UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One) 

For the quarterly period ended September 30, 2015

or

For the transition period from _______________ to _______________

Commission File Number 001- 36163

 

Starwood Waypoint Residential Trust

(Exact name of registrant as specified in its charter)

 

 

(510) 250-2200

(Registrant’s telephone number, including area code)

 

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  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  o    No  x

As of October 31, 2015, there were 37,972,764 of the registrant’s common shares, par value $0.01 per share, outstanding.

 

 

 

 

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STARWOOD WAYPOINT RESIDENTIAL TRUST

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2015

INDEX

 

 

 

 

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FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q of Starwood Waypoint Residential Trust (“we,” “our” or “us”) contains, in addition to historical information, certain forward-looking statements that involve significant risks and uncertainties, which are difficult to predict, and are not guarantees of future performance. Such statements can generally be identified by words such as “anticipates,” “expects,” “intends,” “will,” “could,” “believes,” “estimates,” “continue,” and similar expressions. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are based on certain assumptions and discuss future expectations, describe future plans and strategies, and contain financial and operating projections or state other forward-looking information. Our ability to predict results or the actual effect of future events, actions, plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in, or implied by, the forward-looking statements. Factors that could materially and adversely affect our business, financial condition, liquidity, results of operations and prospects, as well as our ability to make distributions to our shareholders, include, but are not limited to:

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When considering forward-looking statements, keep in mind the risk factors and other cautionary statements contained in our Annual Report on Form 10-K for the year ended December 31, 2014 and other cautionary statements in this Quarterly Report on Form 10-Q. Readers are cautioned not to place undue reliance on any of these forward-looking statements, which reflect our views as of the date of this Quarterly Report on Form 10-Q. We recommend that readers read this document in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2014 and see the discussion on risk factors in Item 1A. Risk Factors, that was filed with the Securities and Exchange Commission (the “SEC”) on March 6, 2015. Our actual results and performance may differ materially from those set forth in, or implied by, our forward-looking statements. Accordingly, we cannot guarantee future results or performance. Furthermore, except as required by law, we are under no duty to, and we do not intend to, update any of our forward-looking statements after the date of this Quarterly Report on Form 10-Q, whether as a result of new information, future events or otherwise.

 

 

 

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PART I - FINANCIAL INFORMATION

 

 

Item 1. Financial Statements

STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

(Unaudited)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements

 

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STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(Unaudited)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements

 

 

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STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements

 

 

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STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED STATEMENTS OF EQUITY

(in thousands)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements

 

 

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STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited) 

 

 

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The accompanying notes are an integral part of these condensed consolidated financial statements

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STARWOOD WAYPOINT RESIDENTIAL TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Note 1.  Organization and Operations

We are a Maryland real estate investment trust formed in May 2012 primarily to acquire, renovate, lease and manage residential assets in select markets throughout the United States. Our objective is to generate attractive risk-adjusted returns for our shareholders over the long-term through dividends and capital appreciation. Our primary strategy is to acquire single-family rental homes (“SFR”) through a variety of channels, renovate these homes to the extent necessary and lease them to qualified residents. We seek to take advantage of macroeconomic trends in favor of leasing homes by acquiring, owning, renovating and managing homes that we believe will (1) generate substantial current rental revenue, which we expect to grow over time, and (2) appreciate in value over the next several years. In addition, we have a significant portfolio of NPLs which we may seek to (1) modify and hold or resell at higher prices if circumstances warrant, thus providing additional liquidity or (2) convert into homes through the foreclosure or other resolution process that can then either be contributed to our rental portfolio or sold.

We were organized as a Maryland corporation in May 2012 as a wholly-owned subsidiary of Starwood Property Trust, Inc. (“SPT”) to own homes and NPLs. Subsequently, we changed our corporate form from a Maryland corporation to a Maryland real estate investment trust and our name from Starwood Residential Properties, Inc. to Starwood Waypoint Residential Trust. On January 31, 2014, SPT completed the spin-off of us to its stockholders (the “Separation”), and we issued approximately 39.1 million common shares. Our shares began trading on February 3, 2014, on the New York Stock Exchange (“NYSE”) under the ticker symbol SWAY. As part of the Separation, SPT also contributed $100.0 million to us, in order to continue to fund our growth and operations. Prior to the Separation, there were also $28.3 million of contributions from SPT.

Starwood Waypoint Residential Partnership, L.P. (our “operating partnership”) was formed as a Delaware limited partnership in May 2012. This wholly-owned subsidiary is the sole general partner of our operating partnership, and we conduct substantially all of our business through our operating partnership. We own 100% of the operating partnership units in our operating partnership (the “OP Units”).

We have a joint venture with Prime Asset Fund VI, LLC (“Prime”), an entity managed by Prime Finance, an asset manager that specializes in acquisition, resolution and disposition of NPLs. We own a greater than 98.75% interest in the joint venture, which holds all of our NPLs. Prime earns a one-time fee from us, equal to a percentage of the value (as determined pursuant to the Amended and Restated Limited Partnership Agreement of PrimeStar Fund I, L.P. (“PrimeStar Fund I”)) of the NPLs and homes we designate as rental pool assets upon disposition or resolution of such assets. Prime also earns a fee in connection with the asset management services that Prime provides to the joint venture’s non-rental pool assets, and the joint venture pays Prime a monthly asset management fee in arrears for all non-rental pool assets acquired.

We intend to operate and to be taxed as a REIT for U.S. federal income tax purposes. We generally will not be subject to U.S. federal income taxes on our REIT taxable income to the extent that we annually distribute all of our REIT taxable income to shareholders and qualify and maintain our qualification as a REIT.

Our Manager

We are externally managed and advised by our Manager pursuant to the terms of a management agreement (the “Management Agreement”), which will not expire until January 31, 2017. Our Manager is an affiliate of Starwood Capital Group, a privately-held private equity firm founded and controlled by Barry Sternlicht, our chairman.

On January 31, 2014, our Manager acquired the Waypoint platform, which is an advanced, technology driven operating platform that provides the backbone for deal sourcing, property underwriting, acquisitions, asset protection, renovations, marketing and leasing, repairs and maintenance, portfolio reporting and property management of homes.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Merger

On September 21, 2015, we and CAH announced the signing of the Merger Agreement to combine the two companies in a stock-for-stock transaction.  In connection with the transaction, we will internalize our Manager. The combined internally managed company (the “Combined Company”) is expected to own and manage over 30,000 homes and have an aggregate asset value of approximately $7.7 billion at the closing of the transaction. The Merger is expected to achieve estimated annualized cost synergies of $40.0 - $50.0 million.

Under the Merger Agreement, CAH shareholders will receive an aggregate of 64,869,583 of our common shares in exchange for all shares of CAH (the “Merger Consideration”). Upon completion of the transaction, our existing shareholders and the former owner of our Manager will own approximately 41% of the Combined Company’s shares combined, while former CAH shareholders will own approximately 59% of the Combined Company’s shares. The share allocation was determined based on each company’s net asset value and is not subject to adjustment. The Combined Company’s shares will continue to trade on the NYSE. We expect to maintain our quarterly dividend of $0.19 per share up to the closing of the Merger. The transaction has been approved by our board of trustees and CAH’s board of directors, and the terms of the Internalization of our Manager were negotiated and approved by a special committee of our board of trustees.  The transaction is expected to close in the first quarter of 2016. Among other things, the transaction is subject to approval of our shareholders and customary closing conditions. Upon the closing of the Internalization and the Merger, the Combined Company will be named “Colony Starwood Homes” and its Common Shares will be listed and traded on the NYSE under the ticker symbol “SFR”.

 

 

Note 2.  Basis of Presentation and Significant Accounting Policies

Basis of Presentation and Principles of Consolidation

The accompanying interim condensed consolidated financial statements are unaudited. These interim condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) and the applicable rules and regulations of the SEC for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The December 31, 2014 condensed consolidated balance sheet was derived from the audited financial statements as of that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. The condensed consolidated financial statements include our accounts and those of our wholly and majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

The accompanying unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments of a normal recurring nature considered necessary to state fairly our financial position as of September 30, 2015, results of operations, comprehensive income (loss) for the three and nine months ended September 30, 2015 and 2014 and cash flows for the nine months ended September 30, 2015 and 2014. The interim results for the three and nine months ended September 30, 2015, are not necessarily indicative of the results that may be expected for the year ending December 31, 2015, or for any other future annual or interim period.

The information included in this Quarterly Report on Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, Quantitative and Qualitative Disclosures About Market Risk and the consolidated financial statements and notes thereto included in Items 7, 7A and 8, respectively, in our Annual Report on Form 10-K for the year ended December 31, 2014, as filed with the SEC on March 6, 2015.

Prior to the Separation, the historical condensed consolidated financial statements were derived from the condensed consolidated financial statements and accounting records of SPT principally representing the single-family segment, using the historical results of operations and historical basis of assets and liabilities of our businesses. The historical condensed consolidated financial statements also include allocations of certain of SPT’s general corporate expenses. Management believes the assumptions and methodologies underlying the allocation of general corporate expenses to the historical results of operations were reasonable. However, such expenses may not be indicative of the actual level of expenses that would have been incurred by us if we had operated as an independent, publicly traded company or of the costs expected to be incurred in the future. As such, the results of operations prior to the Separation, included herein, may not necessarily reflect our results of operations, financial position, or cash flows in the future or what our results of operations, financial position, or cash flows would have been had we been an independent, publicly traded company during the historical periods presented. Transactions between the single-family business segment and other business segments of SPT’s businesses have been identified in the historical condensed consolidated financial statements as transactions between related parties for periods prior to the Separation. We have no expenses allocated to us from SPT in 2014 or 2015.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The non-controlling interest in a consolidated subsidiary is the portion of the equity (net assets) in Prime that is not attributable, directly or indirectly, to us. Non-controlling interests are presented as a separate component of equity in the condensed consolidated balance sheets. In addition, the accompanying condensed consolidated statements of operations include the allocation of the net income or loss in the Prime joint venture to the non-controlling interest holders in Prime.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

The most significant estimate that we make is of the fair value of our properties and NPLs. While home values are typically not a highly subjective estimate on a per-unit basis, given the usual availability of comparable property sale and other market data, these fair value estimates significantly affect the condensed consolidated financial statements, including (1) whether certain assets are identified as being potentially impaired and then, if deemed to be impaired, the amount of the resulting impairment charges, and (2) the allocation of purchase price to individual assets acquired as part of a pool, which have a significant impact on the amount of gain or loss recognized from a subsequent sale, and the subsequent impairment assessment, of individual assets. Beginning in 2014, we elected the fair value option for our NPLs. Estimates pertaining to the fair value of NPLs use a discounted cash flow valuation model and consider alternate loan resolution probabilities, including modification, liquidation, or conversion to rental property. These fair value estimates significantly affect the condensed consolidated financial statements in that changes to the fair value of NPLs for which we have elected the fair value option are reflected in unrealized gains and losses and recorded in current-period earnings.

Significant Accounting Policies

Cash and Cash Equivalents

Cash and cash equivalents include cash in banks and short-term investments. Short-term investments are comprised of highly liquid instruments with original maturities of three months or less. We maintain our cash and cash equivalents in multiple financial institutions with high credit quality in order to minimize our credit loss exposure. At times, these balances exceed federally insurable limits.

Restricted Cash

Restricted cash is primarily comprised of resident security deposits held by us and rental revenues held in accounts controlled by lenders on our debt facilities.

Investments in Real Estate

Property acquisitions are evaluated to determine whether they meet the definition of a business combination or of an asset acquisition under GAAP. For asset acquisitions, we capitalize (1) pre-acquisition costs to the extent such costs would have been capitalized had we owned the asset when the cost was incurred, and (2) closing and other direct acquisition costs. We then allocate the total cost of the property including acquisition costs, between land and building based on their relative fair values, generally utilizing the relative allocation that was contained in the property tax assessment of the same or a similar property, adjusted as deemed necessary.

For acquisitions that do not qualify as an asset acquisition, we evaluate the acquisition to determine if it qualifies as a business combination. For acquired properties where we have determined that the property has a resident with an existing lease in place, we account for the acquisition as a business combination. For acquisitions that qualify as a business combination, we (1) expense the acquisition costs in the period in which the costs were incurred and (2) allocate the cost of the property among land, building and in-place lease intangibles based on their fair value. The fair values of acquired in-place lease intangibles are based on costs to execute similar leases including commissions and other related costs. The origination value of in-place leases also includes an estimate of lost rent revenue at in-place rental rates during the estimated time required to lease up the property from vacant to the occupancy level at the date of acquisition. The in-place lease intangible is amortized over the life of the lease and is recorded in other assets in our condensed consolidated balance sheets.

If, at acquisition, a property needs to be renovated before it is ready for its intended use, we commence the necessary development activities. During this development period, we capitalize all direct and indirect costs incurred in renovating the property.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Once a property is ready for its intended use, expenditures for ordinary maintenance and repairs thereafter are expensed to operations as incurred, and we capitalize expenditures that improve or extend the life of a home and for furniture and fixtures.

We begin depreciating properties to be held and used when they are ready for their intended use. We compute depreciation using the straight-line method over the estimated useful lives of the respective assets. We depreciate buildings and building improvements over 30 years, and we depreciate other capital expenditures over periods ranging from four to 25 years. Land is not depreciated.

Properties are classified as held for sale when they meet the applicable GAAP criteria, including that the property is listed for sale and that it is ready to be sold in its current condition. Held-for-sale properties are reported at the lower of their carrying amount or estimated fair value less costs to sell.

We evaluate our long-lived assets for impairment periodically or whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Significant indicators of impairment may include declines in home values, rental rate and occupancy and significant changes in the economy. We make our assessment at the individual property level because it represents the lowest level of identifiable cash flows. If an impairment indicator exists, we compare the expected future undiscounted cash flows against the net carrying amount of a property. If the sum of the estimated undiscounted cash flows is less than the net carrying amount of the property, we record an impairment loss for the difference between the estimated fair value of the individual property and the carrying amount of the property at that date. To determine the estimated fair value, we primarily consider local broker-pricing opinions (“BPOs”). In order to validate the BPOs received and used in our assessment of fair value of real estate, we perform an internal review to determine if an acceptable valuation approach was used to estimate fair value in compliance with guidance provided by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements.” Additionally, we undertake an internal review to assess the relevance and appropriateness of comparable transactions that have been used by the broker in its BPO and any adjustments to comparable transactions made by the broker in reaching its value opinion. As a further review, we order an independent valuation of the property from a third-party automated valuation model (“AVM”) service provider and compare the AVM value to the BPO value. In cases where the AVM and BPO values differ beyond a tolerated threshold, which we define as ten percent, an internal evaluation is used as our estimated value. Such values represent the estimated amounts at which the homes could be sold in their current condition, assuming the sale is completed within a period of time typically associated with non-distressed sellers. Estimated values may be less precise, particularly in respect of any necessary repairs, where the interior of homes are not accessible for inspection by the broker performing the valuation.

In evaluating our investments in real estate, we determined that certain properties were impaired, which resulted in impairment charges of $0.2 million and $0.3 million during the three months ended September 30, 2015 and 2014, respectively. We recorded impairment charges of $0.9 million and $2.4 million during the nine months ended September 30, 2015 and 2014, respectively.

Non-Performing Loans

We have purchased pools of NPLs which were individually bid on and which we seek to (1) modify and hold or resell at higher prices if circumstances warrant, thus providing additional liquidity or (2) convert into homes through the foreclosure or other resolution process that can then either be contributed to our rental portfolio or sold. Our NPLs are on nonaccrual status at the time of purchase as it is probable that principal or interest is not fully collectible. Generally, when loans are placed on nonaccrual status, accrued interest receivable is reversed against interest income in the current period. Interest payments received thereafter are applied as a reduction to the remaining principal balance as long as concern exists as to the ultimate collection of the principal.

Loans are classified as held for sale when they meet the applicable GAAP criteria, including that the loan is being listed for sale and that it is ready to be sold. Held-for-sale loans are reported at the lower of their carrying amount or estimated fair value.

We evaluate our loans for impairment periodically or whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. As our loans were non-performing when acquired, we generally look to the estimated fair value of the underlying property collateral to assess the recoverability of our investments. As described in our real estate accounting policy above, we primarily utilize the local BPO but also consider any other comparable home sales or other market data, as considered necessary, in estimating a property’s fair value. If the carrying amount of a loan exceeds the estimated fair value of the underlying collateral, we will record an impairment loss for the difference between the estimated fair value of the property collateral and the carrying amount of the loan, inclusive of costs.  During the three and nine months ended September 30, 2015 and 2014, no impairments have been recorded on any of our loans.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

When we convert loans into homes through foreclosure or other resolution process (e.g., through a deed-in-lieu of foreclosure transaction), the property is initially recorded at fair value unless it meets the criteria for being classified as held-for-sale, in which case the property is initially recorded at fair value less estimated costs to sell. The transfer to SFR occurs when we have obtained title to the property through completion of the foreclosure process. SFR also includes a limited number of multi-unit properties. The fair value of these assets at the time of transfer to SFR is estimated using BPOs. BPOs are subject to judgments of a particular broker formed by visiting a property, assessing general home values in an area, reviewing comparable listings, and reviewing comparable completed sales. These judgments may vary among brokers and may fluctuate over time based on housing market activities and the influx of additional comparable listings and sales. Our results could be materially and adversely affected if the judgments used by a broker prove to be incorrect or inaccurate.

Gains are recognized in earnings immediately when the fair value of the acquired property (or fair value less estimated costs to sell for held-for-sale properties) exceeds our recorded investment in the loan, and are reported as realized gain on loan conversion, net in our condensed consolidated statements of operations. Conversely, any excess of the recorded investment in the loan over the fair value of the property (or fair value less estimated costs to sell for held-for-sale properties) would be immediately recognized as a loss. During the three and nine months ended September 30, 2015, we converted $32.2 million and $87.6 million in NPLs into $41.5 million and $111.5 million in real estate assets that resulted in gains of $9.3 million and $23.9 million, respectively. During the three and nine months ended September 30, 2014, we converted $15.2 million and $40.1 million in NPLs into $21.0 million and $57.8 million in real estate assets that resulted in gains of $5.8 million and $17.7 million, respectively.

In situations where property foreclosure is subject to an auction process and a third party submits the winning bid, we recognize the resulting gain as a realized gain on NPLs, net.

Beginning in 2014, we have elected the fair value option for NPL purchases as we have concluded that NPLs accounted for at fair value timely reflect the results of our investment performance. Upon the acquisition of NPLs, we record the assets at fair value, which is the purchase price we paid for the loans on the acquisition date. NPLs are subsequently accounted for at fair value under the fair value option election with unrealized gains and losses recorded in current-period earnings.

We determine the purchase price for NPLs at the time of acquisition by using a discounted cash flow valuation model and considering alternate loan resolution probabilities, including modification, liquidation, or conversion to rental property. Observable inputs to the model include loan amounts, payment history, and property types. Unobservable inputs to the model are discussed in Note 3- Fair Value Measurements.

