ======= ========== ==== ======== ======== ======== ========
3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
(dollars in thousands)
THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 28,684 $ 21,851
Adjustments to reconcile net income to net cash provided by operating activities
(inclusive of amounts related to discontinued operations):
Depreciation and amortization 312 606
Accretion of discount and other amortization 386 (564)
Equity in earnings of unconsolidated subsidiaries (2,086) (1,223)
Deferred rent (258) (706)
Gain on settlement of investments (2,456) (5,052)
Unrealized gain on non-hedge derivatives (2,687) (583)
Change in:
Restricted cash (696) (6,703)
Receivables and other assets (1,539) 376
Due to affiliates (5,883) 797
Accrued expenses and other liabilities 327 (6,405)
--------- ---------
Net cash provided by operating activities 14,104 2,394
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of real estate securities (122,254) (541,897)
Proceeds from sale of real estate securities 6,574 44,445
Deposit on real estate securities (treated as a derivative) (15,539) (15,042)
Purchase of loans (342,878) (50,000)
Repayments of loan and security principal 120,136 75,567
Margin deposit on credit derivative instruments (20,000) --
Proceeds from sale of derivative instruments 342 --
Purchase and improvement of operating real estate (199) (161)
Proceeds from sale of operating real estate 10,693 --
Contributions to unconsolidated subsidiaries -- (26,788)
Distributions from unconsolidated subsidiaries 6,052 5,908
Payment of deferred transaction costs (24) (80)
--------- ---------
Net cash used in investing activities (357,097) (508,048)
--------- ---------
Continued on Page 5
4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
(dollars in thousands)
THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of CBO bonds payable -- 409,588
Repayments of CBO bonds payable (891) --
Issuance of other bonds payable 246,547
Repayments of other bonds payable (31,473) (6,920)
Borrowings under notes payable -- 40,000
Repayments of notes payable (65,320) (2,945)
Borrowings under repurchase agreements 129,430 29,511
Repayments of repurchase agreements (22,780) (36,659)
Issuance of common stock 97,680 86,790
Costs related to issuance of common stock (1,036) (987)
Exercise of common stock options 9,083 481
Dividends paid (26,436) (17,210)
Payment of deferred financing costs (933) (147)
-------- --------
Net cash provided by financing activities 333,871 501,502
-------- --------
NET DECREASE IN CASH AND CASH EQUIVALENTS (9,122) (4,152)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 37,911 60,403
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 28,789 $ 56,251
======== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for interest expense $ 46,232 $ 28,978
Cash paid during the period for income taxes $ 355 $ 386
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Common stock dividends declared but not paid $ 27,349 $ 20,827
Preferred stock dividends declared but not paid $ 1,016 $ 1,016
Deposits used in acquisition of real estate securities (treated as derivatives) $ -- $ 35,457
5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
1. GENERAL
Newcastle Investment Corp. (and its subsidiaries, "Newcastle") is a Maryland
corporation that was formed in 2002. Newcastle conducts its business through
three primary segments: (i) real estate securities and real estate related
loans, (ii) operating real estate, and (iii) residential mortgage loans.
The following table presents information on shares of Newcastle's common stock
issued subsequent to its formation:
Net Proceeds
Year Shares Issued Range of Issue Prices (1) (millions)
---- ------------- ------------------------- ------------
Formation 16,488,517 N/A N/A
2002 7,000,000 $ 13.00 $ 80.0
2003 7,886,316 $20.35-$22.85 $163.4
2004 8,484,648 $26.30-$31.40 $224.3
1st Quarter 2005 3,899,430 $ 29.60 $105.7
----------
March 31, 2005 43,758,911
==========
(1) Excludes shares issued pursuant to the exercise of options and shares
issued to Newcastle's independent directors.
Approximately 2.8 million shares of Newcastle's common stock were held by an
affiliate of the Manager (and its principals, as defined below) at March 31,
2005. In addition, an affiliate of the Manager held options to purchase
approximately 1.3 million shares of Newcastle's common stock at March 31, 2005.
Newcastle is organized and conducts its operations to qualify as a real estate
investment trust ("REIT") for U.S. federal income tax purposes. As such,
Newcastle will generally not be subject to U.S. 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 is party to 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
incentive compensation, both as defined in the Management Agreement.
The accompanying consolidated financial statements and related notes of
Newcastle have been prepared in accordance with accounting principles generally
accepted in the United States for interim financial reporting and the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain
information and footnote disclosures normally included in financial statements
prepared under accounting principles generally accepted in the United States
have been condensed or omitted. In the opinion of management, all adjustments
considered necessary for a fair presentation of Newcastle's financial position,
results of operations and cash flows have been included and are of a normal and
recurring nature. The operating results presented for interim periods are not
necessarily indicative of the results that may be expected for any other interim
period or for the entire year. These financial statements should be read in
conjunction with Newcastle's December 31, 2004 consolidated financial statements
and notes thereto included in Newcastle's annual report on Form 10-K filed with
the Securities and Exchange Commission. Capitalized terms used herein, and not
otherwise defined, are defined in Newcastle's December 31, 2004 consolidated
financial statements.
2. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through three primary segments: real estate
securities and real estate related loans, operating real estate and residential
mortgage loans.
6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in 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:
Real Estate
Securities Residential
and Real Estate Operating Mortgage
Related Loans Real Estate Loans Unallocated Total
--------------- ----------- ----------- ----------- ----------
March 31, 2005 and the Three Months then Ended
Gross revenues $ 69,546 $ 1,276 $ 11,982 $ 147 $ 82,951
Operating expenses (323) (701) (1,291) (6,087) (8,402)
---------- -------- -------- ------- ----------
Operating income (loss) 69,223 575 10,691 (5,940) 74,549
Interest expense (41,330) (158) (7,278) -- (48,766)
Depreciation and amortization -- (116) -- (20) (136)
Equity in earnings of unconsolidated subsidiaries (A) 846 1,007 -- -- 1,853
---------- -------- -------- ------- ----------
Income (loss) from continuing operations 28,739 1,308 3,413 (5,960) 27,500
Income (loss) from discontinued operations -- 1,184 -- -- 1,184
---------- -------- -------- ------- ----------
Net Income (Loss) $ 28,739 $ 2,492 $ 3,413 $(5,960) $ 28,684
========== ======== ======== ======= ==========
Revenue derived from non-U.S. sources:
Canada $ -- $ 4,071 $ -- $ -- $ 4,071
========== ======== ======== ======= ==========
Belgium $ -- $ 532 $ -- $ -- $ 532
========== ======== ======== ======= ==========
Total assets $4,266,025 $ 85,112 $896,204 $26,994 $5,274,335
========== ======== ======== ======= ==========
Long-lived assets outside the U.S.:
Canada $ -- $ 45,871 $ -- $ -- $ 45,871
========== ======== ======== ======= ==========
Belgium $ -- $ 12,027 $ -- $ -- $ 12,027
========== ======== ======== ======= ==========
December 31, 2004
Total assets $4,136,203 $108,322 $658,643 $29,552 $4,932,720
========== ======== ======== ======= ==========
Long-lived assets outside the U.S.:
Canada $ -- $ 57,193 $ -- $ -- $ 57,193
========== ======== ======== ======= ==========
Belgium $ -- $ 12,376 $ -- $ -- $ 12,376
========== ======== ======== ======= ==========
Three Months Ended March 31, 2004
Gross revenues $ 49,841 $ 1,156 $ 4,202 $ 110 $ 55,309
Operating expenses (262) (678) (536) (5,857) (7,333)
---------- -------- -------- ------- ----------
Operating income (loss) 49,579 478 3,666 (5,747) 47,976
Interest expense (25,819) (139) (2,133) -- (28,091)
Depreciation and amortization -- (113) -- -- (113)
Equity in earnings of unconsolidated subsidiaries (A) 1,069 154 -- -- 1,223
---------- -------- -------- ------- ----------
Income (loss) from continuing operations 24,829 380 1,533 (5,747) 20,995
Income (loss) from discontinued operations -- 856 -- -- 856
---------- -------- -------- ------- ----------
Net Income (Loss) $ 24,829 $ 1,236 $ 1,533 $(5,747) $ 21,851
========== ======== ======== ======= ==========
Revenue derived from non-U.S. sources:
Canada $ -- $ 4,704 $ -- $ -- $ 4,704
========== ======== ======== ======= ==========
Belgium $ -- $ 1,974 $ -- $ -- $ 1,974
========== ======== ======== ======= ==========
(A) Net of income taxes on related taxable subsidiaries.
Continued on Page 8
7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
The following table summarizes the activity affecting the equity held by
Newcastle in unconsolidated subsidiaries:
Operating Real Estate Real Estate Loan
Subsidiary Subsidiary
--------------------- ----------------
BALANCE AT DECEMBER 31, 2004 $17,778 $23,452
Contributions to unconsolidated subsidiaries -- --
Distributions from unconsolidated subsidiaries (4,956) (1,096)
Equity in earnings of unconsolidated subsidiaries 1,240 846
------- -------
BALANCE AT MARCH 31, 2005 $14,062 $23,202
======= =======
Summarized financial information related to Newcastle's unconsolidated
subsidiaries was as follows (in thousands):
Operating
Real Estate Real Estate Loan
Subsidiary (A) (B) Subsidiary (A) (C)
------------------------ ------------------------
March 31, December 31, March 31, December 31,
2005 2004 2005 2004
--------- ------------ --------- ------------
Assets $ 81,652 $ 89,222 $46,667 $47,170
Liabilities (53,000) (53,000) -- --
Minority interest (528) (666) (263) (266)
-------- -------- ------- -------
Equity $ 28,124 $ 35,556 $46,404 $46,904
======== ======== ======= =======
Equity held by Newcastle $ 14,062 $ 17,778 $23,202 $23,452
======== ======== ======= =======
Three Months Ended Three Months Ended
March 31, March 31,
---------------------- ---------------------
2005 2004 2005 2004
--------- ----------- --------- ---------
Revenues $ 4,347 $ 314 $ 1,713 $ 2,216
Expenses (1,822) -- (12) (66)
Minority interest (47) (6) (9) (12)
-------- -------- ------- -------
Net income (loss) $ 2,478 $308 $ 1,692 $ 2,138
======== ======== ======= =======
Newcastle's equity in
net income (loss) $ 1,240 $154 $ 846 $ 1,069
======== ======== ======= =======
(A) The unconsolidated subsidiaries' summary financial information is presented
on a fair value basis, consistent with their internal basis of accounting.
