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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 |
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For the fiscal year ended December 31, 2004 |
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 |
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For the transition period
from to . |
Commission file number 001-31828
LUMINENT MORTGAGE CAPITAL, INC.
(Exact name of registrant as specified in its charter)
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Maryland
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06-1694835 |
(State or other jurisdiction of
incorporation or organization) |
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(I.R.S. Employer
Identification No.) |
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909 Montgomery Street, Suite 500
San Francisco, California |
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94133 |
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(Address of principal executive offices) |
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(Zip Code) |
Registrant’s telephone number, including area code:
(415) 486-2110
Securities registered pursuant to Section 12(b) of the
Act:
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Name of Each Exchange on Which Registered |
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Common Stock, par value $0.001 per share |
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New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the
Act:
None
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 requirements for the past
90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of
registrant’s knowledge, in a definitive proxy or
information statement incorporated by reference in Part III
of this Form 10-K or any amendment to this
Form 10-K. þ
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the
Act). Yes þ No o
The aggregate market value of the voting common stock held by
non-affiliates of the registrant as of June 30, 2004 was
$437,481,924, based on 36,456,827 shares of our common
stock then held by non-affiliates and a the price at which our
common stock was last sold on the New York Stock Exchange as of
such date.
The number of shares of our common stock outstanding on
February 28, 2005 was 37,841,280.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of our proxy statement for our 2005 Annual Meeting of
Stockholders are incorporated by reference in Items 10, 11,
12, 13 and 14 of Part III of this Annual Report on
Form 10-K.
INDEX
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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains certain
forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Forward-looking
statements are those that are not historical in nature. They can
often be identified by their inclusion of words such as
“will,” “anticipate,” “estimate,”
“should,” “expect,” “believe,”
“intend” and similar expressions. Any projection of
revenues, earnings or losses, capital expenditures,
distributions, capital structure or other financial terms is a
forward-looking statement.
Our forward-looking statements are based upon our
management’s beliefs, assumptions and expectations of our
future operations and economic performance, taking into account
the information currently available to us. Forward-looking
statements involve risks and uncertainties, some of which are
not currently known to us, that might cause our actual results,
performance or financial condition to be materially different
from the expectations of future results, performance or
financial condition we express or imply in any forward-looking
statements. Some of the important factors that could cause our
actual results, performance or financial condition to differ
materially from expectations are:
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interest rate mismatches between our mortgage-backed securities
and the borrowings we use to fund our purchases of such
securities; |
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changes in interest rates and mortgage prepayment rates; |
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our ability to obtain or renew sufficient funding to maintain
our leverage strategies; |
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potential impacts of our leveraging policies on our net income
and cash available for distribution; |
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our limited operating history and the limited experience of
Seneca Capital Management LLC, or Seneca, our management
company, in managing a real estate investment trust, or REIT; |
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the ability of our board of directors to change our operating
policies and strategies without stockholder approval or notice
to you; |
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effects of interest rate caps on our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities; |
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the degree to which our hedging strategies may or may not
protect us from interest rate volatility; |
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the fact that Seneca could be motivated to recommend riskier
investments in an effort to maximize its incentive compensation
under its management agreement with us; |
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potential conflicts of interest arising out of our relationship
with Seneca, on the one hand, and Seneca’s relationships
with other third parties, on the other hand; |
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our ability to invest up to 10% of our investment portfolio in
lower-credit quality mortgage-backed securities that carry an
increased likelihood of default or rating downgrade relative to
investment-grade securities; |
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your inability to review the assets that we will acquire with
the net proceeds of any securities we offer; and |
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the other important factors described in this Annual Report on
Form 10-K, including those under the captions
“Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” “Risk
Factors” and “Quantitative and Qualitative Disclosures
about Market Risk.” |
We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new
information, future events or otherwise. In light of these
risks, uncertainties and assumptions, the events described by
our forward-looking events might not occur. We qualify any and
all of our forward-looking statements by these cautionary
factors. In addition, you should carefully review the risk
factors described in
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other documents we file from time to time with the Securities
and Exchange Commission, including the Quarterly Reports on
Form 10-Q to be filed by Luminent Mortgage Capital, Inc. in
2005.
This Annual Report on Form 10-K contains market data,
industry statistics and other data that have been obtained from,
or compiled from, information made available by third parties.
We have not independently verified their data.
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PART I
Our Company
Background
We were incorporated in April 2003 to invest primarily in
U.S. agency and other highly-rated, single-family,
adjustable-rate, hybrid adjustable-rate and fixed-rate
mortgage-backed securities, which we acquire in the secondary
market. Our strategy is to acquire mortgage-related assets,
finance these purchases in the capital markets and use leverage
in order to provide an attractive return on stockholders’
equity. Through this strategy, we seek to earn income, which is
generated from the spread between the yield on our earning
assets and our costs, including the interest cost of the funds
we borrow.
We commenced operations in June 2003, following the completion
of a private placement of our common stock, in which we raised
net proceeds of approximately $159.7 million. On
December 18, 2003, we completed an initial public offering
of our common stock in which we raised net proceeds of
approximately $157.0 million. On December 19, 2003,
our common stock began trading on the New York Stock Exchange,
or NYSE, under the trading symbol “LUM.” On
March 29, 2004, we completed a follow-on public offering of
our common stock in which we raised net proceeds of
approximately $157.5 million.
We are externally managed and advised by Seneca Capital
Management LLC, or Seneca, pursuant to a management agreement
between Seneca and us. We have a full-time chief financial
officer who is not employed by Seneca, and who provides us with
dedicated financial management, analysis and investor relations
capability.
We have elected to be taxed as a Real Estate Investment Trust,
or REIT, under the Internal Revenue Code of 1986, as amended. As
such, we will routinely distribute substantially all of the REIT
taxable net income generated from our operations to our
stockholders. As long as we retain our REIT status, we generally
will not be subject to U.S. federal or state taxes on our
income to the extent that we distribute our net income to our
stockholders.
In February 2005, we entered into a Controlled Equity Offering
Sales Agreement with Cantor Fitzgerald & Co., pursuant
to the shelf registration statement on Form S-3 filed on
January 3, 2005. See Note 14 to our financial
statements in Item 8 of this Annual Report on
Form 10-K for further discussion.
Effective March 9, 2005, we hired S. Trezevant
Moore, Jr. as our President and Chief Operating Officer. In
conjunction with Mr. Moore’s appointment, Albert J.
Gutierrez has resigned as President but continues to concentrate
on management of our agency and AAA mortgage-backed securities
portfolio.
Assets
We invest primarily in adjustable-rate and hybrid
adjustable-rate mortgage-backed securities. Adjustable-rate
mortgage-backed securities have interest rates that reset
periodically, typically every six months or on an annual basis.
Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the
loan — typically three, five, seven or
10 years — and thereafter reset periodically in a
manner similar to adjustable-rate mortgage-backed securities.
See Note 3 to our financial statements included in
Item 8 of this Annual Report on Form 10-K for further
discussion.
We have acquired and will seek to acquire additional assets that
will produce competitive returns, taking into consideration the
amount and nature of the anticipated returns from the
investment, our ability to pledge the investment for secured,
collateralized borrowings and the costs associated with
financing, managing, securitizing and reserving for these
investments. We expect that substantially all of the
mortgage-backed securities that we acquire will be agency-backed
or have AAA credit ratings from at least one
nationally-recognized statistical rating agency, and most of the
securities will be hybrid adjustable-rate mortgage-backed
securities.
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We review the credit risk associated with each potential
investment and may diversify our portfolio to avoid undue
geographic, insurer, industry and other types of concentrations.
By maintaining a large percentage of our assets in high quality
and highly-rated assets, many of which are guaranteed under
limited circumstances as to payment of a limited amount of
principal and interest by federal agencies or federally
chartered entities such as Fannie Mae, Freddie Mac or Ginnie
Mae, we believe we can mitigate our exposure to losses from
credit risk.
We have financed our acquisition of mortgage-backed securities
by investing our equity and by borrowing at short-term rates
under repurchase agreements. We intend to continue to finance
our acquisitions in this manner.
Borrowings
On December 31, 2004, we had borrowing arrangements with
17 different investment banking firms and other lenders, 12
of which were in use as of that date. These borrowing
arrangements facilitated the purchase of our initial portfolio
of securities through the leveraging of our private placement
proceeds and provided us with sufficient borrowing capacity to
fully leverage the net proceeds of our initial public offering
and follow-on public offering. The repurchase agreements are
secured by mortgage-backed securities. We intend to seek to
renew repurchase agreements as they mature under the
then-applicable borrowing terms of the counterparties to our
repurchase agreements. See Note 4 to our financial
statements in Item 8 of this Annual Report on
Form 10-K for further discussion.
We generally seek to borrow between eight and 12 times the
amount of our equity. We actively manage the adjustment periods
and the selection of the interest rate indices of our borrowings
against the interest rate adjustment periods and the selection
of interest rate indices on our mortgage-backed securities in
order to manage our liquidity and interest rate related risks.
Hedging
We may choose to engage in various hedging activities designed
to match more closely the terms of our assets and liabilities.
Hedging involves risk and typically involves costs, including
transaction costs. The costs of hedging can increase as the
periods covered by the hedging increase and during periods of
rising and volatile interest rates. We may increase our hedging
activity and, thus, increase our hedging costs during such
periods when interest rates are volatile or rising. We generally
intend to hedge as much of the interest rate risk as Seneca
determines is in the best interest of our stockholders, after
considering the cost of such hedging transactions and our desire
to maintain our status as a REIT. Our policies do not contain
specific requirements as to the percentages or amount of
interest rate risk that we hedge. There can be no assurance that
our hedging activities will have the desired beneficial impact
on our results of operations or financial condition. Moreover,
no hedging activity can completely insulate us from the risks
associated with changes in interest rates and prepayment rates.
At December 31, 2004, we have engaged in short sales of
Eurodollar futures contracts as a means of mitigating our
interest rate risk on forecasted interest expense associated
with the benchmark rate on forecasted rollover/reissuance of
repurchase agreements or the interest rate repricing of
repurchase agreements for a specified future time period, which
is defined as the calendar quarter immediately following the
contract expiration date. At December 31, 2004, we have
also entered into interest rate swap contracts to mitigate our
interest rate risk associated with the benchmark rate on
forecasted rollover/reissuance of repurchase agreements or the
interest rate repricing of repurchase agreements for the period
defined by maturity of the interest rate swap. See Note 12
to our financial statements in Item 8 of this Annual Report
on Form 10-K for further discussion.
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Business Strategy
Our Operating Policies and Programs
Our board of directors has established the following four
primary operating policies to implement our business strategies:
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asset acquisition policy; |
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capital/liquidity and leverage policies; |
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credit risk management policy; and |
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asset/liability management policy. |
Our asset acquisition policy provides guidelines for acquiring
investments in order to maintain compliance with our overall
investment strategy. In particular, we acquire a portfolio of
investments that can be grouped into specific categories. Each
category and our respective investment guidelines are as follows:
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Category I — At least 75% of our total assets
will generally be residential mortgage-related securities and
short-term investments. Assets in this category are rated within
one of the two highest rating categories by at least one
nationally-recognized statistical rating organization, or will
be obligations guaranteed by federal agencies or federally
chartered agencies, such as Fannie Mae, Freddie Mac or Ginnie
Mae. |
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Category II — At least 90% of our total
assets will consist of Category I investments plus
mortgage-related securities that are rated at least investment
grade by at least one nationally-recognized statistical rating
organization. |
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Category III — No more than 10% of our
total assets may be of a type not meeting any of the above
criteria. Among the types of assets generally assigned to this
category are mortgage-related securities rated below investment
grade and leveraged mortgage derivative securities, shares of
other REITs or other investments. |
We expect to acquire only those mortgage-related assets that we
believe our manager has the necessary expertise to evaluate and
manage, that we can readily finance and that are consistent with
our overall investment strategy and our asset acquisition
policy. Generally, we expect to hold our mortgage-backed
securities until maturity. Therefore, we generally do not seek
to acquire assets with investment returns that are attractive
only in a limited range of scenarios. Future interest rates and
mortgage prepayment rates are difficult to predict and, as a
result, we seek to acquire mortgage-backed securities that we
believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
We expect most of our acquisitions to consist of adjustable-rate
mortgage-backed securities, hybrid adjustable-rate
mortgage-backed securities and fixed-rate mortgage-backed
securities. We anticipate that our investments in fixed-rate
mortgage-backed securities will be focused in shorter-term
mortgages, including balloon mortgages. We may, however,
purchase longer-term fixed-rate mortgage-backed securities if we
view the potential net returns as attractive or if the
acquisition of such assets serves to reduce or diversify the
overall risk profile of our portfolio.
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Capital/ Liquidity and Leverage Policies |
We employ a leverage strategy to increase our investment assets
by borrowing against existing mortgage-backed securities and
using the proceeds to acquire additional mortgage-backed
securities. We generally seek to borrow between eight to 12
times the amount of our equity, although our borrowings may vary
from time to time depending on market conditions and other
factors deemed relevant by our manager and our board of
directors. We believe that this strategy provides us an adequate
capital base to protect against interest rate
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environments in which our borrowing costs might exceed our
interest income from mortgage-backed securities.