For NPLs acquired in 2014, the fair value of each loan is adjusted in each subsequent reporting period as the loan proceeds to a particular resolution (i.e., modification or conversion to a SFR).  As a loan approaches resolution, the resolution timeline for that loan decreases and costs embedded in the discounted cash flow model for loan servicing, foreclosure costs, and property insurance are incurred and removed from future expenses. The shorter resolution timelines and reduced future expenses, typically each increases the fair value of the loan. The increase in the value of the loan is recognized in unrealized gains on NPLs in our condensed consolidated statements of operations.  Upon the sale of NPLs that results in the recognition of a realized gain or loss, we reclassify what had previously been recorded in unrealized (loss) gain on NPLs, net to realized gains on NPLs, net. During the three and nine months ended September 30, 2015, we recorded unrealized losses of $4.0 million and unrealized gains of $34.4 million, respectively, on the fair value of loans.  During the three and nine months ended September 30, 2014, we recorded $13.7 million and $17.3 million, respectively, in unrealized gains on the fair value of the loans.

Capitalized Costs

We capitalize certain costs incurred in connection with successful property acquisitions and associated stabilization activities, including tangible property improvements and replacements of existing property components. Included in these capitalized costs are certain personnel costs associated with time spent by certain personnel in connection with the planning and execution of all capital additions activities at the property level as well as third-party acquisition agreement fees.  Indirect costs are allocations of certain department costs, including personnel costs that directly relate to capital additions activities. We also capitalize property taxes and homeowners’ association (“HOA”) fees dues during periods in which property stabilization is in progress. We charge to expense as incurred costs that do not relate to capital additions activities, including ordinary repairs, maintenance, resident turnover costs and general and administrative expenses. We also defer successful leasing costs and amortize them over the life of the lease, which is typically one to two years.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Purchase Deposits

We make various deposits relating to property acquisitions, including transactions where we have agreed to purchase a home subject to certain conditions being met before closing, such as satisfactory home inspections and title search results. Our purchase deposit balances are recorded in other assets in our condensed consolidated balance sheets.

Derivative Instruments

We are exposed to certain risks arising from both our business operations and economic conditions.  We principally manage our exposures to a wide variety of business and operational risks through the management of our core business activities. We manage economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of our debt funding and the use of derivative financial instruments.  Specifically, we enter into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates.  Our derivative financial instruments are used to manage differences in the amount, timing, and duration of our known or expected cash receipts and our known or expected cash payments principally related to our borrowings.

As required by ASC 815, “Derivatives and Hedging,” we record all derivatives in the condensed consolidated balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  We may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or we elect not to apply hedge accounting. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income (“OCI”) and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.

Derivatives not designated as hedges are derivatives that do not meet the criteria for hedge accounting under GAAP or for which we have not elected to designate as hedges. We do not use these derivatives for speculative purposes, but instead they are used to manage our exposure to interest rate changes. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in loss on derivative financial instruments, net in our condensed consolidated statements of operations.

Convertible Notes

ASC Topic 470-20, “Debt with Conversion and Other Options,” requires the liability and equity components of convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate. The initial proceeds from the sale of convertible notes are allocated between a liability component and an equity component in a manner that reflects interest expense at the rate of similar nonconvertible debt that could have been issued at such time. The equity component represents the excess initial proceeds received over the fair value of the liability component of the notes as of the date of issuance. We measure the fair value of the debt component of our convertible notes as of the issuance date based on our nonconvertible debt borrowing rate. The equity component of the convertible notes is reflected within additional paid-in capital in our condensed consolidated balance sheets, and the resulting debt discount is amortized over the period during which the convertible notes are expected to be outstanding (the maturity date) as additional non-cash interest expense. The additional non-cash interest expense attributable to the convertible notes will be recorded in subsequent periods through the maturity date as the notes accrete to their par value.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Securitization/Sale and Financing Arrangements

We may periodically sell our financial assets. In connection with these transactions, we may retain or acquire senior or subordinated interests in the related assets. Gains and losses on such transactions are recognized using the guidance in ASC Topic 860, “Transfers and Servicing,” which is based on a financial components approach that focuses on control. Under this approach, after a transfer of financial assets that meets the criteria for treatment as a sale – legal isolation, ability of transferee to pledge or exchange the transferred assets without constraint, and transferred control – an entity recognizes the financial assets it retains and any liabilities it has incurred, derecognizes the financial assets it has sold, and derecognizes liabilities when extinguished. We determine the gain or loss on sale of the assets by allocating the carrying value of the sold asset between the sold asset and the interests retained based on their relative fair values, as applicable. The gain or loss on sale is the difference between the cash proceeds from the sale and the amount allocated to the sold asset. If the sold asset is being accounted for pursuant to the fair value option, there is no gain or loss.

Revenue Recognition

Rental revenue, net of concessions, is recognized on a straight-line basis over the term of the lease. The initial term of our residential leases is generally one to two years, with renewals upon consent of both parties on an annual or monthly basis.

We periodically evaluate the collectability of our resident and other receivables and record an allowance for doubtful accounts for any estimated probable losses. This allowance is estimated based on payment history and probability of collection. We generally do not require collateral other than resident security deposits. Our allowance for doubtful accounts was $0.6 million and $0.3 million as of September 30, 2015 and December 31, 2014, respectively. Bad debt expense amounts are recorded as property operating and maintenance expenses in the condensed consolidated statements of operations. During the three and nine months ended September 30, 2015, we incurred bad debt expense of $0.6 million and $1.5 million, respectively.  During the three and nine months ended September 30, 2014, we incurred bad debt expense of $0.9 million and $2.0 million, respectively.

We recognize sales of real estate when the sale has closed, title has passed, adequate initial and continuing investment by the buyer is received, possession and other attributes of ownership have been transferred to the buyer, and we are not obligated to perform significant additional activities after closing. All these conditions are typically met at or shortly after closing.

We recognize realized gains on loan conversions, net in each reporting period when our NPLs are converted to SFRs. The transfer to SFR occurs when we have obtained legal title to the property upon completion of the foreclosure. The fair value of these assets at the time of transfer to real estate owned is estimated using BPOs.  BPOs are subject to judgments of a particular broker formed by visiting a property, assessing general home values in an area, foreclosure timelines, reviewing comparable listings and reviewing comparable completed sales. These judgments may vary among brokers and may fluctuate over time based on housing market activities and the influx of additional comparable listings and sales.  We evaluate the validity of the BPOs received pursuant to the policy described above under “-Investments in Real Estate.” Our results could be materially and adversely affected if the judgments used by a broker prove to be incorrect or inaccurate.

We recognize realized gains on NPLs upon payoff of principal balance.  The gain is calculated by subtracting basis from net proceeds of payoff.

Earnings (Loss) Per Share

We use the two-class method to calculate basic and diluted earnings per common share (“EPS”) as our restricted share units (“RSUs”) are participating securities as defined by GAAP. We calculate basic EPS by dividing net income (loss) attributable to us for the period by the weighted-average number of common shares outstanding for the period. Diluted-earnings per share reflect the potential dilution that could occur from shares issuable in connection with the RSUs and convertible senior notes, except when doing so would be anti-dilutive.

Share-Based Compensation

The fair value of our RSUs granted is recorded as expense on a straight-line basis over the vesting period for the award, with an offsetting increase in shareholders' equity. For grants to trustees, the fair value is determined based upon the share price on the grant date. For non-employee grants, the fair value is based on the share price when the shares vest, which requires the amount to be adjusted in each subsequent reporting period based on the fair value of the award at the end of the reporting period until the award has vested.

16

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Income Taxes

We intend to operate as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), and intend to comply with the Code with respect thereto. Accordingly, we will not be subject to federal income tax as long as certain asset, income, dividend distribution, and share ownership tests are met. Many of these requirements are technical and complex, and if we fail to meet these requirements, we may be subject to federal, state, and local income tax and penalties. A REIT's net income from prohibited transactions is subject to a 100% penalty tax. We have taxable REIT subsidiaries (“TRSs”) where certain investments may be made and activities conducted that (1) may have otherwise been subject to the prohibited transactions tax and (2) may not be favorably treated for purposes of complying with the various requirements for REIT qualification. The income, if any, within the TRSs is subject to federal and state income taxes as a domestic C corporation based upon the TRSs' net income. We recorded provisions of approximately $16,000 and $0.4 million for the three and nine months ended September 30, 2015, respectively.  We recorded provisions of approximately $19,000 and $0.5 million for the three and nine months ended September 30, 2014, respectively.

Reclassification of Prior Period Amounts

In 2014, we reclassified amounts related to our credit facilities in the condensed consolidated balance sheet and the condensed consolidated statements of cash flows to disaggregate amounts related to our senior SFR facility and master repurchase agreement to conform to the current period’s presentation. We also reclassified amounts related to additions to real estate in the condensed consolidated statements of cash flows to disaggregate amounts related to initial renovations to single-family rentals and other capital expenditures for single-family rentals.

Further, we reclassified certain prior period amounts related to realized gains (losses) on sales of investments in real estate, net in the condensed consolidated statements of operations to disaggregate amounts related to realized gains (losses) on sales of investments in real estate, net and realized loss on sales of divestiture homes, net to conform to the current period’s presentation.

Geographic Concentrations

We hold significant concentrations of homes and NPLs with collateral in the following regions of the country in excess of 10% of our total portfolio, and as such are more vulnerable to any adverse macroeconomic developments in such areas:

Single-Family Rentals

 

 

Non-Performing Loans

 

 

17

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Recent Accounting Pronouncements

In August 2015, the FASB issued No. Accounting Standards Update (“ASU”) 2015-15, “Interest – Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements.” The guidance in ASU 2015-03 does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to line-of-credit arrangements, the SEC staff stated that they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. This ASU is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The new guidance should be applied on a retrospective basis. We are currently evaluating the new guidance to determine the impact it may have on our condensed consolidated financial statements.

In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date (ASU 2015-14).” ASU 2015-14 defers the effective date of ASU 2014-09 by one year, and would allow entities the option to early adopt ASU 2014-09 as of the original effective date. We do not anticipate that the adoption of ASU 2015-14 will have a material impact on our condensed consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015-03, “Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” The new standard requires that all costs incurred to issue debt be presented in the balance sheet as a direct deduction from the carrying value of the associated debt liability, consistent with the presentation of a debt discount. The standard also indicates that debt issuance costs do not meet the definition of an asset because they provide no future economic benefit. This ASU is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The new guidance should be applied on a retrospective basis. We are currently evaluating the new guidance to determine the impact it may have on our condensed consolidated financial statements.

In February 2015, the FASB issued ASU No. 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis.” The new standard amends the consolidation guidance in ASC 810 and significantly changes the consolidation analysis required under current GAAP. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. We are currently evaluating the new guidance to determine the impact it may have on our condensed consolidated financial statements.

In November 2014, the FASB issued ASU No. 2014-16, “Derivatives and Hedging (Topic 815) - Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity.” Certain classes of shares include features that entitle the holders to preferences and rights (such as conversion rights, redemption rights, voting powers and liquidation and dividend payment preferences) over the other shareholders. Shares that include embedded derivative features are referred to as hybrid financial instruments, which must be separated from the host contract and accounted for as a derivative if certain criteria are met under Subtopic 815-10. One criterion requires evaluating whether the nature of the host contract is more akin to debt or to equity and whether the economic characteristics and risks of the embedded derivative feature are “clearly and closely related” to the host contract. In making that evaluation, an issuer or investor may consider all terms and features in a hybrid financial instrument, including the embedded derivative feature that is being evaluated for separate accounting or may consider all terms and features in the hybrid financial instrument, except for the embedded derivative feature that is being evaluated for separate accounting. The use of different methods can result in different accounting outcomes for economically similar hybrid financial instruments. Additionally, there is diversity in practice with respect to the consideration of redemption features in relation to other features when determining whether the nature of a host contract is more akin to debt or to equity. The amendments apply to all reporting entities that are issuers of, or investors in, hybrid financial instruments that are issued in the form of a share.  The amendments in ASU No. 2014-16 are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption, including adoption in an interim period, is permitted. We are currently evaluating the impacts of the adoption of ASU No. 2014-16 on our condensed consolidated financial statements.

In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements – Going Concern (Subtopic 2015-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” (“ASU 2014-15”). ASU 2014-15 introduces an explicit requirement for management to assess and provide certain disclosures if there is substantial doubt about an entity’s ability to continue as a going concern. ASU 2014-15 is effective for the annual period ending after December 15, 2016. We do not anticipate that the adoption of ASU 2014-15 will have a material impact on our consolidated financial statements.

18

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

In June 2014, the FASB issued ASU 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures” (“ASU 2014-11”). ASU 2014-11 amends the accounting guidance for repurchase-to-maturity transactions and repurchase agreements executed as repurchase financings, and requires additional disclosure about certain transactions by the transferor. ASU 2014-11 is effective for certain transactions that qualify for sales treatment for the first interim or annual period beginning after December 15, 2014. The new disclosure requirements for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that qualify for secured borrowing treatment is effective for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. We have historically recorded our repurchase arrangements as secured borrowings and, accordingly, the adoption of ASU 2014-11 did not have a material impact on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”). ASU 2014-09 broadly amends the accounting guidance for revenue recognition. ASU 2014-09 is effective for the first interim or annual period beginning after December 15, 2016, and is to be applied prospectively. We do not anticipate that the adoption of ASU 2014-09 will have a material impact on our consolidated financial statements.

 

 

Note 3. Fair Value Measurements

GAAP establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial assets and liabilities at fair values. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below:

Level I—Quoted prices in active markets for identical assets or liabilities.

Level II—Prices are determined using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing an asset or liability. These may include quoted prices for similar items, interest rates, speed of prepayments, credit risk, and others.

Level III—Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment), unobservable inputs may be used. Unobservable inputs reflect our own assumptions about the factors that market participants would use in pricing an asset or liability, and would be based on the best information available.

Cash and Cash Equivalents, Resident and Other Receivables, Restricted Cash, and Purchase Deposits

Fair values approximate carrying values due to their short-term nature. These valuations have been classified as Level I.

Our assets measured at fair value on a nonrecurring basis are those assets for which we have recorded impairments. See Note 2- Basis of Presentation and Significant Accounting Policies for information regarding significant considerations used to estimate the fair value of our investments in real estate. The assets for which we have recorded impairments, measured at fair value on a nonrecurring basis, are summarized below (in thousands):

 

 

 

For a summary of our activity for our real estate carried at fair value during the nine months ended September 30, 2015, refer to Note 5-Real Estate.

19

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The following table presents the amount of NPLs converted to real estate measured at fair value on a non-recurring basis during the three and nine months ended September 30, 2015 and 2014 (in thousands):

 

 

Fair Value Option

The guidance in ASC 825, “Financial Instruments,” provides a fair value option election that allows entities to make an irrevocable election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The decision to elect the fair value option is determined on an instrument-by-instrument basis and must be applied to an entire instrument and is irrevocable once elected. Assets and liabilities measured at fair value pursuant to this guidance are required to be reported separately in our condensed consolidated balance sheets from those instruments using another accounting method. We have concluded that NPLs accounted for at fair value timely reflect the results of our investment performance.

For a summary of our Level III activity for our NPLs carried at fair value during the nine months ended September 30, 2015, refer to Note 6-Non-Performing Loans.

The following table presents the fair value of our financial instruments in the condensed consolidated balance sheets (in thousands):

 

 

As the transaction for our asset-backed securitization certificates and asset-backed securitization liability closed December 19, 2014, and there has not been a fundamental change in the market since the transaction closed, we concluded that the carrying value approximates fair value as of September 30, 2015 and December 31, 2014. We have determined that our valuation of these arrangements should be classified in Level III of the value hierarchy. The fair value of our convertible senior notes is estimated by discounting the contractual cash flows at the interest rate we estimate such notes would bear if sold in the current market. We have determined that our valuation of our convertible senior notes should be classified in Level III of the fair value hierarchy. The senior SFR facility and master repurchase agreement are recorded at their aggregate principal balance and not at fair value. The fair value was estimated based on the rate at which a similar credit facility would be priced today.

20

---

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The significant unobservable inputs used in the fair value measurement of our NPLs are discount rates, alternate loan resolution probabilities, resolution timelines, and the value of underlying properties. Significant changes in any of these inputs in isolation could result in a significant change to the fair value measurement. A decline in the discount rate in isolation would increase the fair value. A decrease in the housing pricing index in isolation would decrease the fair value. Individual loan characteristics, such as location and value of underlying collateral, affect the loan resolution probabilities and timelines. An increase in the loan resolution timeline in isolation would decrease the fair value. A decrease in the value of underlying properties in isolation would decrease the fair value.

The following table sets forth quantitative information about the significant unobservable inputs used to measure the fair value of our NPLs as of September 30, 2015 and December 31, 2014:

 

 

 

Note 4. Net Loss per Share

Our shares began trading on February 3, 2014 on the NYSE under the ticker symbol “SWAY.” In our calculation of EPS, the numerator for both basic and diluted EPS is net earnings (loss) attributable to us. For periods prior to January 31, 2014, the denominator for basic and diluted EPS is based on the number of our common shares outstanding on the January 31, 2014. On January 31, 2014, SPT stockholders of record as of the close of business on January 24, 2014, received one of our common shares for every five shares of SPT common stock held as of the record date. Basic and diluted EPS and the average number of common shares outstanding were calculated using the number of our common shares outstanding immediately following the distribution and as adjusted for subsequent issuances and repurchases. The number of shares at January 31, 2014 was used to calculate basic and diluted EPS as none of the equity awards were outstanding prior to the distribution. We use the two-class method in calculating basic and diluted EPS.

 

 

The dilutive effect of outstanding RSUs is reflected in diluted net income per share, but not diluted net loss per share, by application of the treasury share method, which includes consideration of share-based compensation required by GAAP. As we reported a net loss for the three and nine months ended September 30, 2015, and the corresponding periods of 2014, both basic and diluted net loss per share are the same.

For the three and nine months ended September 30, 2015, 0.7 million of our common shares subject to RSUs were excluded from the computation of diluted net loss per share, and the RSUs do not participate in losses.  For the three and nine months ended September 30, 2014, 0.9 million of our common shares subject to RSUs were excluded from the computation of diluted net loss per share, and the RSUs do not participate in losses.

21

---

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

For the three and nine months ended September 30, 2015 and 2014, the potential common shares contingently issuable upon the conversion of our 3.00% Convertible Senior Notes due 2019 (the “2019 Convertible Notes”) and our 4.50% Convertible Senior Notes due 2017 (the “2017 Convertible Notes” and, together with the 2019 Convertible Notes, the “Convertible Senior Notes”) were also excluded from the computation of diluted net loss per share as we have the intent and ability to settle the obligation in cash.      

Equity Transactions

On May 6, 2015, our board of trustees authorized a share repurchase program (the “2015 Program”). Under the 2015 Program, we may repurchase up to $150.0 million of our common shares beginning May 6, 2015 and ending May 6, 2016. During the nine months ended September 30, 2015, we repurchased 0.3 million common shares for $8.3 million under the 2015 Program. We did not repurchase any common shares under the 2015 Program during the three months ended September 30, 2015.

