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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2001
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from: ________ to ________
Commission File No. 001-13937
ANTHRACITE CAPITAL, INC.
(Exact name of Registrant as specified in its charter
MARYLAND 13-3978906
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
40 East 52nd Street
New York, New York 10022
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(Address of principal executive office) (Zip Code)
(212) 409-3333
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(g) of the Act: Not Applicable
Securities registered pursuant to Section 12(b) of the Act:
COMMON STOCK, $.001 PAR VALUE NEW YORK STOCK EXCHANGE (NYSE)
(Title of each class) (Name of each exchange on
which registered)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to
such filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark 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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |X|
As of March 25, 2002, the aggregate market value of the registrant's Common
Stock, $.001 par value, held by nonaffiliates of the registrant, computed by
reference to the closing price of $11.74 as reported on the New York Stock
Exchange as of the close of business on March 25, 2002: $537,114,112 (for
purposes of this calculation affiliates include only directors and executive
officers of the Company).
The number of shares of the registrant's Common Stock, $.001 par value,
outstanding as of March 25, 2002 was 45,924,297 shares.
ANTHRACITE CAPITAL, INC. AND SUBSIDIARIES
2001 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
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PAGE
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PART I
Item 1. Business............................................................................................4
Item 2. Properties .......................................................................................20
Item 3. Legal Proceedings .................................................................................20
Item 4. Submission of Matters to a Vote of
Security Holders ..................................................................................20
PART II
Item 5. Market for the Registrant's Common Equity
and Related Stockholder Matters ...................................................................21
Item 6. Selected Financial Data ...........................................................................21
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations .....................................................23
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ........................................44
Item 8. Financial Statements and Supplementary Data .......................................................48
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure ............................................................84
PART III
Item 10. Directors and Executive Officers of the Registrant ................................................85
Item 11. Executive Compensation ............................................................................85
Item 12. Security Ownership of Certain Beneficial Owners and Management ....................................85
Item 13. Certain Relationships and Related Transactions ....................................................85
PART IV
Item 14. Exhibits ..........................................................................................85
Signatures ........................................................................................85
Cautionary Statement Regarding Forward-Looking Statements
Certain statements contained herein are not, and certain statements
contained in future filings by Anthracite Capital, Inc. (the "Company") with
the SEC, in the Company's press releases or in the Company's other public or
stockholder communications may not be based on historical facts and are
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements which are based on
various assumptions (some of which are beyond the Company's control) may be
identified by reference to a future period or periods, or by the use of
forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms, or
the negative of those terms. Actual results could differ materially from
those set forth in forward-looking statements due to a variety of factors,
including, but not limited to, those related to the economic environment,
particularly in the market areas in which the Company operates, competitive
products and pricing, fiscal and monetary policies of the U.S. government,
changes in prevailing interest rates, acquisitions and the integration of
acquired businesses, credit risk management, asset/liability management, the
financial and securities markets and the availability of and costs
associated with sources of liquidity. The Company does not undertake, and
specifically disclaims any obligation, to publicly release the result of any
revisions which may be made to any forward-looking statements to reflect the
occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.
PART I
ITEM 1. BUSINESS
All dollar figures expressed herein are expressed in thousands, except share
amounts or per share amounts.
General
Anthracite Capital, Inc. (the "Company"), a Maryland corporation, is a real
estate finance company that generates income based on the spread between the
interest income on its mortgage loans and securities investments and the
interest expense from borrowings used to finance its investments. The
Company seeks to earn high returns on a risk-adjusted basis to support a
consistent quarterly dividend. The Company has elected to be taxed as a Real
Estate Investment Trust, therefore, its income is largely exempt from
corporate taxation. This allows the Company to generate a higher level of
earnings than otherwise attainable by a taxable finance company making
similar investments. The Company commenced operations on March 24, 1998.
In the past five years the real estate finance markets have evolved
significantly as the capital markets play a larger role along with the
traditional commercial banking sources of capital. This has created
opportunities for companies that have expertise in both areas. The Company's
external manager, BlackRock Financial Management, Inc. (the "Manager" or
"BlackRock"), provides significant experience in traditional real estate
loan origination and servicing along with capital markets, investing and
risk management expertise.
The Company's business focuses on (i) investing in below investment grade
Commercial Mortgage Backed Securities (CMBS) where the Company has the right
to control the foreclosure/workout process on the underlying loans; (ii)
originating high yield commercial real estate loans, which includes senior
interests in partnerships that own real property and are reported as real
estate or joint venture investments; and (iii) acquiring investment grade
real estate related securities, including Government guaranteed residential
mortgage backed securities to act as a liquidity support for the other two
operations.
The Company's management believes that this represents an integrated
strategy where each asset class supports the others and creates additional
value for shareholders over and above operating each in isolation. The CMBS
portfolio provides diversification and high loss adjusted returns over a
weighted average life of approximately 10 years, the commercial real estate
loans provide high risk adjusted returns for shorter periods of time, and
the investment grade securities is an actively managed portfolio that
supports the liquidity needs of the Company while earning attractive
returns.
These strategies are pursued within an aggregate risk management framework
that seeks to limit the exposure of the Company's equity and earnings to
changes in interest rates and other exogenous factors beyond the Company's
control.
The day-to-day operations of the Company are managed by BlackRock, subject
to the direction and oversight of the Company's board of directors (the
"Board of Directors"). The Manager is a wholly owned subsidiary of
BlackRock, Inc., which is listed for trading on the New York Stock Exchange
("NYSE") under the symbol "BLK". BlackRock, Inc. is 70% owned by PNC Bank,
National Association ("PNC Bank"), which is itself a wholly owned subsidiary
of PNC Bank Corp (NYSE: PNC). Established in 1988, the Manager is a
registered investment adviser under the Investment Advisers Act of 1940, as
amended (the "Investment Advisers Act"), and is one of the largest
investment management firms in the United States. The Manager, in its
discretion, subject to the supervision of the Board of Directors, evaluates
and monitors the Company's assets and how long such assets should be held in
the Company's portfolio. The Manager is permitted to actively manage the
Company's assets, and such assets may or may not be held to maturity.
Although the Company intends to manage its assets actively, it does not
intend to acquire, hold or sell assets in such a manner that such assets
would be characterized as dealer property for Federal income tax purposes.
Commercial Real Estate Loans
High yield commercial real estate loan originations represent the Company's
efforts to take advantage of opportunities in the real estate finance
markets on a targeted basis. The traditional first lien real estate lender
has shifted its focus to originating loans that can be sold into a
securitization in the capital markets. To achieve the best execution for
this strategy first lien lenders will generally reduce their loan to value
ratios. Borrowers continue to require the same leverage to achieve their
required equity returns, so alternative sources of capital are needed to
fill the financing gap between the first lien lender and the borrower's
equity. The Company's high yield commercial real estate loan originations,
also known as mezzanine loans, fill this gap on a secured basis at very
attractive prices and terms. An effective mezzanine-lending program can
achieve superior risk adjusted returns versus alternative investments.
The type of investments in this class include loans secured by second
mortgages, subordinated participations in first mortgages, loans secured by
partnership interests and preferred equity interests in real estate limited
partnerships. The weighted average life of these investments is generally
two to three years and average leverage is 1:1 debt to equity generally
funded with the debt coterminous with the investment. These investments have
fixed or floating rate coupons, and some provide additional earnings through
an IRR look back or profit participation.
The Company performs significant due diligence before making investments to
evaluate risks and opportunities in this sector. The Company generally
focuses on strong sponsorship, attractive real estate fundamentals, and
pricing and structural characteristics that provide significant control over
the underlying asset.
At December 31, 2001 the Company owned eight separate mezzanine investments
with an average investment of approximately $16,600 and is focused on
adding to this on a strategic basis. The real estate underlying each of the
Company's mezzanine investments is performing in accordance with
underwritten expectations. The typical current returns on Company's equity
range from 11% - 24% with additional earning potential from profit
participations and IRR look back features. This asset class earns a high
yield and allows the Company to maintain flexibility to move quickly in
search of the highest risk adjusted returns.
Commercial Mortgage Backed Securities
The Company owns below investment grade classes of ten different CMBS and
has been an active bidder for this asset class. These CMBS investments are
fixed rate securities backed by pools of first mortgage loans on commercial
real estate assets located across the country. Owning commercial real estate
loans in this form allows the Company to earn attractive loss adjusted
returns while achieving significant diversification across geographic areas
and property types. The total par amount of these investments is $733,830,
the total fair market value at year-end was $360,159 representing an average
dollar price of 49.08. The unlevered yield on this portfolio is
approximately 10.9% before adjusting for expected losses and 10.1% on a
loss-adjusted basis. The Company anticipates receiving approximately
two-thirds of its stated par amount with the remainder representing assumed
credit losses. Income is reported to shareholders after taking into account
assumed credit losses.
The Company uses a sophisticated Intranet-based performance monitoring
system to track the credit experience of the loans in the CMBS pools. The
Company receives remittance reports monthly and can closely monitor any
delinquent loans or other issues that may affect the performance of the
loans. The Company also reviews its credit assumptions on a quarterly basis
using updated debt service coverage information on each loan in the pools
and reviewing economic trends on both a national and regional level.
Investment Grade Real Estate Related Securities
A key element in managing the risk of owning a portfolio of mezzanine loans
and below investment grade CMBS is to maintain sufficient liquid assets to
support these investments during periods of reduced liquidity in the
financial markets. The Company's portfolio of liquid assets is generally
comprised of government guaranteed residential fixed rate and adjustable
rate mortgages, and BBB or higher rated commercial mortgage backed
securities. At year-end, the portfolio represented approximately 75% of the
Company's total assets or 30% of the Company's equity (net of financing)
and provides a ready source of cash that can be used to support the
Company's other investment operations, if needed. This allows the Company
to earn attractive returns on equity while still maintaining significant
liquidity. This portfolio is leveraged more than the mezzanine and CMBS
portfolios but significantly lower than a typical investment grade
portfolio.
At December 31, 2001, the Company's assets were allocated among these three
categories as follows:
Percent of
Invested Debt to
Assets Liabilities Net Capital Equity Ratio
------ ----------- --- ------- ------------
Cash and liquidity portfolio $1,730,323 (1) $1,598,614 $131,709 31.8% 12.14
Below investment grade CMBS 360,159 178,631 181,528 43.8% 0.98
Mezzanine loans, Joint Ventures
and Equity Investment 159,738 58,693 101,045 24.4% 0.58
--------- --------- ------- ---- ----
Total Invested Assets 2,250,220 1,835,938 414,282 100.0% 4.43
========= ========= ======= ====== ====
(1) The Cash and liquidity portfolio consists of cash and cash equivalents, restricted cash, investment grade
securities and securities held for trading.