(B) Included in the operating real estate segment.
(C) Included in the real estate securities and real estate related loans
segment.
8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
3. REAL ESTATE SECURITIES
The following is a summary of Newcastle's real estate securities at March 31,
2005, all of which are classified as available for sale and are therefore marked
to market through other comprehensive income.
Weighted Average
-----------------------------------
Gross Unrealized S&P
Current Face Amortized ----------------- Carrying Number of Equivalent Maturity
Asset Type Amount Cost Basis Gains Losses Value Securities Rating Coupon Yield (Years)
- ---------- ------------ ---------- ------- -------- ---------- ---------- ---------- ------ ----- --------
CMBS-Conduit $1,018,290 $ 990,663 $41,037 $(15,280) $1,016,420 161 BBB- 6.17% 6.81% 7.26
CMBS-Large Loan 578,517 575,402 8,994 (471) 583,925 68 BBB 5.48% 5.76% 2.10
CMBS- B-Note 166,283 163,812 2,442 (2,332) 163,922 28 BB+ 6.51% 6.79% 6.21
Unsecured REIT Debt 715,070 729,943 26,595 (8,837) 747,701 86 BBB 6.47% 6.09% 7.23
ABS-Manufactured Housing 235,257 211,367 3,288 (5,939) 208,716 12 B 7.19% 8.84% 6.36
ABS-Home Equity 320,503 318,735 6,255 -- 324,990 46 A- 4.67% 4.79% 3.73
ABS-Franchise 74,607 72,627 1,703 (887) 73,443 17 BBB+ 7.19% 8.44% 5.39
Agency RMBS 310,454 312,444 339 (2,812) 309,971 7 AAA 4.68% 4.48% 3.32
---------- ---------- ------- -------- ---------- --- --- ---- ---- ----
Total/Average (A) $3,418,981 $3,374,993 $90,653 $(36,558) $3,429,088 425 BBB 5.95% 6.23% 5.54
========== ========== ======= ======== ========== === === ==== ==== ====
(A) The total current face amount of fixed rate securities was $2,570.4
million, and of floating rate securities was $848.6 million.
Unrealized losses that are considered other than temporary are recognized
currently in income. There were no such losses incurred during the three months
ended March 31, 2005. The unrealized losses on Newcastle's securities are
primarily the result of market factors, rather than credit impairment, and
Newcastle believes their carrying values are fully recoverable over their
expected holding period. None of the securities were delinquent as of March 31,
2005.
Securities in an
Unrealized Loss
Position
Less Than Twelve
Month $1,206,519 $1,213,721 $-- $(23,196) $1,190,525 134 BBB 5.82% 5.83% 6.52
Twelve or More Months 174,123 175,482 -- (13,362) 162,120 24 BBB- 5.62% 5.62% 7.39
---------- ---------- --- -------- ---------- --- --- ---- ---- ----
Total $1,380,642 $1,389,203 $-- $(36,558) $1,352,645 158 BBB 5.79% 5.80% 6.63
========== ========== === ======== ========== === === ==== ==== ====
The unrealized losses on most of the securities in the "Twelve or More Months"
category were mostly caused by changes in market interest rates as well as some
change in market credit spreads. With respect to two of such securities, the
unrealized losses were primarily caused by market perceptions of the credit
quality of such securities. None of the securities in this category are in
default or delinquent and Newcastle has performed credit analyses in relation to
such securities which support its belief that the carrying values of such
securities are fully recoverable over their expected holding period. Although
management expects to hold these securities until their recovery, there is no
assurance that such securities will not be sold or at what price they may be
sold.
4. REAL ESTATE RELATED LOANS AND RESIDENTIAL MORTGAGE LOANS
The following is a summary of real estate related loans and residential mortgage
loans at March 31, 2005. The loans contain various terms, including fixed and
floating rates, self-amortizing and interest only. They are generally subject to
prepayment.
Weighted
Current Average Delinquent
Face Carrying Loan Wtd. Avg. Maturity Carrying
Loan Type Amount Value Count Yield (Years) (C) Amount
- --------- -------- -------- ------ --------- ----------- ----------
B-Notes $117,159 $117,598 22 6.85% 2.52 $ --
Mezzanine Loans (A) 103,558 103,538 5 7.27% 2.27 --
Bank Loans 146,299 146,299 3 7.14% 1.89 --
Real Estate Loans 12,609 12,182 1 19.73% 2.75 --
ICH CMO Loans (B) 190,345 187,872 115 8.17% 2.51 22,527
Total Real Estate
-------- -------- ------ ----- ---- -------
Related Loans $569,970 $567,489 146 7.71% 2.31 $22,527
======== ======== ====== ===== ==== =======
Residential Loans $572,842 $581,528 1,502 3.73% 3.74 $ 9,155
Manufactured Housing
Loans 323,656 307,451 8,021 7.85% 4.92 2,492
-------- -------- ------ ----- ---- -------
Total Residential
Mortgage Loans $896,498 $888,979 $9,523 5.15% 4.16 $11,647
======== ======== ====== ===== ==== =======
9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
(A) One of these loans has a contractual exit fee which Newcastle will begin to
accrue if and when management believes it is probable that such exit fee
will be received.
(B) In October 2003, pursuant to FIN No.46, Newcastle consolidated an entity
which holds a portfolio of commercial mortgage loans which has been
securitized. This investment, which is referred to as the ICH CMO, was
previously treated as a non-consolidated residual interest in such
securitization. Newcastle exercises no control over the management or
resolution of these assets. The primary effect of the consolidation is the
requirement that Newcastle reflect the gross loan assets and gross bonds
payable of this entity in its financial statements.
(C) The weighted average maturity for the residential mortgage loan portfolio
was calculated based on a constant prepayment rate (CPR) of 20%.
Newcastle has entered into credit derivative instruments with a major investment
bank, whereby Newcastle receives the sum of all interest, fees and any positive
change in value amounts (the total return cash flows) from a reference asset
with a specified notional amount, and pays interest on such notional plus any
negative change in value amounts from such asset. These agreements are recorded
in Derivative Assets and treated as non-hedge derivatives for accounting
purposes and are therefore marked to market through income. Under the
agreements, Newcastle is required to post an initial margin deposit to an
interest bearing account and additional margin may be payable in the event of a
decline in value of the reference asset. Any margin on deposit, less any
negative change in value amounts, will be returned to Newcastle upon termination
of the contract. The following table presents information on these instruments
as of March 31, 2005.
Reference Notional Margin Receive Pay Fair
Month Executed Asset Amount Amount Interest Rate Interest Rate Value
- -------------- ------------------------------- -------- ------- ------------- ------------- ------
November 2004 Term loan to a retail mall REIT $106,760 $18,190 LIBOR + 2.25% LIBOR + 0.500% $1,855
February 2005 Term loan to a diversified real $100,000 $20,000 LIBOR + 3.00% LIBOR + 0.625% $ 192
estate and finance company
10
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
5. RECENT ACTIVITIES
In April 2005, Newcastle completed its seventh CBO financing, whereby a
portfolio of real estate securities and loans was purchased by a
consolidated subsidiary which issued $447.0 million face amount of
investment grade senior bonds and $53.0 million face amount of
non-investment grade subordinated bonds in a private placement. The
non-investment grade bonds were retained by Newcastle and the $442.0
million carrying amount of the investment grade bonds, which bore interest
at a weighted average effective rate, including discount and issue cost
amortization and the effect of hedges, of 4.48%, had an expected weighted
average life of approximately 8.9 years. The largest tranche, the $323.0
million face amount of Class I-MM notes, was issued subject to remarketing
procedures and related agreements whereby the securities are remarketed and
sold on a periodic basis. Five classes of the senior bonds bear floating
interest rates. Newcastle obtained an interest rate swap in order to hedge
its exposure to the risk of changes in market interest rates with respect
to these bonds.
Newcastle enters into short-term warehouse agreements with major investment
banks for the right to purchase commercial mortgage backed securities,
unsecured REIT debt, real estate related loans and asset backed securities
for its real estate securities portfolios, prior to their being financed
with CBOs. These agreements are treated as non-hedge derivatives for
accounting purposes and are therefore marked to market through current
income. If the related CBO is not consummated, except as a result of
Newcastle's gross negligence, willful misconduct or breach of contract,
Newcastle will be required to pay the Net Loss, if any, as defined, up to
the related deposit, less any Excess Carry Amount, as defined, earned on
such deposit. The following table summarizes the agreements (in thousands):
March 31, 2005 Income Recorded
---------------------------------------------- ------------------
Deal Collateral Aggregate Fair Three Months Ended
Status Accumulated (1) Deposit Value March 31, 2005
------ --------------- --------- ------- ------------------
Open $370,768 $40,440 $41,793 $844
(1) Excludes $32.5 million of collateral accumulated on balance sheet and
recorded in real estate securities.