Depending on the different cost of borrowing funds at different
maturities, we expect to vary the maturities of our borrowed
funds to attempt to produce lower borrowing costs. In general,
our borrowings are short-term. We actively manage, on an
aggregate basis, both the interest rate indices and interest
rate adjustment periods of our borrowings against the interest
rate indices and interest rate adjustment periods related to our
mortgage-backed securities.
We expect to continue to finance our mortgage-backed securities
primarily at short-term borrowing rates through repurchase
agreements and, to a lesser extent, our equity capital. We
anticipate that, upon repayment of each borrowing under a
repurchase agreement, we will use the collateral immediately for
borrowing under a new repurchase agreement. In the future we may
also employ borrowings under lines of credit, term loans and
other collateralized financings that we may establish with
approved institutional lenders and we may employ long-term
borrowings.
On December 31, 2004, we had established borrowing
arrangements with 17 different investment banking firms and
other lenders. A repurchase agreement, although structured as a
sale and repurchase obligation, acts as a financing under which
we effectively pledge our mortgage-backed securities as
collateral to secure a short-term loan. Generally, the other
party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the
maturity of the repurchase agreement, we are required to repay
the loan and correspondingly receive back our collateral. While
used as collateral, the mortgage-backed securities continue to
pay principal and interest to us. In the event of our insolvency
or bankruptcy, certain repurchase agreements may qualify for
special treatment under the U.S. Federal Bankruptcy Code,
the effect of which, among other things, would be to allow the
creditor under the agreement to avoid the automatic stay
provisions of the U.S. Federal Bankruptcy Code and to
foreclose on the collateral without delay. In the event of the
insolvency or bankruptcy of the lender during the term of a
repurchase agreement, the lender may be permitted, under
applicable insolvency laws, to repudiate the agreement, and our
claim against the lender for damages may be treated simply as an
unsecured creditor. In addition, if the lender is a broker or
dealer subject to the Securities Investor Protection Act of
1970, or an insured depository institution subject to the
Federal Deposit Insurance Act, our ability to exercise our
rights to recover our securities under a repurchase agreement or
to be compensated for any damages resulting from the
lender’s insolvency may be further limited by those
statutes. These claims would be subject to significant delay
and, if and when received, may be substantially less than the
damages we actually incur. As a result, we expect to enter into
collateralized borrowings only with institutions that we believe
are financially sound and which are rated investment grade by at
least one nationally-recognized statistical rating organization.
Substantially all of our borrowing agreements require us to
deposit additional collateral in the event the market value of
existing collateral declines, which may require us to sell
assets to reduce our borrowings. We have designed our liquidity
management policy to maintain an adequate capital base
sufficient to provide required liquidity to respond to the
effects under our borrowing arrangements of interest rate
movements and changes in the market value of our mortgage-backed
securities. However, a major disruption in the repurchase or
other market that we rely on for short-term borrowings would
harm our results of operations unless we were able to arrange
alternative sources of financing on comparable terms.
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Credit Risk Management Policy |
We review credit risk associated with each of our potential
investments, and seek to reduce risk from sellers and servicers
by obtaining representations and warranties. In addition, we
seek to diversify our portfolio of mortgage-backed securities to
avoid undue geographic, insurer, industry and certain other
types of concentration risk. Our manager monitors the overall
portfolio risk in order to determine appropriate levels of
provision for losses we may experience.
We generally determine, at the time of purchase, whether or not
a mortgage-related asset complies with our credit risk
management policy guidelines, based upon the most recent
information utilized by us. Such compliance is not expected to
be affected by events subsequent to such purchase, such as
changes in
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characterization, value or rating of any specific
mortgage-related assets or economic conditions or events
generally affecting any mortgage-related assets of the type we
hold.
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Asset/Liability Management Policy |
Interest Rate Risk Management. To the extent consistent
with maintaining our status as a REIT, we seek to manage our
interest rate risk exposure to protect our portfolio of
mortgage-backed securities and related debt against the effects
of major interest rate changes. We generally seek to manage our
interest rate risk by:
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monitoring and adjusting, if necessary, the interest rate
sensitivity of our mortgage-backed securities compared with the
interest rate sensitivities of our borrowings; |
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attempting to structure our borrowing agreements to have a range
of different maturities, terms, amortizations and interest rate
adjustment periods; |
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using derivatives, financial futures, swaps, options, caps,
floors and forward sales, to adjust the interest rate
sensitivity of our mortgage-backed securities and our
borrowings; and |
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actively managing, on an aggregate basis, the interest rate
indices, interest rate adjustment periods, and gross reset
margins of our mortgage-backed securities and the interest rate
indices and adjustment periods of our borrowings. |
As a result, we expect to be able to adjust the average
maturity/adjustment period of our borrowings on an ongoing basis
by changing the mix of maturities and interest rate adjustment
periods as borrowings mature or are renewed. Through the use of
these procedures, we attempt to reduce the risk of differences
between interest rate adjustment periods of our adjustable-rate
mortgage-backed securities and our related borrowings.
We manage the assets in our portfolio with regard to risk
characteristics such as duration, in order to carefully limit
the overall interest rate risk of our portfolio. On occasion, we
may alter the overall duration in order to better protect the
portfolio in order to protect stockholder value. Similarly, we
manage the duration of our liabilities. Generally, we seek to
reduce the gap between the duration of our assets and our
liabilities to a level that is consistent with protection of the
portfolio during volatile interest rate environments. The means
by which we seek to accomplish this objective will vary over
time, and may include the use of hedging instruments and the
alteration of the duration of the asset and/or the liability
side of our balance sheet through asset purchases or sales and
through the assumption or the retirement of repurchase
agreements of varying maturities or the structuring of other
financing arrangements.
Depending on market conditions and the cost of the transactions,
we may conduct hedging activities in connection with our
portfolio management. When we engage in hedging activities, we
intend to do so in a manner consistent with our election to
qualify as a REIT. The goal of any hedging strategy we adopt
will be to lessen the effects of interest rate changes and to
enable us to earn net interest income in periods of generally
rising, as well as declining or static, interest rates.
Specifically, consistent with our existing hedging program, any
future hedging program would likely be formulated with the
intent to offset some of the potential adverse effects of
changes in interest rate levels relative to the interest rates
on the mortgage-backed securities held in our investment
portfolio, as well as differences between the interest rate
adjustment indices and maturity or reset periods related to our
mortgage-backed securities and our borrowings. See further
discussion of our current hedging program at Item 7.