The Company's anticipated yields to maturity on its investments are based
upon a number of assumptions that are subject to certain business and
economic uncertainties and contingencies. Examples of such contingencies
include, among other things, expectation of credit losses, the rate and
timing of principal payments (including prepayments, repurchases, defaults
and liquidations), the pass-through or coupon rate, and interest rate
fluctuations. Additional factors that may affect the Company's anticipated
yields to maturity on its subordinated CMBS include interest payment
shortfalls due to delinquencies on the underlying mortgage loans and the
timing and magnitude of credit losses on the mortgage loans underlying the
subordinated CMBS that are a result of the general condition of the real
estate market (including competition for tenants and their related credit
quality) and changes in market rental rates. As these uncertainties and
contingencies are difficult to predict and are subject to future events,
which may alter these assumptions, no assurance can be given that the
Company's anticipated yields to maturity will be achieved.
The following is a summary of the types of assets, among others, that the
Company may invest in from time to time;
Mortgage Backed Securities (MBS). The Company acquires both investment grade
and non-investment grade classes of MBS from various sources. MBS typically
are divided into two or more interests, sometimes called "tranches" or
"classes." The senior classes are often securities which, if rated, would
have ratings ranging from low investment grade "BBB" to higher investment
grades "A," "AA" or "AAA." The junior, subordinated classes typically would
include one or more non-investment grade classes, which, if rated, would
have ratings below investment grade "BBB." Such subordinated classes also
typically include an unrated higher-yielding, credit support class (which
generally is required to absorb the first losses on the underlying mortgage
loans).
MBS are generally issued either as "CMOs" or "Pass-Through Certificates."
CMOs are debt obligations of special purpose corporations, owner trusts or
other special purpose entities secured by commercial mortgage loans or MBS.
Pass-Through Certificates evidence interests in trusts, the primary assets
of which are mortgage loans. CMO Bonds and Pass-Through Certificates may be
issued or sponsored by agencies or instrumentalities of the United States
Government or private originators of, or investors in, mortgage loans,
including savings and loan associations, mortgage bankers, commercial banks,
investment banks and other entities. MBS may not be guaranteed by an entity
having the credit status of a governmental agency or instrumentality and in
this instance are generally structured with one or more of the types of
credit enhancements described below. In addition, MBS may be illiquid.
The Company acquires both CMBS and Residential Mortgage Backed Securities
(RMBS). The mortgage collateral supporting CMBS may be pools of whole loans
or other MBS, or both. Unlike RMBS, which typically are collateralized by
thousands of single-family mortgage loans, CMBS are collateralized generally
by a more limited number of commercial or multifamily mortgage loans with
larger principal balances than those of single-family mortgage loans. As a
result, a loss on a single mortgage loan underlying a CMBS will have a
greater negative effect on the yield of such CMBS, especially the
subordinated MBS in such CMBS.
Mortgage Loans. The Company acquires or originates fixed and adjustable-rate
mortgage loans secured by senior, mezzanine or subordinate liens on
multifamily residential, commercial, single-family (one-to-four unit)
residential or other real property as a significant part of its investment
strategy ("Mortgage Loans").
Mortgage loans may be originated by or purchased from various suppliers of
mortgage assets throughout the United States and abroad, such as savings and
loan associations, banks, mortgage bankers, home builders, insurance
companies and other mortgage lenders. The Company acquires mortgage loans
directly from originators and from entities holding mortgage loans
originated by others. The Company also originates its own mortgage loans,
particularly on mezzanine financing of mortgage loans and real property
portfolios.
The Company may invest in or provide loans used to finance construction,
loans secured by real property and used as interim financing, and loans
secured by junior liens on real property. The Company may invest in
multifamily and commercial mortgage loans that are in default, or for which
default is likely or imminent, or for which the borrower is making monthly
payments in accordance with a forbearance plan.
The Company may provide mezzanine financing on commercial property that is
subject to first lien mortgage debt. The Company's mezzanine financing takes
the form of subordinated loans, commonly known as second mortgages, or in
the case of loans originated for securitization, partnership loans (also
known as pledge loans) or preferred equity investments. For example, on a
commercial property subject to a first lien mortgage loan with a principal
balance equal to 65% of the value of the property, the Company could lend
the owner of the property (typically a partnership) an additional 15% to 20%
of the value of the property.
Typically in a mezzanine mortgage loan, as security for its loan, the
property owner would pledge to the Company either the property subject to
the first lien (giving the Company a second lien position typically subject
to an inter-creditor agreement), or the limited partnership and/or general
partnership interest in the property owner. If the property owner's general
partnership interest is pledged, then the Company would be in a position to
take over the operation of the property in the event of a default by the
property owner. By borrowing against the additional value in their
properties, the property owners obtain additional cash to apply to
property improvements, the purchase price of the property, or alternative
uses. Mezzanine mortgage loans generally provide the Company with the right
to receive a stated interest rate on the loan plus various commitment
and/or exit fees. In certain instances, subject to the REIT Provisions of
the Internal Revenue Code of 1986 (the "Code"), the Company may negotiate
to receive a percentage of net operating income or gross revenues from the
property, payable to the Company on an ongoing basis, and a percentage of
any increase in value of the property, payable upon maturity or refinancing
of the loan, or the Company will otherwise seek terms to allow the Company
to charge an interest rate that would provide an attractive risk-adjusted
return. Alternatively, the mezzanine mortgage loans can take the form of a
non-voting preferred equity investment in a single purpose entity borrower
with substantially similar economic terms.
The Company may acquire or originate mortgage loans secured by real property
located outside the United States or acquire such real property. The Company
has no limitations on the geographic scope of its investments in foreign
real properties and such investments may be made in a single foreign country
or among several foreign countries as the Board of Directors may deem
appropriate. Investing in real estate related assets located in foreign
countries creates risks associated with the uncertainty of foreign laws and
markets and risks related to currency conversion. The Company may be subject
to foreign income tax with respect to its investments in foreign real estate
related assets. Any foreign tax credit that otherwise would be available to
the Company for Federal income tax purposes will not flow through to the
Company's stockholders.
Multifamily and Commercial Real Properties. The Company believes that under
appropriate circumstances the acquisition of multifamily and commercial real
properties may offer significant opportunities to the Company. The Company's
policy is to conduct an investigation and evaluation of the real properties
in a portfolio of real properties before purchasing such a portfolio. Prior
to purchasing real estate related assets, the Manager generally will
identify and contact real estate brokers and/or appraisers in the relevant
market areas to obtain rent and sale comparables for the assets in the
portfolio contemplated to be acquired. This information is used to
supplement due diligence performed by the Manager's employees.
The Company may acquire real properties with known material environmental
problems and Mortgage Loans secured by such real properties subsequent to an
environmental assessment that would reasonably indicate that the present
value of the cost of clean-up or remediation would not exceed the
realizable value from the disposition of the mortgage property.
The Company may invest in net leased real estate on a leveraged basis. Net
leased real estate is generally defined as real estate that is net leased to
tenants who are customarily responsible for paying all costs of owning,
operating, and maintaining the leased property during the term of the lease,
in addition to paying a monthly net rent to the landlord for the use and
occupancy of the premises ("Net Leased Real Estate"). The Company will
consider investing in Net Leased Real Estate that is either leased to
creditworthy tenants or is underlied by real estate that can be leased to
other tenants in the event of a default of the initial tenant.
Other Real Estate Related Assets. The Company may invest in a variety of
other real estate related investments, the principal features of which are
summarized below.
Pass-Through Certificates. The Company's investments in residential mortgage
assets are currently and expected to be concentrated in Pass-Through
Certificates. The Pass-Through Certificates to be acquired by the Company
will consist primarily of pass-through certificates issued by Federal
National Mortgage Associates (FNMA), Federal Home Loan Mortgage Corporation
(FHLMC) and Government National Mortgage Associates (GNMA), as well as
privately issued adjustable-rate and fixed-rate mortgage pass-through
certificates. The Pass-Through Certificates to be acquired by the Company
will represent interests in mortgages that will be secured by liens on
single-family (one-to-four units) residential properties, multifamily
residential properties, and commercial properties. Pass-Through Certificates
backed by adjustable-rate Mortgage Loans are subject to lifetime interest
rate caps and to periodic interest rate caps that limit the amount an
interest rate can change during any given period. The Company's borrowings
are generally not subject to similar restrictions. In a period of increasing
interest rates, the Company could experience a decrease in net income or
incur losses because the interest rates on its borrowings could exceed the
interest rates on adjustable-rate Pass-Through Certificates owned by the
Company. The impact on net income of such interest rate changes will depend
on the adjustment features of the mortgage assets owned by the Company, the
maturity schedules of the Company's borrowings and related hedging.
Privately Issued Pass-Through Certificates. Privately Issued Pass-Through
Certificates are structured similar to the FNMA, FHLMC and GNMA pass-through
certificates discussed below and are issued by originators of and investors
in Mortgage Loans, including savings and loan associations, savings banks,
commercial banks, mortgage banks, investment banks and special purpose
subsidiaries of such institutions. Privately Issued Pass-Through
Certificates are usually backed by a pool of conventional Mortgage Loans and
are generally structured with credit enhancement such as pool insurance or
subordination. However, Privately Issued Pass-Through Certificates are
typically not guaranteed by an entity having the credit status of FNMA,
FHLMC or GNMA guaranteed obligations.
FNMA Certificates. FNMA is a federally chartered and privately owned
corporation. FNMA provides funds to the mortgage market primarily by
purchasing Mortgage Loans on homes from local lenders, thereby replenishing
their funds for additional lending.
FNMA Certificates may be backed by pools of Mortgage Loans secured by
single-family or multi-family residential properties. The original terms to
maturity of the Mortgage Loans generally do not exceed 40 years. FNMA
Certificates may pay interest at a fixed rate or adjustable rate. Each
series of FNMA adjustable-rate certificates bears an initial interest rate
and margin tied to an index based on all loans in the related pool, less a
fixed percentage representing servicing compensation and FNMA's guarantee
fee. The specified index used in each such series has included the Treasury
Index, the 11th District Cost of Funds Index, LIBOR and other indices.
Interest rates paid on fully-indexed FNMA adjustable-rate certificates equal
the applicable index rate plus a specified number of basis points ranging
typically from 125 to 250 basis points. In addition, the majority of FNMA
adjustable-rate certificates issued to date have evidenced pools of Mortgage
Loans with monthly, semi-annual or annual interest rate adjustments.