In March 2005, Newcastle closed on the sale of the vacant property in the
Bell Canada portfolio for CAD $14.3 million (USD $11.8 million) and
recorded a gain of approximately $0.5 million. In March 2005, Newcastle
agreed to the terms for a sale of the industrial/distribution property in
the Bell Canada portfolio. The terms include a gross sale price of CAD
$47.6 million (USD $39.3 million at March 31, 2005) and Newcastle has
received a nonrefundable deposit thereon. This property is classified as
Real Estate Held for Sale.
An unconsolidated subsidiary of Newcastle's that owns a portfolio of
convenience and retail gas stores had entered into a property management
agreement with a third party servicer which, in March 2005, was transferred
to an affiliate of our Manager; the related fees, approximately $20,000 per
year for three years, were not changed.
In January 2005, Newcastle sold 3.3 million shares of its common stock in a
public offering at a price to the public of $29.60 per share, for net
proceeds of approximately $96.6 million. For the purpose of compensating
the Manager for its successful efforts in raising capital for Newcastle, in
connection with this offering, Newcastle granted options to the Manager to
purchase 330,000 shares of Newcastle's common stock at the public offering
price, which were valued at approximately $1.1 million.
During the first quarter of 2005, Newcastle's Manager and certain of the
Manager's employees exercised options to purchase approximately 0.6 million
shares of Newcastle's common stock. In connection with this exercise,
Newcastle received proceeds of approximately $9.1 million.
In January 2005, Newcastle, through a consolidated subsidiary, acquired a
portfolio of approximately 8,100 manufactured housing loans for an
aggregate purchase price of approximately $308.2 million. The loans, which
were all current at the time of acquisition, are primarily fixed rate with
a weighted average coupon of approximately 9.00% and a weighted average
remaining term of approximately 5.00 years. Newcastle's acquisition was
initially funded with approximately $246.5 million of one-year debt
provided by two investment banks which is subject to adjustment based on
the market value and performance of the related portfolio. The debt bears
interest at LIBOR + 1.25%. Newcastle obtained an interest rate swap in
order to hedge its exposure to the risk of changes in market interest rates
with respect to this financing and the anticipated permanent financing of
this portfolio.
In January 2005, Newcastle entered into a servicing agreement with a
portfolio company of a private equity fund advised by an affiliate of
Newcastle's manager for them to service the above described portfolio of
manufactured housing loans. As compensation under the servicing agreement,
the portfolio company will receive, on a monthly basis, a net servicing fee
equal to 1.00% per annum on the unpaid principal balance of the loans being
serviced.
11
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
(dollars in tables in thousands, except per share data)
6. DERIVATIVE INSTRUMENTS
The following table summarizes the notional amounts and fair (carrying) values
of Newcastle's derivative financial instruments as of March 31, 2005.
Notional Amount Fair Value Longest Maturity
--------------- ---------- ----------------
Interest rate caps treated as hedges (A) $ 381,909 $ 2,591 October 2015
Interest rate swaps, treated as hedges (A) $2,119,950 $31,696 November 2018
Non-hedge derivative obligations (A) (B) (B) $ (527) July 2038
(A) Included in Derivative Assets or Derivative Liabilities, as applicable.
Derivative Liabilities also includes accrued interest.
(B) Represents two essentially offsetting interest rate caps and two
essentially offsetting interest rate swaps, each with notional amounts of
$32.5 million, an interest rate cap with a notional amount of $17.5
million, and one interest rate swap with a notional amount of $2.0 million
7. 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
outstanding stock options. Net income available for common stockholders is equal
to net income less preferred dividends.
The following is a reconciliation of the weighted average number of shares of
common stock outstanding on a diluted basis.
THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
---------- ----------
Weighted average number of shares of common
stock outstanding, basic 43,221,792 34,401,800
Dilutive effect of stock options, based
on the treasury stock method 407,286 574,578
---------- ----------
Weighted average number of shares of common
stock outstanding, diluted 43,629,078 34,976,378
========== ==========
As of March 31, 2005, Newcastle's outstanding options were summarized as
follows:
Held by the Manager 1,293,407
Issued to the Manager and subsequently transferred to
certain of the Manager's employees 655,890
Held by directors 13,000
---------
Total 1,962,297
=========
8. INCOME TAXES
Newcastle Investment Corp. is organized and conducts its operations to qualify
as a REIT under the Internal Revenue Code. A REIT will generally not be subject
to U.S. federal income tax on that portion of its income that it distributes to
its 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 elected to treat NC Circle Holdings II LLC as a
taxable REIT subsidiary ("TRS"), effective February 27, 2004. NC Circle Holdings
II LLC owns a portion of Newcastle's investment in one of its unconsolidated
subsidiaries. To the extent that NC Circle Holdings II LLC generates taxable
income, Newcastle has provided for relevant income taxes based on a blended
statutory rate of 40%. Newcastle accounts for income taxes in accordance with
the provisions of SFAS No. 109 "Accounting for Income Taxes." Under SFAS No.
109, Newcastle accounts for income taxes using the asset and liability method
under which deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. No such material differences have been recognized through March 31, 2005.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following should be read in conjunction with the unaudited consolidated
financial statements and notes included herein.
GENERAL
Newcastle Investment Corp. is a real estate investment and finance company. We
invest in real estate securities, loans and other real estate related assets. We
seek to deliver stable dividends and attractive risk-adjusted returns to our
stockholders through prudent asset selection, active management and the use of
match-funded financing structures, which reduce our interest rate and financing
risks. Our objective is to maximize the difference between the yield on our
investments and the cost of financing these investments while hedging our
interest rate risk. We emphasize asset quality, diversification, match-funded
financing and credit risk management.
We own a diversified portfolio of moderately credit sensitive real estate debt
investments including securities and loans.
Our portfolio of real estate securities includes commercial mortgage backed
securities (CMBS), senior unsecured debt issued by property REITs, real estate
related asset backed securities (ABS) and agency residential mortgage backed
securities (RMBS). Mortgage backed securities are interests in or obligations
secured by pools of mortgage loans. We generally target investments rated A
through BB, except for our agency RMBS which are generally considered AAA rated.
We also own, directly and indirectly, interest in loans and pools of loans,
including real estate related loans, commercial mortgage loans, residential
mortgage loans, and manufactured housing loans. We also own, directly and
indirectly, interests in operating real estate.
We employ leverage in order to achieve our return objectives. We do not have a
predetermined target debt to equity ratio as we believe the appropriate leverage
for the particular assets we are financing depends on the credit quality of
those assets. As of March 31, 2005, our debt to equity ratio was approximately
4.7 to 1. We maintain access to a broad array of capital resources in an effort
to insulate our business from potential fluctuations in the availability of
capital. We utilize multiple forms of financing including collateralized bond
obligations (CBOs), other securitizations, and term loans, as well as short term
financing in the form of repurchase agreements.
We seek to match-fund our investments with respect to interest rates and
maturities in order to minimize the impact of interest rate fluctuations on
earnings and reduce the risk of refinancing our liabilities prior to the
maturity of the investments. We seek to finance a substantial portion of our
real estate securities and loans through the issuance of debt securities in the
form of CBOs, which are obligations issued in multiple classes secured by an
underlying portfolio of securities. Our CBO financings offer us the structural
flexibility to buy and sell certain investments to manage risk and, subject to
certain limitations, to optimize returns.
We were formed in 2002 as a subsidiary of Newcastle Investment Holdings Corp.
(referred to herein as Holdings). Prior to our initial public offering, Holdings
contributed to us certain assets and liabilities in exchange for approximately
16.5 million shares of our common stock. Our operations commenced in July 2002.
In May 2003, Holdings distributed to its stockholders all of the shares of our
common stock that it held, and it no longer owns any of our common equity. As of
March 31, 2005, approximately 2.8 million shares of our common stock were held
by an affiliate of our manager and its principals. In addition, an affiliate of
our manager held options to purchase approximately 1.3 million shares of our
common stock at March 31, 2005.
The following table presents information on shares of our common stock issued
since our formation:
Net Proceeds
Year Shares Issued Range of Issue Prices (1) (millions)
---- ------------- ------------------------- ------------
Formation 16,488,517 N/A N/A
2002 7,000,000 $ 13.00 $ 80.0
2003 7,886,316 $20.35-$22.85 $163.4
2004 8,484,648 $26.30-$31.40 $224.3
1st Quarter 2005 3,899,430 $ 29.60 $105.7
----------
March 31, 2005 43,758,911
==========
(1) Excludes shares issued pursuant to the exercise of options and shares
issued to Newcastle's independent directors.
13
We are organized and conduct our operations to qualify as a REIT for U.S.
federal income tax purposes. As such, we will generally not be subject to U.S.
federal income tax on that portion of our income that is distributed to
stockholders if we distribute at least 90% of our REIT taxable income to our
stockholders by prescribed dates and comply with various other requirements.
We conduct our business by investing in three primary business segments: (i)
real estate securities and real estate related loans, (ii) operating real estate
and (iii) residential mortgage loans.
Revenues attributable to each segment are disclosed below (unaudited) (in
thousands).
Real Estate Securities Residential
For the Three Months and Real Estate Operating Mortgage
Ended March 31, Related Loans Real Estate Loans Unallocated Total
-------------------- ---------------------- ----------- ----------- ----------- -------
2005 $69,546 $1,276 $11,982 $147 $82,951
2004 $49,841 $1,156 $ 4,202 $110 $55,309
14
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 U.S. generally accepted accounting principles
("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.
Various Interest Entities
In December 2003, Financial Accounting Standards Board Interpretation ("FIN")
No. 46R "Consolidation of Variable Interest Entities" was issued as a
modification of FIN 46. FIN 46R clarified the methodology for determining
whether an entity is a variable interest entity ("VIE") and the methodology for
assessing who is the primary beneficiary of a VIE. VIEs are defined as entities
in which equity investors do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity to
finance its activities without additional subordinated financial support from
other parties. A VIE is required to be consolidated by its primary beneficiary,
and only by its primary beneficiary, which is defined as the party who will
absorb a majority of the VIE's expected losses or receive a majority of the
expected residual returns as a result of holding variable interests.
