UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2011

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number 001-34436

 


 

Starwood Property Trust, Inc.

(Exact name of registrant as specified in its charter)

 

Maryland

 

27-0247747

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification No.)

 

 

 

591 West Putnam Avenue

 

 

Greenwich, Connecticut

 

06830

(Address of Principal Executive Offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code:

(203) 422-8100

 


 

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) 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 definition of “accelerated filer, large accelerated filer, and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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

 

The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of November 3, 2011, was 93,009,460.

 

 

 



 

Special Note Regarding Forward Looking Statements

 

This Quarterly Report on Form 10-Q contains certain forward-looking statements, including without limitation, statements concerning our operations, economic performance and financial condition. 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 developed by combining currently available information with our beliefs and assumptions and are generally identified by the words “believe,” “expect,” “anticipate” and other similar expressions. Forward-looking statements do not guarantee future performance, which may be materially different from that expressed in, or implied by, any such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates.

 

These forward-looking statements are based largely on our current beliefs, assumptions and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or within our control, and which could materially affect actual results, performance or achievements. Factors that may cause actual results to vary from our forward-looking statements include, but are not limited to:

 

· factors described in our Annual Report on Form 10-K for the year ended December 31, 2010, including those set forth under the captions “Risk Factors” and “Business”;

 

· defaults by borrowers in paying debt service on outstanding items;

 

· impairment in the value of real estate property securing our loans;

 

· availability of mortgage origination and acquisition opportunities acceptable to us;

 

· national and local economic and business conditions;

 

· general and local commercial real estate property conditions;

 

· changes in federal government policies;

 

· changes in federal, state and local governmental laws and regulations;

 

· increased competition from entities engaged in mortgage lending;

 

· changes in interest rates; and

 

· the availability of and costs associated with sources of liquidity.

 

In light of these risks and uncertainties, there can be no assurances that the results referred to in the forward-looking statements contained in this Quarterly Report on Form 10-Q will in fact occur. Except to the extent required by applicable law or regulation, we undertake no obligation to, and expressly disclaim any such obligation to, update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, changes to future results over time or otherwise.

 

2



 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Balance Sheets

(Unaudited, amounts in thousands, except share and per share data)

 

 

 

As of

 

 

 

 

 

September
30, 2011

 

As of
December 31, 2010

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

84,835

 

$

226,854

 

Receivable for securities sold

 

 

22,214

 

Loans held for investment

 

1,816,047

 

1,230,783

 

Loans held for sale at fair value

 

121,229

 

144,163

 

Loans held in securitization trust

 

50,311

 

50,297

 

Mortgage backed securities, available-for-sale, at fair value

 

352,100

 

397,680

 

Other investments

 

43,515

 

14,177

 

Accrued interest receivable

 

14,066

 

9,564

 

Derivative assets

 

3,649

 

337

 

Other assets

 

11,517

 

5,336

 

Total Assets

 

$

2,497,269

 

$

2,101,405

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Payable for unsettled securities purchased

 

$

 

$

47,178

 

Accounts payable and accrued expenses

 

5,182

 

5,527

 

Related-party payable

 

7,754

 

5,050

 

Dividends payable

 

41,556

 

29,081

 

Derivative liabilities

 

21,062

 

9,400

 

Secured financing agreements

 

604,335

 

579,659

 

Collateralized debt obligation in securitization trust

 

53,421

 

54,086

 

Deferred offering costs

 

 

27,195

 

Other liabilities

 

7,732

 

7,000

 

Total Liabilities

 

741,042

 

764,176

 

Commitments and contingencies (Note 13)

 

 

 

 

 

Equity:

 

 

 

 

 

Starwood Property Trust, Inc. Stockholders’ Equity:

 

 

 

 

 

Preferred stock, $0.01 per share, 100,000,000 shares authorized, no shares issued and outstanding

 

 

 

Common stock, $0.01 per share, 500,000,000 shares authorized, 93,635,310 issued and 93,293,310 outstanding as of September 30, 2011, and 71,021,342 issued and outstanding as of December 31, 2010

 

926

 

706

 

Additional paid-in capital

 

1,825,019

 

1,337,953

 

Treasury stock (342,000 and - shares as of September 30, 2011 and December 31, 2010 respectively)

 

(5,981

)

 

Accumulated other comprehensive (loss) income

 

(9,465

)

8,203

 

Accumulated deficit

 

(54,726

)

(19,302

)

Total Starwood Property Trust, Inc. Stockholders’ Equity

 

1,755,773

 

1,327,560

 

Noncontrolling interests in consolidated subsidiaries

 

454

 

9,669

 

Total Equity

 

1,756,227

 

1,337,229

 

Total Liabilities and Stockholders’ Equity

 

$

2,497,269

 

$

2,101,405

 

 

See notes to condensed consolidated financial statements

 

3



 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Operations

(Unaudited, amounts in thousands, except share and per share data)

 

 

 

Three-Months
Ended September 30

 

Nine-Months
Ended September 30

 

 

 

2011

 

2010

 

2011

 

2010

 

Net interest margin:

 

 

 

 

 

 

 

 

 

Interest income from mortgage-backed securities

 

$

6,195

 

$

6,348

 

$

20,176

 

$

15,382

 

Interest income from loans

 

51,879

 

21,451

 

125,643

 

47,777

 

Interest expense

 

(7,321

)

(4,977

)

(21,723

)

(9,961

)

Net interest margin

 

50,753

 

22,822

 

124,096

 

53,198

 

Expenses:

 

 

 

 

 

 

 

 

 

Management fees (including $2,922 and $1,749 for the three-months ended September 30, 2011 and 2010, and $10,268 and $4,617 for the nine-months ended September 30, 2011 and 2010 of non-cash stock-based compensation)

 

10,004

 

6,860

 

29,014

 

16,622

 

Acquisition and investment pursuit costs

 

1,201

 

(25

)

1,820

 

253

 

General and administrative (including $69 and $30 for the three-months ended September 30, 2011 and 2010, and $164 and $68 for the nine-months ended September 30, 2011 and 2010 of non-cash stock-based compensation)

 

2,177

 

1,800

 

7,041

 

4,966

 

Total expenses

 

13,382

 

8,635

 

37,875

 

21,841

 

Income before other income (expense) and income taxes

 

37,371

 

14,187

 

86,221

 

31,357

 

Interest income from cash balances

 

63

 

233

 

326

 

1,073

 

Other income

 

975

 

42

 

1,422

 

42

 

Other-than-temporary impairment (“OTTI”)

 

(892

)

 

(2,621

)

 

Gains on sales of investments

 

4,961

 

10,016

 

20,836

 

10,014

 

Net realized foreign currency gains

 

(61

)

17

 

(63

)

17

 

Net gains (losses) on currency hedges

 

8,617

 

(5,350

)

2,382

 

(9,044

)

Net (losses) on interest rate hedges

 

(19,171

)

 

(25,982

)

 

Gains on credit spread hedges

 

2,259

 

 

3,730

 

 

Unrealized losses on loans held for sale at fair value

 

(10,679

)

 

(1,725

)

 

Unrealized foreign currency remeasurement (losses) gains

 

(9,403

)

4,306

 

(4,245

)

7,702

 

Income before income taxes

 

14,040

 

23,451

 

80,281

 

41,161

 

Income tax (benefit) provision

 

(463

)

168

 

741

 

208

 

Net Income

 

14,503

 

23,283

 

79,540

 

40,953

 

Net income attributable to non-controlling interests

 

(25

)

(600

)

(1,191

)

(1,480

)

Net income attributable to Starwood Property Trust, Inc.

 

$

14,478

 

$

22,683

 

$

78,349

 

$

39,473

 

Net income per share of common stock:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.16

 

$

0.47

 

$

0.95

 

$

0.83

 

Diluted

 

$

0.15

 

$

0.47

 

$

0.94

 

$

0.81

 

Weighted average number of shares of common stock outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

93,249,249

 

47,837,616

 

82,234,976

 

47,750,058

 

Diluted

 

94,596,978

 

48,626,550

 

83,755,295

 

48,626,550

 

 

 

 

 

 

 

 

 

 

 

Distributions declared per common share

 

$

0.44

 

$

0.33

 

$

1.30

 

$

0.80

 

 

See notes to condensed consolidated financial statements

 

4



 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited, amounts in thousands, except share and per share data)

 

 

 

Common Stock

 

Additional

 

 

 

 

 

Accumulated
Other
Comprehensive

 

Total
Starwood
Property
Trust, Inc.

