EXHIBIT 99.1
FORWARD-LOOKING INFORMATION AND RISK FACTORS
Our Annual Report on Form l0-K for the year ended December 31, 2003, our 2003
Annual Report to Shareholders, any of our Quarterly Reports on Form 10-Q or
Current Reports on Form 8-K of the Company, or any other oral or written
statements made in press releases or otherwise by or on behalf of Capital Trust,
may contain forward-looking statements within the meaning of the Section 21E of
the Securities and Exchange Act of 1934, as amended, which involve certain risks
and uncertainties. Forward-looking statements predict or describe our future
operations, our business plans, our business and investment strategies and
portfolio management and the performance of our investments and funds under
management. These forward-looking statements are identified by their use of such
terms and phrases as "intends," "intend," "intended," "goal," "estimate,"
"estimates," "expects," "expect," "expected," "project," "projected,"
"projections," "plans," "seeks," "anticipates," "anticipated," "should,"
"could," "may," "will," "designed to," "foreseeable future," "believe,"
"believes" and "scheduled" and similar expressions. Our actual results or
outcomes may differ materially from those anticipated. Readers are cautioned not
to place undue reliance on these forward-looking statements, which speak only as
of the date the statement was made. We undertake no obligation to publicly
update or revise any forward-looking statements, whether as a result of new
information, future events or otherwise.
Our actual results may differ significantly from any results expressed or
implied by these forward-looking statements. Some, but not all, of the factors
that might cause such a difference include, but are not limited to:
o the general political, economic and competitive conditions, in the
United States;
o the level and volatility of prevailing interest rates and credit
spreads, adverse changes in general economic conditions and real estate
markets, the deterioration of credit quality of borrowers and the risks
associated with the ownership and operation of real estate;
o a significant compression of the spreads of the interest rates earned on
interest-earning assets over the interest rates paid on interest-bearing
liabilities that adversely affects operating results;
o adverse developments in the availability of desirable loan and
investment opportunities and the ability to obtain and maintain targeted
levels of leverage and borrowing costs;
o adverse changes in local market conditions, competition, increases in
operating expenses and uninsured losses affecting a property owner's
ability to cover operating expenses and the debt service on financing
provided by us;
o authoritative generally accepted accounting principles or policy changes
from such standard-setting bodies as the Financial Accounting Standards
Board and the Securities and Exchange Commission; and
o the risk factors set forth below.
Risks Related to Our Investment Program
Our existing loans and investments expose us to a high degree of risk
associated with investing in commercial real estate-related assets.
Real estate historically has experienced significant fluctuations and
cycles in performance that may result in reductions in the value of our real
estate-related investments. The performance and value of our loans and
investments once originated or acquired by us depends on many factors beyond our
control. The ultimate performance and value of our investments is subject to the
varying degrees of risk generally incident to the ownership and operation of the
commercial properties which collateralize or support our investments. The
ultimate performance and value of our loans and investments depends upon the
commercial property owner's ability to
operate the property so that it produces cash flows needed to pay the interest
and principal due to us on our loans and investments. Revenues and cash flows
may be adversely affected by:
o changes in national economic conditions;
o changes in local real estate market conditions due to changes in
national or local economic conditions or changes in local property
market characteristics;
o competition from other properties offering the same or similar
services;
o changes in interest rates and in the availability of mortgage
financing;
o the ongoing need for capital improvements, particularly in older
structures;
o changes in real estate tax rates and other operating expenses;
o adverse changes in governmental rules and fiscal policies, civil
unrest, acts of God, including earthquakes, hurricanes and other
natural disasters, acts of war or terrorism, which may decrease the
availability of or increase the cost of insurance or result in
uninsured losses;
o adverse changes in zoning laws;
o the impact of present or future environmental legislation and
compliance with environmental laws; and
o other factors that are beyond our control and the control of the
commercial property owners.
In the event that any of the properties underlying our loans or
investments experiences any of the foregoing events or occurrences, the value
of, and return on, such investments, our profitability and the market price of
our class A common stock would be negatively impacted.
We may change our investment strategy without shareholder consent which may
result in riskier investments than our current investments.
As part of our strategy, we may seek to expand our investment activities
beyond real estate-related investments. We may change our investment activities
at any time without the consent of our shareholders, which could result in our
making investments that are different from, and possibly riskier than, our
current real estate investments. New investments we may make outside of our area
of expertise may not perform as well as our current portfolio of real estate
investments.
We are exposed to the risks involved with making subordinated investments.
Our investments involve the risks attendant to investments consisting of
subordinated loan positions. In many cases, management of our investments and
our remedies with respect thereto, including the ability to foreclose on or
direct decisions with respect to the collateral securing such investments, is
subject to the rights of senior lenders and the rights set forth in
inter-creditor or servicing agreements.
We may not be able to obtain the level of leverage necessary to optimize our
return on investment.
Our return on investment depends, in part, upon our ability to grow our
balance sheet portfolio of invested assets and those of our funds through the
use of leverage at interest rates that are lower than the interest rates earned
on our investments. We generally obtain leverage through bank credit facilities,
repurchase agreements and other borrowings. Our ability to obtain the necessary
leverage on attractive terms ultimately depends upon the quality of the
portfolio assets that are being pledged and our ability to maintain interest
coverage ratios meeting prevailing market underwriting standards which vary
according to lenders' assessments of our and our funds' creditworthiness and the
terms of the borrowings. Our failure to obtain and/or maintain leverage at
desired levels, or to obtain leverage on attractive terms, could have a material
adverse effect on our performance or that of our funds. Moreover, we are
dependent upon a few lenders to provide the primary credit facilities for our
origination or acquisition of loans and investments. Our ability to obtain
financing through collateralized debt obligations is subject to conditions in
the debt capital markets, which may be adverse from time to time, that affect
the level of investor demand for such securities, which are impacted by factors
beyond our control.
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We are subject to the risks of holding leveraged investments.