On April 24, 2014, our board of trustees authorized a share repurchase program (the “2014 Program”). Under the 2014 Program, we could have repurchased up to $150.0 million of our common shares beginning April 17, 2014 and ending April 17, 2015. During fiscal year 2014, we repurchased 1.3 million common shares for $34.3 million under the 2014 Program.  The 2014 Program expired on April 17, 2015 and we did not repurchase any shares pursuant to the 2014 Program during 2015.

On October 15, 2014, we paid a quarterly dividend of $0.14 per common share, totaling $5.5 million, to shareholders of record at the close of business on September 30, 2014. On January 15, 2015, we paid a quarterly dividend of $0.14 per common share, totaling $5.4 million, to shareholders of record at the close of business on December 31, 2014.  On April 15, 2015, we paid a quarterly dividend of $0.14 per common share, totaling $5.4 million, to shareholders of record at the close of business on March 31, 2015. On July 15, 2015, we paid a quarterly dividend of $0.14 per common share, totaling $5.4 million to shareholders of record at the close of business on June 30, 2015. On July 31, 2015, our board of trustees declared a quarterly dividend of $0.19 per common share. Total dividend payments of $7.3 million were made on October 15, 2015 to shareholders of record at the close of business on September 30, 2015.

 

 

Note 5. Real Estate

The following table summarizes transactions within our home portfolio for the year ended December 31, 2014 and the nine months ended September 30, 2015 (in thousands):⁽¹⁾

 

 

 

 

22

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Note 6. Non-Performing Loans

We hold our NPLs within a consolidated subsidiary that we established with Prime. We hold a controlling interest in the subsidiary and, as such, have the power to direct its significant activities while Prime manages the subsidiary's day-to-day operations. Should this subsidiary realize future returns in excess of specific thresholds, Prime may receive incremental incentive distributions in excess of their ownership interest.

The following table summarizes transactions within our NPLs for the year ended December 31, 2014 and the nine months ended September 30, 2015:

 

 

See Note 3- Fair Value Measurements for information regarding significant unobservable inputs used to measure the fair value of our NPLs as of September 30, 2015 and December 31, 2014.

Total unpaid principal balance (“UPB”) for our first-lien NPL portfolio as of September 30, 2015 and December 31, 2014, was $625.8 million and $968.7 million, respectively.

 

 

Note 7. Debt

Senior SFR Facility

On June 13, 2014, Starwood Waypoint Borrower, LLC (“SFR Borrower”), a wholly-owned indirect subsidiary of ours that was established as a special-purpose entity (“SPE”) to own, acquire and finance, directly or indirectly, substantially all of our SFRs, entered into an Amended and Restated Master Loan and Security Agreement evidencing a $1.0 billion secured revolving credit facility (“SFR Facility”) with a syndicate of financial institutions led by Citibank, N.A., as administrative agent. The SFR Facility replaced our $500.0 million credit facility with Citibank, N.A., as sole lender. The SFR Facility was subsequently amended on July 31, 2014, and December 19, 2014, to clarify certain definitions in the agreement. The outstanding balance on this facility as of September 30, 2015 and December 31, 2014, was approximately $697.4 million and $441.2 million, respectively.

23

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The SFR Facility is set to mature on February 3, 2017, subject to a one-year extension option which would defer the maturity date to February 5, 2018. The SFR Facility includes an accordion feature that may allow the SFR Borrower to increase availability thereunder by $250.0 million, subject to meeting specified requirements and obtaining additional commitments. The SFR Facility has a variable interest rate of London Interbank Offered Rate (“LIBOR”) plus a spread, which will equal 2.95% during the first three years and then 3.95% during any extended term, subject to a default rate of an additional 5% on amounts not paid when due. The SFR Borrower is required to pay a commitment fee on the unused commitments at a per annum rate that varies from zero to 0.25% depending on the principal amounts outstanding. The SFR Facility is secured by all assets of the SFR Borrower and its subsidiaries and also by a pledge of the SFR Borrower’s equity. The facility contains customary terms, conditions precedent, affirmative and negative covenants, limitations, and other conditions for credit facilities of this type, including requirements for cash reserves and restrictions on incurring additional indebtedness, creation of liens, mergers and fundamental changes, sales or other dispositions of property, changes in the nature of the SFR Borrower’s business, investments, and capital expenditures. The facility is also subject to certain financial covenants concerning our liquidity and tangible net worth, and to requirements that SFR Borrower maintain minimum levels of debt service coverage and debt yield.

In connection with the SFR Facility, we provided a limited guaranty and recourse indemnity with respect to specified losses due to fraud, misrepresentation, misapplication of funds, physical waste, breaches of specified representations, warranties, and covenants and a full guaranty in the event that SFR Borrower or its subsidiaries file insolvency proceedings or violate certain covenants that result in their being substantively consolidated with any other entity that is subject to a bankruptcy proceeding. Availability under the SFR Facility is limited by a formula equal to the lower of 60% of the SFR Borrower’s acquisition cost of a home or 60% of its value (increasing to the lower of 65% of acquisition cost and initial capital expenditures or 70% of its value once a property is stabilized) as such value is established by an independent BPO.

The facility includes customary events of default. The occurrence of an event of default will permit the lenders to terminate their commitments under the facility and accelerate payment of all amounts outstanding thereunder. In addition, if a default or a failure to observe the asset performance triggers should occur and be continuing, all of the rental income associated with the real estate properties of the SFR Borrower and its subsidiaries will, after payment of specified operating expenses, asset management fees, and interest, be required to prepay the loans under the facility, which will preclude the SFR Borrower from being able to make distributions on its equity for our benefit.

Master Repurchase Agreement

On September 1, 2015, we (in our capacity as guarantor), PrimeStar Fund I (a limited partnership in which we own, indirectly, at least 98.75% of the general partnership and limited partnership interests) and Wilmington Savings Fund Society, FSB, not in its individual capacity but solely as trustee of PrimeStar-H Fund I Trust (“PrimeStar-H”) (a trust in which we own, indirectly, at least 98.75% of the beneficial trust interests), amended our master repurchase agreement with Deutsche Bank AG, Cayman Islands Branch (“Deutsche Bank AG”).  The repurchase agreement, which provided maximum borrowings of up to $500.0 million, had a maturity date of September 11, 2015, and interest which accrued on advances under the repurchase agreement at a per annum rate based on 30-day LIBOR (or the rate payable by a commercial paper conduit administered or managed by Deutsche Bank AG, to the extent Deutsche Bank AG utilizes such a commercial paper conduit to finance its advances under the repurchase agreement) plus 3% (the “Spread”), has been amended to change the maximum borrowings, extend the maturity date to March 1, 2017 and decrease the Spread to 2.375%. The maximum borrowing means, as of September 1, 2015, approximately $386.1 million; provided, however, that thereafter the maximum borrowings shall be reduced to an amount equal to the aggregate outstanding borrowings on any given date and, thereafter, shall be reduced commensurately with each reduction in the aggregate outstanding borrowings.  The repurchase agreement is secured, among other things, by PrimeStar Fund I’s ownership interest in certificates that evidence 100% of the ownership interests in PrimeStar-H. The repurchase agreement is used to finance the acquired pools of NPLs secured by residential real property by PrimeStar-H and by various wholly-owned subsidiaries of PrimeStar-H.

Advances under the repurchase agreement accrue interest at a per annum rate based on 30-day LIBOR (or the rate payable by a commercial paper conduit administered or managed by Deutsche Bank AG, to the extent Deutsche Bank AG utilizes such a commercial paper conduit to finance its advances under the repurchase agreement) plus 2.375%. During the existence of an event of default under the repurchase agreement, interest accrues at the post-default rate, which is based on the applicable pricing rate in effect on such date plus an additional 3%. The initial maturity date of the repurchase agreement is March 1, 2017, subject to a six month extension option, which may be exercised by PrimeStar Fund I upon the satisfaction of certain conditions set forth in the repurchase agreement. Borrowings are available under the repurchase agreement until March 1, 2017.  In connection with the repurchase agreement, we provided a guaranty, under which we guaranty the obligations of PrimeStar I, L.P. under the repurchase agreement and ancillary transaction documents. The outstanding balance on September 30, 2015 and December 31, 2014, on this facility was approximately $331.2 million and $454.2 million, respectively.

24

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The repurchase agreement and ancillary transaction documents, including the guaranty, contain various affirmative and negative covenants concerning our liquidity and tangible net worth and maximum leverage ratio.

Convertible Senior Notes

On July 7, 2014, we issued $230.0 million in aggregate principal amount of the 2019 Convertible Notes. The sale of the 2019 Convertible Notes generated gross proceeds of $230.0 million and net proceeds of approximately $223.9 million, after deducting the initial purchasers’ discounts and estimated offering expenses paid by us.  The net proceeds from the offering were used to acquire additional homes and NPLs, to repurchase our common shares and for general corporate purposes. Interest on the 2019 Convertible Notes is payable semiannually in arrears on January 1 and July 1 of each year, beginning on January 1, 2015. The 2019 Convertible Notes will mature on July 1, 2019.

On October 14, 2014, we issued $172.5 million in aggregate principal amount of the 2017 Convertible Notes. The sale of the 2017 Convertible Notes generated gross proceeds of $172.5 million and net proceeds of approximately $167.8 million, after deducting the initial purchasers’ discounts and estimated offering expenses paid by us.  The net proceeds from the offering were used to acquire additional homes and NPLs, to repurchase our common shares and for general corporate purposes. Interest on the 2017 Convertible Notes will be payable semiannually in arrears on April 15 and October 15 of each year, beginning on April 15, 2015. The 2017 Convertible Notes will mature on October 15, 2017.

The following tables summarize the terms of the Convertible Senior Notes outstanding as of September 30, 2015 (in thousands, except rates):

 

 

 

25

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Terms of Conversion

As of September 30, 2015, the conversion rate applicable to the 2019 Convertible Notes was 30.5896 common shares per $1,000 principal amount of the 2019 Convertible Notes, which was equivalent to a conversion price of approximately $32.69 per common share. The conversion rate for the 2019 Convertible Notes is subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, following certain events that occur prior to the maturity date, we will increase the conversion rate for a holder who elects to convert its 2019 Convertible Notes in connection with such an event in certain circumstances. At any time prior to January 1, 2019, holders may convert the 2019 Convertible Notes at their option only under specific circumstances as defined in the indenture agreement (the “Indenture Agreement”) dated as of July 7, 2014, between us and our trustee, Wilmington Trust, National Association (the “Convertible Notes Trustee”).  On or after January 1, 2019, until the close of business on the second scheduled trading day immediately preceding the maturity date of the 2019 Convertible Notes, holders may convert all or any portion of the 2019 Convertible Notes at any time. Upon conversion, we will pay or deliver, as the case may be, cash, common shares, or a combination of cash and common shares, at our election.

As of September 30, 2015, the conversion rate applicable to the 2017 Convertible Notes was 33.2934 common shares per $1,000 principal amount of 2017 Convertible Notes (equivalent to a conversion price of approximately $30.04 per common share). The conversion rate for the 2017 Convertible Notes is subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, following certain events that occur prior to the maturity date, we will increase the conversion rate for a holder who elects to convert its 2017 Convertible Notes in connection with such an event in certain circumstances.  At any time prior to April 15, 2017, holders may convert the 2017 Convertible Notes at their option only under specific circumstances as defined in the Indenture (together with the Indenture Agreement, the “Indentures”) dated as of October 14, 2014, between us and the Convertible Notes Trustee.  On or after April 15, 2017, until the close of business on the second scheduled trading day immediately preceding the maturity date of the 2017 Convertible Notes, holders may convert all or any portion of the 2017 Convertible Notes at any time. Upon conversion, we will pay or deliver, as the case may be, cash, common shares, or a combination of cash and common shares, at our election.

We may not redeem the Convertible Senior Notes prior to their maturity dates except to the extent necessary to preserve our status as a REIT for U.S. federal income tax purposes, as further described in the Indentures.  If we undergo a fundamental change as defined in the Indentures, holders may require us to repurchase for cash all or any portion of their Convertible Senior Notes at a fundamental change repurchase price equal to 100% of the principal amount of the Convertible Senior Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date.

The Indentures contain customary terms and covenants and events of default. If an event of default occurs and is continuing, the Convertible Notes Trustee by notice to us, or the holders of at least 25% in aggregate principal amount of the outstanding Convertible Senior Notes, by notice to us and the Convertible Notes Trustee, may, and the Convertible Notes Trustee at the request of such holders shall, declare 100% of the principal of and accrued and unpaid interest on all the Convertible Senior Notes to be due and payable. However, in the case of an event of default arising out of certain events of bankruptcy, insolvency or reorganization in respect to us (as set forth in the Indentures), 100% of the principal of and accrued and unpaid interest on the Convertible Senior Notes will automatically become due and payable.

Asset-Backed Securitizations

On December 19, 2014, we completed our first securitization transaction of $504.5 million, which involved the issuance and sale in a private offering of single-family rental pass-through certificates (the “Certificates”) issued by a trust (the “Trust”) established by us. The Certificates represent beneficial ownership interests in a loan secured by a portfolio of 4,095 single-family homes operated as rental properties (collectively, the “Properties”) contributed from our portfolio of single-family homes to a newly-formed SPE indirectly owned by us.  Subsequent to December 19, 2014, we repaid $2.0 million in principal and reduced the portfolio to 4,081 single-family homes and the total proceeds of the securitization to $502.5 million (excluding the Class G Certificate described below).  Net proceeds of $477.7 million from the offering to third parties were distributed to our operating partnership, and used, primarily, to repay a portion of the SFR Facility of our subsidiary, SFR Borrower, for acquisitions, and for general corporate purposes. A principal-only bearing subordinate Certificate, Class G, in the amount of $26.6 million, was retained by us.

26

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Each class of Certificate (other than Class G and Class R) offered to investors (the “Offered Certificates”) accrues interest at a rate based on one-month LIBOR, plus a pass-through rate ranging from 1.30% to 4.55%. The table below shows the balance and pass-through rate for each class of the Offered Certificates as of September 30, 2015. The weighted-average of the fixed-rate spreads of the Offered Certificates is approximately 2.37%. Taking into account the discount at which certain of the certificates were sold, and assuming the successful exercise of the three one-year extension options of the Loan Agreement (as defined below) and amortization of the discount over the resulting fully extended period, the effective weighted-average of the fixed-rate spreads of the Offered Certificates is 2.46%.

As of September 30, 2015, the Offered Certificates had the following par certificate balances, pass-through rates, and ratings:

 

 

The assets of the Trust consist primarily of a single componentized promissory note issued by a SPE, SWAY 2014-1 Borrower, LLC, a Delaware limited liability company (the “Borrower”), evidencing a monthly-pay mortgage loan with an initial principal balance of $531.0 million, having six floating rate components and one fixed-rate component (the “Loan”). The Loan has a two-year term with three 12-month extension options and is guaranteed by the Borrower’s sole member (the “Equity Owner”), also a SPE owned by us. The Loan is secured by a pledge of all of the assets of the Borrower, including first-priority mortgages on the Properties, and the Equity Owner’s obligations under its guaranty is secured by a pledge of all of the assets of the Equity Owner, including a security interest in the sole membership interest in the Borrower. SWAY Depositor, LLC, our wholly-owned subsidiary, (the “Depositor”), the Borrower, and the Equity Owner are under our common control.

The Loan was originated on December 19, 2014 between JPMorgan Chase Bank, National Association (the “Loan Seller”) and the Borrower.  The Loan Seller sold the Loan to the Depositor, which then transferred the Loan to the Securitization Trustee (as defined below) of the Trust in exchange for the issuance of the Certificates.  The Certificates were issued pursuant to a Trust and Servicing Agreement (the “Trust and Servicing Agreement”) between the Depositor, Midland Loan Services, a Division of PNC Bank, National Association, as servicer and as special servicer, Wells Fargo Bank, National Association, as certificate administrator, and Christiana Trust, a division of Wilmington Savings Fund Society, FSB, as trustee (the “Securitization Trustee”). Distributions will be made on the Certificates monthly on the fourth business day following the 13th day of each month (or, if such 13th day is not a business day, the immediately preceding business day), commencing in January 2015. The Class A, Class B, Class C, Class D, Class E, and Class F Certificates accrue interest from and including December 19, 2014.  The Class R Certificates represent the residual interests in the Trust real estate mortgage investment conduit and do not have an initial certificate balance, pass-through rate, rating, or rated final distribution date, and will not be entitled to distributions of principal or interest.

The Certificates represent the entire beneficial interest in the trust. The Certificates (other than Class G and Class R) were offered and sold to qualified institutional buyers and non-U.S. persons through the placement agents retained for the transaction pursuant to the exemptions from registration provided by Rule 144A and Regulation S, respectively, under the Securities Act of 1933, as amended.  As part of the securitization transaction, various subsidiaries of us, through both distributions and contributions, transferred the Properties to Borrower, an indirect subsidiary of us, which then entered into the Loan Agreement. The Loan was deposited into the Trust in exchange for the Certificates.

27

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

We evaluated the accounting for the securitization transaction under ASC 860, “Transfers and Servicing.” Specifically, we considered ASC 860-10-40-4 in determining whether the Depositor had surrendered control over the Loan as part of transferring it to the Securitization Trustee. In this evaluation, we first considered and concluded that the transferee (i.e., the Securitization Trustee), which is a fully separate and independent entity, over which we have no control, would not be consolidated by the transferor (i.e., the Depositor). Next, as the Depositor has fully sold, transferred, and assigned all right, title, and interest in the Loan under terms of the Trust and Servicing Agreement, we have concluded that it has no continuing involvement in the Loan.  Lastly, we have considered all other relevant arrangements and agreements related to the transfer of the Loan, noting no facts or circumstances inconsistent with the above analysis.

We have also evaluated the transfer of the Loan from the Depositor to the Securitization Trustee under ASC 860-10-40-5, noting that the Loan has been isolated from the Depositor, even in bankruptcy or receivership, which has been supported by a true sale opinion obtained as part of the securitization transaction. Additionally, the third-party holders of the Certificates are freely able to pledge or exchange their Certificates, and we maintain no other form of effective control over the Loan through repurchase agreements, cleanup calls, or otherwise.  Accordingly, we have concluded that the transfer of the Loan from the Depositor to the Trust meets the conditions for a sale of financial assets under ASC 860-10-40-4 through ASC 860-10-40-5 and have therefore derecognized the Loan in accordance with ASC 860-20.  As such, our condensed consolidated financial statements, through the Borrower, our consolidated subsidiary, will continue to reflect the Properties at historical cost basis and a loan payable will be recorded in an amount equal to the principal balance outstanding on the Loan as discussed in further detail below.

Securitization Loan Agreement

As described above, on December 19, 2014, the Borrower entered into a loan agreement (the “Loan Agreement”), with JPMorgan Chase Bank, National Association, as lender (“Lender”). Pursuant to the Loan Agreement, the Borrower borrowed $531.0 million from Lender. The Loan is a two-year, floating rate loan, composed of six floating rate components, each of which is computed monthly based on one-month LIBOR, plus a fixed component spread, and one fixed rate component. Interest on the Loan Agreement is paid monthly. As part of certain lender requirements in connection with the securitization transaction described above, the Borrower entered into an interest rate cap agreement for the initial two-year term of the Loan, with a LIBOR-based strike rate equal to 3.615%. The outstanding balance on the Loan, as of September 30, 2015 was approximately $527.2 million.