 

Non-

 

 

 

 

 

 

 

Par

 

Paid-In

 

Treasury Stock

 

Accumulated

 

Income

 

Stockholders’

 

Controlling

 

Total

 

 

 

Shares

 

Value

 

Capital

 

Shares

 

Amount

 

Deficit

 

(Loss)

 

Equity

 

Interests

 

Equity

 

Balance, January 1, 2010

 

47,583,800

 

$

476

 

$

895,857

 

 

$

 

$

(8,366

)

$

 

$

887,967

 

$

8,068

 

$

896,035

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation

 

351,084

 

 

 

4,685

 

 

 

 

 

 

 

 

 

4,685

 

 

 

4,685

 

Net income

 

 

 

 

 

 

 

 

 

 

 

39,473

 

 

 

39,473

 

1,480

 

40,953

 

Dividends declared, $0.80 per share

 

 

 

 

 

 

 

 

 

 

 

(38,901

)

 

 

(38,901

)

 

 

(38,901

)

Other comprehensive loss, net

 

 

 

 

 

 

 

 

 

 

 

 

 

8,604

 

8,604

 

1,594

 

10,198

 

Contribution from noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,580

 

2,580

 

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(896

)

(896

)

Balance, September 30, 2010

 

47,934,884

 

$

476

 

$

900,542

 

 

$

 

$

(7,794

)

$

8,604

 

$

901,828

 

$

12,826

 

$

914,654

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, January 1, 2011

 

71,021,342

 

$

706

 

$

1,337,953

 

 

$

 

$

(19,302

)

$

8,203

 

$

1,327,560

 

$

9,669

 

$

1,337,229

 

Proceeds from public offering of common stock

 

22,000,000

 

220

 

476,520

 

 

 

 

 

 

 

 

 

476,740

 

 

 

476,740

 

Underwriting and offering costs

 

 

 

 

 

(1,092

)

 

 

 

 

 

 

 

 

(1,092

)

 

 

(1,092

)

Stock-based compensation

 

550,713

 

 

 

10,432

 

 

 

 

 

 

 

 

 

10,432

 

 

 

10,432

 

Manager incentive fee paid in stock

 

63,255

 

 

 

1,206

 

 

 

 

 

 

 

 

 

1,206

 

 

 

1,206

 

Treasury stock purchased

 

 

 

 

 

 

 

342,000

 

(5,981

)

 

 

 

 

(5,981

)

 

 

(5,981

)

Net income

 

 

 

 

 

 

 

 

 

 

 

78,349

 

 

 

78,349

 

1,191

 

79,540

 

Dividends declared, $1.30 per share

 

 

 

 

 

 

 

 

 

 

 

(113,773

)

 

 

(113,773

)

 

 

(113,773

)

Other comprehensive loss, net

 

 

 

 

 

 

 

 

 

 

 

 

 

(17,668

)

(17,668

)

(1,139

)

(18,807

)

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(9,267

)

(9,267

)

Balance, September 30, 2011

 

93,635,310

 

$

926

 

$

1,825,019

 

342,000

 

$

(5,981

)

$

(54,726

)

$

(9,465

)

$

1,755,773

 

$

454

 

$

1,756,227

 

 

See notes to condensed consolidated financial statements

 

5



 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Comprehensive Income (Loss)

(Unaudited, amounts in thousands)

 

 

 

Three-Months
Ended September 30

 

Nine-Months
Ended September 30

 

 

 

2011

 

2010

 

2011

 

2010

 

Net Income

 

$

14,503

 

$

23,283

 

$

79,540

 

$

40,953

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Change in fair value of cash flow hedges

 

(17

)

(975

)

14

 

(2,297

)

Unrealized (loss) gain in fair value of available-for-sale securities

 

(15,819

)

13,116

 

(11,137

)

12,495

 

Reclassification adjustment for net realized gain on sale of securities

 

 

 

(10,305

)

 

Reclassification for other-than-temporary impairment

 

892

 

 

2,621

 

 

Comprehensive (loss) income

 

(441

)

35,424

 

60,733

 

51,151

 

Less: Comprehensive (loss) income attributable to noncontrolling interests

 

(25

)

(2,194

)

(52

)

(3,074

)

Comprehensive (loss) income attributable to Starwood Property Trust, Inc.

 

$

(466

)

$

33,230

 

$

60,681

 

$

48,077

 

 

See notes to condensed consolidated financial statements

 

6



 

Starwood Property Trust, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited, amounts in thousands)

 

 

 

Nine-Months Ended
September 30, 2011

 

Nine-Months Ended
September 30, 2010

 

Cash Flows from Operating Activities:

 

 

 

 

 

Net Income

 

$

79,540

 

$

40,953

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

Amortization of deferred financing costs

 

2,390

 

336

 

Amortization of net discount on mortgage backed securities (MBS)

 

(12,452

)

(4,418

)

Amortization of net deferred loan fees and discounts

 

(18,461

)

(3,606

)

Amortization of premium from collateralized debt obligations

 

(665

)

 

Stock-based compensation

 

10,432

 

4,685

 

Incentive-fee compensation

 

1,206

 

 

Gain on sale of available-for-sale securities

 

(10,278

)

(760

)

Gain on sale of loans

 

(10,337

)

(9,253

)

Gain on sale of other investments

 

(27

)

 

Unrealized losses on loans held for sale at fair value

 

1,725

 

 

Unrealized losses on interest rate hedges

 

11,099

 

 

Unrealized gains on credit spread hedges

 

(161

)

 

Unrealized (gains) losses on currency hedges

 

(2,674

)

9,020

 

Unrealized foreign currency remeasurement loss (gain)

 

4,245

 

(7,702

)

OTTI

 

2,621

 

 

Changes in operating assets and liabilities:

 

 

 

 

 

Related-party payable

 

2,704

 

1,666

 

Accrued interest receivable, less purchased interest

 

(8,034

)

(5,465

)

Receivable for securities sold

 

 

(9,828

)

Other assets

 

(6,293

)

(186

)

Accounts payable and accrued expenses

 

(345

)

1,546

 

Other liabilities

 

732

 

(2,685

)

Origination of held for sale loans

 

(270,066

)

 

Proceeds from sale of held for sale loans

 

294,149

 

 

Net cash provided by operating activities

 

$

71,050

 

$

14,303

 

Cash Flows from Investing Activities:

 

 

 

 

 

Purchase of mortgage-backed securities

 

(187,133

)

(140,472

)

Proceeds from sale of mortgage-backed securities

 

283,778

 

25,368

 

Proceeds from mortgage-backed securities maturities

 

11,765

 

 

Mortgage-backed securities principal paydowns

 

94,827

 

22,921

 

Purchase of loans held for investment

 

(1,018,480

)

(801,586

)

Loan maturities

 

264,615

 

114,717

 

Proceeds from sale of loans held for investment

 

5,000

 

38,164

 

Loan investment repayments

 

13,092

 

10,008

 

Purchased interest on investments

 

(915

)

(2,789

)

Investments in other investments

 

(37,088

)

(15,028

)

Proceeds from other investment repayments

 

235

 

 

Proceeds from sale of other investments

 

2,844

 

 

Net cash used in investing activities

 

$

(567,460

)

$

(748,697

)

Cash Flows from Financing Activities:

 

 

 

 

 

Borrowings from secured financing arrangements

 

1,016,488

 

283,960

 

Principal repayments on borrowings

 

(991,812

)

(2,623

)

Proceeds from collateralized debt obligations

 

 

54,305

 

Payment of deferred financing costs

 

(2,192

)

(2,885

)

Proceeds from common stock offering

 

476,740

 

 

Payment of underwriting and offering costs

 

(28,287

)

 

Treasury stock purchased

 

(5,981

)

 

Payment of dividends

 

(101,298

)

(28,203

)

Contribution from noncontrolling interest owners

 

 

2,580

 

Distribution to noncontrolling interest owners

 

(9,267

)

(896

)

Net cash provided by financing activities

 

$

354,391

 

$

306,238

 

Net decrease in cash and cash equivalents

 

(142,019

)

(428,156

)

Cash and cash equivalents, beginning of period

 

226,854

 

645,129

 

Cash and cash equivalents, end of period

 

$

84,835

 

$

216,973

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid for interest

 

$

19,475

 

$

9,213

 

Income taxes paid

 

$

1,074

 

$

208

 

Supplemental disclosure of non-cash investing and financing activity:

 

 

 

 

 

Dividends declared, not yet paid

 

$

41,556

 

$

16,047

 

Unsettled securities purchased

 

$

 

$

209

 

Transfer of CMBS from held-to-maturity to available-for-sale

 

$

 

$

259,828

 

 

See notes to condensed consolidated financial statements

 

7



 

Starwood Property Trust, Inc. and Subsidiaries

 

Notes to Condensed Consolidated Financial Statements

 

September 30, 2011

(Unaudited)

 

1. Business and Organization

 

Starwood Property Trust, Inc. (“the Trust” together with its subsidiaries, “we” or the “Company”) is a Maryland corporation that commenced operations (“Inception”) on August 17, 2009 upon the completion of its initial public offering (“IPO”). We are focused primarily on originating, investing in, financing and managing commercial mortgage loans and other commercial real estate debt investments, commercial mortgage-backed securities and residential mortgage-backed securities. We are externally managed and advised by SPT Management, LLC (the “Manager”).

 

We are organized and conduct our operations to qualify as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, the Trust will generally not be subject to U.S. federal corporate income tax on the portion of net income that is distributed to stockholders, if we distribute at least 90% of our taxable income to stockholders by prescribed dates and comply with various other requirements.

 

2. Summary of Significant Accounting Policies

 

Basis of Accounting and Principles of Consolidation

 

The accompanying consolidated financial statements include our accounts and those of our consolidated subsidiaries. All significant intercompany amounts have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“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 and subjective estimates that we make include the estimated cash flows that we expect to receive on our investments, which have a significant impact on the amounts of interest income, credit losses (if any), and estimated fair values that we report and/or disclose.  In addition, the estimated fair values of our loan investments are significantly impacted by the rates that we select to discount their respective estimated cash flows.

 

A non-controlling interest in a consolidated subsidiary is defined as “the portion of the equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent”. Non-controlling interests are presented as a separate component of equity in the condensed consolidated balance sheets. In addition, the presentation of net income attributes earnings to controlling and non-controlling interests.

 

These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the period ended December 31, 2010, as filed with the Securities and Exchange Commission (“SEC”). The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the operating results for the full year.

 

Segment Reporting

 

We are a REIT focused on originating and acquiring real estate-related debt investments and currently operate in one reportable segment.

 

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 and at times these balances exceed federally insurable limits.