Leverage creates an opportunity for increased return on equity, but at the same
time creates other risks. For example, leveraging magnifies changes in the net
worth of our funds. We and our funds will leverage assets only when there is an
expectation that leverage will enhance returns, although we cannot assure you
that the use of leverage will prove to be beneficial. Increases in credit
spreads in the market generally may adversely affect the market value of our
investments. Because borrowings under our credit facilities are secured by our
investments, the borrowings available to us may decline if the market value of
our investments decline. Moreover, we cannot assure you that we and our funds
will be able to meet debt service obligations and, to the extent such
obligations are not met, there is a risk of loss of some or all of our and their
assets through foreclosure or a financial loss if we or they are required to
liquidate assets at a commercially inopportune time to satisfy our debt
obligations.
Our success depends on the availability of attractive investments and our
ability to identify, structure, consummate, manage and realize returns on
attractive investments.
Our operating results are dependent upon the availability of, as well as
our ability to identify, structure, consummate, manage and realize returns on,
credit-sensitive investment opportunities. In general, the availability of
desirable credit sensitive investment opportunities and, consequently, our
balance sheet returns and our funds' investment returns, will be affected by the
level and volatility of interest rates, by conditions in the financial markets,
by general economic conditions, by the market and demand for credit-sensitive
investment opportunities, and by the supply of capital for such investment
opportunities. We cannot assure you that we will be successful in identifying
and consummating investments which satisfy our rate of return objectives or that
such investments, once consummated, will perform as anticipated.
In addition, notwithstanding the fact that we earn base management fees
based upon committed capital during the investment period, if we are not
successful in investing all available equity capital for our funds, the
potential revenues we earn, including base management fees that are charged on
the amount of invested assets after the investment period and incentive
management fees, will be reduced. We may expend significant time and resources
in identifying and pursuing targeted investments, some of which may not be
consummated.
The real estate investment business is highly competitive. Our success
depends on our ability to compete with other providers of capital for real
estate investments.
Our business is highly competitive. We compete for attractive
investments with traditional lending sources, such as insurance companies and
banks, as well as other REITs, specialty finance companies and private equity
funds with similar investment objectives, which may make it more difficult for
us to consummate our target investments. Many of our competitors have greater
financial resources than us, which provides them with greater operating
flexibility.
Our loans and investments may be subject to fluctuations in interest rates
which may not be adequately protected, or protected at all, by our hedging
strategies.
Our current balance sheet investment program emphasizes loans with
"floating" interest rates to protect against fluctuations in interest rates. We
do, however, from time to time make fixed rate loans and purchase fixed rate
securities, which are subject to the risk of fluctuations in interest rates.
Depending on market conditions, fixed rate assets may become a greater portion
of our new loan originations. In such cases, we may employ various hedging
strategies to limit the effects of changes in interest rates, including engaging
in interest rate swaps, caps, floors and other interest rate derivative
products. No strategy can completely insulate us or our funds from the risks
associated with interest rate changes and there is a risk that they may provide
no protection at all. Hedging transactions involve certain additional risks such
as counterparty risk, the legal enforceability of hedging contracts, the early
repayment of hedged transactions and the risk that unanticipated and significant
changes in interest rates may cause a significant loss of basis in the contract
and a change in current period expense. We cannot assure you that we will be
able to enter into hedging transactions or that such hedging transactions will
adequately protect us or our funds against the foregoing risks. In addition,
cash flow hedges which are not perfectly correlated with a variable rate
financing will impact our reported income as gains, and losses on the
ineffective portion of such hedges will be recorded.
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Our loans and investments may be illiquid which will constrain our ability to
vary our portfolio of investments.
Our real estate investments are relatively illiquid. Such illiquidity
may limit our ability to vary our portfolio or our funds' portfolios of
investments in response to changes in economic and other conditions. Illiquidity
may result from the absence of an established market for investments as well as
the legal or contractual restrictions on their resale. In addition, illiquidity
may result from the decline in value of a property securing one of our or our
funds' investments. We cannot assure you that the fair market value of any of
the real property serving as security will not decrease in the future, leaving
our or our funds' investments under-collateralized or not collateralized at all,
which could impair the liquidity and value, as well as our return on such
investments.
We may not have control over certain of our loans and investments.
Our ability to manage our portfolio of loans and investments may be
limited by the form in which they are made. In certain situations, we or our
funds may:
o acquire investments subject to rights of senior classes and
servicers under inter-creditor or servicing agreements;
o acquire only a participation in an underlying investment;
o co-invest with third parties through partnerships, joint ventures
or other entities, thereby acquiring non-controlling interests; or
o rely on independent third party management or strategic partners
with respect to the management of an asset.
Therefore, we may not be able to exercise control over the loan or
investment. Such financial assets may involve risks not present in investments
where senior creditors, servicers or third party controlling investors are not
involved. Our rights to control the process following a borrower default may be
subject to the rights of senior creditors or servicers whose interests may not
be aligned with ours. A third party partner or co-venturer may have financial
difficulties resulting in a negative impact on such asset, may have economic or
business interests or goals which are inconsistent with ours and those of our
funds, or may be in a position to take action contrary to our or our funds'
investment objectives. In addition, we and our funds may, in certain
circumstances, be liable for the actions of our third party partners or
co-venturers.
We may not achieve our targeted rate of return on our investments.
We originate or acquire investments based on our estimates or
projections of overall rates of return on such investments, which in turn are
based on, among other considerations, assumptions regarding the performance of
assets, the amount and terms of available financing to obtain desired leverage
and the manner and timing of dispositions, including possible asset recovery and
remediation strategies, all of which are subject to significant uncertainty. In
addition, events or conditions that we have not anticipated may occur and may
have a significant effect on the actual rate of return received on an
investment.
We are currently experiencing a low interest rate environment which
negatively impacts our ability to originate or acquire investments that produce
rates of returns similar to existing investments that were added to our
portfolio during a higher interest rate environment. As we acquire or originate
investments for our balance sheet portfolio, whether as new additions or as
replacements for maturing investments, there can be no assurance that we will be
able to originate or acquire investments that produce rates of return comparable
to rates on our existing investments.
The commercial mortgage and mezzanine loans we originate or acquire and the
commercial mortgage loans underlying the CMBS in which we invest are subject
to delinquency, foreclosure and loss, which could result in losses to us.