We have historically consolidated our existing CBO transactions (the "CBO
Entities") because we own the entire equity interest in each of them,
representing a substantial portion of their capitalization, and we control the
management and resolution of their assets. We have determined that certain of
the CBO Entities are VIEs and that we are the primary beneficiary of each of
these VIEs and will therefore continue to consolidate them. We have also
determined that the application of FIN 46R did not result in a change in our
accounting for any other entities which were previously consolidated. However,
it did cause us to consolidate one entity which was previously not consolidated,
ICH CMO, as described below under "- Liquidity and Capital Resources." We will
continue to analyze future CBO entities, as well as other investments, pursuant
to the requirements of FIN 46R. These analyses require considerable judgment in
determining the primary beneficiary of a VIE since they involve subjective
probability weighting of subjectively determined possible cash flow scenarios.
The result could be the consolidation of an entity acquired or formed in the
future that would otherwise not have been consolidated or the non-consolidation
of such an entity that would otherwise have been consolidated.
Valuation and Impairment of Securities
We have classified our real estate securities as available for sale. As such,
they are carried at fair value with net unrealized gains or losses reported as a
component of accumulated other comprehensive income. Fair value is based
primarily upon broker quotations, as well as counterparty 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 credit
spreads. Changes in market conditions, as well as changes in the assumptions or
methodology used to determine fair 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. For example, a decline in value is deemed to be other than temporary
if it is probable that we will be unable to collect all amounts due according to
the contractual terms of a security which was not impaired at acquisition.
Temporary declines in value generally result from changes in market factors,
such as market interest rates and credit spreads, or from certain macroeconomic
events, including market disruptions and supply changes, which do not directly
impact our ability to collect amounts contractually due. Significant judgment is
required in this analysis. To date, no such write-downs have been made.
Revenue Recognition on Securities
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 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. For securities
acquired at a discount for credit quality, the income recognized is based on a
"loss adjusted yield" whereby a provision for expected credit losses is accrued
on a periodic basis.
15
Valuation of Derivatives
Similarly, our derivative instruments are carried at fair value pursuant to
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities," as amended. Fair 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. Fair 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.
Impairment of Loans
We purchase, directly and indirectly, real estate related, commercial mortgage
and residential mortgage loans, including manufactured housing loans, to be held
for investment. We must periodically evaluate each of these loans or loan pools
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, or, for loans acquired at a discount for credit quality, when it is
deemed probable that we will be unable to collect as anticipated. 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. In
2003, a loss allowance of approximately $0.1 million was recorded with respect
to the residential mortgage loans in our portfolio. No other loan impairments
have been recorded to date.
Revenue Recognition on Loans
Income on these loans is recognized similarly to that on our securities and is
subject to similar uncertainties and contingencies. For loans acquired at a
discount for credit quality, the income recognized is based on a "loss adjusted
yield" whereby a provision for expected credit losses is accrued on a periodic
basis.
Impairment of Operating Real Estate
We own operating real estate held for investment. We review our operating real
estate for impairment annually or whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. Upon
determination of impairment, we would record a write-down of the asset, which
would be charged to earnings. Significant judgment is required both in
determining impairment and in estimating the resulting write-down. To date, we
have determined that no write-downs have been necessary on the operating real
estate in our portfolio. In addition, when operating real estate is classified
as held for sale, it must be recorded at the lower of its carrying amount or
fair value less costs of sale. Significant judgment is required in determining
the fair value of such properties. At March 31, 2005, we have two properties
classified as held for sale. No losses have been recorded in connection with
such properties.
16
RESULTS OF OPERATIONS
The following table summarizes the changes in our results of operations from the
three months ended March 31, 2004 to the three months ended March 31, 2005
(dollars in thousands):
Period to Period Period to Period
Increase (Decrease) Percent Change Explanation
------------------- ---------------- -----------
Interest Income $30,685 62.6% (1)
Rental and escalation income 117 10.2% (2)
Gain on settlement of investments (3,160) (61.5)% (3)
Interest expense 20,675 73.6% (1)
Property operating expense 53 8.3% (2)
Loan and security servicing expense 801 102.4% (1)
General and administrative expense (249) (21.8)% (4)
Management fee to affiliate 866 36.1% (5)
Incentive compensation to affiliate (402) (16.9)% (5)
Depreciation and amortization 23 20.4% (2)
Equity in earnings of unconsolidated
subsidiaries, net of taxes on
related taxable subsidiaries 630 51.5% (6)
------- -----
Income from continuing operations $ 6,505 31.0%
======= =====
(1) Changes in interest income and expense from the three months ended March
31, 2004 to the three months ended March 31, 2005 are primarily related to
our acquisition of interest bearing assets and related financings, as
follows:
Period to Period Increase (Decrease)
------------------------------------
Interest Income Interest Expense
--------------- ----------------
Real estate security and loan portfolios (A) $11,861 $ 8,447
Agency RMBS 2,325 2,080
Residential mortgage loan portfolio 1,755 2,027
Manufactured housing loan portfolio 6,394 3,118
Other real estate related loans 5,323 533
Other (B) 3,027 4,470
------- -------
$30,685 $20,675
======= =======
(A) Represents our fifth and sixth CBO financings and the acquisition of
the related collateral, as well as the deposit on our seventh CBO
financing.
(B) Primarily due to increasing interest rates on floating rate assets and
liabilities owned during the entire period.
Changes in loan and security servicing expense are also primarily due to
these acquisitions.
(2) These changes are primarily the result of the effect of the sale of certain
properties and the termination of a lease, offset by foreign currency
fluctuations.
(3) These changes are primarily a result of 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.
(4) The decrease in general and administrative expense is primarily a result of
decreased Canadian taxes, offset by increased professional fees related to
our compliance with the Sarbanes-Oxley Act of 2002.
(5) The increase in management fees is a result of our increased size resulting
from our equity issuances during this period. The decrease in incentive
compensation is primarily a result of the FFO loss we recorded related to
the sale of a property during the period, offset by our increased earnings.
(6) The increase in earnings from unconsolidated subsidiaries is primarily a
result of our early 2004 acquisition of an interest in an LLC which owns a
portfolio of convenience and retail gas stores. Note that the amounts shown
are net of income taxes on related taxable subsidiaries.
17
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 REIT taxable income. Our primary sources of funds for liquidity
consist of net cash provided by operating activities, borrowings under loans,
and the issuance of debt and equity securities. Our debt obligations are
generally secured directly by our investment assets.
We expect that our cash on hand and our cash flow provided by operations will
satisfy our liquidity needs with respect to our current investment portfolio
over the next twelve months. However, we currently expect to seek additional
capital in order to grow our investment portfolio. We have an effective shelf
registration statement with the SEC which allows us to issue various types of
securities, such as common stock, preferred stock, depository shares, debt
securities and warrants, from time to time, up to an aggregate of $750 million,
of which approximately $351 million remained available as of March 31, 2005.
We expect to meet our long-term liquidity requirements, specifically the
repayment of our debt obligations, through additional borrowings 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 relating to capital required for the growth of our investment
portfolio 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 maintain access to a
broad array of capital resources in an effort to insulate our business from
potential fluctuations in the availability of capital.
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 core business strategy is dependent upon our ability to
finance our real estate securities and other real estate related assets with
match-funded debt at rates that provide a positive net spread. If spreads for
such liabilities widen or if demand for such liabilities ceases to exist, then
our ability to execute future financings 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 March 31, 2005 we had an unrestricted cash balance of $28.8
million. Our cash flow provided by operations differs from our net income due to
four primary factors: (i) accretion of discount or premium on our real estate
securities and loans, discount on our debt obligations, deferred financing costs
and interest rate cap premiums, and deferred hedge gains and losses, (ii) gains
and losses from sales of assets financed with CBOs, (iii) depreciation of our
operating real estate, and (iv) straight-lined rental income. Proceeds from the
sale of assets which serve as collateral for our CBO financings, 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 match-funded investments are financed long-term and their credit status is
continuously monitored; therefore, these investments are expected to generate a
generally stable current return, subject to interest rate fluctuations. See
"Quantitative and Qualitative Disclosures About Market Risk -- Interest Rate
Exposure" below. Our remaining investments, financed with short term repurchase
agreements, are also subject to refinancing risk upon the maturity of the
related debt. See "Debt Obligations" below.
With respect to our operating real estate, we expect to incur expenditures of
approximately $0.2 million relating to tenant improvements, in connection with
the inception of leases, and capital expenditures during the twelve months
ending March 31, 2006.
With respect to one of our real estate related loans, we were committed to fund
up to an additional $22.7 million at March 31, 2005, subject to certain
conditions to be met by the borrower.