 

8



 

Debt Securities

 

GAAP requires that at the time of purchase, we designate debt securities as held-to-maturity, available-for-sale, or trading depending on our investment strategy and ability to hold such securities to maturity. Held-to-maturity securities are stated at cost plus any premiums or discounts, which are amortized or accreted through the consolidated statements of operations using the effective interest method.  Securities we (i) do not hold for the purpose of selling in the near-term, or (ii) may dispose of prior to maturity, are classified as available-for-sale and are carried at fair value in the accompanying financial statements.  Unrealized gains or losses on available-for-sale securities are reported as a component of accumulated other comprehensive income in stockholders’ equity. As of September 30, 2011, our commercial mortgage backed securities (“CMBS”) and residential mortgage backed securities (“RMBS”) were classified as available-for-sale.  The classification of each investment involves management judgment, which is subject to change.

 

When the estimated fair value of a security is less than its amortized cost, we consider whether there is an other-than-temporary impairment (“OTTI”) in the value of the security. An impairment is deemed an OTTI if (i) we intend to sell the security, (ii) it is more likely than not that we will be required to sell the security before recovering our cost basis, or (iii) we do not expect to recover the entire amortized cost basis of the security even if we do not intend to sell the security or believe it is more likely than not that we will be required to sell the security before recovering our cost basis. If the impairment is deemed to be an OTTI, the resulting accounting treatment depends on the factors causing the OTTI. If the OTTI has resulted from (i) our intention to sell the security, or (ii) our judgment that it is more likely than not that we will be required to sell the security before recovering our cost basis, an impairment loss is recognized in current earnings equal to the entire difference between our amortized cost basis and fair value. Whereas, if the OTTI has resulted from our conclusion that we will not recover our cost basis even if we do not intend to sell the security or believe it is more likely than not that we will be required to sell the security before recovering our cost basis, only the credit loss portion of the impairment is recorded in current earnings, and the portion of the loss related to other factors, such as changes in interest rates, continues to be recognized in accumulated other comprehensive income (loss). Determining whether there is an OTTI may require us to exercise significant judgment and make significant assumptions, including, but not limited to, estimated cash flows, estimated prepayments, loss assumptions, and assumptions regarding changes in interest rates. As a result, actual OTTI losses could differ from reported amounts. Such judgments and assumptions are based upon a number of factors, including (i) credit of the issuer or the underlying borrowers, (ii) credit rating of the security, (iii) key terms of the security, (iv) performance of the underlying loans, including debt service coverage and loan-to-value ratios, (v) the value of the collateral for the underlying loans, (vi) the effect of local, industry, and broader economic factors, and (vii) the historical and anticipated trends in defaults and loss severities for similar securities.

 

Loans Held for Investment

 

We purchase and originate commercial real estate debt and related instruments generally to be held for investment and to maturity. Loans that are held for investment are carried at cost unless the loans are deemed to be impaired.  Cost includes any unamortized acquisition premiums or discounts for purchased loans, and any unamortized loan fees or direct loan origination costs for originated loans.  We evaluate each loan classified as held for investment for impairment at least quarterly.  Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, we record an allowance to reduce the carrying value of the loan to the present value of expected future cash flows discounted at the loan’s contractual effective rate, or the fair value of the collateral if repayment is expected solely from the collateral.

 

Loans Held for Sale

 

Loans that we intend to sell or liquidate in the near-term are classified as held-for-sale and are carried at the lower of amortized cost or fair value, unless we have elected to record any such loans at fair value at the time they were acquired under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 825, Financial Instruments.  Upfront costs and fees related to loans for which the fair value option is elected are recognized in earnings as incurred and not deferred.  See further disclosure regarding loans held for sale in Notes 4 and 12.

 

Revenue Recognition

 

Interest income is accrued based on the outstanding principal amount of the investment security or loan and the contractual terms. Discounts or premiums associated with the purchase of an investment security are amortized into interest income as a yield adjustment on the effective interest method, based on expected cash flows through the expected maturity date of the security. For originated loans that we have not elected to record at fair value under FASB ASC 825, origination fees and direct loan origination costs are also recognized in interest income over the loan term as a yield adjustment using the effective interest method.

 

9



 

Upon the repayment or sale of loans or securities, the excess (or deficiency) of net proceeds over the net carrying value of such securities or loans is recognized as a gain (or loss).

 

Investments in Unconsolidated Entities

 

We own non-controlling equity interests in various privately-held partnerships and limited liability companies.  We use the cost method to account for our investments when we own five percent or less of, and do not have significant influence over, the investees.  We use the equity method to account for all other non-controlling interests in partnerships and limited liability companies.  Cost method investments are initially recorded at cost and income is recorded when distributions are received.  Equity method investments are initially recorded at cost and subsequently adjusted for our share of income or loss, as well as contributions and distributions.

 

We also own certain publicly-traded equity securities.  We have virtually no influence over the activities of the respective issuers due to the minimal percentages we own.  These investments are classified as available-for-sale and reported at fair value in the balance sheet, with unrealized gains and losses reported as a component of other comprehensive (loss) income.  Dividends on our available-for-sale equity securities are recorded in the income statement on the record date.

 

Investments in unconsolidated entities are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is measured based on the excess of the carrying amount of an investment over its estimated fair value. Impairment analyses are based on current plans, intended holding periods and available information at the time the analyses are prepared.

 

Securitization/Sale and Financing Arrangements

 

We periodically sell our financial assets, such as commercial mortgage loans, CMBS and other 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 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 mortgage loans by allocating the carrying value of the underlying mortgage between securities or loans sold and the interests retained based on their 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 securities or loans sold.

 

Acquisition and Investment Pursuit Costs

 

Costs incurred in connection with acquiring investments, as well in pursuing unsuccessful investment acquisitions and loan originations, are charged to current earnings and not deferred.

 

Foreign Currency Transactions

 

Our assets and liabilities denominated in foreign currencies are translated into U.S. dollars using foreign currency exchange rates at the end of the reporting period. Income and expenses are translated at the weighted-average exchange rates for each reporting period. At September 30, 2011 and December 31, 2010, the U.S. dollar was functional currency of all investments denominated in foreign currencies. The effects of translating the assets, liabilities and income of our foreign investments are included in unrealized foreign currency remeasurement (loss) gain in the statements of operations.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of loan investments, CMBS, RMBS, interest receivable, and cash investments. We may place cash investments in excess of insured amounts with high quality financial institutions. We regularly monitor for any credit risk concentrations in our investment portfolio, including evaluating our exposure to various counterparties, markets, property types, contract terms, and other credit metrics.

 

Derivative Instruments and Hedging Activities

 

GAAP provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s

 

10



 

financial position, financial performance, and cash flows. Further, we must provide qualitative disclosures that explain our objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

 

We record all derivatives in the 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 under GAAP. 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 regularly enter into derivative contracts that are intended to economically hedge certain of our risks, even though the transactions may not qualify for, or we may not elect, hedge accounting. In such cases, changes in the fair value of the derivatives are recorded in earnings.

 

Deferred Financing Costs

 

Costs incurred in connection with secured financing are capitalized and amortized over the respective term of the respective facilities as a component of interest expense. As of September 30, 2011 and December 31, 2010, we had approximately $3.9 million and $4.1 million, respectively, of capitalized financing costs, net of amortization. For the three months and nine months ended September 30, 2011, approximately $1.0 million and $2.4 million, respectively, of amortization was included in interest expense.  For the three and nine months ended September 30, 2010, approximately $0.2 and $0.3 million, respectively, of amortization was included in interest expense.

 

Earnings per share

 

We calculate basic earnings per share by dividing net income attributable to us for the period by the weighted average of shares of common stock outstanding for that period. Diluted earnings per share takes into effect any dilutive instruments, such as restricted stock and restricted stock units, except when doing so would be anti-dilutive.

 

Share-based payments

 

We recognize the cost of share-based compensation and payment transactions using the same expense category as would be charged for payments in cash. The fair value of the restricted stock or restricted stock units granted is recorded to expense on a straight-line basis over the vesting period for the award, with an offsetting increase in stockholders’ equity. For grants to employees and directors, the fair value is determined based upon the stock price on the grant date. For non-employee grants, the fair value is based on the stock 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.

 

Income Taxes

 

We have elected to be taxed as a REIT 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 stock 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 100% penalty tax. We have two taxable REIT subsidiaries (“the TRSs”) where certain investments may be made and activities conducted that (i) may have otherwise been subject to the prohibition tax and (ii) 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. For the three and nine months ended September 30, 2011, we recorded an income tax benefit of $0.5 million and a provision for income taxes of $0.7 million related to the activities in our TRSs.  These provisions were determined using a Federal income tax rate of 34% and state income tax rate of 7.5%.  For the three and nine months ended September 30, 2010, we recorded a provision for income taxes of $0.2 million and $0.2 million related to the activities in our TRSs, based on a Federal income tax rate of 33% and state income tax rate of 7.5%.

 

Recent Accounting Pronouncements

 

In April 2011, the FASB issued ASU No. 2011-03, Reconsideration of Effective Control for Repurchase Agreements.  This update revises the criteria for assessing effective control for repurchase agreements and other agreements that both entitle and obligate

 

11



 

a transferor to repurchase or redeem financial assets before their maturity.  The update will be effective for the Company on January 1, 2012, early adoption is prohibited, and the amendments will be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.  We do not believe that the adoption of this standard will have a material impact on our financial position or results of operations.