Our commercial mortgage and mezzanine loans are secured by commercial
property and are subject to risks of delinquency and foreclosure, and risks of
loss that are greater than similar risks associated with loans made on the
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security of single-family residential property. The ability of a borrower to
repay a loan secured by an income-producing property typically is dependent
primarily upon the successful operation of the property rather than upon the
existence of independent income or assets of the borrower. If the net operating
income of the property is reduced, the borrower's ability to repay the loan may
be impaired. Net operating income of an income-producing property can be
affected by, among other things: tenant mix, success of tenant businesses,
property management decisions, property location and condition, competition from
comparable types of properties, changes in laws that increase operating expenses
or limit rents that may be charged; any need to address environmental
contamination at the property; changes in national, regional or local economic
conditions and/or specific industry segments; declines in regional or local real
estate values and declines in regional or local rental or occupancy rates;
increases in interest rates, real estate tax rates and other operating expenses;
and changes in governmental rules, regulations and fiscal policies, including
environmental legislation, acts of God, terrorism, social unrest and civil
disturbances.
Our investments in subordinated CMBS are subject to losses.
In general, losses on an asset securing a mortgage loan included in a
securitization will be borne first by the equity holder of the property, then by
a cash reserve fund or letter of credit, if any, and then by the most junior
security holder. In the event of default and the exhaustion of any equity
support, reserve fund, letter of credit and any classes of securities junior to
those in which we invest, we may not be able to recover all of our investment in
the securities we purchase. In addition, if the underlying mortgage portfolio
has been overvalued by the originator, or if the values subsequently decline
and, as a result, less collateral is available to satisfy interest and principal
payments due on the related mortgage-backed securities, the securities in which
we invest may incur significant losses.
The prices of lower credit quality securities are generally less
sensitive to interest rate changes than more highly rated investments, but more
sensitive to adverse economic downturns and underlying borrower developments. A
projection of an economic downturn, for example, could cause a decline in the
price of lower credit quality securities because the ability of borrowers of the
mortgages underlying the mortgage-backed securities to make principal and
interest payments may be impaired. In such event, existing credit support in the
securitization structure may be insufficient to protect us against loss of our
principal on these securities.
We may experience significant reductions in net income if the impairments on our
CMBS investments are deemed to be "other-than-temporary".
The current fair value of certain of our CMBS investments is less than
their recorded amortized cost. Since our CMBS investments are accounted for as
available-for-sale securities, we have reduced our shareholders equity by an
amount equal to the difference between the amortized cost and the fair value by
taking a charge to other comprehensive income. As of June 30, 2004, these
unrealized losses totaled $35.9 million. Under generally accepted accounting
principles, if there are significant changes in the future to the expected cash
flows from a particular investment due to prepayment or credit loss experience,
the investment will have incurred an other-than-temporary impairment. If that
occurs, we will be required to write down the investment to its fair value and
take a charge to income equal to the unrealized loss, recognizing an offsetting
increase to other comprehensive income with equity remaining unchanged. If we
recognize other-than-temporary impairments on our CMBS investments that have
experienced significant reductions in fair value, the resulting write-downs
could result in significant reductions of our net income for the period in which
the other-than-temporary impairment is recognized.
We may invest in troubled assets that are subject to a higher degree of
financial risk.
We may make investments in non-performing or other troubled assets that
involve a higher degree of financial risk. We cannot assure you that our
investment objectives will be realized or that there will be any return on our
investment. Furthermore, investments in properties subject to work-out
conditions or under bankruptcy protection laws may, in certain circumstances, be
subject to additional potential liabilities that could exceed the value of our
original investment, including equitable subordination and/or disallowance of
claims or lender liability.
We may not be able to acquire eligible investments for a collateralized debt
obligation issuance, or may not be able to issue collateralized debt obligation
securities on attractive terms, which may require us to utilize more costly
financing for our investments.
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We intend to capitalize on opportunities to finance certain of our
investments on a non-recourse, long-term basis, such as through the issuance of
collateralized debt obligations. During the period that we are acquiring these
investments, we intend to finance our purchases through our credit and
repurchase obligation facilities. We use these facilities to finance our
acquisition of investments until we have accumulated a sufficient quantity of
investments, at which time we may refinance these lines through a
securitization, such as a collateralized debt obligation issuance, or other
types of long-term financing. As a result, we are subject to the risk that we
will not be able to acquire a sufficient amount of eligible investments to
maximize the efficiency of a collateralized debt obligation issuance. In
addition, conditions in the capital markets may make the issuance of
collateralized debt obligations less attractive to us when we do have a
sufficient pool of collateral. If we are unable to issue a collateralized debt
obligation to finance these investments, we may be required to utilize other
forms of potentially less attractive financing.
We may not be able to find suitable replacement investments in collateralized
debt obligations with reinvestment periods.
Some collateralized debt obligations have periods where principal
proceeds received from assets securing the collateralized debt obligation can be
reinvested for a defined period of time, commonly referred to as a reinvestment
period. Our ability to find suitable investments during the reinvestment period
that meet the criteria set forth in the collateralized debt obligation
documentation and by rating agencies may determine the success of our
collateralized debt obligation investments. Our potential inability to find
suitable investments may cause, among other things, interest deficiencies,
hyper-amortization of the senior collateralized debt obligation liabilities and
may cause us to reduce the life of our collateralized debt obligations and
accelerate the amortization of certain fees and expenses.
The use of collateralized debt obligation financings with over-collateralization
and interest coverage requirements may have a negative impact on our cash flow.
The terms of collateralized debt obligations will generally provide that
the principal amount of investments must exceed the principal balance of the
related bonds by a certain amount and that interest income exceeds interest
expense by a certain amount. We anticipate that the collateralized debt
obligation terms will provide that, if certain delinquencies and/or losses or
other factors cause a decline in collateral or cash flow levels, the cash flow
otherwise payable on our investment may be redirected to repay classes of CDOs
senior to ours until the issuer or the collateral is in compliance with the
terms of the governing documents. Other tests (based on delinquency levels or
other criteria) may restrict our ability to receive net income from assets
pledged to secure collateralized debt obligations. We cannot assure you that the
performance tests will be satisfied. Nor can we assure you, in advance of
completing negotiations with the rating agencies or other key transaction
parties as to the actual terms of the delinquency tests, over-collateralization
and interest coverage terms, cash flow release mechanisms or other significant
factors upon which net income to us will be calculated. Failure to obtain
favorable terms with regard to these matters may adversely affect the
availability of net income to us. If our investments fail to perform as
anticipated, our over-collateralization, interest coverage or other credit
enhancement expense associated with our collateralized debt obligation
financings will increase.