Management’s Discussion and Analysis of Financial Condition
and Results of Operations, Critical Accounting
Policies — Accounting for Derivative Financial
Instruments and Hedging Activities, Financial
Condition — Hedging Instruments as well as
Note 12 to our financial statements included in
Item 8 — Derivative Instruments and Hedging
Activities.
Under the REIT rules of the Internal Revenue Code, some hedging
activities produce income that is not qualifying income for
purposes of the REIT gross income tests or create assets that
are not qualifying assets for purposes of the REIT assets test.
As a result, we may have to terminate certain hedging activities
before the benefits of such activities are realized. In the case
of excess hedging income, we would be required to pay a penalty
tax for failure to satisfy certain REIT income tests under the
Internal Revenue Code if the excess is
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due to reasonable cause and not willful neglect. If we had
excess hedging income in relation to our mortgage-related
assets, the penalty would result in our disqualification as a
REIT. In addition, asset/liability management involves
transaction costs that increase dramatically as the period
covered by hedging protection increases and that may increase
during periods of fluctuating interest rates.
Prepayment Risk Management. We also seek to lessen the
effects of prepayment of mortgage loans underlying our
securities at a faster or slower rate than anticipated. We
expect to accomplish this objective by using a variety of
techniques that include, without limitation, structuring a
diversified portfolio with a variety of prepayment
characteristics, investing in mortgage-backed securities based
on mortgage loans with prepayment prohibitions and penalties,
investing in certain mortgage security structures that have
prepayment protections and purchasing mortgage-backed securities
at a premium and at a discount. We monitor prepayment risk
through the periodic review of the impact of a variety of
prepayment scenarios on our revenues, net earnings,
distributions, cash flow and net balance sheet market value.
We believe that we have developed cost-effective asset/liability
management policies to mitigate interest rate and prepayment
risks. We monitor our risk management strategies on a regular
basis as market conditions change. However, no strategy can
completely insulate us from interest rate and prepayment risks.
Further, as noted above, certain of the U.S. federal income
tax requirements that we must satisfy to qualify as a REIT limit
our ability to fully hedge our interest rate and prepayment
risks. Therefore, we could be prevented from effectively hedging
our interest rate and prepayment risks.
Description of Mortgage-Related Assets
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Mortgage-Backed Securities |
Pass-Through Certificates. We expect to invest
principally in pass-through certificates, which are securities
representing interests in pools of mortgage loans secured by
residential real property in which payments of both interest and
principal on the securities are generally made monthly. In
effect, these securities pass through the monthly payments made
by the individual borrowers on the mortgage loans that underlie
the securities, net of fees paid to the issuer or guarantor of
the securities. Pass-through certificates can be divided into
various categories based on the characteristics of the
underlying mortgages, such as the term or whether the interest
rate is fixed or variable.
A key feature of most mortgage loans is the ability of the
borrower to repay principal earlier than scheduled, which we
refer to as a prepayment. Prepayments can arise due to sale of
the underlying property, refinancing, foreclosure or other
events. Prepayments result in a return of principal to
pass-through certificate holders. This return may result in a
lower or higher rate of return upon reinvestment of principal,
and is generally referred to as prepayment uncertainty. If a
security purchased at a premium prepays at a higher than
expected rate, then the value of the premium would be eroded at
a faster than expected rate. Similarly, if a discount mortgage
prepays at a lower than expected rate, the amortization towards
par would be accumulated at a slower than expected rate. We
refer to the possibility of these undesirable effects as
prepayment risk.
In general, but not always, declining interest rates tend to
increase prepayments, and rising interest rates tend to slow
prepayments. Like other fixed-income securities, when interest
rates rise, the value of mortgage-backed securities generally
decline. The rate of prepayments on underlying mortgages will
affect the price and volatility of mortgage-backed securities
and may have the effect of shortening or extending the effective
maturity of the security beyond what was anticipated at the time
of purchase. If interest rates rise, our holdings of
mortgage-backed securities may experience reduced returns if the
borrowers of the underlying mortgages pay off their mortgages
later than anticipated, which we refer to as extension risk.
Payment of limited amounts of principal and interest on some
mortgage pass-through securities, although not the market value
of the securities themselves, may be guaranteed by the full
faith and credit of the federal government, including securities
backed by Ginnie Mae, or by agencies or instrumentalities of the
federal government, including Fannie Mae or Freddie Mac.
Mortgage-backed securities created by non-governmental issuers,
including commercial banks, savings and loan institutions,
private mortgage insurance companies, mortgage bankers and other
secondary market issuers, may be supported by various forms of
insurance or
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guarantees, including individual loan, title, pool and hazard
insurance and letters of credit, which may be issued by
governmental entities, private insurers or the mortgage poolers.
The mortgage loans underlying pass-through certificates can
generally be classified in the following four categories:
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Adjustable-Rate Mortgages. Adjustable-rate mortgages, or
ARMs, are those for which the borrower pays an interest rate
that varies over the term of the loan. The interest rate usually
resets based on market interest rates, although the adjustment
of such an interest rate may be subject to certain limitations.
Traditionally, interest rate resets occur at fixed intervals
(for example, once per year). We refer to such ARMs as
“traditional” ARMs. Because the interest rates on ARMs
fluctuate based on market conditions, ARMs tend to have interest
rates that do not deviate from current market rates by a large
amount. ARMs may therefore have less price sensitivity to
interest rates. |
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Fixed-Rate Mortgages. Fixed-rate mortgages are those
where the borrower pays an interest rate that is constant
throughout the term of the loan. Traditionally, most fixed-rate
mortgages have an original term of 30 years. However,
shorter terms (also referred to as final maturity dates) have
become common in recent years. Because the interest rate on the
loan never changes, even when market interest rates change, over
time there can be a divergence between the interest rate on the
loan and current market interest rates, which in turn can make a
fixed-rate mortgage’s price sensitive to market
fluctuations in interest rates. In general, the longer the
remaining term on the mortgage loan, the greater the price
sensitivity. One way to attempt to lower the price sensitivity
of a portfolio of fixed-rate mortgages is to buy those with
shorter remaining terms or maturities. |
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Hybrid Adjustable-Rate Mortgages. A recent development in
the mortgage market has been the popularity of ARMs that do not
reset at regular intervals. Many of these ARMs have a fixed-rate
for the first few years of the loan — typically three,
five, seven or 10 years — and thereafter reset
periodically like a traditional ARM. Effectively such mortgages
are hybrids, combining the features of a pure fixed-rate
mortgage and a “traditional” ARM. Hybrid ARMs have a
price sensitivity to interest rates similar to that of a
fixed-rate mortgage during the period when the interest rate is
fixed and similar to that of an ARM when the interest rate is in
its periodic reset stage. However, because many hybrid ARMs are
structured with a relatively short initial time span during
which the interest rate is fixed, even during that segment of
its existence, the price sensitivity may be low. |
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Balloon Maturity Mortgages. Balloon maturity mortgages
are a type of fixed-rate mortgage. Thus, they have a static
interest rate for the life of the loan. However the term of the
loan is usually quite short and is less than the amortization
schedule of the loan. Typically, this term or maturity is less
than seven years. When the mortgage matures, the investor
receives all of his principal back, which effectively is a price
reset of the invested principal to par. As the balloon maturity
mortgage approaches its maturity date, the price sensitivity of
the mortgage declines. In fact, the price sensitivity for an
agency balloon mortgage with a set maturity is actually lower
than that for an agency hybrid ARM with the same time to
interest rate reset. |
Collateralized Mortgage Obligations. Collateralized
mortgage obligations, or CMOs, are a type of mortgage-backed
security. Interest and principal on a CMO are paid, in most
cases, on a monthly basis. CMOs may be collateralized by whole
mortgage loans, but are more typically collateralized by
portfolios of mortgage pass-through securities guaranteed by
Fannie Mae, Freddie Mac or Ginnie Mae. CMOs are structured into
multiple classes, or tranches, with each class bearing a
different stated maturity. Monthly payments of principal,
including prepayments, are first returned to investors holding
the shortest maturity class; investors holding the longer
maturity classes receive principal only after the first class
has been retired.