 

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement:  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  This update amends the existing fair value guidance to improve consistency in the application and disclosure of fair value measurements in U.S. GAAP and International Financial Reporting Standards.  ASU 2011-04 provides certain clarifications to the existing guidance, changes certain fair value principles, and enhances disclosure requirements.  The update will be effective for the Company on January 1, 2012, early adoption is prohibited, and the amendments will be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.  We have not completed our evaluation as to whether the adoption of this standard will have a material impact on our financial position or results of operations.

 

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income.  Prior to the issuance of ASU 2011-05, existing GAAP allowed three alternatives for presentation of other comprehensive income (“OCI”) and its components in financial statements.  ASU 2011-05 removes the option to present the components of OCI as part of the statement of changes in equity.  In addition, ASU 2011-05 requires consecutive presentation of the statement of operations and OCI and presentation of reclassification adjustments on the face of the financial statements from OCI to net income.  These changes apply to both annual and interim financial statements commencing, with retrospective application, for the fiscal periods beginning after December 15, 2011, with early adoption permitted.  We do not believe that the adoption of this standard will have a material impact on our financial position or results of operations.

 

3. Debt Securities

 

We classified all CMBS and RMBS investments as available-for-sale as of September 30, 2011 and December 31, 2010. The CMBS and RMBS classified as available-for-sale are reported at fair value in the balance sheet with changes in fair value recorded in accumulated other comprehensive (loss) income. The tables below summarize various attributes of our investments in mortgage backed securities available-for-sale as of September 30, 2011 and December 31, 2010 ($000’s):

 

 

 

 

 

 

 

 

 

Unrealized Gains or (Losses) Recognized in Accumulated Other
Comprehensive Income (Loss)

 

 

 

September
30, 2011

 

Purchase
Amortized Cost

 

Credit
OTTI

 

Recorded
Amortized Cost

 

Non-Credit
OTTI

 

Unrealized
Gains

 

Unrealized
Losses

 

Net Fair Value
Adjustment

 

Fair Value

 

CMBS

 

$

192,742

 

$

 

$

192,742

 

$

 

$

 

$

(5,035

)

$

(5,035

)

$

187,707

 

RMBS

 

166,013

 

(2,621

)

163,392

 

 

(435

)

3,345

 

(1,909

)

1,001

 

164,393

 

Total

 

$

358,755

 

$

(2,621

)

$

356,134

 

$

(435

)

$

3,345

 

$

(6,944

)

$

(4,034

)

$

352,100

 

 

September 30, 2011

 

Weighted
Average
Coupon(1)

 

Weighted
Average
Rating (2)

 

Weighted
Average
Life
(Years)

 

CMBS

 

1.96

%

 

CCC+

 

5.3

 

RMBS

 

0.87

%

 

B-

 

4.2

 

 


(1)          Generally calculated using the September 30, 2011 one-month LIBOR rate of 0.23944%.

(2)          Excludes securities that are not rated, whose aggregate fair value was $177.5 million.  Of this amount, $174.7 million are securities where the obligors are certain special purpose entities that were formed to hold substantially all of the assets of a worldwide operator of hotels, resorts and timeshare properties; the securities are unrated but the loan-to-value ratio was approximately 31% at September 30, 2011.

 

December 31, 2010

 

Cost

 

Unrealized
Gains

 

Unrealized
Losses

 

Net Fair Value
Adjustment

 

Fair Value

 

Weighted
Average
Coupon(1)

 

Weighted
Average
Rating

 

Weighted
Average
Life
(Years)

 

CMBS

 

$

266,764

 

$

9,074

 

$

(683

)

$

8,391

 

$

275,155

 

5.6

%

AA-

 

1.8

 

RMBS

 

120,827

 

2,495

 

(797

)

1,698

 

122,525

 

0.6

%

BB-

 

1.3

 

 

 

$

387,591

 

$

11,569

 

$

(1,480

)

$

10,089

 

$

397,680

 

 

 

 

 

 

 

 

12



 


(1)          Calculated using the December 31, 2010 one-month LIBOR rate of 0.2606%.

 

During the nine-months ended September 30, 2011, the purchases and sales trades executed, as well as the principal payments received, were as follows (000’s):

 

 

 

RMBS

 

CMBS

 

Purchases

 

$

139,953

 

$

 

Sales/Maturities

 

49,951

 

223,378

 

Principal payments received

 

52,607

 

42,220

 

 

In June 2011, we exercised a pre-existing right to convert one of our loans into a CMBS in order to maximize the liquidity of our investment.  We therefore reclassified the loan, which had a carrying amount of $176.6 million, from loans held for investment to mortgage-backed securities, available-for-sale, at fair value and recognized an unrealized gain at the time of $7.9 million.

 

During the three and nine months ended September 30, 2011, we sold various CMBS positions with aggregate gross proceeds of $0 million and $211.6 million ($74.0 million after repaying related financing), respectively, which generated gains of approximately $0 million and $9.9 million, respectively. Additionally, $0 million and $11.8 million of our CMBS portfolio matured and paid off during the three and nine months ended September 30, 2011.

 

From Inception through the first two quarters of 2010, a portion of our CMBS portfolio was designated as held-to-maturity. However, during the third quarter of 2010 our investment strategy with respect to these securities changed, and we no longer intended to hold them to maturity. As a result, we reclassified the securities to available-for-sale and recorded an unrealized gain in connection with this reclassification of approximately $10.3 million.

 

As of September 30, 2011, 100%, of the CMBS are variable rate and pay interest at LIBOR plus a weighted average spread of 1.72%.  As of December 31, 2010, 5.0% of the CMBS were variable rate and paid interest at LIBOR plus a weighted average spread of 1.30%.

 

Subject to certain limitations on durations, we have allocated an amount to invest in RMBS that cannot exceed 10% of our total assets. We have engaged a third party manager who specializes in RMBS to execute the trading of RMBS, the cost of which was $0.5 million for the nine-months ended September 30, 2011, which has been recorded as an offset to interest income in the accompanying consolidated statement of operations.  As of September 30, 2011, approximately $160.1 million or 97.4% of the RMBS are variable rate and pay interest at LIBOR plus a weighted average spread of 0.45%. As of December 31, 2010, approximately $120.7 million, or 98.5%, of the RMBS were variable rate and pay interest at LIBOR plus a weighted average spread of 0.31%.  We purchased all of the RMBS at a discount that will be accreted into income over the expected remaining life of the security. The majority of the income from this strategy is earned from the accretion of these discounts.

 

The following table presents the gross unrealized losses and estimated fair value of our securities that are in an unrealized loss position as of September 30, 2011 for which OTTIs (full or partial) have not been recognized in earnings ($000’s):

 

 

 

Estimated Fair Value

 

Unrealized Losses

 

As of September 30, 2011

 

Securities in a loss less
than 12 months

 

Securities in a loss
greater than 12 months

 

Securities in a loss
less than 12 months

 

Securities in a loss
greater than 12 months

 

CMBS

 

$

187,707

 

$

 

$

(5,035

)

$

 

RMBS

 

101,692

 

680

 

(1,790

)

(118

)

Total

 

$

289,399

 

$

680

 

$

(6,825

)

$

(118

)

 

As of September 30, 2011 there were 33 securities with unrealized losses.  After evaluating each security we determined that the impairments on seven of these securities, which totaled $1.3 million, were other-than-temporary. Credit losses represented $0.9 million of this total, which we calculated by discounting the estimated future cash flows of each security at the yield determined as of the initial acquisition date or, if since revised, as of the last date previously revised.  For the three and nine months ended September 30, 2011, our aggregate MBS credit losses (as reported in the income statement) were $0.9 million and $2.6 million, respectively.  We further determined that none of the 26 remaining securities were other-than-temporarily impaired.  We considered a number of factors in reaching this conclusion, including that we did not intend to sell any individual security, it was not considered more likely than not that we would be forced to sell any individual security prior to recovering our amortized cost, and there were no material credit events that would have caused us to otherwise conclude that we would not recover our cost.  We acquired 12 of these securities during August and September 2011 and no material credit events had occurred from the date of acquisition through September 30, 2011.  For seven securities, we compared the present value of the estimated cash flows as of September 30, 2011 to the present value of the

 

13



 

remaining cash flows expected to be collected when we first acquired the securities or, if since revised, as of the last date previously revised; we noted that there had not been an adverse change in the expected cash flows.  The unrealized loss amounts on the remaining seven securities were immaterial individually and in the aggregate.

 

4. Loans

 

Our investments in mortgages and loans held-for-investment are accounted for at amortized cost and the loans held-for-sale are accounted for at the lower of cost or fair value, unless we elect to record such loans at fair value. The following table summarizes our investments in mortgages and loans by subordination class as of September 30, 2011 and December 31, 2010 (dollar amounts in 000’s):

 

September 30, 2011

 

Carrying
Value

 

Face Amount

 

Weighted
Average
Coupon

 

Weighted
Average Life
(years)

 

First mortgages

 

$

765,198

 

$

781,829

 

7.8

%

3.3

 

Subordinated mortgages (1)

 

415,636

 

468,215

 

6.7

%

4.2

 

Mezzanine loans

 

635,213

 

653,348

 

8.5

%

3.2

 

Total loans held for investment

 

1,816,047

 

1,903,392

 

 

 

 

 

First mortgages held for sale at fair value

 

121,229

 

122,954

 

5.9

%

9.2

 

Loans held in securitization trust

 

50,311

 

50,660

 

5.0

%

3.7

 

Total Loans

 

$

1,987,587

 

$

2,077,006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2010

 

Carrying
Value

 

Face
Amount

 

Weighted
Average
Coupon

 

Weighted
Average Life
(years)

 

First mortgages

 

$

757,684

 

$

797,154

 

6.9

%

3.3

 

Subordinated mortgages (1)

 

406,410

 

465,929

 

6.6

%

4.9

 

Mezzanine loans

 

66,689

 

67,883

 

10.8

%

4.8

 

Total loans held for investment

 

1,230,783

 

1,330,966

 

 

 

 

 

First mortgages held for sale at fair value

 

144,163

 

143,901

 

5.7

%

4.9

 

Loans held in securitization trust

 

50,297

 

50,738

 

5.0

%

4.2

 

Total Loans

 

$

1,425,243

 

$

1,525,605

 

 

 

 

 

 


(1)         Subordinated mortgages includes (i) subordinated mortgages that we retain after having sold first mortgage positions related to the same collateral, (ii) B-Notes, and (iii) subordinated loan participations.