We may be required to repurchase loans that we have sold or to indemnify holders
of our collateralized debt obligations.
If any of the loans we originate or acquire and sell or securitize
through collateralized debt obligations do not comply with representations and
warranties that we make about certain characteristics of the loans, the
borrowers and the underlying properties, we may be required to repurchase those
loans or replace them with substitute loans. In addition, in the case of loans
that we have sold instead of retained, we may be required to indemnify persons
for losses or expenses incurred as a result of a breach of a representation or
warranty. Repurchased loans typically require a significant allocation of
working capital to carry on our books, and our ability to borrow against such
assets is limited. Any significant repurchases or indemnification payments could
adversely affect our financial condition and operating results.
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The impact of the events of September 11, 2001 and the resulting effect on
terrorism insurance expose us to certain risks.
The terrorist attacks on September 11, 2001 disrupted the U.S. financial
markets, including the real estate capital markets, and negatively impacted the
U.S. economy in general. Any future terrorist attacks, the anticipation of any
such attacks, and the consequences of any military or other response by the U.S.
and its allies may have a further adverse impact on the U.S. financial markets
and the economy generally. We cannot predict the severity of the effect that
such future events would have on the U.S. financial markets, the economy or our
business.
In addition, the events of September 11 created significant uncertainty
regarding the ability of real estate owners of high profile assets to obtain
insurance coverage protecting against terrorist attacks at commercially
reasonable rates, if at all. With the enactment of the Terrorism Risk Insurance
Act of 2002, insurers must make terrorism insurance available under their
property and casualty insurance policies through the end of 2004, which may be
extended by the Secretary of the Treasury through the end of 2005, but this
legislation does not regulate the pricing of such insurance. The absence of
affordable insurance coverage may adversely affect the general real estate
lending market, lending volume and the market's overall liquidity and may reduce
the number of suitable investment opportunities available to us and the pace at
which we are able to make investments. If the properties that we invest in are
unable to obtain affordable insurance coverage, the value of those investments
could decline and in the event of an uninsured loss, we could lose all or a
portion of our investment.
The economic impact of any future terrorist attacks could also adversely
affect the credit quality of some of our loans and investments. Some of our
loans and investments will be more susceptible to the adverse effects than
others, such as hotel loans, which may experience a significant reduction in
occupancy rates following any future attacks. We may suffer losses as a result
of the adverse impact of any future attacks and these losses may adversely
impact our results of operation.
Risks Related to Our Investment Management Business
Because we commenced our investment management business in 2000, we are
subject to risks and uncertainties associated with developing and operating a
new business, and we may not achieve from this new business the investment
returns that we expect.
Our investment management business commenced in 2000 and, therefore, has
a limited track record of proven results upon which to predict our future
performance. We will encounter risks and difficulties as we proceed to develop
and operate our investment management business. In order to achieve our goals as
an investment manager, we must:
o manage our funds successfully by investing a majority of our funds'
capital in suitable investments that meet the funds' specified
investment criteria;
o actively manage the assets in our portfolios in order to realize
targeted performance;
o incentivize our management and professional staff to the task of
developing and operating the investment management business; and
o structure, sponsor and capitalize future funds and other investment
products under our management that provide investors with
attractive investment opportunities.
If we do not successfully develop and operate our investment management
business to achieve the investment returns that we or the market anticipates,
the market price of our class A common stock could decline.
We may pursue fund management opportunities related to other classes of
investments where we do not have prior investment experience.
We may expand our fund management business to the management of private
equity funds involving other investment classes where we do not have prior
investment experience. We may find it difficult to attract third party investors
without a performance track record involving such investments. Even if we
attract third party investment,
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there can be no assurance that we will be successful in deploying the capital to
achieve targeted returns on the investments.
We face substantial competition from established participants in the private
equity market as we offer mezzanine and other funds to third party investors.
We face significant competition from large financial and other
institutions that have proven track records in marketing and managing private
equity investment funds and otherwise have a competitive advantage over us
because they have access to pre-existing third party investor networks into
which they can channel competing investment opportunities. If our competitors
offer investment products that are competitive with the mezzanine and other fund
investments offered by us, we will find it more difficult to attract investors
and to capitalize our mezzanine and other funds.
Our funds are subject to the risk of defaults by third party investors on
their capital commitments.
The capital commitments made by third party investors to our funds
represent unsecured promises by those investors to contribute cash to the funds
from time to time as investments are made by the funds. Accordingly, we are
subject to general credit risks that the investors may default on their capital
commitments. If defaults occur, we may not be able to close loans and
investments we have identified and negotiated, which could materially and
adversely affect the funds' investment program or make us liable for breach of
contract, in either case to the detriment of our franchise in the private equity
market.
Risks Related to Our Company
We are dependent upon our senior management team to develop and operate our
business.
Our ability to develop and operate our business depends to a substantial
extent on the experience, relationships and expertise of our senior management
and key employees. We cannot assure you that these individuals will remain in
our employ. The employment agreement with our chief executive officer, John R.
Klopp, expires on December 31, 2008, unless further extended. The loss of the
services of our senior management and key employees could have a material
adverse effect on our operations.
There may be conflicts between the interests of our investment funds and us.
We are subject to a number of potential conflicts between our interests
and the interests of our managed investment funds. Although we have agreed to
offer Fund III the first opportunity to invest in investment opportunities which
have characteristics and projected leveraged returns which meet Fund III's
investment and return objectives, we are subject to potential conflicts of
interest in the allocation of investment opportunities between our balance sheet
and our managed funds. In addition, we may make investments that are senior or
junior to, participations in, or have rights and interests different from or
adverse to, the investments made by our managed funds. Our interests in such
investments may conflict with the interests of our managed funds in related
investments at the time of origination or in the event of a default or
restructuring of the investment. In the event a default occurs with respect to
such an investment, the directors of Fund III appointed by us have agreed to
recuse themselves from any vote of the board of Fund III concerning such
investment and our co-sponsor's controlled advisor to Fund III will assume and
perform our asset management responsibility with respect to such investment.