Adjustments in the interest rates paid are generally limited to an annual
increase or decrease of either 100 or 200 basis points and to a lifetime cap
of 500 or 600 basis points over the initial interest rate. Certain FNMA
programs include Mortgage Loans, which allow the borrower to convert the
adjustable mortgage interest rate of its adjustable-rate Mortgage Loan to a
fixed rate. Adjustable-rate Mortgage Loans which are converted into fixed
rate Mortgage Loans are repurchased by FNMA, or by the seller of such loans
to FNMA, at the unpaid principal balance thereof plus accrued interest to
the due date of the last adjustable rate interest payment.
FNMA guarantees to the registered holder of a FNMA Certificate that it will
distribute amounts representing scheduled principal and interest (at the
rate provided by the FNMA Certificate) on the Mortgage Loans in the pool
underlying the FNMA Certificate, whether or not received, and the full
principal amount of any such Mortgage Loan foreclosed or otherwise finally
liquidated, whether or not the principal amount is actually received. The
obligations of FNMA under its guarantees are solely those of FNMA and are
not backed by the full faith and credit of the United States. If FNMA were
unable to satisfy such obligations, distributions to holders of FNMA
Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to holders
of FNMA Certificates would be affected by delinquent payments and defaults
on such Mortgage Loans.
FHLMC Certificates. FHLMC is a privately owned corporate instrumentality of
the United States created pursuant to an Act of Congress. The principal
activity of FHLMC currently consists of the purchase of conforming Mortgage
Loans or participation interests therein and the resale of the loans and
participations so purchased in the form of guaranteed MBS.
Each FHLMC Certificate issued to date has been issued in the form of a
Pass-Through Certificate representing an undivided interest in a pool of
Mortgage Loans purchased by FHLMC. The Mortgage Loans included in each pool
are fully amortizing, conventional Mortgage Loans with original terms to
maturity of up to 40 years secured by first liens on one-to-four unit family
residential properties or multi-family properties.
FHLMC guarantees to each holder of its certificates the timely payment of
interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of
the related Mortgage Loans, but does not guarantee the timely payment of
scheduled principal of the underlying Mortgage Loans. The obligations of
FHLMC under its guarantees are solely those of FHLMC and are not backed by
the full faith and credit of the United States. If FHLMC were unable to
satisfy such obligations, distributions to holders of FHLMC Certificates
would consist solely of payments and other recoveries on the underlying
Mortgage Loans and, accordingly, monthly distributions to holders of FHLMC
Certificates would be affected by delinquent payments and defaults on such
Mortgage Loans.
GNMA Certificates. GNMA is a wholly owned corporate instrumentality of the
United States within HUD. GNMA guarantees the timely payment of the
principal of and interest on certificates that represent an interest in a
pool of Mortgage Loans insured by the FHA and other loans eligible for
inclusion in mortgage pools underlying GNMA Certificates. GNMA Certificates
constitute general obligations of the United States backed by its full faith
and credit.
Collateralized Mortgage Obligations (CMOs). The Company invests, from time
to time, in adjustable rate and fixed rate CMOs issued by private issuers or
FHLMC, FNMA or GNMA. CMOs are a series of bonds or certificates ordinarily
issued in multiple classes, each of which consists of several classes with
different maturities and often complex priorities of payment, secured by a
single pool of Mortgage Loans, Pass-Through Certificates, other CMOs or
other mortgage assets. Principal prepayments on collateral underlying a CMO
may cause it to be retired substantially earlier than the stated maturities
or final distribution dates. Interest is paid or accrues on all interest
bearing classes of a CMO on a monthly, quarterly or semi-annual basis. The
principal and interest on underlying Mortgages Loans may be allocated among
the several classes of a series of a CMO in many ways, including pursuant to
complex internal leverage formulas that may make the CMO class especially
sensitive to interest rate or prepayment risk.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of
diminishing the Company's anticipated return on its investment.
Privately-issued single-family, multi-family and commercial CMOs are
supported by private credit enhancements similar to those used for
Privately-Issued Certificates and are often issued as senior-subordinated
mortgage securities. In general, the Company intends to only acquire CMOs or
multi-class Pass-Through certificates that represent beneficial ownership in
grantor trusts holding Mortgage Loans, or regular interests and residual
interests in REMICs, or that otherwise constitute REIT Real Estate Assets.
Mortgage Derivatives. The Company invests in Mortgage Derivatives, including
Interest-Only securities (IOs), Inverse IOs, Sub IOs and floating rate
derivatives, as market conditions warrant. Mortgage Derivatives provide for
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 Derivatives are highly
sensitive to the rate of prepayments on the underlying Mortgage Loans. In
the event that prepayments on such Mortgage Loans occur more frequently than
anticipated, the rates of return on Mortgage Derivatives representing the
right to receive interest only or a disproportionately large amount of
interest, i.e., IOs, would be likely to decline. Conversely, the rates of
return on Mortgage Derivatives representing the right to receive principal
only or a disproportional amount of principal, i.e., POs, would be likely to
increase in the event of rapid prepayments.
Some IOs in which the Company may invest, such as Inverse IOs, bear interest
at a floating rate that varies inversely with (and often at a multiple of)
changes in a specific index. The yield to maturity of an Inverse IO is
extremely sensitive to changes in the related index. The Company also may
invest in inverse floating rate Mortgage Derivatives, which are similar in
structure and risk to Inverse IOs, except they generally are issued with a
greater stated principal amount than Inverse IOs.
Other IOs in which the Company may invest, such as Sub IOs, have the
characteristics of a Subordinated Interest. A Sub IO is entitled to no
payments of principal; moreover, interest on a Sub IO often is withheld in a
reserve fund or spread account to fund required payments of principal and
interest on more senior tranches of mortgage securities. Once the balance in
the spread account reaches a certain level, excess funds are paid to the
holders of the Sub IO. These Sub IOs provide credit support to the senior
classes and thus bear substantial credit risks. In addition, because a Sub
IO receives only interest payments, its yield is extremely sensitive to the
rate of prepayments (including prepayments as a result of defaults) on the
underlying Mortgage Loans.
IOs can be effective hedging devices because they generally increase in
value as fixed-rate mortgage securities decrease in value. The Company also
may invest in other types of derivatives currently available in the market
and other Mortgage Derivatives that may be developed in the future if the
Manager determines that such investments would be advantageous to the
Company.
FHA and GNMA Project Loans. The Company may invest in loan participations
and pools of loans insured under a variety of programs administered by the
Department of Housing and Urban Development ("HUD"). These loans will be
insured under the National Housing Act and will provide financing for the
purchase, construction or substantial rehabilitation of multifamily housing,
nursing homes and intermediate care facilities, elderly and handicapped
housing, and hospitals.
Similar to CMBS, investments in FHA and GNMA Project Loans will be
collateralized by a more limited number of loans, with larger average
principal balances, than RMBS, and will therefore be subject to greater
performance variability. Loan participations are most often backed by a
single FHA-insured loan. Pools of insured loans, while more diverse, still
provide much less diversification than pools of single-family loans.
FHA insured loans will be reviewed on a case by case basis to identify and
analyze risk factors, which may materially impact investment performance.
Property-specific data such as debt service coverage ratios, loan-to-value
ratios, HUD inspection reports, HUD financial statements and rental
subsidies will be analyzed in determining the appropriateness of a loan for
investment purposes. The Manager will also rely on the FHA insurance
contracts and their anticipated impact on investment performance in
evaluating and managing the investment risks. FHA insurance covers 99% of
the principal balance of the underlying project loans. Additional GNMA
credit enhancement may cover 100% of the principal balance.
Other. The Company may invest in fixed-income securities that are not
mortgage assets, including securities issued by corporations or issued or
guaranteed by U.S. or sovereign foreign entities, loan participations,
emerging market debt, high yield debt and collateralized bond obligations.
Hedging Activities
The Company enters into hedging transactions to protect its investment
portfolio and related borrowings from interest rate fluctuations and other
changes in market conditions. These transactions may include interest rate
swaps, the purchase or sale of interest rate collars, caps or floors,
options, Mortgage Derivatives and other hedging instruments. These
instruments may be used to hedge as much of the interest rate risk as the
Manager determines is in the best interest of the Company's stockholders,
given the cost of such hedges and the need to maintain the Company's status
as a REIT. The Manager may elect to have the Company bear a level of
interest rate risk that could otherwise be hedged when the Manager believes,
based on all relevant facts, that bearing such risk is advisable. The
Manager has extensive experience in hedging mortgages, mortgage-related
assets and related borrowings with these types of instruments.
Hedging instruments often are not traded on regulated exchanges, guaranteed
by an exchange or its clearinghouse, or regulated by any U.S. or foreign
governmental authorities. Consequently, there may be no requirements with
respect to record keeping, financial responsibility or segregation of
customer funds and positions. The Company will enter into these transactions
only with counterparties with long-term debt rated "A" or better by at least
one nationally recognized statistical rating organization. The business
failure of a counterparty with which the Company has entered into a hedging
transaction will most likely result in a default, which may result in the
loss of unrealized profits and force the Company to cover its resale
commitments, if any, at the then current market price. Although generally
the Company will seek to reserve for itself the right to terminate its
hedging positions, it may not always be possible to dispose of or close out
a hedging position without the consent of the counterparty, and the Company
may not be able to enter into an offsetting contract in order to cover its
risk. There can be no assurance that a liquid secondary market will exist
for hedging instruments purchased or sold, and the Company may be required
to maintain a position until exercise or expiration, which could result in
losses.
The Company's hedging activities are intended to address both income and
capital preservation. Income preservation refers to maintaining a stable
spread between yields from mortgage assets and the Company's borrowing costs
across a reasonable range of adverse interest rate environments. Capital
preservation refers to maintaining a relatively steady level in the market
value of the Company's capital across a reasonable range of adverse interest
rate scenarios. However, no strategy can insulate the Company completely
from changes in interest rates.
The Company's hedging policy with regard to its sterling denominated London
Loan, a (pound)21,459 Sterling denominated loan funded in August 1998, is to
minimize its exposure to fluctuations in the sterling exchange rate. As of
December 31, 2001, the Company had forward contracts outstanding which are
intended to hedge currency risk in connection with the Company's investment
in the London Loan.
From time to time the Company may reduce its exposure to market interest
rates by entering into various financial instruments that adjust portfolio
duration. These financial instruments are intended to mitigate the effect of
interest rates on the value of certain assets in the Company's portfolio. At
December 31, 2001, the Company had outstanding short positions of 80
thirty-year U.S. Treasury Bond future contracts, 500 ten-year U.S. Treasury
Note future contracts and a short call swaption with a notional amount of
$400,000. At December 31, 2000, the Company did not have U.S. Treasury
future contracts or swaptions.