 

As of September 30, 2011, approximately $797.6 million, or 40.1% of the loans are variable rate and pay interest at LIBOR plus a weighted average spread of 4.73%.  Of the approximately $797.6 million of floating rate loans, $670.3 million pay interest using one-month LIBOR (0.2394%) and $127.3 million pay interest using three-month LIBOR (0.3743%).  As of December 31, 2010, approximately $332.7 million, or 23.3% of the loans are variable rate and pay interest at LIBOR plus a weighted average spread of 2.3%.  Of the approximately $332.7 million of floating rate loans, $211.5 million pay interest using one-month LIBOR (0.2606%) and $121.2 million pay interest using three-month LIBOR (0.3028%).

 

As described in Note 2, we evaluate our loans for impairment at least quarterly.  Our loans are typically collateralized by real estate. As a result, we regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower. Specifically, a property’s operating results and any cash reserves are analyzed and used to assess (i) whether cash flow from operations is sufficient to cover the debt service requirements currently and into the future, (ii) the ability of the borrower to refinance the loan at maturity, and/or (iii) the property’s liquidation value. We also evaluate the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, we consider the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates. Such impairment analyses are completed and reviewed by asset management and finance personnel who utilize various data sources, including (i) periodic financial data such as property operating statements, occupancy, tenant profile, rental rates, operating expenses, the borrower’s exit plan, and capitalization and discount rates, (ii) site inspections, and (iii) current credit spreads and discussions with market participants.

 

Our evaluation process as described above produces an internal risk rating of between 1 and 5, which is a weighted average of the numerical ratings in the following categories: (i) sponsor capability and financial condition, (ii) loan and collateral performance

 

14



 

relative to underwriting, (iii) quality and stability of collateral cash flows, and (iv) loan structure. We utilize the overall risk ratings as a concise means to monitor any credit migration on a loan as well as on the whole portfolio.  While the overall risk rating is not the sole factor we use in determining whether a loan is impaired, a loan with a higher overall risk rating would tend to have more adverse indicators of impairment, and therefore would be more likely to experience a credit loss.

 

The rating categories generally include the characteristics described below, but these are utilized as guidelines and therefore not every loan will have all of the characteristics described in each category:

 

Rating

 

Characteristics

1

 

·                  Sponsor capability and financial condition - Sponsor is highly rated or investment grade or, if private, the equivalent thereof with significant management experience.

·                  Loan collateral and performance relative to underwriting - The collateral has surpassed underwritten expectations.

·                  Quality and stability of collateral cash flows - Occupancy is stabilized, the property has had a history of consistently high occupancy, and the property has a diverse and high quality tenant mix.

·                  Loan structure - Loan-to-collateral value ratio (“LTV”) does not exceed 65%.  The loan has structural features that enhance the credit profile.

2

 

·                  Sponsor capability and financial condition - Strong sponsorship with experienced management team and a responsibly leveraged portfolio.

·                  Loan collateral and performance relative to underwriting - Collateral performance equals or exceeds underwritten expectations and covenants and performance criteria are being met or exceeded.

·                  Quality and stability of collateral cash flows - Occupancy is stabilized with a diverse tenant mix.

·                  Loan structure - LTV does not exceed 70% and unique property risks are mitigated by structural features.

3

 

·                  Sponsor capability and financial condition - Sponsor has historically met its credit obligations, routinely pays off loans at maturity, and has a capable management team.

·                  Loan collateral and performance relative to underwriting - Property performance is consistent with underwritten expectations.

·                  Quality and stability of collateral cash flows - Occupancy is stabilized, near stabilized, or is on track with underwriting.

·                  Loan structure - LTV does not exceed 80%.

4

 

·                  Sponsor capability and financial condition - Sponsor credit history includes missed payments, past due payment, and maturity extensions.  Management team is capable but thin.

·                  Loan collateral and performance relative to underwriting - Property performance lags behind underwritten expectations.  Performance criteria and loan covenants have required occasional waivers.  A sale of the property may be necessary in order for the borrower to pay off the loan at maturity.

·                  Quality and stability of collateral cash flows - Occupancy is not stabilized and the property has a large amount of rollover.

·                  Loan structure - LTV is 80% to 90%. 

5

 

·                  Sponsor capability and financial condition - Credit history includes defaults, deeds-in-lieu, foreclosures, and/or bankruptcies.

·                  Loan collateral and performance relative to underwriting - Property performance is significantly worse than underwritten expectations.  The loan is not in compliance with loan covenants and performance criteria and may be in default.  Sale proceeds would not be sufficient to pay off the loan at maturity.

 

 

·                  Quality and stability of collateral cash flows - The property has material vacancy and significant rollover of remaining tenants.

·                  Loan structure - LTV exceeds 90%.

 

As of September 30, 2011, the risk ratings by class of loan were as follows (dollar amounts in 000’s):

 

 

 

Balance Sheet Classification

 

 

 

Risk

 

Loans Held for Investment

 

Loans
Held for
Sale

 

Loans held in

 

 

 

Rating
Category

 

First
Mortgages

 

Subordinated
Mortgages

 

Mezzanine
Loans

 

First
Mortgages

 

Securitization
Trust

 

Total

 

1

 

$

 

$

 

$

 

$

 

$

 

$

 

2

 

88,436

 

129,831

 

138,294

 

84,295

 

13,214

 

454,070

 

3

 

642,689

 

232,202

 

489,253

 

36,934

 

37,097

 

1,438,175

 

4

 

34,073

 

53,603

 

7,666

 

 

 

95,342

 

5

 

 

 

 

 

 

 

 

 

$

765,198

 

$

415,636

 

$

635,213

 

$

121,229

 

$

50,311

 

$

1,987,587

 

 

15



 

After reviewing our expected cash flows and risk ratings for each loan as described above, we concluded that no allowance for loan losses was necessary as of September 30, 2011 and December 31, 2010.

 

For the nine months ended September 30, 2011, we originated and acquired loans (including loans held-for-sale) as follows ($000’s):

 

Balance December 31, 2010

 

$

1,425,243

 

Acquisitions/Origination

 

1,243,740

 

Additional funding

 

44,807

 

Capitalized Interest

 

4,404

 

Loans sold

 

(288,812

)

Loan maturities

 

(264,615

)

Transfer out  – loan converted to a security

 

(176,635

)

Principal repayments

 

(13,092

)

Discount/premium amortization

 

18,461

 

Unrealized foreign currency remeasurement loss

 

(4,189

)

Unrealized loss on loans held for sale at fair value

 

(1,725

)

Balance September 30, 2011

 

$

1,987,587

 

 

As disclosed above, we acquired or originated $1.3 billion in loans during the nine months ended September 30, 2011, which included (i) a $165.5 million origination of a first mortgage loan, mezzanine loan and corporate loan on a portfolio of six full service hotels located throughout California; (ii) an acquisition of  90% interest in a $188 million (face amount) mezzanine loan collateralized by an ownership interest in a portfolio of ten office buildings in Northern Virginia for $156.5 million; (iii) an acquisition of a $137.8 million (face amount) mezzanine loan tranche collateralized by ownership interests in 28 hotels located throughout the U.S. for $127.1 million; (iv) an origination of a $175.0 million first mortgage collateralized by a furniture showroom located in North Carolina; and (v) an origination of a $60.5 million first mortgage loan secured by two retail centers in Pennsylvania.

 

5. Other Investments

 

In January 2010, we committed $6.3 million to acquire a 5.6% interest in a privately-held limited liability company formed to acquire assets of a commercial real estate debt management and servicing business primarily for the opportunity to participate in debt opportunities arising from the venture’s special servicing business (the “Participation Right”). In May 2010, we made an additional $3.4 million commitment to the venture to maintain at least a 5% ownership and its corresponding Participation Right. Because we do not have control or significant influence over the venture, the investment is accounted for under the cost method. As of September 30, 2011, we had funded $8.0 million of our commitment. A member of our Board of Directors has a $50,000 investment in the same venture.

 

Through September 30, 2011, we had purchased a net total of $13.8 million ($9.3 million of which was purchased during the nine months ended September 30, 2011) of publicly traded equity securities that are classified as available-for-sale and carried at fair value with changes in fair value recorded to other comprehensive income (loss). For the three and nine months ended September 30, 2011, we had an unrealized loss of $3.0 million and $3.8 million, respectively related to these investments, and recognized dividend income of $0.2 million and $0.6 million, respectively, included as a component of other income in the condensed consolidated statements of income.  All of the equity securities have been in an unrealized loss position for less than 12 months.

 

In June 2011, we acquired a non-controlling 49% interest in a privately-held limited liability company for $25.5 million.  The entity owns a participation in a mezzanine loan, and our share of earnings for the three and nine months ended September 30, 2011 was $0.6 million and $0.6 million, respectively.