For purposes of computing, among other things, interest accrued on the Loan, the Loan is divided into seven components designated as “Component A,” “Component B,” “Component C,” “Component D,” “Component E,” “Component F,” and “Component G.”  Each of the components corresponds to one class of Certificates with the same alphabetical designation and had, at December 19, 2014, an initial component balance equal to the corresponding class of Offered Certificates.

The following table sets forth the principal amount of each component and the component spread added to the one-month LIBOR for each monthly interest period as of September 30, 2015:

 

 

28

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

The Loan is secured by first-priority mortgages on the Properties, which are owned by the Borrower. The Loan is also secured by a first-priority pledge of the equity interests of the Borrower. The initial maturity date of the Loan is January 9, 2017 (the “Initial Maturity Date”). Borrower has the option to extend the Loan beyond the Initial Maturity Date for three successive one-year terms, provided that there is no event of default under the Loan Agreement on each maturity date, Borrower obtains a replacement interest rate cap agreement in a form reasonably acceptable to Lender, and Borrower complies with the other terms set forth in the Loan Agreement. The Loan Agreement requires that the Borrower comply with various affirmative and negative covenants that are customary for loans of this type, including limitations on indebtedness Borrower can incur, limitations on sales and dispositions of the Properties, required maintenance of specified cash reserves, and various restrictions on the use of cash generated by the operations of the Properties while the Loan Agreement is outstanding. The Loan Agreement also includes customary events of default, the occurrence of which would allow the Lender to accelerate payment of all amounts outstanding thereunder and to require that all of the rental income associated with the real estate properties of the Borrower, after payment of specified operating expenses, asset management fees, and interest, be required to prepay the Loan.  The Borrower is also required to furnish various financial and other reports to the Lender.

Our underwriting process for residents of the Properties is consistent with the review and underwriting process for the other SFRs owned by us.  In limited circumstances in which a Property fails to comply with the property covenants and representations in the Loan Agreement and provided there is no event of default, we may substitute a comparable property meeting specified criteria or repay the allocated loan amount for such Property.

In connection with the Loan, we provided the Lender with a limited recourse guaranty agreement under which we agreed to indemnify the Lender against specified losses due to fraud, misrepresentation, misapplication of funds, physical waste, breaches of specified representations, warranties, and covenants, as well as a guaranty of the entire amount of the Loan Agreement, not to exceed the greater of (i) $35.0 million (or if less, the entire outstanding balance of the Components A through F) and (ii) thirty-five percent of the aggregate outstanding balance of Components A through F, in the event that the Borrower files insolvency proceedings or violates certain covenants that result in its being substantively consolidated with any other entity that is subject to a bankruptcy proceeding.

We have accounted for the transfer of the Loan to the Securitization Trustee as a sale under ASC 860 with no resulting gain or loss as the Loan was both originated by the Loan Seller and immediately transferred at the same fair market value. We have also evaluated the purchased Class G certificates as a variable interest in the Trust and concluded that the Class G certificates will not absorb a majority of the Trust's expected losses or receive a majority of the Trust's expected residual returns. Additionally, we have concluded that the Class G certificates do not provide us with any ability to direct activities that could impact the Trust's economic performance. Accordingly, we do not consolidate the Trust and consolidate, at historical cost basis, the 4,081 homes placed as collateral for the Loan and have recorded a $527.2 million net asset-backed securitization liability at September 30, 2015, representing the principal balance outstanding on the Loan, net of unamortized loan discounts of $1.9 million, in the accompanying condensed consolidated balance sheets.  Separately, the $26.6 million of purchased Class G certificates have been reflected as asset-backed securitization certificates in the accompanying condensed consolidated balance sheets as of September 30, 2015.

Interest Rate Caps

In connection with the effectiveness of the SFR Facility, we purchased interest rate caps to protect against increases in monthly LIBOR above 3.0%. Continuation of that cap for an additional year (or purchase of a new rate cap) is a condition to any extension of maturity.

As of September 30, 2015, we had five interest rate caps used to mitigate our exposure to potential future increases in USD-LIBOR rates in connection with the SFR Facility. Interest rate caps involve the receipt of variable-rate amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.  These caps have maturities within the next two years and a total notional amount of $600.0 million. During the three and nine months ended September 30, 2015 and 2014, such derivatives were used to hedge the variable cash flows, indexed to USD-LIBOR, associated with existing variable-rate loan agreements.  The change in fair value of the derivatives is recognized directly in earnings. We recorded losses of $31,000 and $0.3 million during the three and nine months ended September 30, 2015, respectively, and we recorded losses of $0.1 million and $0.6 million for the corresponding periods in 2014.

As of September 30, 2015, we had one interest rate cap used to mitigate our exposure to potential future increases in USD-LIBOR rates in connection with the asset-backed securitization. This cap matures in January 2017 and has a total notional amount of $505.0 million, of which 90% or $454.5 million of the cap notional, was designated in a cash flow hedging relationship as of September 30, 2015. The changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated OCI and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.

29

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Amounts reported in accumulated OCI related to derivatives will be reclassified to interest expense as interest payments are made on our variable-rate debt. Over the next 12 months, we estimate that approximately $86,000 will be reclassified out of accumulated OCI as an increase to interest expense.

The table below presents the fair value of our derivative financial instruments as of September 30, 2015 and December 31, 2014 (in thousands):

 

The tables below present the effect of our derivative financial instruments on the condensed consolidated statements of operations for the three and nine months ended September 30, 2015 and 2014 (in thousands):

 

 

 

 

Currently, we use interest rate cap agreements to manage our interest rate risk. The valuation of derivative contracts is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable inputs, including interest rate curves and implied volatilities.

30

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

We incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.

Although we have determined that the majority of the inputs used to value our derivatives fall within Level II of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level III inputs, such as estimates of current credit spreads to evaluate the likelihood of default by us and our counterparties. However, as of September 30, 2015, we have assessed the significance of the impact of credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level II of the fair value hierarchy.

Total Borrowings

As of September 30, 2015, we had total outstanding borrowings of $1.9 billion, of which borrowings under our SFR Facility and master repurchase agreement were $1.0 billion, and the total recorded amount related to asset-backed securitizations were $527.2 million and the total recorded amount related to the Convertible Senior Notes was $370.2 million. As of September 30, 2015, we had approximately $41.8 million in gross deferred financing costs.  We amortize these costs using the effective interest rate method. As of September 30, 2015, we are in compliance with all of our debt facility requirements.

The following table outlines our total gross interest, including unused commitment and other fees and amortization of deferred financing costs, and capitalized interest for the three and nine months ended September 30, 2015 and 2014 (in thousands):

 

 

The following table summarizes our contractual maturities of our debt as of September 30, 2015 (in thousands):

 

 

 

Note 8. Share-Based Compensation

On January 16, 2014, we adopted (i) the Starwood Waypoint Residential Trust Equity Plan (the “Equity Plan”) which provided for the issuance of our common shares and common share-based awards to persons providing services to us, including without limitation, our trustees, officers, advisors, and consultants and employees of our external Manager, (ii) the Starwood Waypoint Residential Trust Manager Equity Plan (the “Manager Equity Plan”, and together with the Equity Plan, the “Equity Plans”), which provides for the issuance of our common shares and common share-based awards to our Manager, and (iii) the Starwood Waypoint Residential Trust Non-Executive Trustee Share Plan (the “Non-Executive Trustee Share Plan”), which provides for the issuance of common shares and common shares-based awards to our non-executive trustees.

31

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

In connection with the Separation, we granted (1) our Manager 777,574 RSUs and (2) certain employees of our Manager an aggregate of 199,991 of our RSUs. The award of RSUs to our Manager will vest ratably on a quarterly basis over a three-year period ending on April 1, 2017. The awards of RSUs to certain employees of our Manager vest ratably in three annual installments on January 31, 2015, January 31, 2016, and January 31, 2017.  In connection with the Separation, we also granted 8,330 of our restricted common shares to our non-executive trustees (1,666 to each of our five non-executive trustees). These awards of restricted shares vest ratably in three annual installments on January 31, 2015, January 31, 2016, and January 31, 2017, subject to the trustee’s continued service on our board of trustees.

During the nine months ended September 30, 2015, of the 777,574 RSUs awarded to our Manager in connection with the Separation, 194,401 vested. The remaining 323,990 unvested grants will vest ratably on a quarterly basis over a period ending on April 1, 2017. During the nine months ended September 30, 2015, we granted 258,847 new RSUs to certain employees of our Manager which vest over three years, 59,491 RSUs vested and 45,283 RSUs were forfeited. The remaining 332,566 unvested awards of RSUs will vest over a period ending June 30, 2018. During the nine months ended September 30, 2015, we granted 14,387 new restricted shares to our non-executive trustees, 10,333 shares vested and 1,111 shares were forfeited. The remaining 11,273 awards of restricted shares vest ratably in two annual installments on January 31, 2016, and January 31, 2017.

During the nine months ended September 30, 2015, we also granted 4,462 restricted shares to members of our board of trustees in lieu of trustee fees for an aggregate cost of approximately $113,000.

After giving effect to activity described above and summarized in the table below, we have 1,696,285 and 173,225 shares available for grant as of September 30, 2015, for the Equity Plans and Non-Executive Trustee Share Plan, respectively.

The following table summarizes our RSUs and restricted share awards activity during the nine months ended September 30, 2015:

 

 

During the three and nine months ended September 30, 2015, we recorded $2.3 million and $5.7 million of share-based compensation expense, respectively, on our condensed consolidated statements of operations. During the three and nine months ended September 30, 2014, we recorded $2.1 million and $4.6 million of share-based compensation expense, respectively, on our condensed consolidated statements of operations. As of September 30, 2015, $13.5 million of total unrecognized compensation cost related to unvested RSUs and restricted shares is expected to be recognized over a weighted-average period of 1.7 years.

 

 

32

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Note 9. Related-Party Transactions

The accompanying condensed consolidated statements of operations include the following expenses that have been allocated from our Manager for the three and nine months ended September 30, 2015 and 2014, to us. The allocated expenses generally represent (1) certain invoices that our Manager paid on our behalf and (2) the portion of certain expenses that were incurred by our Manager that are estimated to have been attributable to us. We believe the allocation of these expenses is considered appropriate under the SEC guidelines for carve-out financial statements, as we believe that there is reasonable basis for the allocations (in thousands):

 

 

Reimbursement of Costs

We are required to reimburse our Manager for the costs incurred on our behalf. Cost reimbursements to our Manager are made in cash on a monthly basis following the end of each month. Our reimbursement obligation is not subject to any dollar limitation. Because our Manager’s personnel perform certain legal, accounting, due diligence tasks, and other services that outside professionals or outside consultants otherwise would perform, our Manager is paid or reimbursed for the documented cost of performing such tasks. For the three and nine months ended September 30, 2015, we incurred $13.1 million and $43.3 million of costs, respectively. For the three and nine months ended September 30, 2014, we incurred $13.9 million and $39.7 million of costs, respectively.

Management Fees

We pay our Manager a base management fee calculated and payable quarterly in arrears in cash in an amount equal to one-fourth of 1.5% of the daily average of our adjusted market capitalization for the preceding quarter. For purposes of calculating the management fee, our adjusted equity market capitalization means (1) the average daily closing price per our common share during the relevant period, multiplied by (2) (a) the average number of our common shares and securities convertible into our common shares issued and outstanding during the relevant period, plus (b) the maximum number of our common shares issuable pursuant to outstanding rights, options, or warrants to subscribe for, purchase or otherwise acquire our common shares that are in the money on such date, or the common share equivalents, minus (3) the aggregate consideration payable to us on the applicable date upon the redemption, exercise, conversion, and/or exchange of any common share equivalents, plus (x) the average daily closing price per our preferred share during the relevant period, multiplied by (y) average number of our preferred shares issued and outstanding during the relevant period. The amount of management fees incurred by us during the three and nine months ended September 30, 2015, was $4.7 million and $14.3 million, respectively. The amount of management fees incurred by us during the three and nine months ended September 30, 2014, was $4.5 million and $11.3 million, respectively.

Fund XI Portfolio Purchase

On March 3, 2014, we purchased 707 homes from Waypoint Fund XI, LLC (“Fund XI Portfolio”), an entity that certain of our officers had an ownership interest in, for approximately $144.0 million in cash. Pursuant to our policy regarding conflicts of interest, a majority of our independent trustees approved the purchase of Fund XI Portfolio.

 

 

Note 10. Segment Reporting

In the operation of the business, management, including our chief decision maker, our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements. The segment information within this note is reported on that basis.

33

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

We are focused primarily on acquiring SFRs and NPLs and currently operate in two reportable segments. Prior to the Separation, we reported in only one segment. After the Separation, the chief decision maker changed from SPT’s chief executive officer to our Chief Executive Officer who views our NPL activities as a separate segment of our business. In connection with our change in reportable segments, we have created new revenue line items in our condensed consolidated statements of operations associated with our NPL segment. Current and prior amounts previously shown as other income will now be presented as realized gain on NPLs, net and realized gain on loan conversions, net within our revenue section in the condensed consolidated statements of operations as we believe revenues associated with our NPL business segment represent a significant part of our ongoing operations.

We currently have two reportable business segments:

Due to the structure of our business, certain costs incurred by one segment may benefit other segments. Costs that are identifiable are allocated to the segments that benefit so that one segment is not solely burdened by this cost. Allocated costs currently include management fees payable to our Manager and the Separation costs, both of which represent shared costs. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated.

Our reportable segments are strategic business units that offer different channels to acquiring real estate and offer different risk and return profiles. While the SFR business segment provides a direct conduit to real estate, the NPL business segment also provides revenue opportunities through potential gains achieved through the resolution of the NPLs. Further, not all NPLs resolve into the acquisition of real estate resulting in potential gains from the sale or dissolution of the NPL. Additionally, both business segments require differing asset management approaches given the differing nature of the investments.

We have presented certain prior-period amounts within this note to conform to the way we internally manage and monitor segment performance in the current periods.

Assets by Business Segment

 

 

34

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Statements of Operations by Business Segment

 

 

35

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Statements of Operations by Business Segment

 

 

 

36

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

AS OF SEPTEMBER 30, 2015

(Unaudited)

 

Note 11. Commitments and Contingencies

Purchase Commitments

As of September 30, 2015, we had executed agreements to purchase an additional 93 homes in separate transactions for an aggregate purchase price of $15.2 million. As of September 30, 2015, we had not contracted to purchase or sell any NPLs.

Legal and Regulatory

From time to time, we may be subject to potential liability under laws and government regulations and various claims and legal actions arising in the ordinary course of our business. Liabilities are established for legal claims when payments associated with the claims become probable and the costs can be reasonably estimated. The actual costs of resolving legal claims may be substantially higher or lower than the amounts established for those claims. Based on information currently available, we have no legal or regulatory claims that would have a material effect on our condensed consolidated financial statements.  

 

 

Note 12. Subsequent Events

Dividend Declaration

On November 2, 2015, our board of trustees declared a quarterly dividend of $0.19 per common share. Payment of the dividend is expected to be made on December 22, 2015 to shareholders of record at the close of business on December 10, 2015.

Acquisition of Homes

Subsequent to September 30, 2015, we have continued to purchase and sell homes in the normal course of business. For the period from October 1, 2015 through October 20, 2015, we purchased 58 homes with an aggregate acquisition cost of approximately $10.1 million. We did not purchase or sell any NPLs during this subsequent period.

 

 

 

37

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the information included elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2014. In addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially from those referred to herein due to a number of factors, including, but not limited to, risks described in Item 1A. Risk Factors included in our Annual Report on Form 10-K, as well as the factors described in this section.

Overview

We are a Maryland real estate investment trust formed in May 2012 primarily to acquire, renovate, lease and manage residential assets in select markets throughout the United States. Our objective is to generate attractive risk-adjusted returns for our shareholders over the long-term through dividends and capital appreciation. Our primary strategy is to acquire SFR homes through a variety of channels, renovate these homes to the extent necessary, and lease them to qualified residents. We seek to take advantage of the macroeconomic trends in favor of leasing homes by acquiring, owning, renovating and managing homes that we believe will (1) generate substantial current rental revenue, which we expect to grow over time, and (2) appreciate in value over the next several years. In addition, we have a significant portfolio of NPLs which we may seek to (1) modify and hold or resell at higher prices if circumstances warrant, thus providing additional liquidity or (2) convert into homes through the foreclosure or other resolution process that can then either be contributed to our rental portfolio or sold.

We were organized as a Maryland corporation in May 2012 as a wholly-owned subsidiary of SPT to own homes and NPLs. Subsequently, we changed our corporate form from a Maryland corporation to a Maryland real estate investment trust and our name from Starwood Residential Properties, Inc. to Starwood Waypoint Residential Trust. On January 31, 2014, SPT completed the Separation.

Our operating partnership was formed as a Delaware limited partnership in May 2012. This wholly-owned subsidiary is the sole general partner of our operating partnership, and we conduct substantially all of our business through our operating partnership. We own 100% of the OP Units.

We intend to operate and to be taxed as a REIT for U.S. federal income tax purposes. We generally will not be subject to U.S. federal income taxes on our REIT taxable income to the extent that we annually distribute all of our REIT taxable income to shareholders and qualify and maintain our qualification as a REIT.

Prior to the Separation, the historical condensed consolidated financial statements were derived from the condensed consolidated financial statements and accounting records of SPT, principally representing the single-family segment, using the historical results of operations and historical basis of assets and liabilities of our businesses. The historical condensed consolidated financial statements also include allocations of certain of SPT’s general corporate expenses. Management believes the assumptions and methodologies underlying the allocation of general corporate expenses to the historical results of operations were reasonable. However, such expenses may not be indicative of the actual level of expenses that would have been incurred by us if we had operated as an independent, publicly traded company or of the costs expected to be incurred in the future. As such, the results of operations prior to the Separation, included herein, may not necessarily reflect our results of operations, financial position or cash flows in the future or what our results of operations, financial position or cash flows would have been had we been an independent, publicly traded company during the historical periods presented. Transactions between the single-family business segment and other business segments of SPT’s businesses have been identified in the historical condensed consolidated financial statements as transactions between related parties for periods prior to the Separation.

Our Manager

We are externally managed and advised by our Manager pursuant to the terms of the Management Agreement. Our Manager is an affiliate of Starwood Capital Group, a privately-held private equity firm founded and controlled by Barry Sternlicht, our chairman. Starwood Capital Group has invested in most major classes of real estate, directly and indirectly, through operating companies, portfolios of properties and single assets, including multi-family, office, retail, hotel, residential entitled land and communities, senior housing, mixed use and golf courses. Starwood Capital Group invests at different levels of the capital structure, including equity, preferred equity, mezzanine debt and senior debt, depending on the asset risk profile and return expectation.