Finally, our officers and employees may have conflicts in allocating their time
and services among us and our managed funds.
Our balance sheet portfolio continues to have concentrations in mark-to-market
mortgage-backed securities which subjects us to greater variations in equity and
income as we record balance sheet gains and losses on such assets.
Our venture agreement with affiliates of Citigroup Alternative
Investments, LLC placed restrictions on our ability to originate new mezzanine
loan investments for our balance sheet during the investment period for Fund II
which resulted in our balance sheet portfolio becoming more concentrated in
longer term fixed rate mortgage-backed securities that had been originated prior
to 2000. We have adopted accounting policies under which such securities are
recorded as available-for-sale and changes in the market value will impact
either or both shareholders'
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equity or net income depending on the characterization of the change in market
value. If a reduction in market value is deemed to be other than temporary,
generally due to a change in the credit risk, the reduction in value will be
recorded as a reduction of net income. If any of the available-for-sale
securities are sold, the resulting gain or loss will be recorded through the
income statement. All other changes in market value will impact shareholders
equity only.
While the restrictions on our balance sheet investment activities
diminished when the investment period for Fund II ended and we have begun making
new investments for our own account, there can be no assurance that the
concentration in mark-to-market mortgage-backed securities will be reduced in
the near term through new originations. In an environment of relatively low
interest rates, there is also a higher risk that our existing non-mark-to-market
loans will pay off early. To the extent our balance sheet remains concentrated
in mark-to-market assets, we will remain subject to potential swings in equity
and income as we record gains and losses on such assets on our balance sheet. If
interest rates fluctuate and significantly affect the market value of such
mark-to-market assets, the corresponding reductions or increases in our equity
and income may be significant.
We must manage our portfolio in a manner that allows us to rely on an
exclusion from registration under the Investment Company Act of 1940 in order
to avoid the consequences of regulation under that Act.
We rely on an exclusion from registration as an investment company
afforded by Section 3(c)(5)(C) of the Investment Company Act of 1940. Under this
exclusion, we are required to maintain, on the basis of positions taken by the
SEC staff in interpretive and no-action letters, a minimum of 55% of the value
of the total assets of our portfolio in "mortgages and other liens on and
interests in real estate." We refer to this category of investments herein as
"Qualifying Interests." In addition, we must maintain an additional minimum of
25% of the value of our total assets in Qualifying Interests or other real
estate-related assets. Because registration as an investment company would
significantly affect our ability to engage in certain transactions or to
organize ourselves in the manner we are currently organized, we intend to
maintain our qualification for this exclusion from registration. In the past,
when required due to the mix of assets in our balance sheet portfolio, we have
purchased pools of whole loan residential mortgage-backed securities that we
treat as Qualifying Interests based on SEC staff positions. Investments in such
pools of whole loan residential mortgage-backed securities may not represent an
optimum use of our investable capital when compared to the available investments
we target pursuant to our investment strategy. We continue to analyze our
investments and may acquire other pools of whole loan mortgage-backed securities
when and if required for compliance purposes. In addition, certain of our
investments in subordinated CMBS have terms which we believe allows them to be
categorized as Qualifying Interests, including rights to cure any defaults on
senior CMBS classes, rights to acquire such senior classes in the event of a
default or special servicing rights to service defaulted mortgage loans,
including rights to control the oversight and management of the resolution of
such mortgage loans by workout or modification of loan provisions, foreclosure,
deed in lieu of foreclosure or otherwise, and to control decisions with respect
to the preservation of the collateral generally, including property management
and maintenance decisions. We have not obtained an exemptive order or a
no-action letter or other form of interpretive guidance from the SEC or its
staff supporting our position, and, therefore, any decision by the SEC or its
staff which advances a position to the contrary would require us to no longer
treat these investments in subordinated CMBS as Qualifying Interests.
If our portfolio does not comply with the requirements of the exclusion
we rely upon, we could be forced to alter our portfolio by selling or otherwise
disposing of a substantial portion of the assets that are not Qualifying
Interests or by acquiring a significant position in assets that are Qualifying
Interests. Altering our portfolio in this manner may have a material adverse
effect on our investments if we are forced to dispose of or acquire assets in an
unfavorable market.
We may expand our franchise through business acquisitions and the recruitment
of financial professionals, which may present additional costs and other
challenges and may not prove successful.
Our business plan contemplates expansion of our franchise into
complementary investment strategies involving other credit-sensitive structured
financial products. We may undertake such expansion through business
acquisitions or the recruitment of financial professionals with experience in
other products. We may also expend a substantial amount of time and capital
pursuing opportunities to expand into complementary investment strategies that
we do not consummate. The expansion of our operations could place a significant
strain on our management,
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financial and other resources. Our ability to manage future expansion will
depend upon our ability to monitor operations, maintain effective quality
controls and significantly expand our internal management and technical and
accounting systems, all of which could result in higher operating expenses and
could adversely affect our current business, financial condition and results of
operations.
We cannot assure you that we will be able to identify and integrate
businesses or professional teams we acquire to pursue complementary investment
strategies and expand our business. Moreover, any decision to pursue expansion
into businesses with complementary investment strategies will be in the
discretion of our management and may be consummated without prior notice or
shareholder approval. In such instances, shareholders will be relying on our
management to assess the relative benefits and risks associated with any such
expansion.
Risks Relating to Our Class A Common Stock
Because a limited number of shareholders, including members of our management
team, own a substantial number of our shares, decisions made by them may be
detrimental to your interests.