18
Debt Obligations
The following tables present certain information regarding our debt obligations
and related hedges as of March 31, 2005 (unaudited) (dollars in thousands):
Unhedged Weighted
Current Weighted Final Average
Month Face Carrying Average Stated Funding
Debt Obligation/Collateral Issued Amount Value Funding Cost Maturity Cost (1)
- -------------------------- ---------- ---------- ---------- ------------ ---------- --------
CBO Bonds Payable
Real estate securities July 1999 $ 436,008 $ 432,157 4.08% (2) July 2038 4.77%
Real estate securities and loans April 2002 444,000 440,575 3.67% (2) April 2037 6.29%
Real estate securities and loans March 2003 472,000 468,031 3.68% (2) March 2038 4.62%
Real estate securities and loans Sept. 2003 460,000 455,255 3.28% (2) Sept. 2038 4.55%
Real estate securities and loans March 2004 414,000 410,139 3.31% (2) March 2039 4.14%
Real estate securities and loans Sept. 2004 454,500 450,270 3.16% (2) Sept. 2039 4.21%
---------- ---------- ----
2,680,508 2,656,427 4.76%
---------- ---------- ----
Other Bonds Payable
Bell Canada portfolio (3) April 2002 29,769 29,500 7.02% April 2012 7.02%
ICH CMO loans (4) (4) 165,042 165,042 6.61% (2) Aug. 2030 6.62%
Manufactured housing loans (5) Jan. 2005 242,692 241,967 LIBOR+1.25% Jan. 2006 5.45%
---------- ---------- ----
437,503 436,509 6.00%
---------- ---------- ----
Notes Payable
Real estate related loan Nov. 2003 67,127 67,127 LIBOR+1.50% Nov. 2006 4.33%
Real estate related loan Feb. 2004 40,000 40,000 LIBOR+1.25% Feb. 2006 4.10%
Residential mortgage loans (5) Nov. 2004 479,553 479,553 LIBOR+0.15% Nov. 2007 3.11%
---------- ---------- ----
586,680 586,680 3.32%
---------- ---------- ----
Repurchase Agreements (5)
Residential mortgage loans (6) Rolling 62,880 62,880 LIBOR +0.43% Mar. 2005 3.52%
ABS-manufactured housing (7) Rolling 110,293 110,293 LIBOR +0.61% Mar. 2005 4.43%
Agency RMBS (8) Rolling 303,128 303,128 LIBOR +0.13% Jan. 2005 4.17%
Real estate securities Rolling 67,469 67,469 LIBOR +0.61% Various (9) 3.58%
Real estate related loans Rolling 53,500 53,500 LIBOR +0.95% Various (9) 3.78%
---------- ---------- ----
597,270 597,270 4.05%
---------- ---------- ----
Total debt obligations $4,301,961 $4,276,886 4.59%
========== ========== ====
Aggregate
Collateral Face Notional
Weighted Face Weighted Amount of Amount of
Average Amount of Collateral Average Floating Currently
Maturity Floating Carrying Maturity Rate Effective
Debt Obligation/Collateral (Years) Rate Debt Value (Years) Collateral Hedges
- -------------------------- -------- ---------- ---------- ---------- ---------- ----------
CBO Bonds Payable
Real estate securities 4.01 $ 341,008 $ 576,158 5.78 $ -- $ 321,318
Real estate securities and loans 5.21 372,000 480,292 6.12 84,599 290,000
Real estate securities and loans 7.06 427,800 499,823 5.29 152,356 276,060
Real estate securities and loans 7.62 442,500 492,047 4.77 233,272 192,500
Real estate securities and loans 7.38 382,750 429,357 5.95 204,955 165,300
Real estate securities and loans 7.95 442,500 497,319 6.24 254,465 189,373
---- ---------- ---------- ---- ---------- ----------
6.56 2,408,558 2,974,996 5.69 929,647 1,434,551
---- ---------- ---------- ---- ---------- ----------
Other Bonds Payable
Bell Canada portfolio (3) 1.32 -- 45,871 1.69 -- --
ICH CMO loans (4) 2.48 3,664 187,872 2.51 3,664 --
Manufactured housing loans (5) 0.83 242,692 307,451 4.92 -- 240,841
---- ---------- ---------- ---- ---------- ----------
1.48 246,356 541,194 3.81 3,664 240,841
---- ---------- ---------- ---- ---------- ----------
Notes Payable
Real estate related loan 1.64 67,127 83,329 1.65 83,329 --
Real estate related loan 0.83 40,000 50,000 1.85 50,000 --
Residential mortgage loans (5) 1.97 479,553 515,394 3.65 507,870 --
---- ---------- ---------- ---- ---------- ----------
1.85 586,680 648,723 3.25 641,199 --
---- ---------- ---------- ---- ---------- ----------
Repurchase Agreements (5)
Residential mortgage loans (6) 0.25 62,880 66,134 4.41 64,972 --
ABS-manufactured housing (7) 0.23 110,293 155,060 5.85 -- 107,700
Agency RMBS (8) 0.08 303,128 309,970 3.32 -- 295,063
Real estate securities 0.16 67,469 91,569 4.21 32,609 41,795
Real estate related loans 0.51 53,500 70,000 1.61 70,000 --
---- ---------- ---------- ---- ---------- ----------
0.17 597,270 692,733 3.93 167,581 444,558
---- ---------- ---------- ---- ---------- ----------
Total debt obligations 4.51 $3,838,864 $4,857,646 4.90 $1,742,091 $2,119,950
==== ========== ========== ==== ========== ==========
(1) Includes the effect of applicable hedges.
(2) Weighted average, including floating and fixed rate classes.
(3) Denominated in Canadian dollars.
(4) See "Liquidity and Capital Resources" below regarding the consolidation of
ICH CMO.
(5) Subject to potential mandatory prepayments based on collateral value.
(6) The counterparty on this repo is Bear Stearns Mortgage Capital Corporation.
(7) The counterparty on these repos is Greenwich Capital Markets Inc.
(8) The counterparty on this repo is Bank of America Securities LLC.
(9) The longest maturity is October 2005.
19
Our long-term debt obligations existing at March 31, 2005 (gross of $25.1
million of discounts) are expected to mature as follows (unaudited) (in
thousands):
Period from April 1, 2005 through December 31, 2005 $ 602,520
2006 344,568
2007 479,553
2008 --
2009 --
2010 --
Thereafter 2,875,320
----------
Total $4,301,961
==========
Certain of the debt obligations included above are obligations of our
consolidated subsidiaries which own the related collateral. In some cases,
including the CBO and Other Bonds Payable, such collateral is not available to
other creditors of ours.
In connection with the sale of two classes of CBO bonds, we entered into two
interest rate swaps and three interest rate cap agreements that do not qualify
for hedge accounting.
In November 2001, we sold the retained subordinated $17.5 million Class E Note
from our first CBO to a third party. 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 our second CBO. The Class E Note is eliminated in
consolidation.
One class of CBO bonds, with a $395.0 million face amount, was issued subject to
remarketing procedures and related agreements whereby such bonds are remarketed
and sold on a periodic basis. These bonds are fully insured by a third party
with respect to the timely payment of interest and principal thereon.
In October 2003, pursuant to FIN No. 46R, we consolidated an entity which holds
a portfolio of commercial mortgage loans which has been securitized. This
investment, which we refer to as the ICH CMO, was previously treated as a
non-consolidated residual interest in such securitization. We exercise no
control over the management or resolution of these assets. The primary effect of
the consolidation is the requirement that we reflect the gross loan assets and
gross bonds payable of this entity in our financial statements.
In July 2004, we refinanced $342.5 million of the AAA and AA bonds in our first
CBO. $322.5 million of AAA bonds were refinanced at LIBOR + 0.30% from LIBOR +
0.65% and $20.0 million of AA bonds were refinanced at LIBOR + 0.50% from LIBOR
+ 0.80%.
20
Other
We have entered into credit derivative instruments with a major investment bank,
whereby we receive the sum of all interest, fees and any positive change in
value amounts (the total return cash flows) from a reference asset with a
specified notional amount, and pay interest on such notional plus any negative
change in value amounts from such asset. These agreements are recorded in
Derivative Assets and treated as non-hedge derivatives for accounting purposes
and are therefore marked to market through income. Under the agreements, we are
required to post an initial margin deposit to an interest bearing account and
additional margin may be payable in the event of a decline in value of the
reference asset. Any margin on deposit, less any negative change in value
amounts, will be returned to us upon termination of the contract. The following
table presents information on these instruments as of March 31, 2005.
Notional Margin Receive Pay Fair
Month Executed Reference Asset Amount Amount Interest Rate Interest Rate Value
- -------------- ------------------------------- -------- ------- ------------- ------------- ------
November 2004 Term loan to a retail mall REIT $106,760 $18,190 LIBOR + 2.25% LIBOR + 0.500% $1,855
February 2005 Term loan to a diversified real
estate and finance company $100,000 $20,000 LIBOR + 3.00% LIBOR + 0.625% $ 192
We enter into short-term warehouse agreements with major investment banks for
the right to purchase commercial mortgage backed securities, unsecured REIT
debt, real estate related loans and asset backed securities for our real estate
securities portfolios, prior to their being financed with CBOs. These agreements
are treated as non-hedge derivatives for accounting purposes and are therefore
marked to market through current income. If the related CBO is not consummated,
except as a result of our gross negligence, willful misconduct or breach of
contract, we will be required to pay the Net Loss, if any, as defined, up to the
related deposit, less any Excess Carry Amount, as defined, earned on such
deposit. The following table summarizes the agreements (in thousands):
March 31, 2005 Income Recorded
- ----------------------------------------------------- ------------------
Collateral Aggregate Three Months Ended
Deal Status Accumulated(1) Deposit Fair Value March 31, 2005
- ----------- -------------- --------- ---------- ------------------
Open $370,768 $40,440 $41,793 $844
(1) Excludes $32.5 million of collateral accumulated on balance sheet and
recorded in real estate securities.
In April 2005, we completed our seventh CBO financing, whereby a portfolio of
real estate securities and loans was purchased by a consolidated subsidiary
which issued $447.0 million face amount of investment grade senior bonds and
$53.0 million face amount of non-investment grade subordinated bonds in a
private placement. The non-investment grade bonds were retained by us and the
$442.0 million carrying amount of the investment grade bonds, which bore
interest at a weighted average effective rate, including discount and issue cost
amortization and the effect of hedges, of 4.48%, had an expected weighted
average life of approximately 8.9 years. The largest tranche, the $323.0 million
face amount of Class I-MM notes, was issued subject to remarketing procedures
and related agreements whereby the securities are remarketed and sold on a
periodic basis. Five classes of the senior bonds bear floating interest rates.