On January 31, 2014, our Manager acquired the Waypoint platform, which is an advanced, technology driven operating platform that provides the backbone for deal sourcing, property underwriting, acquisitions, asset protection, renovations, marketing and leasing, repairs and maintenance, portfolio reporting and property management of homes.

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Merger

On September 21, 2015, we and CAH announced the signing of the Merger Agreement to combine the two companies in a stock-for-stock transaction.  In connection with the transaction, we will internalize our Manager. The Combined Company is expected to own and manage over 30,000 homes and have an aggregate asset value of approximately $7.7 billion at the closing of the transaction. The Merger is expected to achieve estimated annualized cost synergies of $40.0 - $50.0 million.

Under the Merger Agreement, CAH shareholders will receive an aggregate of 64,869,583 our shares in exchange for all shares of CAH. Upon completion of the transaction, our existing shareholders and the former owner of our Manager will own approximately 41% of the Combined Company’s shares, while former CAH shareholders will own approximately 59% of the Combined Company’s shares. The share allocation was determined based on each company’s net asset value and is not subject to adjustment. The Combined Company’s shares will continue to trade on the NYSE. We expect to maintain our quarterly dividend of $0.19 per share up to the closing of the Merger. The transaction has been approved our board of trustees and CAH’s board of directors, and the terms of our internalization of our Manager were negotiated and approved by a special committee of our board of trustees. The transaction is expected to close in the first quarter of 2016. Among other things, the transaction is subject to the approval of our shareholders and customary closing conditions. Upon the closing of the Internalization and the Merger, the Combined Company will be named “Colony Starwood Homes” and its Common Shares will be listed and traded on the NYSE under the ticker symbol “SFR”.

Our Portfolio

As of September 30, 2015, our portfolio consisted of 17,124 owned homes and homes underlying NPLs, including (1) 14,155 homes and (2) 2,969 homes underlying 3,035 NPLs, of which 2,830 represent first liens and 205 NPLs represent second, third, and unsecured lien NPLs. As of September 30, 2015, the 2,830 of first lien NPLs had an UPB of $625.8 million, a total purchase price of $405.7 million, and were secured by liens on 2,769 homes and 61 parcels of land with a total BPO value of $629.9 million. As of September 30, 2015, our homes that were owned by us for 180 days or longer were approximately 94.6% leased.

As of September 30, 2015, we had executed agreements to purchase properties in 93 separate transactions for an aggregate purchase price of $15.2 million. There can be no assurance that we will close on all of the homes we have contracted to acquire.

Homes

The following table provides a summary of our portfolio of SFRs as of September 30, 2015:

 

 

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The following table provides a summary of our leasing as of September 30, 2015:

 

 

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NPL Portfolio

The following table summarizes our first lien NPL portfolio as of September 30, 2015:

 

 

Factors Which May Influence Future Results of Operations

Our results of operations and financial condition are affected by numerous factors, many of which are beyond our control. The key factors we expect to impact our results of operations and financial condition include our pace of acquisitions and ability to deploy our capital, the time and cost required to stabilize a newly acquired home, rental rates, occupancy levels, rates of resident turnover, our expense ratios and capital structure.

Acquisitions

We continue to grow our portfolio of homes. Our ability to identify and acquire homes that meet our investment criteria may be affected by home prices in our target markets, the inventory of homes available through our acquisition channels and competition for our target assets. We have accumulated a substantial amount of recent data on acquisition costs, renovation costs and time frames for the conversion of homes to rental. We utilize the acquisition process developed by the members of the Waypoint executive team who employ both top-down and bottom-up analyses to underwrite each acquisition opportunity we consider. The underwriting process is supported by our highly scalable technology platform, referred to as Compass, market analytics and a local, cross-functional team. In acquiring new homes, we rely on the expertise of our Manager to acquire our portfolio and will monitor the pace and source of these purchases.

Our operating results depend on sourcing NPLs. As a result of the economic crisis in 2008 that continues through today, we believe that there is currently a large supply of NPLs available to us for acquisition. Properties that are either in foreclosure and have not yet been sold or homes that owners are delaying putting on the market until prices improve are known as shadow inventory. We believe the available amount of shadow inventory provides for a significant acquisition pipeline of assets since we plan on targeting just a small percentage of the population. We further believe that we will be able to purchase NPLs at lower prices than SFRs because sellers of such loans will be able to avoid paying the costs typically associated with home sales, such as broker commissions and closing costs. Generally, we expect that our NPL portfolio may grow at an uneven pace, as opportunities to acquire NPLs may be irregularly timed and may involve large portfolios of loans, and the timing and extent of our success in acquiring such loans cannot be predicted.

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Home Stabilization

Before an acquired home becomes an income-producing asset, we must take possession of the home and renovate, market and lease the home in order to secure a resident. The acquisition of homes involves the outlay of capital beyond payment of the purchase price, including payments for property inspections, closing costs, title insurance, transfer taxes, recording fees, broker commissions, property taxes and HOA fees in arrears. The time and cost involved in stabilizing our newly acquired homes will affect our financial performance and will be affected by the time it takes for us to take possession of the home, the time involved and cost incurred for renovations, and time needed for leasing the home for rental.

Possession can be delayed by factors such as the exercise of applicable statutory or rescission rights by hold-over owners or unauthorized occupants living in the home at the time of purchase and legal challenges to our ownership. The cost associated with transitioning an occupant from an occupied home varies significantly depending on the steps taken to transition the occupant (i.e., willfully vacate, cash for keys, court-ordered vacancy). In some instances where we have purchased a home that is occupied, our Manager has been able to convert the occupant to a short-term or long-term resident.

We expect to control renovation costs by leveraging our Manager’s supplier relationships, as well as those of our Manager’s exclusive partners, to negotiate attractive rates on items, such as appliances, hardware, paint, and carpeting. Our Manager will also make targeted capital improvements, such as electrical, plumbing, HVAC and roofing work that we believe will increase resident satisfaction and lower future repair and maintenance costs. The time to renovate a newly acquired home can vary significantly among homes depending on the acquisition channel by which it was acquired and the age and condition of the home. We expect to reduce the time required to complete renovations through our Manager’s relationship with what we consider to be best-in-class single-family home renovation companies.

Similarly, the time to market and lease a home will be driven by local demand, our marketing techniques and the supply of homes in the market. We will drive to lower lease-up time for our homes through our Manager’s relationships with local brokers and other intermediaries established in the markets where our homes are located, and through the fully-integrated marketing and leasing strategy developed by the members of the Waypoint executive team.

Based on our prior experience, we anticipate that, for most of the non-leased homes that we acquire, the period from our taking possession to leasing a home will range from 30 to 180 days. We expect that most homes that were not leased at the time of acquisition should be leased within six months thereafter and that homes owned for more than six months provide the best indication of how our portfolio will perform over the long-term. As of September 30, 2015, the 11,730 homes we owned for more than 180 days were approximately 94.6% leased. As of December 31, 2014, the 9,066 homes we owned for more than 180 days were approximately 93.4% leased.

Capitalized Costs

We capitalize certain costs incurred in connection with successful property acquisitions and associated stabilization activities, including tangible property improvements and replacements of existing property components. Included in these capitalized costs are certain personnel costs associated with time spent by certain personnel in connection with the planning, execution, and oversight of all capital addition activities at the property level as well as third-party acquisition fees. We capitalized $2.4 million and $9.3 million of such personnel costs for the three and nine months ended September 30, 2015, respectively, to building and improvements in the accompanying condensed consolidated balance sheet. Indirect costs are allocations of certain costs, including personnel costs that directly relate to capital additions activities. We also capitalize property taxes and HOA fees during the periods in which property stabilization is in progress. We charge to expense as incurred costs that do not relate to capital addition activities, including ordinary repairs, maintenance, resident turnover costs and general and administrative expenses. We also defer successful leasing costs and amortize them over the life of the lease, which is typically one to two years. Deferred leasing costs are included in other assets in the accompanying condensed consolidated balance sheets and include $0.5 million and $1.6 million of certain personnel costs which were capitalized for the three and nine months ended September 30, 2015, respectively.

Loan Resolution Methodologies

We and Prime employ various loan resolution methodologies with respect to our NPLs, including loan modification, collateral resolution and collateral disposition. The manner in which a NPL is resolved will affect the amount and timing of revenue we will receive.

We expect that a portion of our NPLs will be returned to performing status primarily through loan modifications. Once successfully modified, we may consider selling these modified loans.

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We believe that a majority of these NPLs will have entered, or may enter into, foreclosure or similar proceedings, ultimately becoming SFR that can be added to our portfolio if they meet our investment criteria or sold through SFR liquidation and short sale processes. The costs we incur associated with converting loans generally include ongoing real estate taxes, insurance and property preservation on the underlying collateral, loan servicing and asset management and legal. We estimate that such costs typically range between $10,000 and $30,000 per foreclosure. The amount of costs incurred is primarily dependent on the length of time it takes to complete the foreclosure. We expect the timeline for these processes to vary significantly, and final resolution could take up to 30 months, but can take as long as three years or more in the most burdensome states with the most difficult foreclosure processes, such as New Jersey and New York (states in which approximately 4.9% and 9.9%, respectively, of our NPLs are located as of September 30, 2015 based on purchase price). The variation in timing could result in variations in our revenue recognition and our operating performance from period to period. There are a variety of factors that may inhibit our ability to foreclose upon a loan and get access to the real property within the time frames we model as part of our valuation process. These factors include, without limitation: state foreclosure timelines and deferrals associated therewith (including with respect to litigation); authorized occupants living in the home; federal, state or local legislative action or initiatives designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures and that serve to delay the foreclosure process; programs that require specific procedures to be followed to explore the refinancing of a residential mortgage loan prior to the commencement of a foreclosure proceeding; and declines in real estate values and sustained high levels of unemployment that increase the number of foreclosures and place additional pressure on the already overburdened judicial and administrative systems.

The exact nature of resolution will be dependent on a number of factors that are beyond our control, including borrower actions, home value, and availability of refinancing, interest rates, conditions in the financial markets, regulatory environment and other factors. In addition, we expect that our real estate assets may decline in value in a rising interest rate environment and that our net income could decline in a rising interest rate environment to the extent such real estate assets are financed with floating rate debt and there is no accompanying increase in rates and net operating income.

The state of the real estate market and home prices will determine proceeds from any sale of homes acquired in settlement of loans. Although we generally intend to own as rental properties the assets we acquire upon foreclosure, we may determine to sell such assets if they do not meet our investment criteria. In addition, while we seek to track real estate price trends and estimate the effects of those trends on the valuations of our portfolios of NPLs, future real estate values are subject to influences beyond our control. Generally, rising home prices are expected to positively affect our results of homes acquired in settlement of loans. Conversely, declining home prices are expected to negatively affect our results of homes acquired in settlement of loans.

Revenue

Our revenue comes primarily from rents collected under lease agreements for our homes. The most important drivers of revenue (aside from portfolio growth) are rental and occupancy rates. Our rental and occupancy rates are affected by macroeconomic factors and local and property-level factors, including market conditions, seasonality and resident defaults, and the amount of time that it takes us to renovate homes upon acquisition and the amount of time it takes us to renovate and re-lease vacant homes.

We also expect non-rental income from our acquired NPLs that are not converted to rentals. Such income will take the form of interest payments on loans that re-perform after being modified and cash flows from loan resolutions, such as short sales, third-party sales at foreclosure auctions and SFR sales.

In each of our markets, we monitor a number of factors that may affect the single-family real estate market and our residents’ finances, including the unemployment rate, household formation and net population growth, income growth, size and make-up of existing and anticipated housing stock, prevailing market rental and mortgage rates, rental vacancies and credit availability. Growth in demand for rental housing in excess of the growth of rental housing supply, among other factors, will generally drive higher occupancy and rental rates. Negative trends in our markets with respect to these metrics or others could adversely affect our rental revenue.

We expect that the occupancy of our portfolio will increase as the proportion of recently acquired homes declines relative to the size of our entire portfolio. Nevertheless, in the near term, our ability to drive revenue growth will depend in large part on our ability to efficiently renovate and lease newly acquired homes, maintain occupancy in the rest of our portfolio and acquire additional homes, both leased and vacant.

Expenses

Our ability to acquire, renovate, lease and maintain our portfolio in a cost-effective manner will be a key driver of our operating performance. We monitor the following categories of expenses that we believe most significantly affect our results of operations.

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Property-Related Expenses

Once we acquire and renovate a home, we have ongoing property-related expenses, including HOA fees (when applicable), taxes, insurance, ongoing costs to market and maintain the home and expenses associated with resident turnover. Certain of these expenses are not under our control, including HOA fees, property insurance and real estate taxes. We expect that certain of our costs, including insurance costs and property management costs, will account for a smaller percentage of our revenue as we expand our portfolio, achieve larger scale and negotiate volume discounts with third-party service providers and vendors.

Loan-Related Expenses

We have a joint venture with Prime, an entity managed by Prime Finance, an asset manager that specializes in acquisition, resolution and disposition of NPLs. We own, indirectly, at least 98.75% interest in the joint venture, which owns all of our NPLs. We and Prime formed the joint venture for the purposes of: (1) acquiring pools or groups of NPLs  and homes either (A) from the sellers who acquired such homes through foreclosure, deed-in-lieu of foreclosure or other similar process or (B) through foreclosure, deed-in-lieu of foreclosure or other similar process; (2) converting NPLs to performing residential mortgage loans through modifications, holding such loans, selling such loans or converting such loans to homes; and (3) either selling homes or renting homes as traditional residential rental properties. Prime has contributed the Prime Percentage Interest, and Prime, in accordance with our instructions (which are based in part on the use of certain analytic tools included in the Waypoint platform), identifies potential NPL acquisitions for the joint venture and coordinates the acquisition, resolution or disposition of any such loans for the joint venture. Our NPLs are serviced by Prime’s team of asset managers or licensed third-party mortgage loan servicers. We have exclusive management decision making control with respect to various matters of the joint venture and control over all decisions of the joint venture through our veto power. We may elect, in our sole and absolute discretion, to delegate certain ministerial or day-to-day management rights related to the joint venture to employees, affiliates or agents of us or Prime.

We also have the exclusive right under the joint venture, exercisable in our sole and absolute discretion, to designate NPLs and homes as rental pool assets (“Rental Pool Assets”). We will be liable for all expenses and benefit from all income from any Rental Pool Assets. The joint venture will be liable for all expenses and benefit from all income from all NPLs and homes not segregated into Rental Pool Assets (“Non-Rental Pool Assets”). We have the exclusive right to transfer any Rental Pool Assets from the joint venture to us, and we intend to exercise such right with respect to any homes held by the joint venture that we, in our sole and absolute discretion, have determined not to sell through the joint venture. Prime earns the Prime Transfer Fee, equal to a percentage of the value (as determined pursuant to the Amended JV Partnership Agreement) of the NPLs and homes we designate as Rental Pool Assets upon disposition or resolution of such assets. The percentage for calculation of the Prime Transfer Fee for all Rental Pool Assets acquired:

(1)prior to March 1, 2014 was 3%; and

(2)on or after March 1, 2014 is:

(a) 2.5% if disposition or resolution occurs prior to the earlier of (i) the date that is two months prior to the expected disposition date for such asset (as originally determined at the time of acquisition of such asset) or (ii) the date that is the end of 80% of the expected disposition period for such asset (as originally determined at the time of acquisition of such asset);

(b) 2% if disposition or resolution occurs within the longer of the period that is: (i) the two months before through the two months following the expected disposition date for such asset (as originally determined at the time of acquisition of such asset) or (ii) the period commencing during the final 20% of the expected disposition period for such asset (as originally determined at the time of acquisition of such asset) and ending an equal number of days after the related expected disposition date; or

(c) 1% if disposition occurs later than the end of the longer of the periods in the foregoing clause (b) for such asset.

In connection with the asset management services that Prime provides to the joint venture’s Non-Rental Pool Assets, the joint venture pays Prime a monthly asset management fee in arrears for all Non-Rental Pool Assets acquired:

(1)prior to March 1, 2014 equal to 0.167% of the aggregate net asset cost to the joint venture of such assets then existing; and

(2)on or after March 1, 2014 equal to:

(a) if the aggregate net asset cost to the joint venture of such assets then existing is $350 million or less, (i) 0.0125% of the aggregate net asset cost to the joint venture of the performing loans (i.e. at least six consecutive months of timely payments) then existing plus (ii) 0.0833% of aggregate net asset cost to the joint venture of the assets then existing but not included in the preceding clause (a)(i) minus (iii) the pro-rata portion of a month such assets that are sold, repaid or converted to Rental Pool Assets during the course of a calculation month; or

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(b) if the aggregate net asset cost to the joint venture of such assets then existing is $350 million or more, (i) 0.0125% of the aggregate net asset cost to the joint venture of the performing loans (i.e. at least six consecutive months of timely payments) then existing plus (ii) 0.05% of aggregate net asset cost to the joint venture of the assets then existing but not included in the preceding clause (b)(i) minus (iii) the pro-rata portion of a month such assets that are sold, repaid or converted to Rental Pool Assets during the course of a calculation month.

Prime’s portion of all cash flow or income distributions from the joint venture with respect to Non-Rental Pool Assets is calculated and distributed based upon defined subsets of Non-Rental Pool Assets referred to as “Legacy Acquisitions” (assets acquired prior to March 1, 2014) and “New Acquisition Tranches” (sequential groupings of assets acquired on or after March 1, 2014 aggregating to $500 million or greater in each case). Prime’s portion of cash flow or income is distributed in the following order and priority with respect the Legacy Acquisitions and each New Acquisition Tranche as follows: (1) Prime’s Percentage Interest until we and Prime realize through distributions a 10% IRR (as defined in the Amended JV Partnership Agreement) on such Legacy Acquisitions or a New Acquisition Tranche, as applicable; (2) 20% of any remaining distributable funds until we and Prime realize through distributions a cumulative 20% IRR on such Legacy Acquisitions or a New Acquisition Tranche, as applicable; and (3) 30% of any remaining distributable funds from such Legacy Acquisitions or a New Acquisition Tranche, as applicable.  Notwithstanding the foregoing, the Amended JV Partnership Agreement provides that (so long as sufficient cash flow exists) we realize a minimum aggregate distributions of a cumulative 10% IRR, and if such minimum aggregate distribution level is not realized pursuant to the distribution order and priority described in the prior sentence, Prime’s cash flow is reduced to permit us to realize such minimum aggregate distribution level. All other funds distributed by the joint venture with respect to Non-Rental Pool Assets are distributed to us.

Property Management and Acquisition Sourcing Companies

Our Manager provides most of our property management services internally. However, in certain markets where we do not own a large number of homes, our Manager utilizes strategic relationships with local property management companies that are recognized leaders in their markets to provide property management, renovation and leasing services for our homes. In addition, our Manager utilizes strategic relationships with regional and local partners to exclusively assist us in identifying individual home acquisition opportunities within our target parameters in our target markets.

Any relationships with third-party property management companies are based on our contractual arrangements, which provide that we will pay the property managers a percentage of the rental revenue and other fees collected from our residents. We expect that our third-party property management expenses will account for a smaller percentage of our revenue as we expand our portfolio and perform a larger percentage of the property management function internally through our Manager. Acquisition sourcing also will be based on our contractual arrangements, which provide that we will pay a commission for each home acquired for our portfolio.