By virtue of their direct and indirect share ownership, John R. Klopp, a
director and our president and chief executive officer, Craig M. Hatkoff, a
director and former officer, and other shareholders indirectly owned by trusts
for the benefit of our chairman of the board, Samuel Zell, have the power to
significantly influence our affairs and are able to influence the outcome of
matters required to be submitted to shareholders for approval, including the
election of our directors, amendments to our charter, mergers, sales of assets
and other acquisitions or sales. The influence exerted by these shareholders
over our affairs might not be consistent with the interests of some or all of
our other shareholders. We cannot assure you that these shareholders will not
exercise their influence over us in a manner detrimental to your interests. As
of June 30, 2004, these shareholders collectively own and control 2,480,805
shares of our class A common stock representing approximately 28.9% of our
outstanding class A common stock. This concentration of ownership may have the
effect of delaying or preventing a change in control of our company, including
transactions in which you might otherwise receive a premium for your class A
common stock, and might negatively affect the market price of our class A common
stock.
Berkley owns 1,635,000 shares of our class A common stock and may
purchase an additional 365,000 shares upon the exercise of warrants, which
assuming the exercise of the warrants, represents 23.1% of our outstanding class
A common stock. The conversion of the outstanding convertible trust preferred
securities held by Vornado Realty, L.P., General Motors Trust Bank, National
Association, as trustee for the GMAM Investment Funds Trust and JPMorgan Chase
Bank, as trustee for the GMAM Group Pension Trust II, could result in other
significant concentrated holdings of our class A common stock. Vornado Realty,
L.P. may acquire 1,424,474 shares of our class A common stock, General Motors
Trust Bank, National Association, as trustee for the GMAM Investment Funds Trust
may acquire 49,856 shares of our class A common stock and JPMorgan Chase Bank,
as trustee for the GMAM Group Pension Trust II may acquire 662,381 shares of our
class A common stock. An officer of Berkley and a person associated with the
General Motor's pension trusts serve on our board of directors and, therefore,
have the power to significantly influence our affairs. Through their significant
ownership of our class A common stock, assuming for this purpose the trust
preferred securities were converted, these security holders may have the ability
to influence the outcome of matters submitted for shareholder approval.
Some provisions of our charter and bylaws, and Maryland law may deter
takeover attempts, which may limit the opportunity of our shareholders to
sell their shares at a favorable price.
Some of the provisions of our charter and bylaws and Maryland law
discussed below could make it more difficult for a third party to acquire us,
even if doing so might be beneficial to our shareholders by providing them with
the opportunity to sell their shares at a premium to the then current market
price.
Issuance of Preferred Stock Without Shareholder Approval. Our charter
authorizes our board of directors to authorize the issuance of up to 100,000,000
shares of preferred stock and up to 100,000,000 shares of class A common stock.
Our charter also authorizes our board of directors, without shareholder
approval, to classify or reclassify any unissued shares of our class A common
stock and preferred stock into other classes or series of stock and to amend our
charter to increase or decrease the aggregate number of shares of stock of any
class or series that may be issued. Our board of directors, therefore, can
exercise its power to reclassify our stock to increase the
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number of shares of preferred stock we may issue without shareholder approval.
Preferred stock may be issued in one or more series, the terms of which may be
determined without further action by shareholders. These terms may include
preferences, conversion or other rights, voting powers, restrictions,
limitations as to dividends or other distributions, qualifications or terms or
conditions of redemption. The issuance of any preferred stock, however, could
materially adversely affect the rights of holders of our class A common stock
and, therefore, could reduce its value. In addition, specific rights granted to
future holders of our preferred stock could be used to restrict our ability to
merge with, or sell assets to, a third party. The power of our board of
directors to issue preferred stock could make it more difficult, delay,
discourage, prevent or make it more costly to acquire or effect a change in
control, thereby preserving the current shareholders' control.
Advance Notice Bylaw. Our bylaws contain advance notice procedures for
the introduction of business and the nomination of directors. These provisions
could discourage proxy contests and make it more difficult for you and other
shareholders to elect shareholder-nominated directors and to propose and approve
shareholder proposals opposed by management.
Maryland Takeover Statutes. We are subject to the Maryland Business
Combination Act which could delay or prevent an unsolicited takeover of us. The
statute substantially restricts the ability of third parties who acquire, or
seek to acquire, control of us to complete mergers and other business
combinations without the approval of our board of directors even if such
transaction would be beneficial to shareholders. "Business combinations" between
such a third party acquiror or its affiliate and us are prohibited for five
years after the most recent date on which the acquiror or its affiliate becomes
an "interested shareholder." An "interested shareholder" would be any person who
beneficially owns 10 percent or more of our shareholder voting power or an
affiliate or associate of ours who, at any time within the two-year period prior
to the date interested shareholder status is determined, was the beneficial
owner of 10 percent or more of our shareholder voting power. If our board of
directors approved in advance the transaction that would otherwise give rise to
the acquiror or its affiliate attaining such status, such as the issuance of
shares of our class A common stock to Berkley, the acquiror or its affiliate
would not become an interested shareholder and, as a result, it could enter into
a business combination with us. Our board of directors could choose not to
negotiate with an acquirer if the board determined in its business judgment that
considering such an acquisition was not in our strategic interests. Even after
the lapse of the five-year prohibition period, any business combination with an
interested shareholder must be recommended by our board of directors and
approved by the affirmative vote of at least:
o 80% of the votes entitled to be cast by shareholders; and
o two-thirds of the votes entitled to be cast by shareholders other
than the interested shareholder and affiliates and associates
thereof.
The super-majority vote requirements do not apply if the transaction
complies with a minimum price requirement prescribed by the statute.
The statute permits various exemptions from its provisions, including
business combinations that are exempted by the board of directors prior to the
time that an interested shareholder becomes an interested shareholder. Our board
of directors has exempted any business combination involving family partnerships
controlled separately by John R. Klopp and Craig M. Hatkoff, and a limited
liability company indirectly controlled by a trust for the benefit of Samuel
Zell and his family. As a result, these persons and Berkley may enter into
business combinations with us without compliance with the super-majority vote
requirements and the other provisions of the statute.