Interest rate swap agreements as of December 31, 2001 and 2000 consisted of
the following:
2001 2000
- ----------------------------------------------------------------- -------------------------------------------------------------
Estimated Average Estimated Unamortized Average
Notional Value Fair Value Unamortized Cost Remaining Term Notional Value Fair Value Cost Remaining Term
- --------------- ------------ ------------------- ---------------- --------------- ------------ ---------------- ---------------
$792,000 $(9,380) $4,764 8.12 years $226,000 $(12,505) $9,471 19.3 years
As of December 31, 2001, the Company had designated $682,000 of the interest
rate swap agreements as cash flow hedges of borrowings under reverse
repurchase agreements.
Financing and Leverage
The Company has financed its assets with the net proceeds of its initial
public, secondary offering, follow-on offerings, the issuance of preferred
stock, short-term borrowings under repurchase agreements, and the lines of
credit discussed below. In the future, operations may be financed by future
offerings of equity securities, and unsecured and secured borrowings. The
Company expects that, in general, it will employ leverage consistent with
the type of assets acquired and the desired level of risk in various
investment environments. The Company's governing documents do not explicitly
limit the amount of leverage that the Company may employ. Instead, the Board
of Directors has adopted an indebtedness policy for the Company that limits
total leverage to a maximum 6.0:1 debt to equity. At December 31, 2001 and
2000, the Company's debt-to-equity ratio was approximately 4.8 to 1 and 3.2
to 1, respectively. The Company anticipates that it will maintain
debt-to-equity ratios between 2.5 to 1 and 5.0 to 1 in the foreseeable
future, although this ratio may be higher or lower from time to time. The
Company's indebtedness policy may be changed by the Board of Directors in
the future.
On July 19, 1999, the Company entered into an $185,000 committed credit
facility with Deutsche Bank, AG (the "Deutsche Bank Facility"). The Deutsche
Bank Facility has a two-year term and provides for a one-year extension at
the Company's option. The Deutsche Bank Facility was extended for a one-year
term thru July 19, 2002, and is currently under negotiation to be extended.
The Deutsche Bank Facility can be used to replace existing reverse
repurchase agreement borrowings and to finance the acquisition of
mortgage-backed securities, loan investments, and investments in real estate
joint ventures. As of December 31, 2001 and December 31, 2000, the
outstanding borrowings under this facility were $43,409 and $53,810,
respectively. Outstanding borrowings under the Deutsche Bank Facility bear
interest at a LIBOR based variable rate
The Company has an agreement with Merrill Lynch which permits the Company to
borrow up to $200,000. As of December 31, 2001 and December 31, 2000, the
outstanding borrowings under this line of credit were $57,113, and $63,453
respectively. The agreement requires assets to be pledged as collateral,
which may consist of rated CMBS, rated RMBS, residential and commercial
mortgage loans, and certain other assets. Outstanding borrowings under this
line of credit bear interest at a LIBOR based variable rate. On January 15,
2002, the facility was renewed for a twelve-month period.
In September 2000, the Company closed a $200,000, one-year term facility
with Merrill Lynch Mortgage Capital Inc. ("Merrill Lynch"), which was used
to finance the Company's residential loan pools. As of December 31, 2001
there were no outstanding borrowings under this facility. As of December 31,
2000 outstanding borrowings were $37,253. Outstanding borrowings under this
facility bear interest at a LIBOR based variable rate. This facility expired
pursuant to its terms in September 2001.
On March 14, 2001 the Company entered into a one-year term facility with PNC
Funding, Inc. which permits the Company to borrow up to $50,000. As of
December 31, 2001, the outstanding borrowing under this facility was
$13,885. The agreement requires assets to be pledged as collateral. The
outstanding borrowings were repaid prior to the expiration on March 13,
2002.
In June 1999, the Company closed a $17,500, three-year term financing
secured by the Company's $35,000 Santa Monica Loan. As of December 31, 2000,
the Company had drawn $17,500; the financing was paid off in March 2001 when
the Santa Monica Loan was paid off.
At the time of the CORE Cap acquisition, CORE Cap was a party to commercial
paper facility agreements with ABN Amro which was used to finance
residential and commercial loans, which are used to collateralize borrowings
under the facility. Following the CORE Cap acquisition, the Company renewed
the facility with ABN Amro, in the amount of $200,000. As of December 31,
2000, outstanding borrowing under the facility was $30,115; this facility
was paid off in 2001.
The Company is subject to various covenants in its lines of credit,
including maintaining a minimum GAAP net worth of $140,000, a debt-to-equity
ratio not to exceed 5.0 to 1, a minimum cash requirement based upon certain
debt to equity ratios, a minimum debt service coverage ratio of 1.5, and a
minimum liquidity reserve of $10,000. Additionally, the Company's GAAP net
worth cannot decline by more than 37% during the course of any two
consecutive fiscal quarters. As of December 31, 2001, the Company was in
compliance with all such covenants.
On December 2, 1999 the Company authorized and issued 1,200,000 shares of
Series A Preferred Stock for aggregate proceeds of $30,000. The Preferred
Stock carries a 10.5% coupon and is convertible into Common Stock at a price
of $7.35 per share. The Series A Preferred Stock has a seven-year maturity
at which time, at the option of the holders, the shares may be converted
into common shares or liquidated for $28.50 per share. On December 21, 2001,
the only Series A Preferred shareholder converted 1,190,000 shares of the
Series A Preferred Stock into 4,096,854 shares of Company Common Stock at a
price of $7.26 per share pursuant to the terms of such preferred stock,
which was $0.09 lower than the original conversion price due to the effects
of anti-dilution provisions in the Series A Preferred Stock. The remaining
10,000 shares of Series A Preferred Stock were converted into 34,427 shares
of the Company's Common Stock in March 2002.
On February 14, 2001 the Company completed a secondary offering of 4,000,000
shares of its Common Stock in an underwritten public offering. The aggregate
net proceeds to the Company (after deducting underwriting fees and expenses)
were approximately $33,300. The Company had granted the underwriters an
option, exercisable for 30 days, to purchase up to 600,000 additional shares
of Common Stock to cover over-allotments. This option was exercised on March
13, 2001 and resulted in net proceeds to the Company of approximately
$5,000.
On May 11, 2001, the Company completed a follow-on offering of 4,000,000
shares of its Common Stock in an underwritten public offering. The aggregate
net proceeds to the Company (after deducting underwriting fees and expenses)
were approximately $37,800. The Company had granted the underwriters an
option, exercisable for 30 days, to purchase up to 600,000 additional shares
of Common Stock to cover over-allotments. This option was exercised on June
6, 2001 and resulted in net proceeds to the Company of approximately $5,675.
On November 7, 2001 the Company completed a follow-on offering of 4,400,000
shares of its Common Stock in an underwritten public offering. The aggregate
net proceeds to the Company (after deducting estimated expenses) were
approximately $39.4 million. On November 13, 2001, the underwriters
exercised an option to purchase an additional 90,000 shares of Common Stock
available through an over-allotment granted to the underwriters and resulted
in net proceeds to the Company of approximately $810.
For the year ended December 31, 2001, the Company issued 2,228,566 shares of
Common Stock under its Dividend Reinvestment Plan. Net proceeds to the
Company were approximately $22,945. No shares were issued for the year ended
December 31, 2000 under the Dividend Reinvestment Plan.
The Company has entered into reverse repurchase agreements to finance most
of its securities available for sale which are not financed under its lines
of credit. The reverse repurchase agreements are collateralized by most of
the Company's securities available for sale and bear interest at rates that
have historically moved in close relationship to LIBOR.
Certain information with respect to the Company's collateralized borrowings
at December 31, 2001 is summarized as follows:
Lines of Credit and Reverse Repurchase Total
Term Loans Agreements Collateralized Borrowings
--------------------- ----------------------- --------------------------
Outstanding borrowings $115,747 $1,720,191 $1,835,938
Weighted average borrowing rate 3.62% 1.94% 2.04%
Weighted average remaining maturity 186 Days 18 Days 29 Days
Estimated fair value of assets pledged $173,139 $1,825,971 $1,999,110
At December 31, 2001, $20,356 of borrowings outstanding under the line of
credit was denominated in pounds sterling, and interest payable is based on
sterling LIBOR.
At December 31, 2001, the Company's collateralized borrowings had the following remaining maturities:
Lines of Credit and Reverse Repurchase Total
Term Loan Agreements Collateralized Borrowings
-------------------- ------------------ ---------------------------
Within 30 days $58,453 $1,700,420 $1,758,873
31 to 59 days - 19,771 19,771
Over 60 days 57,294 - 57,294
-------------------- ------------------ ---------------------------
$115,747 $1,720,191 $1,835,938
==================== ================== ===========================
As of December 31, 2001, $141,591 of the Company's $185,000 committed credit
facility with Deutsche Bank, AG was available for future borrowings, and
$142,887 was available under the Company's $200,000 term facility with
Merrill Lynch.
Under the line of credit and the reverse repurchase agreements, the lender
retains the right to mark the underlying collateral to estimated market
value. A reduction in the value of its pledged assets will require the
Company to provide additional collateral or fund cash margin calls. From
time to time, the Company expects that it will be required to provide such
additional collateral or fund margin calls. The Company maintains adequate
liquidity to meet such calls.
Operating Policies
The Company has adopted compliance guidelines, including restrictions on
acquiring, holding and selling assets, to ensure that the Company meets the
requirements for qualification as a REIT and is excluded from regulation as
an investment company. Before acquiring any asset, the Manager determines
whether such asset would constitute a Real Estate Asset under the REIT
Provisions of the Code. The Company regularly monitors purchases of mortgage
assets and the income generated from such assets, including income from its
hedging activities, in an effort to ensure that at all times the Company's
assets and income meet the requirements for qualification as a REIT and
exclusion under the Investment Company Act of 1940.
The Company's unaffiliated directors review all transactions of the Company
on a quarterly basis to ensure compliance with the operating policies and to
ratify all transactions with PNC Bank and its affiliates, except that the
purchase of securities from PNC Bank and its affiliates require prior
approval. The unaffiliated directors rely substantially on information and
analysis provided by the Manager to evaluate the Company's operating
policies, compliance therewith and other matters relating to the Company's
investments.
In order to maintain the Company's REIT status, the Company generally
intends to distribute to stockholders aggregate dividends equaling at least
95% of its taxable income each year and 90% for years ending after 2000. The
code permits the Company to fulfill this distribution requirement by the end
of the year following the year the taxable income was earned.