We obtained an interest rate swap in order to hedge our exposure to the risk of
changes in market interest rates with respect to these bonds.
In January 2005, we acquired a portfolio of approximately 8,100 manufactured
housing loans for an aggregate purchase price of approximately $308.2 million.
The loans, which were all current at the time of acquisition, are primarily
fixed rate. Our acquisition was initially financed with approximately $246.5
million of one-year bonds which are subject to adjustment based on the market
value and performance of the related portfolio.
21
Stockholders' Equity
Common Stock
The following table presents information on shares of our common stock issued
since December 31, 2004:
Net Proceeds Options Granted
Period Shares Issued Range of Issue Prices(1) (millions) to Manager
------ ------------- ------------------------ ------------ ---------------
First Quarter 2005 3,899,430 $29.60 $105.7 330,000
(1) Excludes shares issued pursuant to the exercise of options and shares
issued to our independent directors.
At March 31, 2005, we had 43,758,911 shares of common stock outstanding.
As of March 31, 2005, our outstanding options were summarized as follows:
Held by the Manager 1,293,407
Issued to the Manager and subsequently transferred
to certain of the Manager's employees 655,890
Held by directors 13,000
---------
Total 1,962,297
=========
Preferred Stock
In March 2003, we issued 2.5 million shares of 9.75% Series B Cumulative
Redeemable Preferred Stock (the "Series B Preferred"). The Series B Preferred
has a $25 liquidation preference, no maturity date and no mandatory redemption.
We have the option to redeem the Series B Preferred beginning in March 2008.
Other Comprehensive Income
During the three months ended March 31, 2005, our accumulated other
comprehensive income changed due to the following factors (in thousands):
Accumulated other comprehensive income, December 31, 2004 $ 71,770
Unrealized (loss) on securities (42,353)
Reclassification of realized (gain) on securities into earnings (1,409)
Foreign currency translation (719)
Reclassification of realized foreign currency translation into
earnings (542)
Unrealized gain on derivatives designated as cash flow hedges 44,637
Reclassification of realized (gain) on derivatives
designated as cash flow hedges into earnings (342)
--------
Accumulated other comprehensive income, March 31, 2005 $ 71,042
========
Our book equity changes as our real estate securities portfolio and derivatives
are marked-to-market each quarter, among other factors. The primary causes of
mark-to-market changes are changes in interest rates and credit spreads. During
the period, increasing interest rates offset by tightening credit spreads
resulted in a net decrease in unrealized gains on our real estate securities
portfolio. In an environment of widening credit spreads and increasing interest
rates, we believe our new investment activities will benefit. While such an
environment will likely result in a decrease in the fair value of our existing
securities portfolio and, therefore, reduce our book equity and ability to
realize gains on such existing securities, it will not directly affect our
earnings or our cash flow or our ability to pay dividends.
In addition, the slight strengthening of the U.S. dollar against both the
Canadian dollar and the Euro has resulted in an increase in unrealized losses on
our Canadian and Belgian operating real estate.
Common Dividends Paid
Declared for Amount
the Period Ended Paid Per Share
- ---------------- -------------- ---------
March 31, 2005 April 27, 2005 $0.625
22
Cash Flow
Net cash flow provided by operating activities increased from $2.4 million for
the three months ended March 31, 2004 to $14.1 million for the three months
ended March 31, 2005. This change primarily resulted from the acquisition and
settlement of our investments as described above.
Investing activities (used) ($357.1 million) and ($508.0 million) during the
three months ended March 31, 2005 and 2004, respectively. Investing activities
consisted primarily of investments made in certain real estate securities and
other real estate related assets, net of proceeds from the sale or settlement of
investments.
Financing activities provided $333.9 million and $501.5 million during the three
months ended March 31, 2005 and 2004, respectively. The equity issuances,
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, the purchase of hedging instruments, the
payment of dividends, and the repayment of debt as described above.
See the consolidated statements of cash flows included in our consolidated
financial statements included herein for a reconciliation of our cash position
for the periods described herein.
INTEREST RATE, CREDIT AND SPREAD RISK
We are subject to interest rate, credit and spread risk with respect to our
investments.
Our primary interest rate exposures relate to our real estate securities, loans
and floating rate debt obligations, 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 and hedges. Changes in the level of interest rates
also can effect, among other things, our ability to acquire real estate
securities and loans, the value of our real estate securities, loans and
derivatives, and our ability to realize gains from the settlement of such
assets.
Our general financing strategy focuses on the use of match-funded structures.
This means that we seek to match the maturities of our debt 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 our earnings. In addition, we generally match-fund
interest rates on our investments 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, which
allows us to reduce the impact of changing interest rates on our earnings. See
"Quantitative and Qualitative Disclosures About Market Risk - Interest Rate
Exposure" below.
Real Estate Securities
Interest rate changes may also impact our net book value as our real estate
securities and related hedge derivatives are marked to market each quarter. Our
loan investments and debt obligations are not marked to market. Generally, as
interest rates increase, the value of our fixed rate securities decreases, and
as interest rates decrease, the value of such securities will increase. In
general, we would expect that over time, decreases in the value of our real
estate securities portfolio attributable to interest rate changes will be offset
to some degree by increases in the 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 real estate securities portfolio is largely financed to maturity through
long-term CBO financings that are not redeemable 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 securities portfolio will not directly affect our recurring earnings or
our ability to pay dividends.
The commercial mortgage and asset backed securities 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 senior unsecured REIT debt securities we invest in reflect comparable credit
risk. Credit risk refers to each individual borrower's ability to make required
interest and principal payments on the scheduled due dates. We believe, based on
our 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 commercial mortgage
and asset backed securities, and the issuer's underlying equity and subordinated
debt, in the case of senior unsecured REIT debt securities, are designed to bear
the first risk of default and loss. We further minimize credit risk by actively
monitoring our real estate securities 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. While we have not
experienced any significant credit losses, in the event of a significant rising
interest rate environment and/or economic downturn, loan and collateral defaults
may increase and result in credit losses that would adversely affect our
liquidity and operating results.
23
Our real estate securities portfolio is diversified by asset type, industry,
location and issuer. At March 31, 2005, we had 456 real estate securities and
loans, excluding the ICH CMO loans as described above. Our largest investment in
a real estate security or real estate related loan was $85.3 million and our
average investment size was $8.3 million at March 31, 2005. Furthermore, our
real estate securities are supported by pools of underlying loans. For instance,
our CMBS investments had over 16,100 underlying loans at March 31, 2005. We
expect that this diversification also helps to minimize the risk of capital
loss. At March 31, 2005, our real estate securities and real estate related
loans (excluding the ICH CMO loans) had an overall weighted average credit
rating of approximately BBB-, and approximately 70% had an investment grade
rating (BBB- or higher).
Our real estate securities are also subject to spread risk. Our fixed rate
securities are valued based on a market credit spread over the rate payable on
fixed rate U.S. Treasuries of like maturity. 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 real estate securities
portfolio would tend to decline. Conversely, if the spread used to value such
securities were to decrease (or "tighten"), the value of our real estate
securities portfolio would tend to increase. Our floating rate securities are
valued based on a market credit spread over LIBOR and are effected similarly by
changes in LIBOR spreads. Such changes in the market value of our real estate
securities portfolio may affect 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. If
the value of our securities subject to repurchase agreements were to decline, it
could affect our ability to refinance such securities upon the maturity of the
related repurchase agreements. See " 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 affect the yield
required on our real estate securities and therefore their value. This would
have similar effects on our real estate securities portfolio and our financial
position and operations to a change in spreads.
Loans
Similar to our real estate securities portfolio, we are subject to credit and
spread risk with respect to our real estate related, commercial mortgage and
residential mortgage loan portfolios. However, unlike our real estate securities
portfolio, our loans do not benefit from the support of junior classes of
securities, but rather bear the first risk of default and loss. We believe that
this credit risk is mitigated through our due diligence process and periodic
reviews of the borrower's payment history, delinquency status, and the
relationship of the loan balance to the underlying property value. At March 31,
2005, our residential mortgage loan portfolio was characterized by high credit
quality borrowers with a weighted average FICO score of 716 at origination, and
had a weighted average loan to value ratio of 72.9%. As of March 31, 2005,
approximately $507.9 million face amount of our residential mortgage loans were
held in securitized form, of which over 94% of the principal balance was AAA
rated.
Our loan portfolios are diversified by geographic location and by borrower. We
believe that this diversification also helps to minimize the risk of capital
loss.
Our loan portfolios are also subject to spread risk. Our floating rate loans are
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 relative
to LIBOR. The value of our floating rate loans 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). Our fixed
rate loans are valued based on a market credit spread over U.S. Treasuries and
are effected similarly by changes in U.S. Treasury spreads. If the value of our
loans subject to repurchase agreements were to decline, it could affect our
ability to refinance such loans upon the maturity of the related repurchase
agreements.
Any credit or spread losses incurred with respect to our loan portfolios would
effect us in the same way as similar losses on our real estate securities
portfolio as described above, except that our loan portfolios are not marked to
market.
OFF-BALANCE SHEET ARRANGEMENTS
As of March 31, 2005, we had the following material off-balance sheet
arrangements:
- The $41.8 million carrying value of our deposit on our seventh real
estate securities portfolio, as described above under "-Liquidity and
Capital Resources." Except as a result of our gross negligence,
willful misconduct or breach of contract, our potential loss is
limited to the amount shown, which is included in our consolidated
balance sheet.
- 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 Canada portfolio, if the related bonds are not fully repaid by
such date. We believe the fair value of this guarantee is negligible
at March 31, 2005.
24
At this time, we do not anticipate a substantial risk of incurring a loss with
respect to any of the arrangements.