We are subject to the Maryland Control Share Acquisition Act. With
certain exceptions, the Maryland General Corporation Law provides that "control
shares" of a Maryland corporation acquired in a control share acquisition have
no voting rights except to the extent approved by a vote of two-thirds of the
votes entitled to be cast on the matter, excluding shares owned by the acquiring
person or by our officers or directors who are our employees, and may be
redeemed by us. "Control shares" are voting shares which, if aggregated with all
other shares owned or voted by the acquirer, would entitle the acquirer to
exercise voting power in electing directors within one of the specified ranges
of voting power. A person who has made or proposes to make a control share
acquisition, upon satisfaction of certain conditions, including an undertaking
to pay expenses, may compel our board
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to call a special meeting of shareholders to be held within 50 days of demand to
consider the voting rights of the "control shares" in question. If no request
for a meeting is made, we may present the question at any shareholders' meeting.
If voting rights are not approved at the shareholders' meeting or if the
acquiring person does not deliver the statement required by Maryland law, then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares, except those for which voting rights have previously been
approved for fair value. If voting rights for control shares are approved at a
shareholders' meeting and the acquirer may then vote a majority of the shares
entitled to vote, then all other shareholders may exercise appraisal rights. The
fair value of the shares for purposes of these appraisal rights may not be less
than the highest price per share paid by the acquirer in the control share
acquisition. The control share acquisition statute does not apply to shares
acquired in a merger, consolidation or share exchange if we are a party to the
transaction, nor does it apply to acquisitions approved or exempted by our
charter or bylaws. We have exempted certain holders identified in our bylaws
from this statute which exemptions extend to Berkley, family partnerships
controlled separately by John R. Klopp and Craig M. Hatkoff, and a limited
liability company indirectly controlled by a trust for the benefit of Samuel
Zell and his family.
We are also subject to the Maryland Unsolicited Takeovers Act which
permits our board of directors, among other things, to elect on our behalf to
stagger the terms of directors, to increase the shareholder vote required to
remove a director and to provide that shareholder-requested meetings may be
called only upon the request of shareholders entitled to cast at least a
majority of the votes entitled to be cast at the meeting. Such an election would
significantly restrict the ability of third parties to wage a proxy fight for
control of our board of directors as a means of advancing a takeover offer. If
an acquirer was discouraged from offering to acquire us, or prevented from
successfully completing a hostile acquisition, you could lose the opportunity to
sell your shares at a favorable price.
Shares eligible for sale in the near future may cause the market price for
our class A common stock to decline.
Sales of a substantial number of shares of our class A common stock in
the public market, or the perception that these sales could occur, may depress
the market price for our class A common stock. These sales could also impair our
ability to raise additional capital through the sale of our equity securities in
the future.
The number and timing of shares of class A common stock available for
sale in the public market is limited by restrictions under federal securities
laws and under agreements that we and each of our executive officers and
directors and certain shareholders have entered into with the underwriters for
our public offering of class A common stock completed in July 2004. Those
agreements restrict these persons from selling, pledging or otherwise disposing
of their shares, subject to specified exceptions, for a period of 90 days after
July 22, 2004 without the prior written consent of the lead underwriter. The
lead underwriter may, however, in its sole discretion, release all or any
portion of the class A common stock from the restrictions of the lockup
agreements. Subject to any restrictions pursuant to other agreements or under
applicable law, 3,993,307 shares will be eligible for sale in the public market
at various times commencing 90 days from July 22, 2004. In addition, 550,835
shares of common stock may be issued pursuant to the exercise of stock options
that are outstanding as of June 30, 2004.
The market value of our class A common stock may be adversely affected by
many factors.
As with any public company, a number of factors may adversely influence
the price of our class A common stock, many of which are beyond our control.
These factors include:
o the level of institutional interest in us;
o the perception of REITs generally and REITs with portfolios similar
to ours, in particular, by market professionals;
o the attractiveness of securities of REITs in comparison to other
companies; and
o the market's perception of our growth potential and potential
future cash dividends.
An increase in market interest rates may lead prospective purchasers of our
class A common stock to expect a higher dividend yield, which would adversely
affect the market price of our class A common stock.
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One of the factors that will influence the price of our class A common
stock will be the dividend yield on our stock (distributions as a percentage of
the price of our stock) relative to market interest rates. An increase in market
interest rates may lead prospective purchasers of our class A common stock to
expect a higher dividend yield, which would adversely affect the market price of
our class A common stock.
Your ability to sell a substantial number of shares of our class A common stock
may be restricted by the low trading volume historically experienced by our
class A common stock.
Although our class A common stock is listed on the New York Stock
Exchange, the daily trading volume of our shares of class A common stock has
historically been lower than the trading volume for certain other companies. As
a result, the ability of a holder to sell a substantial number of shares of our
class A common stock in a timely manner without causing a substantial decline in
the market of the shares, especially by means of a large block trade, may be
restricted by the limited trading volume of the shares of our class A common
stock.
Risks Related to our REIT Status
Our charter does not permit any individual to own more than over 2.5% of our
class A common stock, and attempts to acquire our class A common stock in
excess of the 2.5% limit would be void without the prior approval of our
board of directors.
For the purpose of preserving our qualification as a REIT for federal
income tax purposes, our charter prohibits direct or constructive ownership by
any individual of more than 2.5% of the lesser of the total number or value of
the outstanding shares of our class A common stock as a means of preventing
ownership of more than 50% of our class A common stock by five or fewer
individuals. The charter's constructive ownership rules are complex and may
cause the outstanding class A common stock owned by a group of related
individuals or entities to be deemed to be constructively owned by one
individual. As a result, the acquisition of less than 2.5% of our outstanding
class A common stock by an individual or entity could cause an individual to own
constructively in excess of 2.5% of our outstanding class A common stock, and
thus be subject to the charter's ownership limit. There can be no assurance that
our board of directors, as permitted in the charter, will increase this
ownership limit in the future. Any attempt to own or transfer shares of our
class A common stock in excess of the ownership limit without the consent of our
board of directors will be void, and will result in the shares being transferred
by operation of law to a charitable trust, and the person who acquired such
excess shares will not be entitled to any distributions thereon or to vote such
excess shares.