Regulation
The Company intends to continue to conduct its business so as not to become
regulated as an investment company under the Investment Company Act. Under
the Investment Company Act, a non-exempt entity that is an investment
company is required to register with the SEC and is subject to extensive,
restrictive and potentially adverse regulation relating to, among other
things, operating methods, management, capital structure, dividends and
transactions with affiliates. The Investment Company Act exempts entities
that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under current interpretation by the staff of the
SEC, to qualify for this exemption, the Company, among other things, must
maintain at least 55% of its assets in Qualifying Interests. Pursuant to
such SEC staff interpretations, certain of the Company's interests in agency
pass-through and mortgage-backed securities and agency insured project loans
are Qualifying Interests. In general, the Company will acquire subordinated
CMBS only when such mortgage securities are collateralized by pools of first
mortgage loans, when the Company can monitor the performance of the
underlying mortgage loans through loan management and servicing rights, and
when the Company has appropriate workout/foreclosure rights with respect to
the underlying mortgage loans. When such arrangements exist, the Company
believes that the related subordinated CMBS constitute Qualifying Interests
for purposes of the Investment Company Act. Therefore, the Company believes
that it should not be required to register as an "investment company" under
the Investment Company Act as long as it continues to invest primarily in
such subordinated CMBS and/or in other Qualifying Interests. However, if the
SEC or its staff were to take a different position with respect to whether
the Company's subordinated CMBS constitute Qualifying Interests, the Company
could be required to modify its business plan so that either (i) it would
not be required to register as an investment company or (ii) it would comply
with the Investment Company Act and be able to register as an investment
company. In such event, (i) modification of the Company's business plan so
that it would not be required to register as an investment company would
likely entail a disposition of a significant portion of the Company's
subordinated CMBS or the acquisition of significant additional assets, such
as agency pass-through and mortgage-backed securities, which are Qualifying
Interests or (ii) modification of the Company's business plan to register as
an investment company would result in significantly increased operating
expenses and would likely entail significantly reducing the Company's
indebtedness (including the possible prepayment of the Company's short-term
borrowings), which could also require it to sell a significant portion of
its assets. No assurances can be given that any such dispositions or
acquisitions of assets, or deleveraging, could be accomplished on favorable
terms. Consequently, any such modification of the Company's business plan
could have a material adverse effect on the Company. Further, if it were
established that the Company were an unregistered investment company, there
would be a risk that the Company would be subject to monetary penalties and
injunctive relief in an action brought by the SEC, that the Company would be
unable to enforce contracts with third parties and that third parties could
seek to obtain recission of transactions undertaken during the period it was
established that the Company was an unregistered investment company. Any
such results would be likely to have a material adverse effect on the
Company.
Competition
The Company's net income depends, in large part, on the Company's ability to
acquire mortgage assets at favorable spreads over the Company's borrowing
costs. In acquiring mortgage assets, the Company competes with other
mortgage REITs, specialty finance companies, savings and loan associations,
banks, mortgage bankers, insurance companies, mutual funds, institutional
investors, investment banking firms, other lenders, governmental bodies and
other entities. In addition, there are numerous mortgage REITs with asset
acquisition objectives similar to the Company, and others may be organized
in the future. The effect of the existence of additional REITs may be to
increase competition for the available supply of mortgage assets suitable
for purchase by the Company. Many of the Company's anticipated competitors
are significantly larger than the Company, have access to greater capital
and other resources and may have other advantages over the Company. In
addition to existing companies, other companies may be organized for
purposes similar to that of the Company, including companies organized as
REITs focused on purchasing mortgage assets. A proliferation of such
companies may increase the competition for equity capital and thereby
adversely affect the market price of the Company's Common Stock.
Employees
The Company does not have any employees other than officers, each of whom
are full-time employees of the Manager, whose duties include performing
administrative activities for the Company.
Management Agreement
The Company is managed pursuant to a management agreement, dated March 27,
1998, between the Company and the Manager (the "Management Agreement"),
pursuant to which the Manager is responsible for the day-to-day operations
of the Company and performs such services and activities relating to the
assets and operations of the Company as may be appropriate. The initial two
year term of the Management Agreement was to expire on March 27, 2000; on
March 16, 2000, the Management Agreement was extended for an additional two
years, with the unanimous approval of the unaffiliated directors, on terms
similar to the prior agreement. On March 25, 2002, the Management Agreement
was extended for one year through March 27, 2003, with the unanimous
approval of the unaffiliated directors, on terms similar to the prior
agreement with the following changes: (i) the incentive fee calculation
would be based upon GAAP earnings instead of funds from operations, (ii) the
removal of the four year period to value the Management Agreement in the
event of termination and (iii) subsequent renewal periods of the Management
Agreement would be for one year instead of two years. The Board was advised
by Houlihan Lokey Howard & Zukin Financial Advisors, Inc. ("Houlihan Lokey")
in the renewal process. Houlihan Lokey is a national investment banking and
financial advisory firm. The Manager primarily engages in three activities
on behalf of the Company: (i) acquiring and originating mortgage loans and
other real estate related assets; (ii) asset/liability and risk management,
hedging of floating rate liabilities, and financing, management and
disposition of assets, including credit and prepayment risk management; and
(iii) capital management, structuring, analysis, capital raising and
investor relations activities. In conducting these activities, the Manager
formulates operating strategies for the Company, arranges for the
acquisition of assets by the Company, arranges for various types of
financing and hedging strategies for the Company, monitors the performance
of the Company's assets and provides certain administrative and managerial
services in connection with the operation of the Company. At all times, the
Manager is subject to the direction and oversight of the Company's Board of
Directors.
The Company may terminate, or decline to renew the term of, the Management
Agreement without cause at any time after the first two years upon 60 days
written notice by a majority vote of the unaffiliated directors. Although no
termination fee is payable in connection with a termination for cause, in
connection with a termination without cause, the Company must pay the
Manager a termination fee, which could be substantial. The amount of the
termination fee will be determined by independent appraisal of the value of
the Management Agreement. Such appraisal is to be conducted by a
nationally-recognized appraisal firm mutually agreed upon by the Company and
the Manager. Additionally, at the time of the Core-Cap merger, the Manager
agreed to pay GMAC Mortgage Asset Management, Inc. (GMAC) $12,500 over a
ten-year period (Installment Payment). The Company agreed that should it
terminate the Manager without cause, the Company would pay to the Manager an
amount equal to the Installment Payment less the sum of all payments made by
the Manager to GMAC. As of December 31, 2001, the installment payment would
be $11,000 payable over nine years. The Company does not accrue for this
contingent liability.
In addition, the Company has the right at any time during the term of the
Management Agreement to terminate the Management Agreement without the
payment of any termination fee upon, among other things, a material breach
by the Manager of any provision contained in the Management Agreement that
remains uncured at the end of the applicable cure period.
In order to coincide with the increased scale of the Company, effective July
1, 2001, the Manager reduced the base management fee, payable under the
Mangement Agreement to 0.20% of average invested assets rated above BB+ from
0.35%. Additionally, effective July 1, 2001, the Manager revised the hurdle
rate applicable to the incentive fee from 3.5% over the ten-year U.S.
Treasury Rate, to the greater of 3.5% over the ten-year U.S. Treasury Rate
or 9.5% on the adjusted issue price of the Common Stock. This revision
resulted in $1,689 in savings to the Company during 2001.
Taxation of the Company
The Company has elected to be taxed as a REIT under the Code, commencing
with its taxable year ended December 31, 1998, and the Company intends to
continue to operate in a manner consistent with the REIT Provisions of the
Code. The Company's qualification as a REIT depends on its ability to meet
the various requirements imposed by the Code, through actual operating
results, asset holdings, distribution levels, and diversity of stock
ownership.
Provided the Company qualifies for taxation as a REIT, it generally will not
be subject to Federal corporate income tax on its net income that is
currently distributed to stockholders. This treatment substantially
eliminates the "double taxation" (at the corporate and stockholder levels)
that generally results from an investment in a corporation. If the Company
fails to qualify as a REIT in any taxable year, its taxable income would be
subject to Federal income tax at regular corporate rates (including any
applicable alternative minimum tax). Even if the Company qualifies as a
REIT, it will be subject to Federal income and excise taxes on its
undistributed income.
If in any taxable year the Company fails to qualify as a REIT and, as a
result, incurs additional tax liability, the Company may need to borrow
funds or liquidate certain investments in order to pay the applicable tax,
and the Company would not be compelled to make distributions under the Code.
Unless entitled to relief under certain statutory provisions, the Company
would also be disqualified from treatment as a REIT for the four taxable
years following the year during which qualification is lost. Although the
Company currently intends to operate in a manner designated to qualify as a
REIT, it is possible that future economic, market, legal, tax or other
considerations may cause the Company to fail to qualify as a REIT or may
cause the Board of Directors to revoke the Company's REIT election.
The Company and its stockholders may be subject to foreign, state and local
taxation in various foreign, state and local jurisdictions, including those
in which it or they transact business or reside. The state and local tax
treatment of the Company and its stockholders may not conform to the
Company's Federal income tax treatment.
ITEM 2. PROPERTIES
The Company does not maintain an office and owns no real property. It
utilizes the offices of the Manager, located at 40 East 52nd Street, New
York, New York 10022.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders during
the fourth quarter of 2001, through the solicitation of proxies or
otherwise.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's Common Stock has been listed and is traded on the New York
Stock Exchange under the symbol "AHR" since the initial public offering in
March 1998. The following table sets forth, for the periods indicated, the
high, low and last sale prices in dollars on the New York Stock Exchange for
the Company's Common Stock and the distributions declared by the Company
with respect to the periods indicated as were traded during these respective
time periods.
Last Dividends
1999 High Low Sale Declared
- ---- ------- -------- --------- ---------
First Quarter............................ $7.938 $6.380 $7.500 .29
Second Quarter........................... 7.689 6.500 6.563 .29
Third Quarter............................ 7.125 6.500 6.875 .29
Fourth Quarter........................... 6.938 6.000 6.375 .29
2000
- ----
First Quarter............................ 7.500 6.250 7.125 .29
Second Quarter........................... 7.625 6.625 7.125 .29
Third Quarter............................ 8.625 6.813 8.125 .29
Fourth Quarter........................... 8.188 7.125 7.750 .30
2001
- ----
First Quarter........................... 9.850 7.563 9.650 .30
Second Quarter.......................... 11.080 9.290 11.050 .32
Third Quarter........................... 11.690 10.050 10.400 .32
Fourth Quarter.......................... 11.210 9.500 10.990 .35
2002
- ----
First Quarter through March 25, 2002... 11.86 10.80 11.74 .35
On March 25, 2002, the closing sale price for the Company's Common Stock, as
reported on the New York Stock Exchange, was $11.74. As of March 25, 2002,
there were approximately 544 record holders of the Common Stock and 34
record holders of the Preferred Stock. This figure does not reflect
beneficial ownership of shares held in nominee name.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below as of and for the years ended
December 31, 2001, 2000 and 1999, and the period March 24, 1998
(commencement of operations) through December 31, 1998 has been derived from
the Company's audited financial statements. This information should be read
in conjunction with "Item 1. Business" and "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations", as well as
the audited financial statements and notes thereto included in "Item 8.