Generally, fixed-rate mortgages are used to collateralize CMOs.
However, the CMO tranches need not all have fixed-rate coupons.
Some CMO tranches have floating rate coupons that adjust based
on market interest rates, subject to some limitations. Such
tranches, often called “CMO floaters,” can have
relatively low price sensitivity.
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Mortgage Derivative Securities. We may acquire mortgage
derivative securities in an amount not to exceed 10% of our
total assets. Mortgage derivative securities allow the holder to
receive interest only, principal only or interest and principal
in amounts that are disproportionate to those payable on the
underlying mortgage loans. Payments on mortgage derivative
securities can be highly sensitive to the rate of prepayments on
the underlying mortgage loans. In the event of faster or slower
than anticipated prepayments on these mortgage loans, the rates
of return on interests in mortgage derivative securities
representing the right to receive interest only or a
disproportionately large amount of interest, or interest only
derivatives, would be likely to decline or increase,
respectively. Conversely, the rates of return on mortgage
derivative securities representing the right to receive
principal only or a disproportionate amount of principal, or
principal only derivatives, would be likely to increase or
decrease in the event of faster or slower prepayment speeds,
respectively.
We may also invest in inverse floaters, a class of CMOs with a
coupon rate that resets in the opposite direction from the
market rate of interest to which it is indexed, including LIBOR
or the 11th District Cost of Funds Index, or COFI. Any rise in
the index rate, which can be caused by an increase in interest
rates, causes a drop in the coupon rate of an inverse floater
while any drop in the index rate causes an increase in the
coupon rate of an inverse floater. An inverse floater may behave
like a leveraged security since its interest rate usually varies
by a magnitude much greater than the magnitude of the index rate
of interest. The leverage-like characteristics inherent in
inverse floaters are associated with greater volatility in their
market prices.
We may also invest in other mortgage derivative securities that
may be developed in the future.
Subordinated Interests. We may also acquire subordinated
interests, which are classes of mortgage-backed securities that
are junior to other classes of the same series of
mortgage-backed securities in the right to receive payments from
the underlying mortgage loans. The subordination may be for all
payment failures on the mortgage loans securing or underlying
such series of mortgage securities. The subordination will not
be limited to those resulting from particular types of risks,
including those resulting from war, earthquake or flood, or the
bankruptcy of a borrower. The subordination may be for the
entire amount of the series of mortgage-related securities or
may be limited in amount.
We may acquire and accumulate mortgage loans (i.e., fixed-rate,
ARMs, hybrid and balloon mortgage loans) as part of our
investment strategy until a sufficient quantity has been
accumulated for securitization into high-quality mortgage-backed
securities in order to enhance their value and liquidity.
Pursuant to our asset acquisition policy, the aggregate amount
of any mortgage loans that we acquire and do not immediately
securitize, together with our investments in other
mortgage-related assets that are not Category I or
Category II assets, will not constitute more than 10% of
our total assets at any time. All mortgage loans, if any, will
be acquired with the intention of securitizing them into
high-credit quality mortgage securities. Despite our intentions,
however, we may not be successful in securitizing these mortgage
loans. To meet our investment criteria, mortgage loans we
acquire will generally conform to underwriting guidelines
consistent with high quality mortgages. Applicable banking laws
generally require that an appraisal be obtained in connection
with the original issuance of mortgage loans by the lending
institution. We do not intend to obtain additional appraisals if
we acquire any mortgage loans.
Mortgage loans may be originated by or purchased from various
suppliers of mortgage-related assets throughout the United
States, including savings and loans associations, banks,
mortgage bankers and other mortgage lenders. We may acquire
mortgage loans directly from originators and from entities
holding mortgage loans originated by others. Our board of
directors has not established any limits upon the geographic
concentration of mortgage loans that we may acquire. However,
our asset acquisition policy limits the amount and/or type of
mortgage loans we may acquire.
We may acquire other investments that include equity and debt
securities issued primarily by other mortgage-related finance
companies, interests in mortgage-related collateralized bond
obligations, other
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subordinated interests in pools of mortgage-related assets,
commercial mortgage loans and securities and residential
mortgage loans other than high-credit quality mortgage loans.
These investments are generally considered Category III
investments under our asset acquisition policy and are limited
to 10% of our total assets.
We also intend to operate in a manner that will not subject us
to regulation under the Investment Company Act of 1940. Our
board of directors has the authority to modify or waive our
current operating policies and our strategies without prior
notice to you and without stockholder approval.
Investment Strategy
Our strategy is to invest primarily in U.S. agency and
other highly-rated single-family adjustable-rate and fixed-rate
mortgage-backed securities. We acquire these investments in the
secondary market and seek to acquire assets that will produce
competitive returns after considering the amount and nature of
the anticipated returns from the investment, our ability to
pledge the investment for secured, collateralized borrowings and
the costs associated with financing, managing, securitizing and
reserving for these investments. We do not construct our overall
investment portfolio in order to express a directional
expectation for interest rates or mortgage prepayment rates.