We are also party to two total return swaps which are treated as non-hedge
derivatives. For further information on these investments, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources."
CONTRACTUAL OBLIGATIONS
During the first three months of 2005, we had all of the material contractual
obligations referred to in our annual report on Form 10-K for the year ended
December 31, 2004, as well as the following:
Contract Category Change
- ----------------- ------
Other bonds payable The financing for the January 2005 purchase of a portfolio
of manufactured housing loans was obtained.
The terms of these contracts are described under "Quantitative and Qualitative
Disclosures About Market Risk" below.
INFLATION
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 "Quantitative and
Qualitative Disclosure About Market Risk -- Interest Rate Exposure" below.
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 a Belgian index with respect to the LIV portfolio.
We believe that inflationary increases in expenses will generally be offset by
the expense reimbursements and contractual rent increases described above.
FUNDS FROM OPERATIONS
We believe FFO is one appropriate measure of the operating performance of real
estate companies because it provides investors with information regarding our
ability to service debt and make capital expenditures. We also believe that 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. Furthermore, FFO is used to compute our incentive compensation to
the Manager. FFO, for our purposes, represents net income available for common
stockholders (computed in accordance with GAAP), excluding extraordinary items,
plus depreciation of operating real estate, 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 prior to the commencement of our operations includes certain
adjustments related to our predecessor's investment in Fund I. 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. Our calculation of FFO may be different from the calculation used by
other companies and, therefore, comparability may be limited.
Funds from Operations (FFO) is calculated as follows for the three months ended
March 31, 2005 (unaudited) (in thousands):
Income available for common stockholders $27,161
Operating real estate depreciation 291
Accumulated depreciation on operating real estate sold (1,829)
-------
Funds from Operations (FFO) $25,623
=======
25
Funds from Operations was derived from the Company's segments as follows
(unaudited) (in thousands):
Return
Average Invested FFO for the on
Common Equity Three Invested
for the Three Months Common
Months Ended Ended Equity
Book Equity at March 31, 2005 March 31, (ROE)
March 31, 2005 (2) 2005 (3)
-------------- ---------------- ----------- --------
Real estate securities and real estate related loans $678,296 $655,159 $28,739 17.6%
Operating real estate 54,332 63,226 954 6.0%
Residential mortgage loans 106,721 92,619 3,413 14.7%
Unallocated (1) (68,424) (53,122) (7,483) N/A
-------- -------- ------- ----
Total (2) 770,925 $757,882 $25,623 13.5%
======== ======= ====
Preferred stock 62,500
Accumulated depreciation (2,986)
Accumulated other comprehensive income 71,042
--------
Net book equity $901,481
========
(1) Unallocated FFO represents ($1,523) of preferred dividends and ($5,960) of
corporate general and administrative expense, management fees and incentive
compensation for the three months ended March 31, 2005.
(2) Invested common equity is equal to book equity excluding preferred stock,
accumulated depreciation and accumulated other comprehensive income.
(3) FFO divided by average invested common equity, annualized.
RELATED PARTY TRANSACTIONS
In January 2005, we entered into a servicing agreement with a portfolio company
of a private equity fund advised by an affiliate of our manager for such company
to service a portfolio of manufactured housing loans. As compensation under the
servicing agreement, the portfolio company will receive, on a monthly basis, a
net servicing fee equal to 1.00% per annum on the unpaid principal balance of
the loans being serviced. We acquired a portfolio of such loans in January 2005
at a cost of approximately $308.2 million.
26
ITEM 3. 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,
credit spread risk and foreign currency exchange rate risk. These risks 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.
For a further understanding of how market risk may affect our financial position
or operating results, please refer to "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Application of Critical
Accounting Policies."
INTEREST RATE EXPOSURE
Our primary interest rate exposures relate to our real estate securities, loans
and floating rate debt obligations, as well as our interest rate swaps and caps.
Changes in the general level of interest rates can affect 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 and hedges. Changes in the level of interest rates
also can affect, among other things, our ability to acquire real estate
securities and loans, the value of our real estate securities, loans and
derivatives, and our ability to realize gains from the settlement of such
assets. 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 March 31, 2005, a 100 basis point increase in short term interest
rates would increase our earnings by approximately $0.9 million per annum.
While we have not experienced any significant credit losses, in the event of a
significant rising interest rate environment and/or economic downturn, loan and
collateral defaults may increase and result in credit losses that would
adversely affect our liquidity and operating results.
Interest rate changes may also impact our net book value as our real estate
securities and related hedge derivatives are marked to market each quarter. Our
loan investments and debt obligations are not marked to market. Generally, as
interest rates increase, the value of our fixed rate securities decreases, and
as interest rates decrease, the value of such securities will increase. In
general, we would expect that over time, decreases in the value of our real
estate securities portfolio attributable to interest rate changes will be offset
to some degree by increases in the 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 real estate securities portfolio is largely financed to maturity through
long-term CBO financings that are not redeemable 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. As of March 31, 2005, a 100 basis point change in short term
interest rates would impact our net book value by approximately $38.1 million.
Our general financing strategy focuses on the use of match-funded structures.
This means that we seek to match the maturities of our debt 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 our earnings. In addition, we generally match-fund
interest rates on our investments 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,
which allows us to reduce the impact of changing interest rates on our earnings.
Our real estate securities and real estate related loan portfolio, excluding the
ICH CMO loans as described below, and their respective liabilities had weighted
average lives of 5.22 years and 5.36 years, respectively, as of March 31, 2005.
Our financing strategy is dependent on our ability to place the match-funded
debt we use to finance our investments at rates that provide a positive net
spread. If spreads for such liabilities widen or if demand for such liabilities
ceases to exist, then our ability to execute future financings will be severely
restricted.
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 floating rate interest payments
from the counterparty for fixed interest payments from us. This can effectively
convert a floating rate debt obligation into a fixed rate debt 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.
27
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.
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.
CREDIT SPREAD CURVE EXPOSURE
Our real estate securities are also subject to spread risk. Our fixed rate
securities are valued based on a market credit spread over the rate payable on
fixed rate U.S. Treasuries of like maturity. 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 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 real estate securities
portfolio would tend to decline. Conversely, if the spread used to value such
securities were to decrease (or "tighten"), the value of our real estate
securities portfolio would tend to increase. Our floating rate securities are
valued based on a market credit spread over LIBOR and are effected similarly by
changes in LIBOR spreads. Such changes in the market value of our real estate
securities 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 rates, would also effect the yield
required on our real estate securities and therefore their value. This would
have similar effects on our real estate securities portfolio and our financial
position and operations to a change in spreads.
Our loan portfolios are also subject to spread risk. Our floating rate loans are
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 relative
to LIBOR. The value of our floating rate loans 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). Our fixed
rate loans are valued based on a market credit spread over U.S. Treasuries and
are effected similarly by changes in U.S. Treasury spreads. If the value of our
loans subject to repurchase agreements were to decline, it could affect our
ability to refinance such loans upon the maturity of the related repurchase
agreements.
Any decreases in the value of our loan portfolios due to spread changes would
effect us in the same way as similar changes to our real estate securities
portfolio as described above, except that our loan portfolios are not marked to
market.
As of March 31, 2005, an immediate 25 basis point movement in credit spreads
would impact our net book value by approximately $37.4 million, but would not
directly affect our earnings or cash flow.
CURRENCY RATE EXPOSURE
Our primary foreign currency exchange rate exposures relate to our operating
real estate and related leases. 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 non-U.S. 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 investments in the LIV portfolio and the Bell Canada portfolio. These
properties are financed utilizing debt denominated in their respective local
currencies (the Euro and the Canadian Dollar). The net equity invested in these
portfolios at March 31, 2005, approximately $12.8 million and $24.7 million,
respectively, is exposed to foreign currency exchange risk.
28
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 instruments 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, credit spread and currency rate
environments as of March 31, 2005 and do not take into consideration the effects
of subsequent interest rate, credit spread or currency rate fluctuations.
We note that the values of our investments in real estate securities, loans and
derivative instruments, primarily interest rate hedges on our debt obligations,
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.
Interest Rate Risk
We held the following interest rate and credit spread risk sensitive instruments
at March 31, 2005 (unaudited) (dollars in thousands):
Carrying Principal Balance or Weighted Average Maturity
Value Notional Amount Yield/Funding Cost Date Fair Value
---------- -------------------- ------------------ -------- ----------
ASSETS:
Real estate securities, available for sale (1) $3,429,088 $3,418,981 6.23% (1) $3,429,088
Real estate securities portfolio deposit (2) 41,793 (2) (2) (2) 41,793
Real estate related loans (3) 567,489 569,970 7.71% (3) 571,249
Residential mortgage loans (4) 888,979 896,498 5.15% (4) 888,979
Interest rate caps, treated as hedges (5) 2,591 381,909 N/A (5) 2,591
Interest rate swaps, treated as hedges (6) 31,696 2,119,950 N/A (6) 31,696
Total return swaps (7) 2,047 206,760 N/A (7) 2,047
LIABILITIES:
CBO bonds payable (8) 2,656,427 2,680,508 4.76% (8) 2,716,079
Other bonds payable (9) 436,509 437,503 6.00% (9) 443,144
Notes payable (10) 586,680 586,680 3.32% (10) 586,680
Repurchase agreements (11) 597,270 597,270 4.05% (11) 597,270
Non-hedge derivative obligations (12) 527 (12) N/A (12) 527
(1) These securities contain various terms, including fixed and floating rates,
self-amortizing and interest only. Their weighted average maturity is 5.54
years. The fair value of these securities is estimated by obtaining third
party broker quotations, if available and practicable, and counterparty
quotations.