Financial Statements and Supplementary Data".
For the Year For the Year For the Year Ended March 24, 1998
(In thousands, except per share data) Ended December Ended December December through December
31, 2001 31, 2000 31, 1999 31, 1998
- ------------------------------------------------- --------------- --------------- ------------------ -----------------
Operating Data:
- --------------
Total income $131,220 $97,642 $57,511 $46,055
Expenses 72,136 60,839 33,280 29,004
Other gains (losses) (910) 2,523 2,442 (18,440)
Cumulative transition adjustment (1,903) - - -
Net income (loss) 56,271 39,326 26,673 (1,389)
Net income (loss) available to common shareholders 47,307 32,261 26,389 (1,389)
Per Share Data:
- --------------
Net income (loss):
Basic 1.41 1.37 1.27 (0.07)
Diluted 1.35 1.28 1.26 (0.07)
Dividends declared per common share 1.29 1.17 1.16 .92
Balance sheet Data:
- ------------------
Total assets 2,613,276 1,033,651 679,662 956,395
Total liabilities 2,229,903 760,993 481,379 774,666
Total stockholders' equity 383,115 242,254 168,261 181,729
Redeemable convertible preferred stock 258 30,404 30,022 -
The net loss in 1998 reflects realized losses of $18,262 resulting from the
sale of a substantial portion of the Company's available for sales
securities and termination of an interest rate swap agreement.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Dollars in thousands, except per share amounts)
General
The Company's primary long-term objective is to distribute consistent
dividends supported by operating earnings. The Company considers its
operating earnings to be net income available to common shareholders as
determined under GAAP before realized gains (losses) and FAS 133 hedging
adjustments.
Strong GAAP operating earnings are primarily maintained by consistent credit
performance on the Company's investments and stability of the Company's
liability structure. To achieve its objective the Company is focused on
increasing its size and capital base. This should lead to increased
diversification of credit exposures and improved diversification of
financing sources creating a more stable earnings platform. Where increased
size can be achieved without diluting common shareholders equity the Company
will pursue it aggressively.
The Company's business focuses on (i) investing in below investment grade
CMBS where the Company has the right to control the foreclosure or workout
process on the underlying loans; (ii) originating high yield commercial real
estate loans, which includes senior interests in partnerships that own real
property and are reported as real estate or joint venture investments; and
(iii) acquiring investment grade real estate related securities, including
Government guaranteed residential mortgage backed securities to act as a
liquidity support for the other two operations.
The Company's management believes that this represents an integrated
strategy where each asset class supports the others and creates additional
value for shareholders over and above operating each in isolation. The CMBS
portfolio provides diversification and high loss adjusted returns over a
weighted average life of approximately 10 years, the commercial real estate
loans provide high risk adjusted returns for shorter periods of time, and
the investment grade securities is an actively managed portfolio that
supports the liquidity needs of the Company while earning attractive
returns.
These strategies are pursued within an aggregate risk management framework
that seeks to limit the exposure of the Company's equity and earnings to
changes in interest rates, capital availability and other factors beyond the
Company's control.
In 2001 the Company continued to focus on maintaining liquidity, increasing
capital base and reducing risk where feasible. During 2001, the Company
issued 15,918,565 shares of Common Stock for cash at levels that were
accretive to shareholder book value. In addition $65,600 of commercial
assets were paid off in the first half of the year. The Company deployed
most of its new capital and maturity proceeds into Government guaranteed
residential mortgages. This strategy was highly effective in an environment
in which the U.S. economy was slowing. The steep yield curve created by the
Federal Reserve Board's aggressive reduction of short-term rates resulted in
significant income opportunities for investments in this sector. This
further served to allow the Company to maintain its cautious approach to the
commercial real estate sector, yet still increase earnings per share. This
in turn put upward pressure on the dividends resulting in an increase in
annualized dividends of $0.20 per share, a 17% increase.
Invested equity in the investment grade portfolio reached a peak of 47.4% at
the end of the third quarter 2001 and fell to 31.8% by the end of the fourth
quarter of 2001. The Company records these assets on its balance sheet in
the categories Securities available for sale - Investment grade securities
and Securities held for trading. Generally, the Company has maintained 25%
of its invested equity in this sector to act as a liquidity reserve in
support of commercial assets.
During the fourth quarter of 2001, signs of improving economic activity in
the United States began to appear, according to some sources and
indications. In reaction to this, the Company began to hedge short-term
rates more actively and shifted its investment focus back to commercial real
estate assets. Management saw the trend of tightening first mortgage
underwriting and wider spreads was creating more favorable risk adjusted
returns in the CMBS markets. Additionally, the feasibility of issuing term
debt secured by these assets was improving through an increasingly active
collateralized debt obligation ("CDO") market. During the fourth quarter of
2001 the Company closed on approximately $108,000 par value of CMBS. The
focus of these acquisitions has generally been towards office and retail
properties throughout the United States with less emphasis on lodging
properties. The Company is also aggressively pursuing a matched funding
strategy for its CMBS assets as greater liquidity in the capital markets
increases the probability of executing a term financing transaction in the
CDO market.
Reportable earnings also benefited from economies of scale as the Company
has grown. Effective July 1, 2001 the Manager reduced the base management
fee payable to the Manager under the Management Agreement by over 42% on
investment grade assets. Quarterly base management fees on a per share basis
were $0.047 per share for the quarter ended December 31, 2001, as compared
to $0.059 per share for the quarter ended December 31, 2000. Additionally,
the Manager reduced the incentive fee, payable to the Manager under the
Management Agreement, by raising the threshold of its participation in
income of the Company from 350 basis points over the 10 year Treasury (8.23%
for the quarter ended December 31, 2001) to the greater of that amount or
9.50%. This threshold is based on the adjusted issue price of the Common
Stock. At December 31, 2001, the adjusted issue price of the Common Stock
was $11.75 compared to the GAAP book value of $7.53. The increase to a 9.50%
threshold on adjusted issue price increased the earnings threshold from
$0.97 to $1.12 per share and from 12.9% to 14.9% return on equity based upon
December 31, 2001 GAAP book value. In aggregate, the fee reductions adopted
by the Manager increased return on equity by 122 basis points, and increased
GAAP book value by $0.02 per share, for the quarter ended December 31, 2001.
Critical Accounting Policies
Management's discussion and analysis of financial condition and results of
operations is based on the amounts reported in the Company's consolidated
financial statements. These financial statements are prepared in accordance
with accounting principles generally accepted in the United States of
America. In preparing the financial statements, management is required to
make various judgments, estimates and assumptions that affect the reported
amounts. Changes in these estimates and assumptions could have a material
effect on the Company's financial statements. The following is a summary of
the Company's accounting policies that are the most affected by management
judgments, estimates and assumptions:
Securities Available for Sale
The Company has designated its investments in mortgage-backed securities,
mortgage-related securities and certain other securities as available for
sale. Securities available for sale are carried at estimated fair value with
the net unrealized gains or losses reported as a component of accumulated
other comprehensive income (loss) in stockholders' equity. Many of these
investments are relatively illiquid, and their values must be estimated by
management. In making these estimates, management generally utilizes market
prices provided by dealers who make markets in these securities, but may,
under certain circumstances, adjust these valuations based on management's
judgment. Changes in the valuations do not affect the Company's reported
income or cash flows, but impact stockholders' equity and, accordingly, book
value per share.
Management must also assess whether unrealized losses on securities reflect
a decline in value which is other than temporary, and, accordingly, write
the impaired security down to its fair value, through earnings. Significant
judgment is required in this analysis.
Income on these securities is recognized based upon a number of assumptions
that are subject to uncertainties and contingencies. Examples of these
include, among other things, the rate and timing of principal payments
(including prepayments, repurchases, defaults and liquidations), the
pass-through or coupon rate and interest rate fluctuations. Additional
factors that may affect the Company's reported interest income on its
mortgage securities include interest payment shortfalls due to delinquencies
on the underlying mortgage loans, and the timing and magnitude of credit
losses on the mortgage loans underlying the securities that are a result of
the general condition of the real estate market (including competition for
tenants and their related credit quality) and changes in market rental
rates. These uncertainties and contingencies are difficult to predict and
are subject to future events which may alter the assumptions.
Securities Held for Trading
The Company has designated certain other securities as held for trading.
Securities held for trading are also carried at estimated fair value, but
changes in fair value are included in income. The valuations of these
securities and the interest income recognized are subject to the same
uncertainties as those discussed above.
Mortgage Loans
The Company purchases and originates commercial mortgage loans to be held as
long-term investments. The Company also has an investment in a private
opportunity fund which invests in commercial mortgage loans, and is managed
by the same entity that manages the Company. Management must periodically
evaluate each of these loans for possible impairment. Impairment is
indicated when it is deemed probable that the Company will not be able to
collect all amounts due according to the contractual terms of the loan. If a
loan is determined to be impaired, the Company would establish a reserve for
possible losses, and a corresponding charge to earnings. Given the nature of
the Company's loan portfolio and the underlying commercial real estate
collateral, significant judgment is required in determining impairment and
the resulting loss allowance. To date, the Company has determined that no
loss allowances have been necessary on the loans in its portfolio or held by
the opportunity fund.
Real Estate Joint Ventures
The Company makes investments in real estate entities over which the Company
exercises significant influence, but not control. The real estate held by
such entities must be regularly reviewed for impairment, and would be
written down to its estimated fair value, through earnings, if impairment is
determined to exist. This review involves assumptions about the future
operating results of the real estate, and market factors, all of which are
subjective and difficult to predict. To date, the Company has determined
that none of the real estate held by its joint ventures is impaired.
Derivative Instruments
The Company utilizes various hedging instruments (derivatives) to hedge
interest rate and foreign currency exposures or to modify the interest rate
or foreign currency characteristics of related Company investments. All
derivatives are carried at fair value, generally estimated by management
based on valuations provided by the counterparty to the derivative contract.
For accounting purposes, Company management must decide whether to designate
these derivatives as hedging borrowings, securities available for sale,
trading securities, or foreign currency exposure. This designation decision
affects the manner in which the changes in the fair value of the derivatives
are reported.
Market Conditions and Their Effect on Company Performance
The principal performance risks that the Company faces are (i) credit risk
on the CMBS and commercial real estate loans it underwrites; (ii) interest
rate risk, which affects the market value of the Company's assets and the
cost of funds needed to finance these assets and (iii) liquidity risk, which
affects the Company's ability to finance itself over the long term.
Credit Risk and Company Performance: The Company's primary risk is
commercial real estate credit risk. These investments take two forms: (1)
below investment grade CMBS 2) commercial real estate loans.