 

6. Secured Financing Agreements

 

On March 31, 2010, Starwood Property Mortgage Sub-1, L.L.C. (“SPM Sub-1”), our indirect wholly-owned subsidiary, entered into a Master Repurchase and Securities Contract (the “Wells Repurchase Agreement”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Wells Repurchase Agreement is secured by approximately $390.8 million of the diversified loan portfolio purchased from Teachers Insurance and Annuity Association of America on February 26, 2010 (“the TIAA Portfolio”). The Wells Repurchase Agreement provides for asset purchases of up to $109.5 million. Advances under the Wells Repurchase Agreement

 

16



 

accrue interest at a per annum pricing rate equal to the sum of one-month LIBOR plus the pricing margin of 3.0%. If an event of default (as such term is defined in the Wells Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable and interest accrues at the default rate, which is equal to the pricing rate plus 4.0%. The maturity date of the Wells Repurchase Agreement is May 31, 2013. The Wells Repurchase Agreement allowed for advances through May 31, 2010.  As of September 30, 2011, $109.5 million was outstanding under the Wells Repurchase Agreement and the carrying value of the pledged collateral was $163.4 million. The Trust guarantees the obligations of SPM Sub-1 under the Wells Repurchase Agreement up to a maximum liability of 25% of the then currently outstanding repurchase price of all purchased assets.

 

On August 6, 2010, Starwood Property Mortgage Sub-2, L.L.C. (“SPM Sub-2”), our indirect wholly-owned subsidiary, entered into a second Master Repurchase and Securities Contract with Wells Fargo, which second repurchase facility was amended and restated by SPM Sub-2 and Starwood Property Mortgage Sub-2-A, L.L.C. (“SPM Sub-2-A”), our indirect wholly-owned subsidiary, on February 28, 2011, pursuant to an Amended and Restated Master Repurchase and Securities Contract (the “Second Wells Repurchase Agreement”). The Second Wells Repurchase Agreement is being used by SPM Sub-2 and SPM Sub-2-A to finance the acquisition or origination of commercial mortgage loans (and participations therein) and mezzanine loans. The Second Wells Repurchase Agreement provides for asset purchases of up to $350 million.  Advances under the Second Wells Repurchase Agreement accrue interest at a per annum pricing rate equal to the sum of one-month LIBOR plus a margin of between 1.75% and 6.0% depending on the type of asset being financed. If an event of default (as such term is defined in the Second Wells Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest accrues at the default rate, which is equal to the pricing rate plus 4.0%. The initial maturity date of the Second Wells Repurchase Agreement is August 5, 2013, subject to two one-year extension options, each of which may be exercised by us upon the satisfaction of certain conditions. Pursuant to a Guarantee and Security Agreement, dated August 6, 2010, as amended and restated by an Amended and Restated Guarantee and Security Agreement, dated February 28, 2011 (the “Second Wells Repurchase Guarantee”), the Trust guarantees the obligations of SPM Sub-2 and SPM Sub-2-A under the Wells Repurchase Agreement up to a maximum liability of either 25% or 100% of the then-currently outstanding repurchase price of purchased assets, depending upon the type of asset being financed. As of September 30, 2011, $238.0 million was outstanding under the Second Wells Repurchase Agreement and the carrying value of the pledged collateral was $415.8 million.  Note 14 contains disclosure of a subsequent event related to the Second Wells Repurchase Agreement.

 

On December 2, 2010, Starwood Property Mortgage Sub-3, L.L.C. (“SPM Sub-3”), our indirect wholly-owned subsidiary, entered into a Master Repurchase Agreement with Goldman Sachs Mortgage Company, which repurchase facility was amended and restated by SPM Sub-3 and Starwood Property Mortgage Sub-3-A, L.L.C. (“SPM Sub-3-A”), our indirect wholly-owned subsidiary, on February 28, 2011, pursuant to an Amended and Restated Master Repurchase Agreement (the “Goldman Repurchase Agreement”). The Goldman Repurchase Agreement will be used to finance the acquisition or origination by SPM Sub-3 and SPM Sub-3-A of commercial mortgage loans that are eligible for CMBS securitization. The Goldman Repurchase Agreement provides for asset purchases of up to $150 million. The Trust guarantees the obligations of SPM Sub-3 and SPM Sub-3-A under the Goldman Repurchase Agreement up to a maximum liability of 25% of the then-currently outstanding repurchase price of all purchased loans.  Advances under the Goldman Repurchase Agreement accrue interest at a per annum pricing rate equal to the sum of one-month LIBOR plus a margin of between 1.95% and 2.25% depending on the loan-to-value ratio of the purchased mortgage loan. If an event of default (as such term is defined in the Goldman Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest accrues at the default rate, which is equal to the pricing rate plus 2.0%.  The maturity date of the Goldman Repurchase Agreement is December 3, 2012. As of September 30, 2011, $92.2 million was outstanding under the Goldman Repurchase Agreement and the carrying value of the pledged collateral was $121.2 million.

 

On March 18, 2011, Starwood Property Mortgage, L.L.C. (“SPM”), an indirect wholly-owned subsidiary of the Trust, entered into a third Master Repurchase and Securities Contract with Wells Fargo (“the Wells RMBS Repurchase Agreement”).  The Wells RMBS Repurchase Agreement is being used by SPM to finance the acquisition and ownership of RMBS and provides for asset purchases up to $100.0 million. Advances under the Wells RMBS Repurchase Agreement generally accrue interest at a per annum pricing rate equal to one-month LIBOR plus a margin of 1.5%.  If an event of default (as such term is defined in the Wells RMBS Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest accrues at the default rate, which is equal to the pricing rate plus 4.0%.  The facility is scheduled to terminate on March 16, 2012 but can be extended subject to certain conditions.  The Trust has guaranteed the obligations of SPM under the Wells RMBS Repurchase Agreement.  As of September 30, 2011, $38.9 million was outstanding and the carrying value of the RMBS collateral was $132.4 million.

 

On June 30, 2011, Starwood Property Mortgage Sub-4, L.L.C. (“SPM Sub-4”) and Starwood Property Mortgage Sub-4-A, L.L.C. (“SPM Sub-4-A”), our indirect wholly-owned subsidiaries, entered into a Mortgage Loan Purchase Agreement (the “Deutsche Repurchase Agreement”) with Deutsche Bank AG, Cayman Islands Branch. The Deutsche Repurchase Agreement provides for asset purchases of up to $150 million. The Trust has guaranteed the obligations of SPM Sub-4 and SPM Sub-4-A under the Deutsche Repurchase Agreement up to a maximum liability of the sum of (a) the greater of (i) 25% of the then currently outstanding repurchase price of all purchased loans, and (ii) $20,000,000, plus (b) all obligations associated with hedging.  Advances under the Deutsche Repurchase Agreement accrue interest at a pricing rate equal to the sum of one-month LIBOR plus a margin of between 1.85% and 2.5% depending on the property type and loan-to-value ratio of the purchased mortgage asset. If an event of default (as such term is defined in the Deutsche Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest accrues at the default rate, which is equal to the pricing rate plus 4.0%.  The maturity date of the Deutsche Repurchase Agreement is June 30, 2012 with two one-year extension options, subject to satisfaction of certain conditions. As of September 30, 2011, there were no borrowings under the Deutsche Repurchase Agreement.

 

17



 

On June 28, 2011, SPT Rosslyn Holdings, L.L.C. (“SPT Rosslyn”), our indirect wholly-owned subsidiary, entered into a Master Repurchase Agreement (the “Second Deutsche Repurchase Agreement”) with Deutsche Bank AG, New York Branch (“Deutsche NY”).  In connection with the Second Deutsche Repurchase Agreement, SPT Rosslyn transferred assets to Deutsche NY, with such transfer providing access to repurchase borrowings of up to $117.4 million.  Interest on these borrowings accrues at a pricing rate equal to one-month LIBOR plus a margin of between 3.5% and 5.0%, depending on the loan-to-value.  If an event of default (as such term is defined in the Second Deutsche Repurchase Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest accrues at the default rate, which is equal to the pricing rate plus 5.0%.  As of September 30, 2011, SPT Rosslyn had borrowed $5.3 million under this facility and the carrying value of the pledged collateral was $162.1 million.  The borrowing matures in May 2012.  The Trust has guaranteed the obligations of SPT Rosslyn under the Second Deutsche Repurchase Agreement.

 

Under the Wells Repurchase Agreement, the Second Wells Repurchase Agreement, the Goldman Repurchase Agreement, the Wells RMBS Repurchase Agreement, the Deutsche Repurchase Agreement, and the Second Deutsche Repurchase Agreement, the counterparty retains the sole discretion over both whether to purchase the loan or security from us and, subject to certain conditions, the market value of such loan or security for purposes of determining whether we are required to pay margin to the counterparty.

 

On December 3, 2010, SPT Real Estate Sub II, LLC (“SPT II”), our wholly-owned subsidiary, entered into a term loan Credit Agreement (the “BAML Credit Agreement”) with Bank of America, N.A. (“Bank of America”) as administrative agent and as lender, and us and certain of our subsidiaries as guarantors. The BAML Credit Agreement provides for loans of up to $120.3 million. The initial draw under the BAML Credit Agreement was used, in part, to partially finance the acquisition of a senior secured note due March 15, 2015 in the amount of $205.0 million (the “Purchased Note”) from Bank of America. The Purchased Note was converted into a security in June 2011 (refer to Note 3) and is due from certain special purpose entities that were formed to hold substantially all of the assets of a worldwide operator of hotels, resorts and timeshare properties.