Future interest rates and mortgage prepayment rates are
difficult to predict and, as a result, we seek to acquire
mortgage-backed securities that we believe provide acceptable
returns over a broad range of interest rate and prepayment
scenarios. When evaluating the purchase of mortgage-backed
securities, we analyze whether the purchase will permit us to
continue to satisfy the minimum 55% portfolio whole-pool
requirement, with which we must comply to maintain our REIT
status. We also assess the relative value of the mortgage-backed
security and how well it would fit into our existing portfolio
of mortgage-backed securities. Many aspects of a mortgage-backed
security, and the dynamic interaction of its characteristics
with those of our portfolio, can influence our perception of
what that security is worth and the amount of premium we would
be willing to pay to own the specific security. The
characteristics of each potential investment we analyze
generally include, but are not limited to, the following:
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origination year — the underwriting year for
the mortgages comprising the mortgage-backed security. This
characteristic helps to determine how “seasoned” the
mortgage-backed security is and can influence our expectations
for the investment’s future cash flows. In the current low
interest rate environment, mortgages that were originated
several years ago (when interest rates were higher) tend to have
been refinanced. Those borrowers who did not refinance their
homes during the period of lower interest rates may be
relatively less likely than more recent borrowers to refinance
during the remaining life of their mortgages. Therefore, the
expected cash flows from a potential investment with an earlier
origination year could exhibit less sensitivity to changes in
interest rates. |
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originator — the financial services entity that
underwrites the mortgages comprising the mortgage-backed
security. Originators do not have homogeneous underwriting
standards. The particular underwriting standards utilized by an
originator tend to influence the characteristics of the
borrowers in its mortgage loan pools which, in turn, can
influence the pool’s prepayment rates and other cash flows.
When analyzing a pool of mortgages, it can be useful to review
the historical cash flows exhibited by the originator’s
prior mortgage loan pools. For example, we may limit the premium
we would be willing to pay for a security if the originator has
a history of early refinancings. The quality of the
originator’s underwriting standards and the terms it offers
borrowers can also be important to our purchase decisions. These
variables potentially include the originator’s required
loan documentation, FICO scores, loan-to-value ratios,
prepayment penalties, cap rates and assumability terms. Any of
these variables might influence our expectations regarding the
timing of cash flows from an originator’s mortgage-backed
securities and, thus, their attractiveness for our portfolio. |
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coupon — the weighted-average mortgage coupon
of the mortgage-backed security. Higher coupons are initially
attractive because they can generate more interest income for us
than lower-coupon mortgage-backed securities. However, the
sustainability of cash flows from higher-coupon pools is less
predictable because, all else being equal, higher-coupon
mortgages have a greater probability of being refinanced than
lower-coupon mortgages. We generally analyze a mortgage-backed
security’s coupon |
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in comparison to current market rates to form an expectation
regarding how sustainable the interest income from the
investment will be. |
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margin — the spread between an adjustable-rate
mortgage’s market index and the interest rate that the
borrower must pay to service the mortgage. Similar to higher
coupons, higher margins are attractive because they can generate
more interest income for us than lower-margin mortgage-backed
securities. However, higher-margin mortgage pools may be more
prone to experience faster refinancing rates because high-margin
borrowers are relatively more likely to find opportunities to
refinance into mortgages with lower spreads to the index. As a
result, the sustainability of the yield from an investment in a
high-margin mortgage pool is less certain and the premium we
would be willing to pay on such an investment, all else being
equal, is less. |
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periodic cap — the amount by which the interest
rate on an adjustable-rate mortgage can adjust during a
specified period, usually six or 12 months. In rapidly
rising interest rate environments, higher periodic caps are more
attractive because they reduce the risk of the adjustable-rate
mortgage coupon not being able to reset fully upwards to the
current market rate. Conversely, in rapidly falling interest
rate environments, lower periodic caps increase the probability
that the mortgage’s coupon will reset to a level that
remains above the current market rate. |
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lifetime cap — the maximum interest rate that a
specific ARM can have during its lifetime. The lifetime cap of a
mortgage is often correlated with market interest rates at the
time of origination. An ARM originated in a low interest rate
environment will frequently have a lower lifetime cap than a
comparably structured mortgage originated in a high interest
rate environment. If interest rates rise sufficiently, an ARM
with a lifetime cap can effectively behave like a fixed-rate
mortgage because the coupon of the ARM cannot adjust above the
lifetime cap, and will thus remain effectively fixed at that
level until rates fall. Higher lifetime caps tend to make
particularly structured hybrid or adjustable-rate mortgage pools
more attractive investment candidates. |
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time-to-reset — the number of months before the
current coupon of the hybrid or adjustable-rate mortgage will
reset. Time-to-reset is an important consideration as we
structure the timing of interest rate adjustments on the
mortgage-backed securities in our portfolio relative to changes
in our borrowing costs. |
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loan-to-value — the ratio between the original
loan amount and the value of the collateral securing the
mortgage loan. We consider this factor less important in a
decision to purchase agency-backed mortgage securities but it
can be an important factor when purchasing non-agency
securities. This factor also influences the subordination levels
required by the national rating agencies to receive AAA-rated
status. |
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geographic dispersion — the degree to which the
properties underlying the pooled mortgage loans are
geographically dispersed. We prefer greater geographic
dispersion because we seek to limit our exposure to specific
states or regions, which might be experiencing relatively
greater economic difficulties, to create a more stable portfolio. |
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price and prepayment expectations — the
expected yield of the mortgage-backed security under various
assumptions about future economic conditions. A mortgage-backed
security’s ultimate yield is determined by its price and
its actual prepayment levels. We generally form expectations,
based on the above factors, regarding how the mortgage
pool’s prepayment levels will change over time, including
in response to possible changes in prevailing interest rates and
other economic conditions, so as to determine whether its
offered price creates a yield that is attractive and fits well
with the expected structure of our portfolio and our borrowing
costs under those scenarios. |
We generally consider these factors when evaluating an
investment’s relative value and the impact it would likely
have on our overall portfolio. We do not assign a particular
weight to any factor because the relative importance of the
various factors varies, depending upon the characteristics we
seek for our portfolio and our borrowing cost structure.
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We do not currently originate mortgage loans or provide other
types of financing to the owners of real estate and we do not
service any mortgage loans. However, in the future, we may elect
to originate mortgage loans or other types of financing, and we
may elect to service mortgage loans and other types of financing.
Financing Strategy
We finance the acquisition of our mortgage-backed securities
with short-term borrowings and term loans with a term of less
than one year and, to a lesser extent, equity capital. After
analyzing the then-applicable interest rate yield curves, we may
finance with long-term borrowings from time to time. The amount
of borrowing we employ depends on, among other factors, the
amount of our equity capital. We use leverage to attempt to
increase potential returns to our stockholders. Pursuant to our
capital/liquidity and leverage policies, we seek to strike a
balance between the under-utilization of leverage, which reduces
potential returns to our stockholders, and the over-utilization
of leverage, which increases risk by reducing our ability to
meet our obligations to creditors during adverse market
conditions.