Investment Management and Corporate Overhead

We incur significant general and administrative costs, including those costs related to being a public company and costs incurred under the Management Agreement. We expect these costs to decline as a percentage of revenue as our portfolio grows. As a result, in addition to management fees, we will incur costs related to reimbursing our Manager for our allocable share of compensation paid to certain of our Manager’s officers. Under the Management Agreement, we pay the fees described in Item 1. Financial Statements (Unaudited), Note 9 – Related-Party Transactions-Reimbursement of Costs included in this Quarterly Report on Form 10-Q.

Income Taxation

We intend to operate and to be taxed as a REIT for federal income tax purposes. Our qualification as a REIT depends on our satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements on a continuing basis. Our ability to satisfy the asset tests depends upon our analysis of the characterization and fair values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis.

If we were to fail to qualify as a REIT in any taxable year, we would be subject to federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and dividends paid to our shareholders would not be deductible by us in computing our taxable income. Any resulting corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our shareholders, which in turn could have an adverse impact on the value of our common shares. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from taxation as a REIT for the four taxable years following the year in which we failed to qualify as a REIT.

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Critical Accounting Policies

The preparation of financial statements in accordance with GAAP requires us to make certain judgments and assumptions, based on information available at the time of our preparation of the financial statements, in determining accounting estimates used in preparation of the statements. Our significant accounting policies are described in Item 8. Financial Statements and Supplementary Data (Unaudited), Note 2 – Basis of Presentation and Significant Accounting Policies in our Annual Report on Form 10-K filed on March 6, 2015.

Accounting estimates are considered critical if the estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made and if different estimates reasonably could have been used in the reporting period or changes in the accounting estimate are reasonably likely to occur from period to period that would have a material impact on our financial condition, results of operations or cash flows.

Growth of Investment Portfolio

Since our inception in May 2012, we have grown our portfolio significantly in a disciplined manner through targeted acquisitions and intend to continue to do so. Our portfolio, net of dispositions, increased through each quarter-end since our inception. During the nine months ended September 30, 2015, we increased our home portfolio by 1,829 homes, net of sales activities. The table below summarizes the growth of our portfolio holdings as of September 30, 2015 and December 31, 2014.

 

 

Recent Developments

Developments During the Third Quarter of 2015

Subsequent Events

Refer to Item 1. Financial Statements (Unaudited), Note 12 - Subsequent Events included in this Quarterly Report on Form 10-Q for disclosure regarding significant transactions that occurred subsequent to September 30, 2015.

Results of Operations

The main components of our net loss of $11.2 and $14.6 million, for the three and nine months ended September 30, 2015, respectively, as compared to our net loss of $6.7 million and $34.1 million, for the three and nine months ended September 30, 2014, respectively, were as follows:

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Revenues

 

 

 

Our revenues come primarily from rents collected under lease agreements for our homes, sales or liquidations of NPLs and the conversion of loans into rental real estate. The most important drivers of our revenues (aside from portfolio growth) are rental and occupancy rates. Our rental and occupancy rates are affected by macroeconomic factors and local and property-level factors, including market conditions, seasonality and resident defaults, and the amount of time that it takes us to renovate and lease homes upon acquisition and the amount of time it takes us to renovate and re-lease vacant homes.

For the three and nine months ended September 30, 2015, we experienced an increase in total revenues of 120% and 118%, respectively, as compared to the same periods in 2014. The increases are primarily due to an increase in rental revenues and net gains realized upon the liquidation of a portion of our NPL portfolio. The increase in rental revenues is primarily attributable to portfolio growth. During the nine months ended September 30, 2015, we increased our home portfolio by 1,829 homes, net of sales activities. We expect to continue to grow our home portfolio in 2015. We recorded gains of $9.3 million and $5.8 million for the three months ended September 30, 2015 and 2014, respectively, upon conversion of $32.2 million and $15.2 million in NPLs into $41.5 million and $21.0 million in real estate assets during the three months ended September 30, 2015 and 2014, respectively. We recorded gains of $23.9 million and $17.7 million for the nine months ended September 30, 2015 and 2014, respectively, upon conversion of $87.6 million and $40.1 million in NPLs into $111.5 million and $57.8 million in real estate assets during the nine months ended September 30, 2015 and 2014, respectively. We also liquidated portions of our NPL portfolio that did not meet our requirements for conversion into SFR that resulted in a net gain of $26.0 million and $40.5 million for the three and nine months ended September 30, 2015, respectively. The increase in net gains over the same periods in 2014 was driven by acquisitions of NPLs during 2014 and a bulk sale of 461 NPLs in September 2015. Other property revenues include tenant charge backs, late charges and early-termination charges.

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Expenses

 

 

 

For the three and nine months ended September 30, 2015, we experienced an increase in total expenses of 53% and 75%, respectively, as compared to the same periods in 2014. Relative to total revenues, total expenses decreased to 106% and 123% for the three and nine months ended September 30, 2015, respectively, from 152% and 153% for the three and nine months ended September 30, 2014, respectively. These improvements in efficiency, as further discussed below, are primarily driven by economies of scale and improvements in business processes.

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Property Operating and Maintenance

Included in property operating and maintenance expenses are bad debt, utilities and landscape maintenance, repairs and maintenance on leased properties, HOA fees and expenses associated with resident turnover in vacancy periods between lease dates. Also included are third-party management fees and expenses allocated to us from our Manager. During the three and nine months ended September 30, 2015, property operating and maintenance expense increased by $2.8 million and $10.5 million, respectively, from the same periods in 2014 resulting from increases related to the growth in the size of our portfolio of leased and unleased homes. Relative to rental and other property revenues, property operating and maintenance expenses decreased to 23% and 23% for the three and nine months ended September 30, 2015, respectively, from 28% and 32% for the three and nine months ended September 30, 2014, respectively. These improvements in efficiency are primarily driven by economies of scale and improvements in business processes.

Real Estate Taxes and Insurance

Real estate taxes and insurance are expensed once a property is rent ready. During the three and nine months ended September 30, 2015, real estate taxes and insurance increased $4.8 million and $14.7 million, respectively, as compared to the same periods in 2014. This increase related to the growth in the size of our portfolio of homes that are rent ready.

Mortgage Loan Servicing Costs

Mortgage loan servicing costs represent loan servicing fees and costs, lien-protection expenditures (e.g., property taxes) and property preservation costs. During the three and nine months ended September 30, 2015, mortgage loan servicing costs increased $2.5 million and $12.0 million, respectively, as compared to the same periods in 2014. This increase related to the growth in the size of our NPL portfolio during 2014. The amount of mortgage loan servicing costs that we incur will generally fluctuate with the size of our NPL portfolio, which is expected to decrease in future periods.

NPL Management Fees and Expenses

NPL management fees and expenses are primarily composed of general and administrative expenses from our Prime joint venture and our management fee paid to the joint venture. During the three and nine months ended September 30, 2015, these expenses decreased by $0.4 million and increased by $1.5 million, respectively, compared to the same periods in 2014. The decrease during the three months ended September 30, 2015, was primarily related to the conversion of NPLs to SFRs and the liquidation of a portion of our NPL portfolio; primarily the sale 461 re-performing loans. The size of our NPL portfolio has decreased to 2,969 NPLs as of September 30, 2015, from 4,975 NPLs as of September 30, 2014. The increase during the nine months ended September 30, 2015, was primarily due to increased pursuit costs and acquisitions of NPLs during 2014.

General and Administrative

General and administrative expenses are primarily composed of allocated expenses from our Manager (see Item 1. Financial Statements (Unaudited), Note 9-Related-Party Transactions included in this Quarterly Report on Form 10-Q), as well as standard professional service costs such as legal and audit fees and preparation of tax filings. When compared to the three and nine months ended September 30, 2014, general and administrative expense decreased by $0.7 million and $2.6 million during the three and nine months ended September 30, 2015, respectively, due to a reduction in allocated expenses from our Manager as well as improvements in efficiency primarily attributable to economies of scale and lower headcount.

Share-Based Compensation

As discussed in Item 1. Financial Statements (Unaudited), Note 8 - Share-Based Compensation included in this Quarterly Report on Form 10-Q, we adopted the Equity Plan, the Manager Equity Plan and the Non-Executive Trustee Share Plan on January 16, 2014. Grants issued under these plans in 2015 and 2014 for the three and nine months ended September 30, 2015, resulted in an increase of $0.2 million and $1.1 million, respectively, for share-based compensation expense as compared to the same periods in 2014. These changes were due to a greater number of shares vesting in the three and nine months ended September 30, 2015 as compared to the corresponding periods in 2014.     

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Investment Management Fees

As discussed in Item 1. Financial Statements (Unaudited), Note 9-Related-Party Transactions included in this Quarterly Report on Form 10-Q, we pay our Manager a base management fee calculated and payable quarterly in arrears in cash in an amount equal to one-fourth of 1.5% of the daily average of our adjusted market capitalization for the preceding quarter. During the three and nine months ended September 30, 2015, investment management fees increased by $0.1 million and $3.1 million, respectively, as compared to the same periods in 2014 primarily due to fees only being incurred for a portion of the first quarter of 2014, after the Separation and the inclusion of our convertible senior notes, which were issued in the second half of 2014, as components of adjusted market capitalization in 2015.

Acquisition Fees and Other Expenses

Our acquisition fees and other expenses for the three and nine months ended September 30, 2015 have increased by approximately $27,000 and $0.2 million, respectively, as compared to the same periods in 2014 as a result of increased acquisition activity during 2015.

Interest Expense, including Amortization

Interest expense increased by $8.3 million and $38.8 million during the three and nine months ended September 30, 2015 as compared to the same periods in 2014, primarily resulting from our aggregate borrowings of $1.9 billion (see Item 1. Financial Statements (Unaudited), Note 7 - Debt included in this Quarterly Report on Form 10-Q for a description of the debt instruments we entered in the year ended December 31, 2014). Except as disclosed in Item 1. Financial Statements (Unaudited), Note 7 – Debt included in this Quarterly Report on Form 10-Q, we did not engage in any new financing activities, aside from net borrowing from existing facilities, during the three and nine months ended September 30, 2015.

Depreciation and Amortization

Depreciation and amortization includes depreciation on real estate assets placed in-service and amortization of deferred leasing costs and lease intangibles. During the three and nine months ended September 30, 2015, depreciation and amortization increased by $10.5 million and $34.8 million, respectively, as compared to 2014, primarily as a result of the increased number of properties being acquired and placed in service.

Separation Costs

Separation costs, which consisted primarily of legal and other professional service costs, were costs incurred in relation to the Separation. During the three months ended March 31, 2014, we recorded $3.5 million of such costs related to the Separation. There were no costs incurred subsequent to the three months ended March 31, 2014, and no additional Separation costs are anticipated.

Transaction-Related Expenses

Transaction-related expenses primarily includes professional fees, consulting services fees and other expenses incurred in connection with the Internalization and the Merger.  These expenses include fees for legal, accounting and investment banking services, due diligence activities, and other services that are customary to be incurred in connection with internalization and merger transactions. During the three months ended September 30, 2015, we recorded $4.3 million of such costs related to the Internalization and the Merger. There were no transaction-related expenses incurred prior to the three months ended September 30, 2015. We expect to incur additional transaction-related expenses in the future.

Finance-Related Expenses and Write-off of Loan Costs

Finance-related expenses decreased by $0.6 million and $4.6 million during the three and nine months ended September 30, 2015 as compared to the same periods in 2014 (see Item 1. Financial Statements (Unaudited), Note 7 - Debt included in this Quarterly Report on Form 10-Q for a description of the debt instruments we entered in the year ended December 31, 2014). Except as disclosed in Item 1. Financial Statements (Unaudited), Note 7 – Debt included in this Quarterly Report on Form 10-Q, we did not engage in any new financing activities, aside from net borrowing from existing facilities, during the three and nine months ended September 30, 2015.

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Impairment of Real Estate

We evaluate our long-lived assets for impairment periodically or whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. During the three and nine months ended September 30, 2015, we recorded a decrease of $0.1 million and $1.5 million, respectively, of impairment expense as compared to the same periods in 2014. The primary reason for the decrease in impairment expense was the increase in fair value related to home price appreciation in our markets. Impairment expense may fluctuate widely in the future as a result of macroeconomic and other factors.

Other Income (Expense)

Other income and expense consists primarily of activities related to our sales of investments in real estate as well as unrealized gains on NPLs, net and loss on derivative financial instruments, net. During the three and nine months ended September 30, 2015, these activities resulted in income, net of gains and losses, which decreased $19.6 million and increased $16.6 million, respectively, compared to the same periods in 2014. This increase is primarily attributable to the growth in the size of our NPL portfolio during 2014 and the bulk sale of 461 NPLs in September 2015. Upon the sale of NPLs that results in the recognition of a realized gain or loss, we reclassify what had previously been recorded in unrealized (loss) gain on NPLs, net to realized gains on NPLs, net. During the three and nine months ended September 30, 2015, $14.2 million and $20.5 million, respectively, were reclassified from unrealized (loss) gain on NPLs, net to realized gains on NPLs, net on our condensed consolidated statements of operations. There were no such reclassifications in the corresponding periods in 2014. The gross realized gains on sales of investments in real estate and divesture homes for the three and nine months ended September 30, 2015 were $5.0 million and $12.5 million, respectively, compared to $1.1 million and $2.5 million for the corresponding periods in 2014. The gross realized losses on sales of investments in real estate and divestiture homes for the three and nine months ended September 30, 2015 were $6.8 million and $13.4 million, respectively, compared to $1.0 million and $2.6 million for the corresponding periods in 2014.

Liquidity and Capital Resources

Liquidity is a measure of our ability to meet potential cash requirements, fund and maintain our assets and operations, make interest payments and make distributions to our shareholders and other general business needs. Our liquidity and capital resources as of September 30, 2015 and December 31, 2014 included cash and cash equivalents of $109.8 million and $175.2 million, respectively. Our liquidity, to a certain extent, is subject to general economic, financial, competitive and other factors that are beyond our control. Our near-term liquidity requirements consist primarily of acquiring and renovating properties, funding our operations and making interest payments and distributions to our shareholders.

The acquisition of properties involves the outlay of capital beyond payment of the purchase price, including payments for property inspections, closing costs, title insurance, transfer taxes, recording fees, broker commissions, property taxes or HOA fees in arrears. In addition, we also regularly make significant capital expenditures to renovate and maintain our properties. Our ultimate success will depend in part on our ability to make prudent, cost-effective decisions measured over the long term with respect to these expenditures.

In addition, we expect to strategically liquidate a portion of our NPL investments. Under our joint venture agreement with Prime with respect to the joint venture that owns all of our NPLs, we designate acquired NPLs as being either (1) Rental Pool Assets, for which our intended strategy is to convert NPLs into homes through the foreclosure or other resolution process and then renovate (as deemed necessary) and lease the homes to qualified residents, or (2) Non-Rental Pool Assets, for which the intended strategy is to (a) convert the NPLs into homes through the foreclosure or other resolution process and then sell the homes or (b) modify and hold or resell at higher prices the NPLs, which we are expecting to liquidate a majority of the Non-Rental Pool Assets, which aggregated approximately $471.7 million as of September 30, 2015, over the next 12-18 months.

To qualify as a REIT, we will be required to distribute annually at least 90% of our REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and to pay tax at regular corporate rates to the extent that we annually distribute less than 100% of our net taxable income. On January 15, 2015, we paid a quarterly dividend of $0.14 per common share, or $5.4 million to shareholders of record at the close of business on December 31, 2014. On April 15, 2015, we paid a quarterly dividend of $0.14 per common share, or $5.4 million to shareholders of record at the close of business on March 31, 2015. On July 15, 2015, we paid a quarterly dividend of $0.14 per common share, or $5.4 million to shareholders of record at the close of business on June 30, 2015. On October 15, 2015, we paid a quarterly dividend of $0.19 per common share, or $7.3 million to shareholders of record at the close of business on September 30, 2015. On November 2, 2015, our board of trustees declared a quarterly dividend of $0.19 per common share. Payment of the dividend is expected to be made on December 22, 2015 to shareholders of record at the close of business on December 10, 2015. Any future distributions payable are indeterminable at this time.

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Capital Resources

As of September 30, 2015, we have completed the following debt transactions (for further disclosure, see Item 1. Financial Statements (Unaudited), Note 7 – Debt included in this Quarterly Report on Form 10-Q).

Senior SFR Facility

On June 13, 2014, SFR Borrower, a wholly-owned indirect subsidiary of ours that was established as a SPE to own, acquire and finance, directly or indirectly, substantially all of our SFRs, entered into an Amended and Restated Master Loan and Security Agreement evidencing our $1.0 billion SFR Facility with a syndicate of financial institutions led by Citibank, N.A. as administrative agent. The SFR Facility replaced our existing $500.0 million credit facility with Citibank, N.A., as sole lender. The SFR Facility was subsequently amended on July 31, 2014 and December 19, 2014 to clarify certain definitions in the agreement. The outstanding balance on this facility as of September 30, 2015 was approximately $697.4 million.

The SFR Facility is set to mature on February 3, 2017, subject to a one-year extension option which would defer the maturity date to February 5, 2018. The SFR Facility includes an accordion feature that may allow the SFR Borrower to increase availability thereunder by $250.0 million, subject to meeting specified requirements and obtaining additional commitments. The SFR Facility has a variable interest rate of LIBOR plus a spread which will equal 2.95% during the first three years and then 3.95% during any extended term, subject to a default rate of an additional 5% on amounts not paid when due. The SFR Borrower is required to pay a commitment fee on the unused commitments at a per annum rate that varies from zero to 0.25% depending on the principal amounts outstanding.

Master Repurchase Agreement

On September 1, 2015, we (in our capacity as guarantor), PrimeStar Fund I (a limited partnership in which we own, indirectly, at least 98.75% of the general partnership and limited partnership interests) and Wilmington Savings Fund Society, FSB, not in its individual capacity but solely as trustee of PrimeStar-H (a trust in which we own, indirectly, at least 98.75% of the beneficial trust interests), amended our master repurchase agreement with Deutsche Bank AG. The repurchase agreement, which provided maximum borrowings of up to $500 million, had a maturity date of September 11, 2015, and interest which accrued on advances under the repurchase agreement at a per annum rate based on 30-day LIBOR (or the rate payable by a commercial paper conduit administered or managed by Deutsche Bank AG, to the extent Deutsche Bank AG utilizes such a commercial paper conduit to finance its advances under the repurchase agreement) plus 3%, has been amended to change the maximum borrowings, extend the maturity date to March 1, 2017 and decrease the Spread to 2.375%. The maximum borrowing means, as of September 1, 2015, approximately $386.1 million; provided, however, that thereafter the maximum borrowings shall be reduced to an amount equal to the aggregate outstanding borrowings on any given date and, thereafter, shall be reduced commensurately with each reduction in the aggregate outstanding borrowings.  