Our charter contains a provision that exempts certain of our officers,
directors and their related persons from this ownership limit and we increased
the limit for William R. Berkley to 6.0% and for one other major shareholder of
Berkley identified to us to 4.0%. The 2.5% ownership limit may have the effect
of precluding a change in control of us by a third party without the consent of
our board of directors, even if such change in control would be in the interest
of our shareholders or would result in a premium to the price of our class A
common stock (and even if such change in control would not reasonably jeopardize
our REIT status). The ownership limit exemptions and the reset limits granted to
date would limit our board of directors' ability to reset limits in the future
and at the same time maintain compliance with the REIT qualification requirement
prohibiting ownership of more than 50% of our class A common stock by five or
fewer individuals.
There are no assurances that we will be able to pay dividends in the future.
We intend to pay quarterly dividends and to make distributions to our
shareholders in amounts such that all or substantially all of our taxable income
in each year, subject to certain adjustments, is distributed. This, along with
other factors, should enable us to qualify for the tax benefits accorded to a
REIT under the Internal Revenue Code. All distributions will be made at the
discretion of our board of directors and will depend on our earnings, our
financial condition, maintenance of our REIT status and such other factors as
our board of directors may deem relevant from time to time. There are no
assurances that we will be able to pay dividends in the future. In addition,
some of our distributions may include a return of capital, which would reduce
the amount of capital available to operate our business.
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Recent tax legislation may have negative consequences for REITs.
Recent tax legislation allows certain corporations to pay dividends that
qualify for a reduced tax rate in the hands of certain shareholders. This
legislation generally does not apply to REITs. Although the legislation does not
adversely affect the tax treatment of REITs, it may cause investments in
non-REIT corporations to become relatively more desirable. As a result, the
capital markets may be less favorable to REITs, such as ourselves, when they
seek to raise equity capital, and the prices at which REIT equity securities
trade, including our class A common stock, may decline or underperform non-REIT
corporations.
We will be dependent on external sources of capital to finance our growth.
As with other REITs, but unlike corporations generally, our ability to
finance our growth must largely be funded by external sources of capital because
we generally will have to distribute to our shareholders 90% of our taxable
income in order to qualify as a REIT, including taxable income where we do not
receive corresponding cash. Our access to external capital will depend upon a
number of factors, including general market conditions, the market's perception
of our growth potential, our current and potential future earnings, cash
distributions and the market price of our class A common stock.
If we do not maintain our qualification as a REIT, we will be subject to tax
as a regular corporation and face a substantial tax liability. Our taxable
REIT subsidiaries will be subject to income tax.
We expect to operate so as to qualify as a REIT under the Internal
Revenue Code. However, qualification as a REIT involves the application of
highly technical and complex Internal Revenue Code provisions for which only a
limited number of judicial or administrative interpretations exist. Even a
technical or inadvertent mistake could jeopardize our REIT status. Furthermore,
new tax legislation, administrative guidance or court decisions, in each
instance potentially with retroactive effect, could make it more difficult or
impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any
tax year, then:
o we would be taxed as a regular domestic corporation, which under
current laws, among other things, means being unable to deduct
distributions to shareholders in computing taxable income and being
subject to federal income tax on our taxable income at regular
corporate rates;
o any resulting tax liability could be substantial, could have a
material adverse effect on our book value and could reduce the
amount of cash available for distribution to shareholders; and
o unless we were entitled to relief under applicable statutory
provisions, we would be required to pay taxes, and thus, our cash
available for distribution to shareholders would be reduced for
each of the years during which we did not qualify as a REIT.
Income from our fund management business is expected to be realized by
one of our taxable REIT subsidiaries, and, accordingly, will be subject to
income tax.
Complying with REIT requirements may cause us to forego otherwise attractive
opportunities.
In order to qualify as a REIT for federal income tax purposes, we must
continually satisfy tests concerning, among other things, our sources of income,
the nature of our investments in commercial real estate and related assets, the
amounts we distribute to our shareholders and the ownership of our stock. We may
also be required to make distributions to shareholders at disadvantageous times
or when we do not have funds readily available for distribution. Thus,
compliance with REIT requirements may hinder our ability to operate solely on
the basis of maximizing profits.
Complying with REIT requirements may force us to liquidate or restructure
otherwise attractive investments.
In order to qualify as a REIT, we must also ensure that at the end of
each calendar quarter, at least 75% of the value of our assets consists of cash,
cash items, government securities and qualified REIT real estate assets. The
remainder of our investments in securities cannot include more than 10% of the
outstanding voting securities of any
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one issuer or 10% of the total value of the outstanding securities of any one
issuer. In addition, no more than 5% of the value of our assets can consist of
the securities of any one issuer. If we fail to comply with these requirements,
we must dispose of a portion of our assets within 30 days after the end of the
calendar quarter in order to avoid losing our REIT status and suffering adverse
tax consequences.
Complying with REIT requirements may force us to borrow to make distributions
to shareholders.
From time to time, our taxable income may be greater than our cash flow
available for distribution to shareholders. If we do not have other funds
available in these situations, we may be unable to distribute substantially all
of our taxable income as required by the REIT provisions of the Internal Revenue
Code. Thus, we could be required to borrow funds, sell a portion of our assets
at disadvantageous prices or find another alternative. These options could
increase our costs or reduce our equity.
The "taxable mortgage pool" rules may limit the manner in which we effect
future securitizations.
Certain of our future securitizations could be considered to result in
the creation of taxable mortgage pools for federal income tax purposes. Since we
conduct our operations to qualify as a REIT, so long as we own 100% of the
equity interests in a taxable mortgage pool, we would not be adversely affected
by the characterization of the securitization as a taxable mortgage pool
(assuming that we do not have any shareholders who might cause a corporate
income tax to be imposed upon us by reason of our owning a taxable mortgage
pool). We would be precluded, however, from selling to outside investors equity
interests in such securitizations or from selling any debt securities issued in
connection with such securitizations that might be considered to be equity
interests for tax purposes. These limitations will preclude us from using
certain techniques to maximize our returns from securitization transactions. If
the securitization vehicles in which we participate were considered a taxable
mortgage pool, shareholders who are tax-exempt and shareholders who are not
United States persons may be required to pay tax on their share of any excess
inclusion income.
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