We borrow at short-term rates using repurchase agreements.
Repurchase agreements are generally short-term in nature. We
seek to actively manage the adjustment periods and the selection
of the interest rate indices of our borrowings against the
adjustment periods and the selection of indices on our
mortgage-backed securities in order to limit our liquidity and
interest rate related risks. We generally seek to diversify our
exposure by entering into repurchase agreements with multiple
lenders. In addition, we only enter into repurchase agreements
with institutions that we believe are financially sound and that
meet credit standards approved by our board of directors.
Growth Strategy
In addition to the strategies described above, we use other
strategies to seek to generate earnings and distributions to our
stockholders, including:
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increasing the size of our balance sheet at a rate faster than
the rate of increase in our operating expenses; |
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using leverage to increase the size of our balance
sheet; and |
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lowering our effective borrowing costs over time by seeking
direct funding with collateralized lenders. |
Industry Trends
The U.S. residential mortgage market has experienced
considerable growth over the past 12 years, with total
outstanding U.S. residential mortgage debt growing from
approximately $3.0 trillion in 1992 to approximately
$7.7 trillion at September 30, 2004, according to the
Federal Reserve Board. According to the same source, the total
amount of U.S. residential mortgage debt securitized into
mortgage-backed securities has grown from approximately
$1.4 trillion in 1992 to approximately $4.3 trillion
at September 30, 2004, approximately $3.4 trillion of
which was agency-backed and therefore generally consistent with
our investment guidelines. At September 30, 2004,
approximately $87.9 billion of the available
mortgage-backed securities were held by REITs.
Competition
When we invest in mortgage-backed securities and other
investment assets, we compete with a variety of institutional
investors, including other REITs, insurance companies, mutual
funds, hedge funds, pension funds, investment banking firms,
banks and other financial institutions that invest in the same
types of assets. Many of these investors have greater financial
resources and access to lower costs of capital than we do. The
existence of these competitive entities, as well as the
possibility of additional entities forming in the future, may
increase the competition for the acquisition of mortgage-backed
securities, resulting in higher prices and lower yields on
assets.
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Certain United States Federal Income Tax Considerations
The following discussion summarizes the material
U.S. federal income tax considerations regarding our
qualification and taxation as a REIT and the material
U.S. federal income tax consequences resulting from the
acquisition, ownership and disposition of our common stock. The
following discussion is not exhaustive of all possible tax
considerations. This summary neither gives a detailed discussion
of any state, local or foreign tax considerations nor discusses
all of the aspects of U.S. federal income taxation that may
be relevant to you in light of your particular circumstances or
to particular types of stockholders that are subject to special
tax rules, such as insurance companies, tax-exempt entities,
financial institutions or broker-dealers, foreign corporations
or partnerships, persons who are not citizens or residents of
the United States, stockholders that hold our stock as a hedge,
part of a straddle, conversion transaction or other arrangement
involving more than one position, or stockholders whose
functional currency is not the U.S. dollar. This discussion
assumes that you will hold our common stock as a “capital
asset,” generally property held for investment, under the
Internal Revenue Code.
You are urged to consult with your own tax advisor regarding
the specific consequences to you of the purchase, ownership and
sale of stock in an entity electing to be taxed as a REIT,
including the federal, state, local, foreign and other tax
considerations of such purchase, ownership, sale and election
and the potential changes in applicable tax laws.
Recent Tax Legislation
On October 22, 2004, the President signed into law the
American Jobs Creation Act of 2004 (the “Jobs Act”),
which amended certain rules relating to REITs. The relevant
provisions of the Jobs Act are discussed in this section.
General
We elected to be taxed as a REIT under the Internal Revenue Code
commencing with our taxable year ending December 31, 2003.
Our qualification and taxation as a REIT depend on our ability
to continue to meet, through actual annual operating results,
distribution levels, diversity of stock ownership, and the
various other qualification tests imposed under the Internal
Revenue Code discussed below. No assurance can be given that our
actual results for any particular taxable year will satisfy
these requirements. See “— Failure to Qualify as
a REIT.” In addition, our continuing qualification as a
REIT depends on future transactions and events that cannot be
known at this time.
So long as we qualify for taxation as a REIT, we generally will
be permitted a deduction for dividends we pay to our
stockholders. As a result, we generally will not be required to
pay federal corporate income taxes on our net income that is
currently distributed to our stockholders. This treatment
substantially eliminates the “double taxation” that
ordinarily results from investment in a corporation. Double
taxation means taxation once at the corporate level when income
is earned and once again at the stockholder level when this
income is distributed. We will be required to pay
U.S. federal income tax, however, as follows:
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we will be required to pay tax at regular corporate rates on any
undistributed REIT taxable net income, including undistributed
net capital gain; |
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we may be required to pay the “alternative minimum
tax” on our items of tax preference; and |
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if we have (1) net income from the sale or other
disposition of “foreclosure property” which is held
primarily for sale to customers in the ordinary course of
business or (2) other non-qualifying income from
foreclosure property, we will be required to pay tax at the
highest corporate rate on this income. Foreclosure property is
generally defined as property acquired through foreclosure or
after a default on a loan secured by the property or on a lease
of the property. |
We will be required to pay a 100% tax on any net income from
prohibited transactions. Prohibited transactions are, in
general, sales or other taxable dispositions of property, other
than foreclosure property, held primarily for sale to customers
in the ordinary course of business. Under existing law, whether
property is
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held as inventory or primarily for sale to customers in the
ordinary course of a trade or business depends on all the facts
and circumstances surrounding the particular transaction.
If we fail to satisfy the 75% gross income test or the 95% gross
income test discussed below, but nonetheless maintain our
qualification as a REIT because certain other requirements
(including that our failure was due to reasonable cause) are
met, we will be subject to a tax equal to:
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the greater of (1) the amount by which 75% of our gross
income exceeds the amount qualifying under the 75% gross income
test described below, and (2) the amount by which 95% of
our gross income exceeds the amount qualifying under the 95%
gross income test described below, multiplied by, |
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a fraction intended to reflect our profitability. |
Pursuant to the Jobs Act, commencing with our taxable year
beginning on January 1, 2005, if we fail to satisfy any of
the REIT asset tests, as described below, by more than a de
minimis amount, due to reasonable cause and we nonetheless
maintain our REIT qualification because of specified cure
provisions, we will be required to pay a tax equal to the
greater of $50,000 or the highest corporate tax rate multiplied
by our net income generated by the nonqualifying assets.