CMBS are debt instruments with a stated par amount and a fixed or floating
rate coupon. The cash flow used to pay the CMBS comes from a pool of
commercial real estate secured by first mortgages. The credit losses that
occur on the underlying mortgages are charged first to the CMBS with the
lowest credit rating. These CMBS are commonly referred to as the "first
loss" securities.
Commercial real estate loans are loans made directly to a borrower that are
secured by some form of commercial real estate. These loans may be secured
by a subordinated interest in a first mortgage, a second mortgage, or
interests in a partnership that owns commercial real estate. Additionally,
the Company has made preferred equity investments in partnerships that own
commercial real estate.
CMBS: The Company considers delinquency information from the Lehman Brothers
Conduit Guide for 1998 vintage transactions to be the most relevant measure
of credit performance market conditions applicable to its below investment
grade CMBS holdings. The broader measure of all transactions tracked in the
Conduit Guide since 1994 also provides relevant comparable information. The
delinquency statistics are shown in the table below:
--------------------------------------------------------------------------------------------------------------------------------
| | Lehman Brothers Conduit Guide For 1998 Vintage | Lehman Brothers Conduit Guide For All Transactions |
| | Transactions | |
|---------------|------------------------------------------------------|---------------------------------------------------------|
| Date | Number of | Collateral | % | Number of | Collateral | % |
| | Securitizations | Balance | Delinquent | Securitizations | Balance | Delinquent |
|---------------|-------------------|------------------|---------------|-------------------|------------------|------------------|
| 12/31/01 | 39 | $51,321,238 | 1.51% | 210 | $185,756,237 | 1.51% |
|---------------|-------------------|------------------|---------------|-------------------|------------------|------------------|
| 12/31/00 | 41 | 52,890,768 | 0.77 | 180 | 158,597,044 | 0.77 |
|---------------|-------------------|------------------|---------------|-------------------|------------------|------------------|
| 12/31/99 | 41 | 54,338,032 | 0.47 | 147 | 131,892,534 | 0.51 |
|---------------|-------------------|------------------|---------------|-------------------|------------------|------------------|
| 12/31/98 | 38 | 53,256,049 | 0.17 | 106 | 94,839,000 | 0.34 |
--------------- ------------------------------------------------------ ---------------------------------------------------------
Morgan Stanley Dean Witter (MSDW) also tracks CMBS loan delinquencies using
a slightly smaller universe. The MSDW index tracks all CMBS transactions
with more than $200,000 of collateral that have been seasoned for at least
one year. This will generally adjust for the lower delinquencies that occur
in newly originated collateral. As of December 31, 2000 the MSDW index
indicated that delinquencies on 144 securitizations was 1.01%. As of
December 31, 2001 this same index tracked 174 securitizations with
delinquencies of 1.85%. See the section titled "Quantitative and Qualitative
Disclosures About Market Risks" for a detailed discussion of how
delinquencies and loan losses affect the Company.
The Company's below investment grade CMBS portfolio has a total par amount
of $733,830. Of this amount, $134,433 is the par of the securities that
represent the first loss on the underlying mortgages, and $560,596 is the
par of the securities that represent the remaining tranches owned by the
Company when the Company owns the first loss security. There are 1,911
underlying loans supporting the Company's first loss CMBS with an aggregate
principal balance of over $9.9 billion as of December 31, 2001. The total
below investment grade CMBS portfolio represents 43.8% of invested equity at
year end.
The Company manages its credit risk through conservative underwriting,
diversification, active monitoring of loan performance and exercise of its
right to control the workout process as early as possible. All of these
processes are based on the extensive intranet-based analytic systems
developed by BlackRock.
In underwriting loans, the Company performs site inspections and/or desktop
reviews of all loans in the pools. This process includes detailed analysis
of regional economic factors, industry outlooks, project viability and
documentation. Unacceptable risks are removed from the pool prior to closing
the transaction. An assumption of expected losses is developed and the
securities are priced accordingly. Earnings are reported net of the
assumption that credit losses will occur.
The Company maintains diversification of credit exposures through its
underwriting process and can shift its focus in future investments by
adjusting the mix of loans in subsequent acquisitions. During 2001 the
Company added $13,938 of par of first loss CMBS. The collateral profile of
the new investment was specifically underwritten to reduce the Company's
exposure to the lodging sector. The comparative profiles of the loans
underlying the Company's CMBS by property type are:
---------------------------------------------------------------------------------------
| 12/31/01 | 12/31/00 |
| Exposure | Exposure |
|------------------------------------------------------|--------------------------------|
|Property Type Loan Balance % of Total | Loan Balance % of Total |
|------------------------------------------------------|--------------------------------|
|Multifamily $3,432,708 34.6% | $3,176,333 34.8% |
|Retail 2,763,045 27.9 | 2,429,959 26.6 |
|Office 1,866,338 18.8 | 1,724,130 18.9 |
|Lodging 853,935 8.6 | 861,094 9.4 |
|Industrial 604,852 6.1 | 547,037 6.0 |
|Healthcare 353,697 3.6 | 367,989 4.0 |
|Parking 35,225 0.4 | 30,608 0.3 |
|------------------------------------------------------|--------------------------------|
|Total $9,909,800 100% | $9,137,150 100% |
- ---------------------------------------------------------------------------------------
Active monitoring of loan performance is a critical function that is
performed via electronic uploads of information gathered from the loan
servicers, PNC Bank and external data providers. This Internet-based system
allows the Company to monitor payments, debt service coverage ratios,
regional economic statistics, general real estate market trends and other
relevant factors.
The Company also uses the Internet-based system to monitor delinquencies.
The Company updates this information monthly allowing for more detailed
analysis of loans before problems develop.
The following table shows a comparison of these delinquencies:
------------------------------------------------------------------------------------------------------------------------------
| | 2001 | 2000 |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
| | | Number of | % of | | Number of | % of |
| | Principal | Loans | Collateral | Principal | Loans | Collateral |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Past due 30 days to 60 days | $15,401 | 5 | 0.15% | $6,319 | 3 | 0.07% |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Past due 60 days to 90 days | 9,865 | 4 | 0.10 | 7,963 | 2 | 0.09 |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Past due 90 days or more | 112,017 | 18 | 1.13 | 28,526 | 5 | 0.31 |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Real Estate owned | 8,805 | 1 | 0.09 | 10,145 | 2 | 0.11 |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Total Delinquent | $146,088 | 28 | 1.47% | $52,953 | 12 | 0.58% |
|--------------------------------|---------------|-------------|---------------|-----------------|-------------|---------------|
|Total Loan Portfolio | $9,909,800 | 1,911 | | $9,137,150 | 1,756 | |
- -------------------------------------------------------------------------------------------------------------------------------
Of the 28 delinquent loans as of December 31, 2001, two were delinquent due
to technical reasons, one was REO and being marketed for sale, five were in
foreclosure, and the remaining 20 loans were in some form of workout
negotiations. Aggregate realized losses of $3,455 were taken in 2001. This
brings aggregate losses to $5,056. This is in line with the Company's loss
expectations as realized losses are expected to increase on the 1998 vintage
loans as they age.
The subordinated CMBS owned by the Company has a delinquency experience of
1.47%, which is slightly better than 1.51% for directly comparable
collateral pursuant to the Lehman Brothers Conduit Guide for 1998
vintage transactions. The Company expects delinquencies to continue to rise
throughout 2002 in line with expectations.
During 2001 the Company also experienced early payoffs of $53,722, which
represents 0.54% of the year-end pool balance. These loans were paid-off at
par with no loss. The anticipated losses attributable to these loans will
be reallocated to the loans remaining in the pools.
Subsequent to December 31, 2001, two of the 28 delinquent loans were brought
current and 12 loans became delinquent. Additionally, two other loans with a
total balance of $16,829 were paid off at par with no loss to the Company.
The unrealized loss on the Company's holdings of CMBS at December 31, 2001
was $96,956. This decline in the value of the investment portfolio
represents market valuation changes and is not due to credit experience or
credit expectations. The adjusted purchase price of the Company's CMBS
portfolio as of December 31, 2001 represents approximately 62% of its par
amount. The market value of the Company's CMBS portfolio as of December 31,
2001 represents approximately 49% of its par amount. As the portfolio
matures the Company expects to recoup the unrealized loss, provided that the
credit losses experienced are not greater than the credit losses assumed in
the purchase analysis. The Company performs a detailed review of its loss
assumptions on a quarterly basis and will adjust them when it believes that
credit experience or expectations justify such an adjustment. As of December
31, 2001 the Company concluded that real estate credit fundamentals remain
solid, and the Company believes there has been no material change in the
credit quality of its portfolio. As the portfolio matures and expected
losses occur subordination levels of the lower rated classes of a CMBS
investment will be reduced. This may cause the lower rated classes to be
downgraded. This would negatively affect the market value and liquidity of
the portfolio.
Commercial Real Estate Markets: There is typically a lagged impact of
economic conditions on commercial real estate. The most obvious fundamental
impacts have been the precipitous drop in office demand and hence asking
rents, a reduction in business travel and hence RevPar in the lodging
sector, a substantial increase in rent concessions by apartment operators
and an increase in tenant bankruptcies, particularly in retail. These
effects will continue to be seen even as the public equity markets reflect
economic recovery.
The often-noted counterbalance to these negative demand factors is the
better-managed supply pipeline. The far greater information availability and
transparency of the real estate markets as compared to the 1980's has
clearly had a positive effect in aggregate on lender discipline. Aggregate
construction starts were down across all property types in 2001 with the
biggest year over year percentage declines in office and industrial. The
biggest decline by far over the past two years has been in hotel room
additions; down 30%. Despite the greater aggregate health of the markets, it
is important to note that in "New Economy" submarkets the Company finds
conditions as bad or worse than they were in the early 1990's. Just as
euphoria gripped sectors of the public equity markets, it similarly affected
certain sectors of commercial real estate.
With cap rates trending up on softening fundamentals, the bid/ask spread
between buyers and sellers of property widened in 2001 and aggregate
transaction volume declined by 13% according to data from Granite Partners.
The biggest declines were in office (22%) and multifamily (12%). Despite
negative flows from foreign property funds the Company believes there
remains substantial liquidity available for U.S. real estate equity
investments with unspent allocations from pension funds likely representing
the largest single source, and with equity REITs prepared to invest as they
see accretive opportunities.