(2) The fair value of the real estate securities portfolio deposit, which is
treated as a non-hedge derivative, is determined by obtaining third party
broker quotations on the underlying securities, if available and
practicable, and counterparty quotations, including a counterparty
quotation on the portion of the fair value resulting from the Excess Carry
Amount, as defined, earned on such deposit. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations-Liquidity and
Capital Resources" for a further discussion of this deposit.
(3) Represents the following loans:
Carrying Loan Weighted Avg. Weighted Average Floating Rate Loans as
Loan Type Value Count Yield Maturity (Years) a % of Carrying Amount Fair Value
- --------- -------- ----- ------------- ---------------- ---------------------- ----------
B-Notes $117,598 22 6.85% 2.52 83.5% $117,598
Mezzanine Loans 103,538 5 7.27% 2.27 100.0% 103,538
Bank Loans 146,299 3 7.14% 1.89 100.0% 146,299
Real Estate Loans 12,182 1 19.73% 2.75 --% 12,329
ICH CMO Loans 187,872 115 8.17% 2.51 2.0% 191,485
-------- --- ----- ---- ----- --------
$567,489 146 7.71% 2.31 62.0% $571,249
======== === ===== ==== ===== ========
29
The fixed rate B-Notes were valued by obtaining counterparty quotations.
The rest of the B-Notes as well as the mezzanine loans, bank loans, and
real estate loans, with one exception, bear floating rates of interest and
we believe that, for similar financial instruments with comparable credit
risks, their effective rates approximate market rates. Accordingly, the
carrying amounts outstanding are believed to approximate fair value. The
one fixed rate loan was valued by discounting expected future receipts by a
rate calculated by imputing a spread over a market index on the date of
borrowing. The ICH CMO loans were valued by discounting expected future
receipts by a rate calculated based on current market conditions for
comparable financial instruments, including market interest rates and
credit spreads.
(4) This aggregate portfolio of residential loans consists of a portfolio of
floating rate residential mortgage loans as well as a portfolio of
primarily fixed rate manufactured home loans. The portfolio of residential
mortgage loans has a weighted average maturity of 3.74 years. We believe
that, for similar financial instruments with comparable credit risks, the
effective rate on this portfolio approximates a market rate. Accordingly,
the carrying amount of this portfolio is believed to approximate fair
value. The manufactured housing loan portfolio, which has a weighted
average maturity of 4.92 years, was valued by discounting expected future
receipts by a rate calculated based on current market conditions for
comparable financial instruments, including market interest rates and
credit spreads. Based on this analysis, the carrying amount of this
portfolio is believed to approximate fair value.
(5) Represents cap agreements as follows:
Notional Balance Effective Date Maturity Date Capped Rate Strike Rate Fair Value
---------------- -------------- -------------- ------------- ----------- ----------
$302,290 Current March 2009 1-Month LIBOR 6.50% $ 502
18,000 January 2010 October 2015 3-Month LIBOR 8.00% 404
8,619 December 2010 June 2015 3-Month LIBOR 7.00% 588
53,000 May 2011 September 2015 1-Month LIBOR 7.50% 1,097
-------- ------
$381,909 $2,591
======== ======
The fair value of these agreements is estimated by obtaining counterparty
quotations.
(6) Represents swap agreements as follows (in thousands):
Notional Balance Effective Date Maturity Date Swapped Rate Fixed Rate Fair Value
---------------- -------------- -------------- ------------- ---------- ----------
$ 19,028 Current July 2005 1-Month LIBOR 6.1755% $ (112)
302,290 Current March 2009 1-Month LIBOR* 3.1250% 9,465
290,000 Current April 2011 3-Month LIBOR 5.9325% (17,541)
276,060 Current March 2013 3-Month LIBOR 3.8650% 14,481
192,500 Current March 2015 1-Month LIBOR 4.8880% (1,698)
165,300 Current March 2014 3-Month LIBOR 3.9945% 8,703
189,373 Current September 2014 3-Month LIBOR 4.3731% 7,016
240,841 Current February 2014 1-Month LIBOR 4.2070% 3,825
11,000 Current November 2008 1-Month LIBOR 3.5400% 326
7,500 Current July 2018 1-Month LIBOR 4.8300% 23
5,500 Current November 2018 1-Month LIBOR 4.4800% 71
65,200 Current January 2009 1-Month LIBOR 3.6500% 1,813
6,500 Current March 2009 1-Month LIBOR 3.3360% 265
81,104 Current October 2009 1-Month LIBOR 3.7150% 1,459
77,145 Current September 2009 1-Month LIBOR 3.7090% 1,376
26,557 Current December 2009 1-Month LIBOR 3.8290% 414
9,001 Current August 2009 1-Month LIBOR 4.0690% 74
26,116 Current February 2010 1-Month LIBOR 4.1030% 227
40,256 Current April 2010 1-Month LIBOR 4.5310% (121)
34,884 Current March 2010 1-Month LIBOR 4.5260% (105)
21,295 Current January 2009 1-Month LIBOR 3.2900% 868
20,500 Current September 2011 1-Month LIBOR 4.2225% 524
12,000 Current January 2015 1-Month LIBOR 4.5100% 343
---------- --------
$2,119,950 $ 31,696
========== ========
* up to 6.50%
(7) Represents total return swaps which are treated as non-hedge derivatives.
The fair value of these agreements, which is included in Derivative Assets,
is estimated by obtaining counterparty quotations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" for a further discussion of these swaps.
30
(8) These bonds were valued by discounting expected future payments by a rate
calculated based on current market conditions for comparable financial
instruments, including market interest rates and credit spreads. The
weighted average maturity of the CBO bonds payable is 6.56 years. The CBO
bonds payable amortize principal prior to maturity based on collateral
receipts, subject to reinvestment requirements.
(9) The Bell Canada bonds were valued, in U.S. dollars at the period end
exchange rate, by discounting expected future payments by a rate calculated
by imputing a spread over a market index on the date of borrowing. It
amortizes principal periodically with a balloon payment at maturity in
April 2012. The ICH CMO bonds were valued by discounting expected future
payments by a rate calculated based on current market conditions for
comparable financial instruments, including market interest rates and
credit spreads. They amortize principal prior to maturity based on
collateral receipts and their final stated maturity is in August 2030. The
manufactured housing loan bonds mature in January 2006, bear a floating
rate of interest, and are subject to adjustment monthly based on the agreed
upon market value of the loan portfolio. We believe that, for similar
financial instruments with comparable credit risks, their effective rate
approximates a market rate. Accordingly, the carrying amount outstanding is
believed to approximate fair value.
(10) The first real estate related loan financing matures in November 2006,
bears a floating rate of interest and amortizes principal based on
collateral receipts. The second real estate related loan financing matures
in February 2006, bears a floating rate of interest, and amortizes
principal based on collateral receipts. The residential mortgage loan
financing matures in November 2007, bears a floating rate of interest, and
is subject to adjustment monthly based on the agreed upon market value of
the loan portfolio. We believe that, for similar financial instruments with
comparable credit risks, their effective rates approximate market rates.
Accordingly, the carrying amounts outstanding are believed to approximate
fair value.
(11) 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. These agreements mature
in one to seven months.
(12) 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
one interest rate swap with a notional amount of $2.0 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 latter swap is January 2009. The fair value of these agreements is
estimated by obtaining counterparty quotations.
Currency Rate Risk
We held the following currency rate risk sensitive balances at March 31,
2005 (unaudited) (U.S. dollars; in thousands, except exchange rates):
Carrying Current Effect of a 5% Effect of a 5%
Amount Local Exchange Negative Change Negative Change
(USD) Currency Rate to USD in Euro Rate in CAD Rate
-------- -------- ----------- --------------- ---------------
Assets:
LIV portfolio $12,027 Euro 0.7714 $(601) N/A
Bell Canada portfolio 45,871 CAD 1.2104 N/A $(2,294)
LIV other, net 790 Euro 0.7714 (40) N/A
Bell Canada other, net 8,297 CAD 1.2104 N/A (415)
Liabilities:
Bell Canada bonds 29,500 CAD 1.2104 N/A 1,475
----- -------
Total $(641) $(1,234)
===== =======
USD refers to U.S. dollars; CAD refers to Canadian dollars.
31
ITEM 4. CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures. The Company's management, with the
participation of the Company's Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Company's disclosure
controls and procedures (as such term is defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act")) as of the end of the period covered by this report. The
Company's disclosure controls and procedures are designed to provide
reasonable assurance that information is recorded, processed, summarized
and reported accurately and on a timely basis. Based on such evaluation,
the Company's Chief Executive Officer and Chief Financial Officer have
concluded that, as of the end of such period, the Company's disclosure
controls and procedures are effective.
(b) Internal Control Over Financial Reporting. There have not been any changes
in the Company's internal control over financial reporting (as such term is
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the
fiscal quarter to which this report relates that have materially affected,
or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
32
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is not party to any material legal proceedings.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
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 Articles Supplementary Relating to the Series B Preferred Stock
(incorporated by reference to the Registrant's Quarterly Report on
Form 10-Q for the period ended March 31, 2003, Exhibit 3.3).
3.3 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 Amended and Restated Management and Advisory Agreement by and among
the Registrant and Fortress Investment Group LLC, dated September23,
2003 (incorporated by reference to the Registrant's Registration
Statement on Form S-11 (File No. 333-106135), Exhibit 10.1).
31.1 Certification of Chief Executive Officer as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 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.
32.2 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.
33
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized:
NEWCASTLE INVESTMENT CORP.
(REGISTRANT)
By: /s/ Wesley R. Edens
------------------------------------
Name: Wesley R. Edens
Title: Chairman of the Board
Chief Executive Officer
Date: May 10, 2005
By: /s/ Debra A. Hess
------------------------------------
Name: Debra A. Hess
Title: Chief Financial Officer
Date: May 10, 2005
34