Pursuant to the Jobs Act, commencing with our taxable year
beginning on January 1, 2005, if we fail to satisfy any
provision of the Internal Revenue Code that would result in our
failure to qualify as a REIT other than a violation of the REIT
gross income or asset tests described below and the violation is
due to reasonable cause, we will retain our REIT qualification
but we will be required to pay a penalty of $50,000 for each
such failure.
We will be required to pay a 4% excise tax on the excess of the
required distribution over the amounts actually distributed if
we fail to distribute during each calendar year at least the sum
of:
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85% of our real estate investment trust ordinary income for the
year; |
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95% of our real estate investment trust capital gain net income
for the year; and |
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any undistributed taxable income from prior periods. |
This distribution requirement is in addition to, and different
from the distribution requirements discussed below in the
section entitled “— Distributions Generally.”
If we acquire any asset from a corporation that is or has been
taxed as a C corporation under the Internal Revenue Code in
a transaction in which the basis of the asset in our hands is
determined by reference to the basis of the asset in the hands
of the C corporation, and we subsequently recognize gain on
the disposition of the asset during the 10-year period beginning
on the date on which we acquired the asset, then we will be
required to pay tax at the highest regular corporate tax rate on
this gain to the extent of the excess of:
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the fair market value of the asset, over |
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our adjusted basis in the asset, in each case determined as of
the date on which we acquired the asset. |
A C corporation is generally defined as a corporation
required to pay full corporate-level tax. The results described
in this paragraph with respect to the recognition of gain will
apply unless we make an election under Treasury regulation
Section 1.337(d)-7(c) to cause the C corporation to
recognize all of the gain inherent in the property at the time
of our acquisition of the asset.
Finally, we could be subject to an excise tax if our dealings
with any taxable REIT subsidiaries are not at arm’s length.
Requirements for Qualification as a REIT
The Internal Revenue Code defines a REIT as a corporation, trust
or association:
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that is managed by one or more trustees or directors; |
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that issues transferable shares or transferable certificates to
evidence beneficial ownership; |
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that would be taxable as a domestic corporation but for
Sections 856 through 859 of the Internal Revenue Code; |
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that is not a financial institution or an insurance company
within the meaning of the Internal Revenue Code; |
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that is beneficially owned by 100 or more persons; |
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not more than 50% in value of the outstanding stock of which is
owned, actually or constructively, by five or fewer individuals,
including specified entities, during the last half of each
taxable year; and |
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that meets other tests, described below, regarding the nature of
its income and assets and the amount of its distributions. |
The Internal Revenue Code provides that all of the first four
conditions stated above must be met during the entire taxable
year and that the fifth condition must be met during at least
335 days of a taxable year of 12 months, or during a
proportionate part of a taxable year of less than 12 months.
Stock Ownership Tests
Our stock must be beneficially held by at least
100 persons, which we refer to as the “100 stockholder
rule,” and no more than 50% of the value of our stock may
be owned, directly or indirectly, by five or fewer individuals
at any time during the last half of the taxable year, which we
refer to as the “5/50 rule.” In determining whether
five or fewer individuals hold our shares, certain attribution
rules of the Internal Revenue Code apply. For purposes of the
5/50 rule, pension trusts and other specific tax-exempt entities
generally are treated as individuals, except that certain
tax-qualified pension funds are not considered individuals and
beneficiaries of such trusts are treated as holding shares of a
REIT in proportion to their actuarial interests in the trust for
purposes of the 5/50 rule. Our charter imposes repurchase
provisions and transfer restrictions to avoid having more than
50% of the value of our stock being held by five or fewer
individuals. These stock ownership requirements must be
satisfied in each taxable year. We are required to solicit
information from certain of our record stockholders to verify
actual stock ownership levels, and our charter provides for
restrictions regarding the transfer of our stock in order to aid
in meeting the stock ownership requirements. We will be treated
as satisfying the 5/50 rule if we comply with the demand letter
and record keeping requirements discussed below, and if we do
not know, and by exercising reasonable diligence would not have
known, whether we failed to satisfy the 5/50 rule. We satisfied
the stock ownership tests immediately following our initial
public offering and we will use reasonable efforts to monitor
our stock ownership in order to ensure continued compliance with
these tests. If we were to fail either of the stock ownership
tests, we would generally be disqualified from REIT status.
To monitor our compliance with the stock ownership tests, we are
required to maintain records regarding the actual ownership of
our shares of stock. To do so, we are required to demand written
statements each year from the record holders of certain
percentages of our shares of stock in which the record holders
are to disclose the actual owners of the shares (i.e., the
persons required to include our dividends in gross income). A
REIT with 2,000 or more record stockholders must demand
statements from record holders of 5% or more of its shares, one
with fewer than 2,000, but more than 200, record stockholders
must demand statements from record holders of 1% or more of its
shares, while a REIT with 200 or fewer record stockholders must
demand statements from record holders of 0.5% or more of its
shares. A list of those persons failing or refusing to comply
with this demand must be maintained as part of our records. A
stockholder who fails or refuses to comply with the demand must
submit a statement with his or her tax return disclosing the
actual ownership of the shares of stock and certain other
information.
Income Tests
We must satisfy two gross income requirements annually to
maintain our qualification as a REIT:
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under the “75% gross income test,” we must derive at
least 75% of our gross income, excluding gross income from
prohibited transactions, from specified real estate sources,
including rental income, |
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interest on obligations secured by mortgages on real property or
on interests in real property, gain from the disposition of
“qualified real estate assets,” i.e., interests in
real property, mortgages secured by real property or interests
in real property, and some other assets, and income from certain
types of temporary investments; and |
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under the “95% gross income test,” we must derive at
least 95% of our gross income, excluding gross income from
prohibited transactions, from (1) the sources of income
that satisfy the 75% gross income test, (2) dividends,
interest and gain from the sale or disposition of stock or
securities, including some interest rate swap and cap
agreements, options, futures and forward contracts entered into
to hedge variable rate debt incurred to acquire qualified real
estate assets, or (3) any combination of the foregoing.
Amounts from qualified hedges will generally not constitute
gross income and therefore will be disregarded for purposes of
the 95% gross income test if certain identification and other
requirements are satisfied, and will be treated as nonqualifying
income for the 95% and 75% gross income tests if such
requirements are not satisfied. |
For purposes of the 75% and 95% gross income tests, a REIT is
deemed to have earned a proportionate share of the income earned
by any partnership, or any limited liability company treated as
a partnership for U.S. federal income tax purposes, in
which it owns an interest, which share is determined by
reference to its capital interest in such entity, and is deemed
to have earned the income earned by any qualified REIT
subsidiary (in general