Commercial Real Estate Loans: The Company also owns seven loans and two
preferred equity interests in partnerships that own office buildings. The
Company's commercial loan portfolio generally emphasizes larger transactions
located in metropolitan markets as compared to the loans in the CMBS
portfolio. Exposures based on geography and asset type follows:
Principal Property
Location Balance % Type LTV DSCR
----------------------------------- -----------------------------------------------------------------------
Los Angeles $22,500 14.9% Office 78.0% 1.14
Tyson's Corner 22,000 14.6 Office 74.0 1.90
San Francisco 20,876 13.8 Office 76.0 1.13
San Francisco 17,892 11.9 Hotel 69.0 1.20
London* 31,199 20.7 Hotel 65.0 1.15
New York City 13,170 8.7 Office 66.0 1.25
Chicago 15,000 9.9 Multifamily 90.0 1.10
Suburban Philadelphia 3,159 2.1 Office 90.0 1.21
Tallahassee 5,158 3.4 Office 75.0 1.20
------------------------- -------------------
Total $150,954 100% 74.0% 1.27
------------------------- -------------------
Diversification by Asset Type
-----------------------------
Office 57.6%
Full Service Lodging 32.5%
Multifamily 9.9%
* The London Loan is translated into US dollars using the December 31, 2001
sterling exchange rate of (pound)0.687852.
The Los Angeles Loan, a $22,500 subordinate class of a $60,850 loan, is
secured by the borrower's interest in a 54-story office tower in downtown
Los Angeles, California. The loan matures in December 2002, which may be
extended at the borrower's option for two additional one-year periods.
The Tyson's Corner Loan is a $22,000 subordinate interest in a $92,000 first
mortgage secured by two ten-story office buildings located in Tyson's
Corner, Virginia. The loan matures in April 2004, which may be extended at
the borrower's option for two additional one-year periods.
The San Francisco Loan consists of two subordinate interests in a $125,000
note secured by an 11-story 394,457 square foot office building located in
the financial district of San Francisco, California. These two subordinated
interests total $20,876 and have a weighted average rating of BB+. The loan
matures in December 2007.
The San Francisco Hotel Loan is a $17,892 mezzanine loan secured by a lien
on the borrower's interest in a full service hotel located in San Francisco,
California. The loan matures in May 2003.
The London Loan is a (pound)21,459 Sterling denominated loan that was funded
in August of 1998. It is secured by five luxury hotel properties in and
around London. As of December 31, 2001 the London Loan was valued at 90.0%
of par, a decrease from 97.0% of par as of December 31, 2000.
At the beginning of the fourth quarter 2001, the occupancy of both hotel
assets declined significantly in the wake of the September 11th tragedy.
Occupancy for both assets has subsequently improved and is within the
Company's underwritten range of expectations.
The New York City Loan is a $13,170 subordinate interest in a $57,750 first
mortgage secured by a commercial office building located in midtown New York
City. The building is currently 100% leased. The loan matures in January
2004. The Company also owns the $6,080 BBB- rated CMBS security which is
senior to the Company's $13,170 interest.
The Chicago Loan was a $30,000 mezzanine loan originated in August of 2000.
The loan is secured by a second mortgage on a condominium conversion project
in Chicago, Illinois, and a first mortgage on an adjacent land parcel, as
well as the borrower's partnership interest in the property. The Company
originated this loan in September of 2000, for a 24-month term. Condominium
unit sales at the project currently exceed expectations. Due to this strong
demand the borrower paid off $15,000 of this loan with prepayment penalties
in December of 2000.
None of the loans have experienced any delinquency to-date. All loans are
performing at or above underwritten expectations, and all loans are expected
to pay off in full at or before their stated maturities.
The suburban Philadelphia investment is a $3,159 preferred equity interest
in a partnership that owns two office buildings totaling approximately
190,000 square feet. One property is in the western suburb of Paoli while
the other is in the northern suburb of Newtown. The Paoli property is 100%
occupied and the Newtown property is 80% occupied. The expected life of the
investment is three years.
The Tallahassee investment is a $5,158 preferred equity interest in a
partnership that owns a 500,000 square foot mixed-use office/retail
building. The Company's preferred equity interest represents 36.4% of the
partnership. The building is 99% occupied. Primary office tenants include
various Florida state government agencies on long-term leases. The expected
life of the investment is four years.
Interest Rate Risk and Company Performance: The Company generally makes
investments at long-term rates and borrows money to fund those investments
at short-term rates. The level of short-term rates and their relationship to
long-term rates directly affects the net investment income of the Company.
The value of the Company's assets is generally based on market rates for
ten-year U.S. Treasury notes and credit spreads. The Company generally
pledges its assets when it borrows funds. The value of the assets pledged
affects the amount of money the Company can borrow at a given time.
During 2001 the yield on the ten-year U.S. Treasury Note dropped by 7 basis
points from 5.11% to 5.04%. During 2001 the yield on the ten-year note was
as low as 4.20% and as high as 5.52%. Short-term rates decreased steadily
throughout the year as one month LIBOR decreased by 469 basis points from
6.56% to 1.87 %. See below the section titled, "Quantitative and Qualitative
Disclosures About Market Risk" for a detailed discussion of how interest
rates and spreads affect the Company.
Credit spreads represent the premium above the treasury rates required by
the market to take credit risk. CMBS credit spreads remain at historically
wide levels despite continued strength in the commercial real estate credit
markets. The chart below compares the credit spreads for high yield CMBS to
high yield corporate bonds.
Average Credit Spreads (in basis points)*
BB CMBS BB Corporate Difference
------- ------------ ----------
As of December 31, 2001 590 496 94
As of December 31, 2000 558 523 35
B CMBS B Corporate Difference
------ ----------- ----------
As of December 31, 2001 1051 709 342
As of December 31, 2000 987 978 9
* Source - Lehman Brothers CMBS High Yield Index & Lehman Brothers High
Yield Index
All of the Company's borrowings bear interest at rates that are determined
with reference to LIBOR. To the extent that interest rates on the Company's
borrowings increase without an offsetting increase in the interest rates
earned on the Company's investments and hedges, the Company's earnings could
be negatively affected. The chart below compares the rate for ten-year U.S.
Treasury securities to the one-month LIBOR rate.
Ten Year One month
U.S Treasury Securities LIBOR Difference
----------------------- ----- ----------
December 31, 2001 5.04% 1.87% 3.17%
December 31, 2000 5.12 6.56 1.44
The decrease in LIBOR from December 31, 2000 to December 31, 2001 had a
positive impact on the Company's financing costs.
The Company actively hedges its exposure to both short-term and long-term
rates. The degree of hedging and the choice of hedging instruments depends
on market conditions. This information is reviewed on a daily basis and
changes are made accordingly. The Company uses a combination of interest
rate futures contracts and interest rate swap agreements to hedge these
exposures.
Liquidity Risk: The Company acquires its investments using its capital and
borrowed funds. The availability of funds is a key component of the
Company's operations. During times of market uncertainty the availability of
this type of financing can be very limited. The Company funds itself mainly
through short-term secured lending arrangements with various counterparties.
These arrangements are generally for 30 day terms and are rolled over for 30
day periods at the end of each term. The Company also has a committed
borrowing facility from Deutsche Bank in the amount of $185 million. This
facility matures in July of 2002 and is currently under negotiation to be
extended.
The Company's debt to equity ratio has been approximately 4:1 throughout
2001. The three investment operations of the Company are all financed on a
secured basis at levels that takes into account the specific risks of that
asset class. As of December 31, 2001 the Company's CMBS portfolio is
financed at a debt to equity ratio of .98:1, commercial lending at .58:1,
and while the high credit quality of the RMBS portfolio allows for financing
levels of up to 20:1, the Company operates this portfolio at much more
conservative levels of 12:1. Generally the Company maintains debt to equity
ratios of 1.5:1 on CMBS, 1:1 on commercial lending and 9:1 on RMBS.
The Company manages this risk by maintaining diverse counterparties, keeping
at least 25% of invested equity in liquid assets and seeking matched funding
opportunities in secured lending markets such as a CDO.
The Investment Grade assets portfolio acts as the store of liquidity and
would be used to support the financing of the credit sensitive assets at
times of impaired liquidity. These assets can be sold quickly to raise cash
in support of the Company's main investment operations.
Yields on residential mortgage-backed securities fell steadily during the
third quarter 2001 as evidence of a weaker economy, exacerbated by the
terrorist attacks of September 11, continued to accumulate. Typically,
yields of mortgage-backed securities lag declines in other interest rates
due to rising prepayment expectations. This was generally the case during
the quarter as yield spreads widened against both Treasuries and interest
rate swaps, particularly along the shorter end of the yield curve. However,
during the second half of September 2001, the significant incremental yield
of mortgage-backed securities over other short and intermediate duration
assets attracted sizable demand from financial institutions. Therefore,
despite poor prepayment fundamentals and rising supply, demand indicators
were exceptionally strong.
This trend reversed dramatically in the fourth quarter as yields were
exceptionally volatile. Investors reduced interest rate exposure in
anticipation of a reversal in Federal Reserve Board policy. The sell-off was
exacerbated by the lengthening durations of mortgage securities, which
thereby increased the amount of securities that needed to be sold. The
combination of increased realized volatility and duration uncertainty hurt
the sector during the quarter. While rising interest rates should ultimately
improve fundamentals and technicals for the sector, the violent nature of
the sell-off led to poor relative performance for mortgage-backed securities
during November and December.
During 2001 the Company increased the size of the Investment Grade portfolio
significantly. The capital markets were favorable for issuing stock and the
Company took advantage of that opportunity. The proceeds raised were
invested immediately into the investment grade portfolio. Investments were
generally made in fixed rate 15 year Government guaranteed residential
mortgage backed securities issued by FNMA or FHLMC. The portfolio is
comprised mainly of low coupon mortgages that were acquired at a slight
discount to par. This would serve to protect the Company during periods of
high pre-payment. The prepayment characteristics of RMBS generally cause the
value of these securities to increase less in falling interest rate
environments and decrease at a greater rate in rising interest rate
environments. The equity duration of this portfolio is generally hedged to
five years using interest rate swaps and futures.
Recent Events
In March 2002 the remaining 10,000 shares of the Series A Preferred Stock
were converted into 34,427 shares of Company Common Stock at a price of
$7.26 per share pursuant to its terms.
In February 2002, the Company sold the FMACT Class C bond, resulting in a
realized loss of $3,610.
On March 25, 2002, the Management Agreement was extended for one year
through March 27, 2003, with the unanimous approval of the unaffiliated
directors, on terms similar to the prior agreement with the following
changes; (i) the incentive fee calculation would be based on GAAP earnings
instead of FFO, (ii) removal of the four year period to value the investment
agreement in case of termination, and (iii) subsequent renewal periods of
the Management Agreement would be for one year instead of two years.
Funds From Operations (FFO)
Most industry analysts, including the Company, consider FFO an appropriate
supplementary measure of operating performance of a REIT. In general, FFO
adjusts net income for non-cash charges such as depreciation, certain
amortization expenses and gains or losses from debt restructuring and sales
of property