Advances under the repurchase agreement accrue interest at a per annum rate based on 30-day LIBOR (or the rate payable by a commercial paper conduit administered or managed by Deutsche Bank AG, to the extent Deutsche Bank AG utilizes such a commercial paper conduit to finance its advances under the repurchase agreement) plus 2.375%. During the existence of an event of default under the repurchase agreement, interest accrues at the post-default rate, which is based on the applicable pricing rate in effect on such date plus an additional 3%. The initial maturity date of the repurchase agreement is March 1, 2017, subject to a six-month extension option, which may be exercised by PrimeStar Fund I upon the satisfaction of certain conditions set forth in the repurchase agreement.  Borrowings are available under the repurchase agreement until March 1, 2017.  Advances under the purchase agreement were used to acquire NPLs during the year ended December 31, 2014. During 2015, we have sold certain of the NPLs and used a portion of those proceeds for payments against the repurchase agreement. The table below represents the weighted-average quarterly balance, maximum month-end balance and the quarter-end balance for each of the quarters in 2014 and 2015 (amounts in millions):

 

 

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Convertible Senior Notes

On July 7, 2014, we issued $230.0 million in aggregate principal amount of the 2019 Convertible Notes. The sale of the 2019 Convertible Notes generated gross proceeds of $230.0 million and net proceeds of approximately $223.9 million, after deducting the initial purchasers’ discounts and estimated offering expenses paid by us.  Interest on the 2019 Convertible Notes is payable semiannually in arrears on January 1 and July 1 of each year, beginning on January 1, 2015. The 2019 Convertible Notes will mature on July 1, 2019.

On October 14, 2014, we issued $172.5 million in aggregate principal amount of the 2017 Convertible Notes. The sale of the 2017 Convertible Notes generated gross proceeds of $172.5 million and net proceeds of approximately $167.8 million, after deducting the initial purchasers’ discounts and estimated offering expenses paid by us.  Interest on the 2017 Convertible Notes will be payable semiannually in arrears on April 15 and October 15 of each year, beginning on April 15, 2015. The 2017 Convertible Notes will mature on October 15, 2017.

Asset-Backed Securitization Transaction

On December 19, 2014, we completed our first securitization transaction of $504.5 million, which involved the issuance and sale in a private offering of single-family rental Certificates issued by the Trust established by us. The Certificates represent beneficial ownership interests in a loan secured by a portfolio of 4,095 SFRs operated as rental properties contributed from our portfolio of SFRs to a newly-formed SPE indirectly owned by us.  Subsequent to December 19, 2014, we repaid $2.0 million in principal and reduced the portfolio to 4,081 single-family homes and the total proceeds of the securitization to $502.5 million (excluding the Class G Certificate described below).  Net proceeds of $477.7 million from the offering to third parties were distributed to our operating partnership, and used, primarily, to repay a portion of the senior SFR Facility of our subsidiary, SFR Borrower, for acquisitions, and for general corporate purposes. A principal-only bearing subordinate Certificate, Class G, in the amount of $26.6 million, was retained by us.

Each class of Certificate (other than Class G and Class R) offered to investors, accrues interest at a rate based on one-month LIBOR plus a pass-through rate ranging from 1.30-4.55%. The weighted-average of the fixed-rate spreads of the Offered Certificates is approximately 2.37%. Taking into account the discount at which certain of the certificates were sold, and assuming the successful exercise of the three one-year extension options of the Loan Agreement and amortization of the discount over the resulting fully extended period, the effective weighted-average of the fixed-rate spreads of the Offered Certificates is 2.46%.

On December 19, 2014, the Borrower entered into the Loan Agreement, with JPMorgan Chase Bank, National Association, as Lender. Pursuant to the Loan Agreement, the Borrower borrowed $531.0 million from the Lender. The Loan is a two-year, floating rate loan, composed of six floating rate components, each of which is computed monthly based on one-month LIBOR plus a fixed component spread, and one fixed rate component. Interest on the Loan Agreement is paid monthly. As part of certain lender requirements in connection with the securitization transaction described above, the Borrower entered into an interest rate cap agreement for the initial two-year term of the Loan, with a LIBOR-based strike rate equal to 3.615%. The outstanding balance on this transaction, net of discounts, as of September 30, 2015 was approximately $527.2 million.

Interest Rate Caps

In connection with the effectiveness of the SFR Facility, we purchased interest rate caps to protect against increases in monthly LIBOR above 3.0%. Continuation of that cap for an additional year (or purchase of a new rate cap) is a condition to any extension of maturity.

As of September 30, 2015, we had five interest rate caps used to mitigate our exposure to potential future increases in USD-LIBOR rates in connection with the SFR Facility. Interest rate caps involve the receipt of variable-rate amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.  These caps have maturities within the next two years and a total notional amount of $600.0 million.

As of September 30, 2015, we had one interest rate cap used to mitigate our exposure to potential future increases in USD-LIBOR rates in connection with the asset-backed securitization. This cap matures in January 2017 and has a total notional amount of $505.0 million, of which 90 percent or $454.5 million of the cap notional, was designated in a cash flow hedging relationship as of September 30, 2015.

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Distributions to Shareholders

We seek to generate income for distribution to our shareholders, typically by earning a spread between the yield on our stabilized portfolio of single-family rentals assets and the cost of borrowings. Our REIT taxable income, which serves as the basis for distributions to our shareholders, is generated primarily from this spread. The negative net cash flows from operating activities reported in our consolidated statements of cash flows primarily relate to development period expenses.  However, cash flows related to our stabilized portfolio of single-family rental homes are positive and sufficient to support distributions to our shareholders.

Cash Flows

The following table summarizes our cash flows for the nine months ended September 30, 2015 and 2014:

 

 

Our cash flows from operating activities primarily depend upon the occupancy level of our homes, the rental rates achieved on our leases, the collectability of rent from our residents and the level of our operating expenses and other general and administrative costs. Before any home we own begins generating revenue, we must take possession of, renovate, market and lease the home. In the meantime, we incur acquisition and investment pursuit costs, as well as both operating and overhead expenses, without corresponding revenue, which contributes to the net use of cash in operating activities. Our net cash flows used in operations of $63.5 million and $58.1 million for the nine months ended September 30, 2015 and 2014, respectively, are reflective of such activities.

Our net cash used in investing activities is generally used to fund acquisitions and capital expenditures. Net cash used in investing activities was $110.1 million for the nine months ended September 30, 2015 due primarily to the $313.7 million spent on the acquisition of homes, $93.1 million spent on the renovation of newly acquired homes and $10.1 spent on other capitalized improvements to our real estate; offset in part by proceeds from the sale of divestiture homes of $117.3 million, proceeds from the sale of NPLs of $112.7 million, proceeds from the sale of real estate of $29.6 million, and liquidation, principal repayments and other proceeds on loans of $47.1 million. Net cash used in investing activities was $1.4 billion for the nine months ended September 30, 2014 due primarily to the $808.4 million and $162.2 million spent on the acquisition and renovation of newly acquired homes, respectively, and the $486.5 million spent on acquiring new NPLs, offset in part by liquidation and other proceeds from loans of $27.4 million.

Our net cash related to financing activities is generally affected by any borrowings, capital activities net of any dividends and distributions paid to our common shareholders and non-controlling interests. Our net cash provided by financing activities was $108.2 million for the nine months ended September 30, 2015 substantially all of which resulted from our net borrowings on our debt facilities, which totaled $133.1 million offset in part by the payment of dividends and repurchases of common shares which totaled $16.3 million and $8.3 million, respectively. Net borrowings on our debt facilities consisted of borrowings of $258.8 million on our senior SFR facility and were offset in part by payments against our senior SFR Facility and master repurchase agreement totaling $2.6 million and $123.0 million, respectively. Cash flows provided by financing activities totaled $1.5 billion during the nine months ended September 30, 2014, primarily resulting from our net borrowings on our debt facilities, which totaled $1.2 billion, proceeds from the issuance of convertible senior notes of $230.0 million and equity contributions, which totaled $128.3 million. Net borrowings on our debt facilities consisted of borrowings of $1.2 billion and $466.5 million on our senior SFR Facility and master repurchase agreement, respectively, and were offset in part by payments against our senior SFR Facility and master repurchase agreement totaling $416.9 million and $18.2 million, respectively.

Recent Accounting Pronouncements

See Item 1. Financial Statements (Unaudited), Note 2 – Basis of Presentation and Significant Accounting Policies included in this Quarterly Report on Form 10-Q for disclosure of recent accounting pronouncements that may have an impact on our condensed consolidated financial statements, their presentation or disclosures.

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Off-Balance Sheet Arrangements

We have relationships with entities and/or financial partnerships, such as entities often referred to as SPEs or variable interest entities (“VIEs”), in which we are not the primary beneficiary and therefore none of these such relationships or financial partnerships are consolidated in our operating results. We are not obligated to provide, nor have we provided, any financial support for any SPEs or VIEs. As such, the risk associated with our involvement is limited to the carrying value of our investment in the entity. Refer also to Item 1. Financial Statements (Unaudited), Note 7 - Debt included in this Quarterly Report on Form 10-Q for further discussion and for discussion of guarantees and/or obligations arising from our financing activities.

Aggregate Contractual Obligations

The following table summarizes the effect on our liquidity and cash flows from certain contractual obligations, including estimated interest, as of September 30, 2015:

 

 

The table above does not include amounts due under the Management Agreement or the agreement we have with Prime as it does not have fixed and determinable payments. In addition, the table above does not give effect to the subsequent events described in Item 1. Financial Statements (Unaudited), Note 12-Subsequent Events included in this Quarterly Report on Form 10-Q or to any potential extension of term obligations.

Non-GAAP Measures

Funds from Operations and Core Funds from Operations

Funds from operations (“NAREIT FFO”) is used by industry analysts and investors as a supplemental performance measure of an equity REIT. NAREIT FFO is defined by the National Association of Real Estate Investment Trusts (“NAREIT”) as net income or loss (computed in accordance with GAAP) excluding gains or losses from sales of previously depreciated real estate assets, plus depreciation and amortization of real estate assets and adjustments for unconsolidated partnerships and joint ventures.  

We believe that NAREIT FFO is a meaningful supplemental measure of the operating performance of our single-family rental business because historical cost accounting for real estate assets in accordance with GAAP assumes that the value of real estate assets diminishes predictably over time, as reflected through depreciation. Because real estate values have historically risen or fallen with market conditions, management considers NAREIT FFO an appropriate supplemental performance measure because it excludes historical cost depreciation, as well as gains or losses related to sales of previously depreciated homes, from GAAP net income. By excluding depreciation and gains or losses on sales of real estate, management uses NAREIT FFO to measure returns on its investments in real estate assets. However, because NAREIT FFO excludes depreciation and amortization and captures neither the changes in the value of the homes that result from use or market conditions nor the level of capital expenditures to maintain the operating performance of the homes, all of which have real economic effect and could materially affect our results from operations, the utility of NAREIT FFO as a measure of our performance is limited.

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We believe that “Core FFO” is a meaningful supplemental measure of our operating performance for the same reasons as NAREIT FFO and adjusting for non-routine items that when excluded allows for more comparable periods. Our Core FFO begins with NAREIT FFO as defined by the NAREIT White Paper and is adjusted for share-based compensation, non-recurring costs associated with the Separation, acquisition fees and other expenses, write-off of loan costs, loss on derivative financial instruments, amortization of derivative financial instruments cost, severance expense, non-cash interest expense related to amortization on convertible senior notes, and other non-comparable items, as applicable.

Management also believes that NAREIT FFO and Core FFO, combined with the required GAAP presentations, is useful to investors in providing more meaningful comparisons of the operating performance of a company’s real estate between periods or as compared to other companies. NAREIT FFO and Core FFO do not represent net income or cash flows from operations as defined by GAAP and is not intended to indicate whether cash flows will be sufficient to fund cash needs. It should not be considered an alternative to net income as an indicator of the REIT’s operating performance or to cash flows as a measure of liquidity. Our NAREIT FFO and Core FFO may not be comparable to the NAREIT FFO of other REITs due to the fact that not all REITs use the NAREIT or similar Core FFO definition.

The following table sets forth a reconciliation of our net loss as determined in accordance with GAAP and its calculation of NAREIT FFO and Core FFO for the three and nine months ended September 30, 2015 and the corresponding periods of 2014:

 

 

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. The primary market risk that we are exposed to is interest rate risk.

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We are exposed to interest rate risk from (1) our acquisition and ownership of NPLs and (2) debt financing activities. Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in interest rates may affect the fair value of our NPLs and homes underlying such loans as well as our financing interest rate expense.

We currently do not intend to hedge the risk associated with our NPLs and homes underlying such loans. However, we have and may undertake risk mitigation activities with respect to our debt financing interest rate obligations. We expect that our debt financing may at times be based on a floating rate of interest calculated on a fixed spread over the relevant index, as determined by the particular financing arrangement. A significantly rising interest rate environment could have an adverse effect on the cost of our financing. To mitigate this risk, we use derivative financial instruments such as interest rate swaps and interest rate options in an effort to reduce the variability of earnings caused by changes in the interest rates we pay on our debt.

These derivative transactions are entered into solely for risk management purposes, not for investment purposes. When undertaken, these derivative instruments likely will expose us to certain risks such as price and interest rate fluctuations, timing risk, volatility risk, credit risk, counterparty risk and changes in the liquidity of markets. Therefore, although we expect to transact in these derivative instruments purely for risk management, they may not adequately protect us from fluctuations in our financing interest rate obligations.

We currently borrow funds at variable rates using secured financings. At September 30, 2015, we had $1.6 billion of variable rate debt outstanding, of which $1.1 billion was protected by interest rate caps. The estimated aggregate fair market value of this debt was $1.6 billion. If the weighted-average interest rate on this variable rate debt had been 100 basis points higher or lower, the annual interest expense would increase or decrease by $15.6 million, respectively.

 

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2015.

Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting as such term is defined in Rules 13a- 15(f) and 15d-15(f) under the Exchange Act during the three months ended September 30, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II

OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we are party to claims and routine litigation arising in the ordinary course of our business. We do not believe that the results of any such claims or litigation individually, or in the aggregate, will have a material adverse effect on our business, financial position or results of operations. See Item 1. Financial Statements (Unaudited), Note 11 – Commitments and Contingencies included in this Quarterly Report on Form 10-Q.

Item 1A. Risk Factors

Except as otherwise noted below, there have been no material changes to the risk factors disclosed under the heading Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2014 filed on March 6, 2015.

Risks Relating to the Internalization and the Merger

The ownership percentage of our common shareholders will be diluted by the Internalization and the Merger.

The Internalization and the Merger will dilute the ownership percentage of our common shareholders. Upon the closing of the Internalization and the Merger, our existing shareholders will own approximately 35.2% of the Combined Company, Starwood Capital Group (as the former owner of our Manager) will own approximately 5.8% of the Combined Company and former CAH investors will own approximately 59.0% of the Combined Company, in each case, on a fully diluted basis (based on shares outstanding as of September 30, 2015 and assuming (1) the issuance and redemption for our common shares of the 6,400,000 OP Units of our operating partnership to be received by Starwood Capital Group in the Internalization (the “Internalization Consideration”) and (2) the issuance of the Merger Consideration.  Consequently, our shareholders, as a general matter, may have less influence over the management and policies of the Combined Company after the Internalization and Merger than they currently exercise over our management and policies.

The Internalization and the Merger may not be accretive to our common shareholders.

Because OP Units and our common shares will be issued in the Internalization and the Merger, respectively, it is possible that, although we currently expect the Internalization and the Merger to be accretive to earnings per share and Core FFO per share, the Internalization and the Merger may be dilutive to our earnings per share and Core FFO per share, if, among other thing, we incur higher than expected expenses in connection with the Internalization and the Merger or fail to realize the cost savings and other benefits of the Internalization and the Merger in a timely manner or at all. The failure of the Internalization and the Merger to be accretive to our common shareholders could have a material adverse effect on our business, financial condition and results of operations.

The closing of the Internalization and the Merger is subject to many conditions and if these conditions are not satisfied or waived, the Internalization and the Merger will not be completed. Failure to complete the Internalization and the Merger could materially adversely affect us.

The closing of the Internalization and the Merger is subject to a number of conditions, including the approval by our shareholders of the proposal to approve the Internalization (the “Internalization Proposal”) and the proposal to approve the issuance of our common shares to be issued in the Merger (the “Merger Share Issuance Proposal”), which make the closing and the timing of the closing of the Internalization and the Merger uncertain. The Merger Agreement may be terminated if the Internalization and the Merger are not completed by the June 30, 2016 (the “Outside Date”), so long as such party’s breach of the Merger Agreement has not been the cause of, or resulted in, the failure of the Internalization and the Merger to be completed by the Outside Date. The Contribution Agreement, may be terminated if the Internalization has not been completed by the Outside Date.

There can be no assurance that the conditions to the closing of the Internalization and the Merger will be satisfied or waived or that the Internalization and the Merger will be completed. Failure to complete the Internalization and the Merger may adversely affect our results of operations and business prospects for the following reasons, among others:

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There may be unexpected delays in the closing of the Internalization and the Merger, which could impact our ability to timely achieve the benefits associated with the Internalization and the Merger.

Certain events may delay the closing of the Internalization and the Merger, such as our failure to timely receive shareholder approval or failure to satisfy the other closing conditions to which the Internalization and the Merger are subject.  We cannot assure you that the conditions to the closing of the Internalization and the Merger will be satisfied or waived, if permitted, or that any adverse effect, event, development or change will not occur, or provide any assurances as to whether or when the Internalization and the Merger will be completed.  The Merger Agreement provides that either we or CAH may terminate the Merger Agreement if the Merger has not occurred by the Outside Date, subject to extension as described in the Merger Agreement. Similarly, the Contribution Agreement may be terminated if the Internalization has not been completed by the Outside Date.  Any delay in the closing of the Internalization and the Merger could materially reduce or, if the Merger Agreement and the Contribution Agreement are terminated, eliminate the benefits expected to be obtained by the Combined Company in the Internalization and the Merger.

The number of OP Units and common shares constituting the Internalization Consideration and the Merger Consideration, respectively, is fixed and will not be adjusted in the event of any change in either our or CAH’s share price.

Upon the closing of the Internalization and the Merger, (1) Starwood Capital Group will contribute all equity interests in our Manager to the Operating Partnership in exchange for the issuance of 6,400,000 OP Units to Starwood Capital Group and (2) all of the shares of CAH common stock will be converted into the right to receive an aggregate of 64,869,583 common shares, with cash paid in lieu of fractional shares. The number of OP Units and common shares constituting the Internalization Consideration and the Merger Consideration was fixed in the Contribution Agreement and the Merger Agreement, respectively, and will not be adjusted for changes in the market price of either common shares or CAH common stock. Changes in the price of common shares prior to the Internalization and the Merger will affect the market value of the Internalization Consideration and the Merger Consideration that Starwood Capital Group and CAH stockholders, respectively, will receive on the date of the closing of the Internalization and the Merger. Share price changes may result from a variety of factors (many of which are beyond either company’s control), including the following factors:

The price of the OP Units and our common shares upon the closing of the Internalization and the Merger may vary from its respective price on the date the Contribution Agreement and Merger Agreement were executed, on the date of the proxy statement and on the date of the special meeting of shareholders relating to the Internalization and the Merger (the “Special Meeting”). As a result, the market value of the Internalization Consideration and Merger Consideration will also vary.