 

Advances under the BAML Credit Agreement accrue interest at a per annum rate based on LIBOR or a base rate, at the election of SPT II. The margin can vary between 2.35% and 2.50% over LIBOR, and between 1.35% and 1.50% over base rate, based on the performance of the assets securing the Purchased Note. The initial maturity date of the BAML Credit Agreement is November 30, 2013, subject to a 12 month extension option, exercisable by SPT II upon satisfaction of certain conditions set forth in the BAML Credit Agreement. Bank of America retains the sole discretion, subject to certain conditions, over the market value of collateral assets for purposes of determining whether we are required to pay margin to Bank of America. As of September 30, 2011, $120.3 million was outstanding under the BAML Credit Agreement. The carrying value of the CMBS pledged as collateral under the Credit agreement was $174.7 million as of September 30, 2011.  If an event of default (as such term is defined in the BAML Credit Agreement) occurs and is continuing, amounts borrowed may become due and payable immediately and interest would accrue at an additional 2% per annum over the applicable rate.

 

The following table sets forth our five-year principal repayments schedule for the secured financings assuming no defaults or expected extensions, which excludes the collateralized debt obligation in securitization trust ($000’s)

 

2011 (remainder of)

 

$

2,158

 

2012

 

224,042

 

2013

 

378,135

 

2014

 

 

2015 and thereafter

 

 

Total

 

$

604,335

 

 

Secured financing maturities for the rest of 2011 and 2012 primarily relate to $60.3 million of financings on the TIAA portfolio, $22.4 million on the Wells Repo II and $6.9 million on the BAML Facility.  Additionally, there are secured financing maturities of $92.2 million of financings on the Goldman Repo, $38.9 million on the Wells RMBS Repo and $5.3 million on the Second Deutsche Repurchase Agreement. The financing of the TIAA Portfolio, Second Wells Repurchase Agreement and BAML Credit Agreement generally require principal to be paid down prior to the facilities’ respective maturities if and when we receive principal payments on the loan assets, or sell the loan assets, that we have pledged as collateral.

 

7. Loan Securitization/Sale Activities

 

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2010, the collateralized debt obligation in securitization trust in the condensed consolidated balance sheets relates to two contributed loans that we securitized in a structure that did not qualify for sale treatment under GAAP. As of September 30, 2011, the balance of the loans pledged to the securitization trust was $50.3 million and the related liability of the securitization trust was $53.4 million.

 

18



 

During the three months ended September 30, 2011, we sold loans with a carrying value of $154.4 million into a securitization resulting in proceeds, net of financing repayments, of $69.7 million.  Effective control of the loans was surrendered in the loan transfer and it was therefore treated as a sale under GAAP, resulting in a realized gain of $5.1 million.  However, we effectively broke even on this transaction considering the realized gains on the credit hedges of $2.2 million and realized losses on the interest rate hedges of $7.4 million that were terminated in connection with the loans being sold.

 

During the second quarter of 2011, we sold a loan to an independent third party for gross proceeds of $78.4 million.  Effective control of the loan was surrendered in the transaction and it was therefore treated as sale under GAAP, resulting in a gain of $3.4 million.  We effectively realized a net gain of $2.9 million on this transaction considering the realized loss on the interest rate hedge of $0.5 million that was terminated in connection with the loan being sold.

 

During the first quarter of 2011, we contributed three loans to a securitization trust for approximately $56 million in gross proceeds.  Effective control of the loans was surrendered in the loan transfer and it was therefore treated as a sale under GAAP, resulting in a gain of $1.9 million.  We effectively realized a net gain of $1.8 million on this transaction considering the realized losses on the interest rate hedges of $0.1 million that was terminated in connection with the loans being sold.

 

8. Derivatives and Hedging Activity

 

Risk Management Objective of Using Derivatives

 

We are exposed to certain risk arising from both our business operations and economic conditions. We principally manage our exposures to a wide variety of business and operational risks through management of our core business activities. We manage economic risks, including interest rate, foreign exchange, 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, credit spreads, and foreign exchange rates. Our derivative financial instruments are used to manage differences in the amount, timing, and duration of the known or expected cash receipts and known or expected cash payments principally related to our investments, anticipated level of loan sales, and borrowings.

 

Cash Flow Hedges of Interest Rate Risk

 

Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposure to interest rate movements. To accomplish this objective, we primarily use interest rate swaps as part of our interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for us making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

 

In connection with our repurchase agreements, we have entered into five interest rate swaps that have been designated as cash flow hedges of the interest rate risk associated with forecasted interest payments. As of September 30, 2011, the aggregate notional amount of our interest rate swaps designated as cash flow hedges of interest rate risk totaled $187.1 million.  Under these agreements, we will pay fixed monthly coupons at a fixed rates ranging from 0.722% to 2.228% of the notional amount to the counterparty and receive floating rate LIBOR-based payments. Our interest rate swaps designated as cash flow hedges of interest rate risk have maturities ranging from November 2012 to November 2015.

 

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 and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and nine months ended September 30, 2011 we recorded $0 and $45 thousand, respectively, as hedge ineffectiveness in earnings, which is included in interest expense on the condensed consolidated statements of income. During the three and nine months ended September 30, 2010, the Company recorded no hedge ineffectiveness in earnings.

 

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the associated variable-rate debt. Over the next twelve months, we estimate that an additional $1.5 million will be reclassified as an increase to interest expense.  We are hedging our exposure to the variability in future cash flows for forecasted transactions over a maximum period of 53 months.

 

Non-designated Hedges

 

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, rather we use them to

 

19



 

manage our exposure to foreign exchange rates, interest rate changes, and certain credit spreads.  Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings.

 

During 2010, we entered into a series of forward contracts whereby we agree to sell an amount of GBP for an agreed upon amount of USD at various dates through October of 2013.  These forward contracts were executed to economically fix the USD amount of GBP-denominated cash flows expected to be received by us related to our GBP-denominated loan investment.  During the first nine months of 2011, we entered into a series of forward contracts whereby we agree to sell an amount of EUR for an agreed upon amount of USD at various dates through June of 2014.  These forward contracts were executed to economically fix the USD amount of EUR-denominated cash flows expected to be received by us related to our mezzanine loan in Germany.  As of September 30, 2011, we had ten foreign exchange forward derivatives to sell GBP with a total notional amount of GBP 98.7 million and 15 foreign exchange forward derivatives to sell EUR with a total notional amount of EUR 67.8 million that were not designated as hedges in qualifying hedging relationships.

 

During 2010 and 2011, we entered into several interest rate swaps that were not designated as hedges.  Under these agreements, we pay fixed monthly coupons at fixed rates ranging from 0.716% to 3.10% of the notional amount to the counterparty and receive floating rate LIBOR.  These interest rate swaps are used to limit the price exposure of certain assets due to changes in benchmark USD-LIBOR swap rates from which the pricing of these assets is in part derived.  As of September 30, 2011, the aggregate notional amount of these interest rate swaps totaled $265.0 million. Changes in the fair value of these interest rate swaps are recorded directly in earnings.

 

During the nine months ended September 30, 2011, we entered into a series of derivatives that are intended to hedge against increases in market credit spreads of commercial mortgage-backed securities.  Such movements would have a negative impact on the proceeds we expect to receive from contributing loans into commercial mortgage loan securitizations.  The aggregate notional amount of the remaining derivative is $25.0 million and it matures in December 2011.  Under the terms of the contract, a market credit spread index was defined at the contract’s inception by reference to a portfolio of specific independent CMBS.  To the extent the referenced credit spread index increases, our counterparty pays us.  To the extent the referenced credit spread index decreases, we pay our counterparty.  We pay/receive approximately every 30 days based upon the movement in the referenced index during such period.    We were due $0.2 million as of September 30, 2011.  As movements in the referenced index are settled each month, the $0.2 million receivable as of September 30, 2011 is considered to be a reasonable estimate of the contract’s fair value as of that date.

 

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of September 30, 2011 and December 31, 2010.

 

Tabular Disclosure of Fair Values of Derivative Instruments ($000’s)

 

 

 

Derivatives in an Asset Position

 

Derivatives in a Liability Position

 

 

 

As of September 30, 2011

 

As of December 31,
2010

 

As of September, 2011

 

As of December 31,
2010

 

 

 

Balance
Sheet
Location

 

Fair
Value

 

Balance
Sheet
Location

 

Fair
Value

 

Balance
Sheet
Location

 

Fair
Value

 

Balance
Sheet
Location

 

Fair
Value

 

Derivatives designated as hedging instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

N/A

 

$

 

Derivative Assets

 

$

89

 

Derivative Liabilities

 

$

1,611

 

Derivative Liabilities

 

$

1,714

 

Total derivatives designated as hedging instruments

 

 

 

$

 

 

 

$

89

 

 

 

$

1,611

 

 

 

$

1,714

 

Derivatives not designated as hedging instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

N/A

 

$

 

Derivative Assets

 

$

248

 

Derivative Liabilities

 

$

11,154

 

Derivative Liabilities

 

$

303

 

Foreign exchange contracts

 

Derivative Assets

 

3,588

 

N/A

 

 

Derivative Liabilities

 

 

8,297

 

Derivative Liabilities

 

 

7,383

 

Credit spread derivatives

 

Derivative Assets

 

 

61

 

N/A

 

 

N/A

 

 

N/A

 

 

Total derivatives not designated as hedging instruments

 

 

 

$

3,649

 

 

 

$

248

 

 

 

$

19,451

 

 

 

$

7,686

 

 

Cash flow hedges impact for the three months ended September 30, 2011:

 

20



 

Derivative type for
cash flow hedge 

 

Amount of loss
recognized in
OCI
on derivative
(effective portion)