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Because the Internalization and the Merger will be completed after the date of the Special Meeting, at the time of the Special Meeting, you will not know the exact market value of the OP Units and common shares that Starwood Capital Group and CAH stockholders, respectively, will receive upon the closing of the Internalization and the Merger. As a result, if the market price of common shares increases between the date the Contribution and the Merger Agreement were signed or the date of the Special Meeting and the date of the closing of the Internalization and the Merger, Starwood Capital Group and CAH stockholders will receive OP Units and our common shares, respectively, that have a market value upon the closing of the Internalization and the Merger that is greater than the market value of such shares as of when the Contribution Agreement and the Merger Agreement were signed or the date of the Special Meeting, respectively.

Certain of our trustees and officers have interests in the Internalization and the Merger that are different from, or in addition to, those of our shareholders more generally.

Our executive officers and trustees may have interests in the Internalization that are different from, or in addition to, those of our shareholders more generally.  These interests may present such executive officers and trustees with actual or potential conflicts of interest. Our board of trustees was aware of these interests during its deliberations on the merits of the Internalization and in deciding to recommend that our shareholders vote for the approval of the Internalization Proposal.

The Merger Agreement contains provisions that could discourage a potential competing acquirer of our company from making a favorable proposal and, in specified circumstances, could require us to pay a termination payment of $35 million to the CAH Operating Partnership.

The Merger Agreement contains provisions that restrict our ability to approve or effect other merger transactions. We will be required to pay to CAH Operating Partnership, L.P. or its designee a termination payment of  $35 million in certain circumstances, including if CAH terminates the Merger Agreement because our board of trustees changes its recommendation with respect to the Merger prior to the approval of the Merger Share Issuance Proposal by our shareholders.

The Merger Agreement contains provisions that prevent us from participating in any discussions or otherwise facilitating any inquiry, proposal or offer that may reasonably be expected to lead to a competing acquisition proposal or entering into a competing acquisition agreement, unless certain criteria are satisfied.  

Such provisions could discourage a potential party that might have an interest in us from pursuing a transaction while the Internalization and the Merger are pending, even if such transactions would be in the best interests of our shareholders.

If the Merger Agreement is terminated and after the termination either we or CAH determine to seek another business combination, we may not be able to negotiate a transaction with another party on terms comparable to, or better than, the terms of the transactions contemplated by the Merger Agreement.

The pendency of the Internalization and the Merger could adversely affect our business and operations and those of CAH.

In connection with the pending Internalization and the Merger, some tenants, operators, borrowers, managers or vendors may delay or defer decisions related to their business dealings with us and/or CAH, which could negatively impact our revenues, earnings, cash flows or expenses or those of CAH, as the case may be, regardless of whether the Internalization and the Merger are completed. Similarly, employees of CAH may experience uncertainty about their future roles with the Combined Company following the Internalization and the Merger, which may materially adversely affect the ability of CAH to attract and retain key personnel during the pendency of and after the closings of the Internalization and the Merger. In addition, due to operating covenants in the Contribution Agreement and the Merger Agreement, both we and CAH may be unable, during the pendency of the Internalization and the Merger, to pursue certain strategic transactions, undertake certain significant capital projects, undertake certain significant financing transactions and otherwise pursue other actions that are not in the ordinary course of business without the consent of the other, even if such actions would prove beneficial to us or CAH, respectively.

The unaudited pro forma combined financial information in the proxy statement is presented for illustrative purposes only and the operating results and financial condition of the Combined Company following the closing of the transactions contemplated by the Contribution Agreement and the Merger Agreement may differ and such differences may be material.

The unaudited pro forma combined financial information in the proxy statement is presented for illustrative purposes only and is not necessarily indicative of what the Combined Company’s actual financial position or results of operations would have been had the transactions contemplated by the Contribution Agreement and the Merger Agreement been completed on the dates indicated. Further, the Combined Company’s actual results and financial position following the closing of the Internalization and the Merger may differ materially and adversely from the unaudited pro forma combined financial data that is included in the proxy statement. The unaudited pro forma combined financial information does not reflect future events that may occur after the closing of the

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Internalization and the Merger, including the costs related to the planned integration of our Manager and the two companies and any future nonrecurring charges resulting from the Internalization and the Merger, and does not consider potential impacts of current market conditions on revenues or expense efficiencies. The unaudited pro forma combined financial information presented in the proxy statement is based in part on certain assumptions regarding the Internalization and the Merger that we believe are reasonable under the circumstances. We cannot assure you that the assumptions will prove to be accurate over time.  

Risks Relating to the Combined Company Following the Internalization and the Merger

Upon the closing of the Merger, each of Colony Capital and Thomas J. Barrack, Jr. will control a significant number of votes in any matter, including the election of trustees, presented to common shareholders of the Combined Company for approval.

Our common shares issued in connection with the Merger will result in Colony Capital and Thomas J. Barrack Jr., each controlling, upon the closing of the Merger, a significant number of votes in any matter, including the election of trustees, submitted to a vote of common shareholders of the Combined Company. Thomas J. Barrack, Jr. is the executive chairman of Colony Capital, Inc. (“Colony Capital”) and he will be appointed as a Co-Chairman of the board of trustees of the Combined Company upon the closing of the Merger. Upon the closing of the Merger, Colony Capital, an independent public company, and Thomas J. Barrack, Jr. will together control 52,780,722 common shares of the Combined Company, representing approximately 48.0% of  the outstanding common shares on a fully-diluted basis (based on shares outstanding as of September 30, 2015 and assuming (1) the issuance and redemption for  our common shares of the 6,400,000 OP Units to be received by Starwood Capital Group in the Internalization and (2) the issuance of 64,869,583 of our common shares in the aggregate in the Merger. Each of Colony Capital and Thomas J. Barrack, Jr. have interests that differ from our other shareholders, and, therefore, may exercise their respective votes on matters that may not be consistent with the interests of those other shareholders with respect to any matters.

The Combined Company may compete with Starwood Capital Group in ancillary lines of business and, after the end of the restricted period, Starwood Capital Group may engage in competitive businesses or solicit the Combined Company’s employees for hire, which could have an adverse effect on the Combined Company’s business.

Starwood Capital Group has agreed that, commencing on the closing date of the Internalization and ending on the first anniversary thereof, it will not compete with the Combined Company or solicit its employees, subject to certain exceptions as forth in the Contribution Agreement.  After the expiration of this restricted period, however, Starwood Capital Group will be free to acquire or manage SFR portfolios, which could result in it competing directly with the Combined Company for acquisition opportunities, financing opportunities, tenants and in other aspects of the Combined Company’s business, and they may solicit and hire key employees, each of which could have an adverse effect on the Combined Company’s business.

Additionally, the restrictions do not limit Starwood Capital Group from engaging in lines of business ancillary to SFR homes or other lines of business that the Combined Company might consider in the future. As a result, if the Combined Company were to expand its business strategy, it might compete with Starwood Capital Group in such line of business.

The Combined Company expects to incur substantial expenses related to the Internalization and the Merger.

The Combined Company will incur substantial expenses in connection with completing the Internalization and the Merger and integrating our Manager and CAH’s business, operations, networks, systems, technologies, policies and procedures with those of the Combined Company’s. While the Combined Company expects to incur a certain level of transaction and integration expenses, factors beyond the Combined Company’s control could affect the total amount or the timing of its integration expenses. Many of the expenses that will be incurred, by their nature, are difficult to estimate accurately at the present time. As a result, the transaction and integration expenses associated with the Internalization and the Merger could, particularly in the near term, exceed the savings that the Combined Company expects to achieve from the elimination of the management and duplicative expenses and the realization of economies of scale and cost savings related to the integration of our Manager and our business and that of CAH following the closing of the Internalization and the Merger.  If the expenses the Combined Company incurs as a result of the Internalization and the Merger are higher than anticipated, the Combined Company’s net income per share and Core FFO per share would be adversely affected.

The future results of the Combined Company will suffer if the Combined Company does not effectively manage its expanded portfolio and operations.

The Internalization and the Merger are expected to result in certain benefits to the Combined Company. There can be no assurance, however, regarding when or the extent to which the Combined Company will be able to realize these benefits, which may be difficult, unpredictable and subject to delays. The Internalization and Merger involves the combination of three companies, which currently operate as independent companies. The Combined Company will be required to devote significant management attention and

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resources to integrating our business practices and operations and those of our Manager and CAH. It is possible that the integration process could result in the distraction of the Combined Company’s management, the disruption of the Combined Company’s ongoing business or inconsistencies in the Combined Company’s operations, services, standards, controls, procedures and policies, any of which could adversely affect the ability of the Combined Company to maintain relationships with operators, vendors and employees or to fully achieve the anticipated benefits of the Internalization and the Merger. There may also be potential unknown or unforeseen liabilities, increased expenses, delays or regulatory conditions associated with integrating our Manager and integrating CAH’s portfolio into ours.

Following the Internalization and the Merger, the Combined Company will have an expanded portfolio and operations and likely will continue to expand its operations through additional acquisitions and other strategic transactions, some of which may involve complex challenges. The future success of the Combined Company will depend, in part, upon its ability to manage its expansion opportunities, integrate new operations into its existing business in an efficient and timely manner, successfully monitor its operations, costs, regulatory compliance and service quality, and maintain other necessary internal controls. There can be no assurance that the Combined Company’s expansion or acquisition opportunities will be successful, or that it will realize its expected operating efficiencies, cost savings, revenue enhancements, synergies or other benefits.

The Merger will result in changes to our board of trustees and management that may affect our strategy and operations.

If the Merger is completed, the composition of our board of trustees and management team will change. Following the closing of Internalization and the Merger, our board of trustees will increase from seven to twelve trustees. At the closing of the Merger, the trustees will be Barry Sternlicht, Thomas Barrack, four of our designees and six designees of CAH. Further, the management team will consist of Fred Tuomi as Chief Executive Officer, Arik Prawer as Chief Financial Officer and Douglas R. Brien as President and Chief Operating Officer. This new composition of our board of trustees and management team may affect the Combined Company’s business strategy and operating decisions following the closing of the Internalization and the Merger. In addition, there can be no assurances that the new board of trustees and management team will function effectively as a team and that there will not be any adverse effects on the Combined Company’s business as a result.

The Combined Company may be unable to retain key employees.

The success of the Combined Company after the Internalization and the Merger will depend in part upon its ability to retain key Manager and CAH employees. Key employees may depart either before or after the closing of the Internalization and the Merger because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Combined Company following the Internalization and the Merger. Accordingly, no assurance can be given that our Manager, CAH and, following the Internalization and the Merger, the Combined Company will be able to retain key employees to the same extent as in the past.

The Contribution Agreement provides that Starwood Capital Group shall use commercially reasonable efforts to keep available the services of its present officers and employees and of all other persons who provide material services to us and our subsidiaries. If the Combined Company needs to recruit and hire additional personnel, there may be delays in doing so, the compensation to such employees may be higher, and there could be disruptions to the Combined Company’s business.

The Combined Company may be exposed to risks to which we have not historically been exposed.

We currently have no employees of our own. The Combined Company will have employees following the Internalization and the Merger. As their employer, the Combined Company will be subject to those potential liabilities that are commonly faced by employers, such as workers disability and compensation claims, potential labor disputes and other employee-related liabilities and grievances. Further, the Combined Company will bear the costs of the establishment and maintenance of health, retirement and similar benefit plans for its employees.

The Combined Company may not be able to obtain the anticipated revolving credit facility on favorable terms, or at all, which may affect its ability to consummate future acquisitions and implement its business plan.

Concurrently with or shortly after the closing of the Internalization and the Merger, the Combined Company expects to obtain a revolving credit facility. However, there can be no assurance that the Combined Company will enter into definitive documentation with regard to the anticipated revolving credit facility on favorable terms or at all. The Combined Company’s failure to obtain the anticipated revolving credit facility could render it incapable of consummating future SFR acquisitions, which could have an adverse effect on the Combined Company’s business and the implementation of its business plan.

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Risks Relating to an Investment in Common Shares Following the Internalization and the Merger

The market price of our common shares may decline as a result of the Internalization, the Merger, the issuance of OP Units or the issuance of common shares.

The market price of common shares may decline as a result of the Internalization and the Merger for a number of reasons, including if the Combined Company does not achieve the perceived benefits of the Internalization and the Merger as rapidly or to the extent anticipated by financial or industry analysts, or the effect of the Internalization and the Merger on the Combined Company’s financial results is not consistent with the expectations of financial or industry analysts. In addition, if the Internalization and the Merger are completed, the Combined Company’s shareholders will own interests in a company operating an expanded business with a different mix of properties, risks and liabilities. Current shareholders may not wish to continue to invest in the Combined Company if the Internalization and the Merger are completed, or for other reasons may wish to dispose of some or all of their common shares. If, following the closing of the Internalization and the Merger, there is selling pressure on our common shares that exceeds demand at the market price, the price of our common shares could decline.

In addition, we are unable to predict the potential effects of the issuance of OP Units in connection with the Internalization or common shares in connection with the Merger on the trading activity and market price of our common shares.  The OP Units (or shares issued on redemption thereof) issued to Starwood Capital Group and our common shares issued to certain CAH investors will be subject to a nine-month lock-up period, subject to certain exceptions.  We have granted registration rights to Starwood Capital Group and such CAH investors for the resale of common shares issued as a result of any redemption of OP Units issued in connection with the Internalization or common shares issued in connection with the Merger. Following expiration of the lock-up and the filing and effectiveness of a resale registration statement covering the shares, these shares will be freely transferable without restriction.  These registration rights would facilitate the resale of such securities into the public market, and any such resale would increase the number of our common shares available for public trading. Prior to the Internalization and the Merger, the common stock of CAH was not listed on any national securities exchange and the ability of CAH stockholders to liquidate their investments was limited. As a result, there may be significant pent-up demand for the CAH investors to sell their common shares.  Sales of a substantial number of common shares in the public market, or the perception that such sales might occur, could have a material adverse effect on the price of common shares.

We cannot assure you that the Combined Company will be able to continue paying distributions at the rate we currently pay them.

As noted in the proxy statement, the Combined Company expects to continue our current distribution practices following the Internalization and the Merger. However, common shareholders of the Combined Company may not receive distributions following the Internalization and the Merger equivalent to those currently paid by us for various reasons, including the following:

Our existing and future shareholders have no contractual or other legal right to distributions that have not been declared.

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Legal Risks Related to the Internalization and Merger

Counterparties to certain significant agreements with CAH may have consent rights in connection with the Mergers.

CAH is party to certain agreements that give the counterparty certain rights, including consent rights, in connection with “change in control” transactions or otherwise. Under certain of these agreements, the Merger may constitute a “change in control” or otherwise give rise to consent rights and, therefore, the counterparty may assert its rights in connection with the Merger. Any such counterparty may request modifications of its agreements as a condition to granting a waiver or consent under those agreements, and there can be no assurance that such counterparties will not exercise their rights under the agreements, including termination rights where available. In addition, the failure to obtain consent under one agreement may be a default under other agreements and, thereby, trigger rights of the counterparties to such other agreements, including termination rights where available.

We may have failed to uncover all liabilities of CAH through the due diligence process prior to the Internalization and the Merger, exposing the Combined Company to potentially large, unanticipated costs.

Prior to completing the Internalization and the Merger, we performed certain due diligence reviews of the business of CAH. In view of timing and other considerations relevant to successfully achieving the closing of the Internalization and the Merger, our due diligence reviews have necessarily been limited in nature and may not adequately have uncovered all of the contingent or undisclosed liabilities the Combined Company may incur as a consequence of the Merger. Any such liabilities could cause the Combined Company to experience potentially significant losses, which could materially adversely affect the Combined Company’s business, results of operations and financial condition.

Tax Risks Relating to the Merger

The Combined Company may incur adverse tax consequences, if it or CAH has failed or fails to qualify as a REIT for U.S. federal income tax purposes.

Each of us and CAH has operated in a manner that it believes has allowed it to qualify as a REIT for U.S. federal income tax purposes under the Code and intends to continue to do so through the time of the closing of the Internalization and the Merger. The Combined Company intends to operate in a manner that it believes allows it to qualify as a REIT after the Internalization and the Merger. Neither we nor CAH has requested or plans to request a ruling from the Internal Revenue Service (the “IRS”) that it qualifies as a REIT. Qualification as a REIT involves the application of highly technical and complex Code provisions for which there are only limited judicial and administrative interpretations. The complexity of these provisions and of the applicable regulations of the U.S. Department of the Treasury that have been promulgated under the Code is greater in the case of a REIT that holds its assets through a partnership (which, consistent with our past practices and those of CAH, the Combined Company will do after the Internalization and the Merger). The determination of various factual matters and circumstances not entirely within our control or the control of CAH may affect our or its ability to qualify as a REIT. In order to qualify as a REIT, each of us and CAH must satisfy a number of requirements, including requirements regarding the ownership of our or its shares, respectively, and the composition of our or its gross income and assets. Also, a REIT must make distributions to shareholders annually of at least 90% of its net taxable income, excluding any capital gains.

If either we have failed or fail or CAH has failed or fails to qualify as a REIT and the Internalization and the Merger are completed, the Combined Company may inherit significant tax liabilities and could lose its REIT qualification. Even if the Combined Company retains its REIT qualification, if we have not been or lose or CAH has not been or loses its REIT qualification for a taxable year before the Internalization and the Merger or that includes the Internalization and the Merger, the Combined Company will face serious tax consequences that could substantially reduce its cash available for distribution to its shareholders because:

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As a result of these factors, any failure by us or CAH before the Internalization and the Merger to qualify as a REIT could impair the Combined Company’s ability after the Internalization and the Merger to expand its business and raise capital, and could materially adversely affect the value of common shares.

Other Risks

The Combined Company faces other risks.

The foregoing risks are not exhaustive, and you should be aware that, following the Internalization and the Merger, the Combined Company will face various other risks, including those discussed in reports filed by the Combined Company with the SEC.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On May 6, 2015, our board of trustees authorized the 2015 Program. Under the program, we may repurchase up to $150.0 million of our common shares beginning May 6, 2015 and ending May 6, 2016. During the nine months ended September 30, 2015, we repurchased 0.3 million common shares for $8.3 million under the 2015 Program. We did not repurchase any shares during the three months ended September 30, 2015.

On April 24, 2014, our board of trustees authorized the 2014 Program. Under the 2014 Program, we could have repurchased up to $150.0 million of our common shares beginning April 17, 2014 and ending April 17, 2015. During fiscal year 2014, we repurchased 1.3 million common shares for $34.3 million under the 2014 Program.  The 2014 Program expired on April 17, 2015 and we did not repurchase any shares pursuant to the 2014 Program during 2015.

 

 

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits

Exhibits required by Item 601 of Regulation S-K are filed herewith or incorporated herein by reference and are listed in the attached Exhibit Index immediately following the signature page to this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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