 

Location of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Amount of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Location of loss
recognized in
income on
derivative
(ineffective portion)

 

Amount of loss
recognized in
income on
derivative
(ineffective portion)

 

Interest Rate Swaps

 

$

544

 

Interest Expense

 

$

527

 

Interest Expense

 

$

 

 

Cash flow hedges impact for the three months ended September 30, 2010:

 

Derivative type for
cash flow hedge

 

Amount of loss
recognized in
OCI
on derivative
(effective portion)

 

Location of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Amount of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Location of gain
recognized in
income on
derivative
(ineffective portion)

 

Amount of gain
recognized in
income on
derivative
(ineffective portion)

 

Interest Rate Swaps

 

$

1,573

 

Interest Expense

 

$

598

 

Interest Expense

 

$

 

 

Cash flow hedges impact for the nine months ended September 30, 2011:

 

Derivative type for
cash flow hedge

 

Amount of loss
recognized in
OCI
on derivative
(effective portion)

 

Location of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Amount of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Location of loss
recognized in
income on
derivative
(ineffective portion)

 

Amount of loss
recognized in
income on
derivative
(ineffective portion)

 

Interest Rate Swaps

 

$

1,759

 

Interest Expense

 

$

1,730

 

Interest Expense

 

$

45

 

 

Cash flow hedges impact for the nine months ended September 30, 2010:

 

Derivative type for
cash flow hedge

 

Amount of loss
recognized in
OCI
on derivative
(effective portion)

 

Location of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Amount of loss
reclassified from
accumulated OCI
into income
(effective portion)

 

Location of gain
recognized in
income on
derivative
(ineffective portion)

 

Amount of gain
recognized in
income on
derivative
(ineffective portion)

 

Interest Rate Swaps

 

$

3,475

 

Interest Expense

 

$

1,178

 

Interest Expense

 

$

 

 

Non-Designated derivatives impact for the three months ended September 30, 2011 and September 30, 2010:

 

Derivatives Not Designated

 

Location of Gain/(Loss)
Recognized in Income on

 

Amount of Gain/(Loss)
Recognized in Income on
Derivative

 

as Hedging Instruments 

 

Derivative

 

2011

 

2010

 

Interest Rate Swaps – Realized losses

 

Gains (losses) on interest rate hedges

 

$

(12,302

)

$

 

Interest Rate Swaps – Unrealized losses

 

Gains (losses) on interest rate hedges

 

$

(6,869

)

$

 

Foreign Exchange – Realized losses

 

Gains (losses) on currency hedges

 

$

(86

)

$

(24

)

Foreign Exchange – Unrealized gains(losses)

 

Gains (losses) on currency hedges

 

$

8,703

 

$

(5,326

)

Credit Spread Derivative– Realized gains

 

Gains (losses) on credit spread hedges

 

$

4,539

 

$

 

Credit Spread Derivative– Unrealized losses

 

Gains (losses) on credit spread hedges

 

$

(2,280

)

$

 

 

Non-Designated derivatives impact for the nine months ended September 30, 2011 and September 30, 2010:

 

Derivatives Not Designated

 

Location of Gain/(Loss)
Recognized in Income on

 

Amount of Gain/(Loss)
Recognized in Income on
Derivative

 

as Hedging Instruments

 

Derivative

 

2011

 

2010

 

Interest Rate Swaps – Realized losses

 

Gains (losses) on interest rate hedges

 

$

(14,883

)

$

 

Interest Rate Swaps – Unrealized losses

 

Gains (losses) on interest rate hedges

 

$

(11,099

)

$

 

Foreign Exchange – Realized losses

 

Gains (losses) on currency hedges

 

$

(292

)

$

(24

)

Foreign Exchange – Unrealized gains(losses)

 

Gains (losses) on currency hedges

 

$

2,674

 

$

(9,020

)

Credit Spread Derivative– Realized gains

 

Gains (losses) on credit spread hedges

 

$

3,569

 

$

 

Credit Spread Derivative– Unrealized gains

 

Gains (losses) on credit spread hedges

 

$

161

 

$

 

 

21



 

Credit-risk-related Contingent Features

 

We have entered into agreements with certain of our derivative counterparties that contain provisions where if we were to default on any of our indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, we may also be declared in default on our derivative obligations. We also have certain agreements that contain provisions where if our ratio of principal amount of indebtedness to total assets at any time exceeds 75%, then we could be declared in default of our derivative agreements.

 

As of September 30, 2011 the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, was $20.2 million. As of September 30, 2011, we had posted collateral of $5.6 million related to these agreements. If we had breached any of these provisions at September 30, 2011, we could have been required to settle our obligations under the agreements at their termination liability value of $20.2 million.

 

9. Related-Party Transactions

 

We entered into a management agreement with the Manager upon closing of our IPO, which provides for an initial term of three years with automatic one-year extensions thereafter unless terminated as described below. Under the management agreement, the Manager, subject to the oversight of our board of directors, is required to manage our day-to-day activities, for which the Manager receives a base management fee and is eligible for an incentive fee and stock awards. The Manager is also entitled to charge us for certain expenses incurred on our behalf, as described below.

 

Base Management Fee.    The base management fee is 1.5% of our stockholders’ equity per annum and calculated and payable quarterly in arrears in cash. For purposes of calculating the management fee, our stockholders’ equity means: (a) the sum of (1) the net proceeds from all issuances of our equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus (2) our retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less (b) any amount that we pay to repurchase our common stock since inception. It also excludes (1) any unrealized gains and losses and other non-cash items that have impacted stockholders’ equity as reported in our financial statements prepared in accordance with GAAP, and (2) one-time events pursuant to changes in GAAP, and certain non-cash items not otherwise described above, in each case after discussions between the Manager and our independent directors and approval by a majority of our independent directors. As a result, our stockholders’ equity, for purposes of calculating the management fee, could be greater or less than the amount of stockholders’ equity shown on our financial statements.

 

For the three and nine month period ended September 30, 2011, approximately $6.7 and $17.6 million was incurred for base management fees, respectively, of which $6.7 million was payable at September 30, 2011.  For the three and nine month period ended September 30, 2010, approximately $3.4 million and $10.3 million was incurred for base management fees, respectively, of which $3.5 million was payable at September 30, 2010.

 

Incentive Fee.    From August 17, 2009 (the effective date of the management agreement), the Manager is entitled to be paid the incentive fee described below with respect to each calendar quarter (or part thereof that the management agreement is in effect) if (1) our Core Earnings (as defined below) for the previous 12-month period (or part thereof that the management agreement is in effect) exceeds an 8% threshold, and (2) our Core Earnings for the 12 most recently completed calendar quarters (or part thereof that the management agreement is in effect) is greater than zero.

 

The incentive fee will be an amount, not less than zero, equal to the difference between (1) the product of (x) 20% and (y) the difference between (i) our Core Earnings (as defined below) for the previous 12-month period (or part thereof that the management agreement is in effect), and (ii) the product of (A) the weighted average of the issue price per share of our common stock of all of our public offerings multiplied by the weighted average number of all shares of common stock outstanding (including any restricted stock units, any restricted shares of common stock and other shares of common stock underlying awards granted under our equity incentive plans) in such previous 12-month period (or part thereof that the management agreement is in effect), and (B) 8%, and (2) the sum of any incentive fee paid to the Manager with respect to the first three calendar quarters of such previous 12-month period (or part thereof that the management agreement is in effect). One half of each quarterly installment of the incentive fee is payable in shares of our common stock so long as the ownership of such additional number of shares by the Manager would not violate the 9.8% stock ownership limit set forth in our articles of incorporation, after giving effect to any waiver from such limit that our Board of Directors may grant in the future. The remainder of the incentive fee is payable in cash. The number of shares to be issued to the Manager is equal to the dollar amount of the portion of the quarterly installment of the incentive fee payable in shares divided by the average of the closing prices of our common stock on the New York Stock Exchange for the five trading days prior to the date on which such quarterly installment is paid.

 

Core Earnings is a non-GAAP financial measure. We calculate Core Earnings as GAAP net income (loss) excluding non-cash equity compensation expense, the incentive fee, depreciation and amortization of real estate (to the extent that we own properties), any unrealized gains, losses or other non-cash items recorded in net income for the period, regardless of whether such items are included

 

22



 

in other comprehensive income or loss, or in net income. The amount is adjusted to exclude one-time events pursuant to changes in GAAP and certain other non-cash charges as determined by the Manager and approved by a majority of our independent directors.

 

As of December 31, 2010, the incentive fee payable to the Manager was approximately $1.2 million.  For the three and nine month period ended September 30, 2011, approximately $0.4 million and $1.2 million was incurred for the incentive fee, respectively, none of which remained unpaid at September 30, 2011.   As of September 30, 2011, there was no incentive fee accrued.

 

Expense Reimbursement.    We are required to reimburse the Manager for operating expenses incurred by the Manager on our behalf.  In addition, pursuant to the terms of the management agreement, we are required to reimburse the Manager for the cost of legal, tax, consulting, auditing and other similar services rendered for us by the Manager’s personnel provided that such costs are no greater than those that would be payable if the services were provided by an independent third party. The expense reimbursement is not subject to any dollar limitations but is subject to review by our independent directors. For the three and nine months ended September 30, 2011, approximately $1.0 million and $2.8 million was incurred, respectively, for executive compensation and other reimbursable expenses of which approximately $1.1 million was payable as of September 30, 2011.  For the three and nine months ended September 30, 2010, approximately $0.4 million and $1.2 million was incurred, respectively, for executive compensation and other reimbursable expenses of which approximately $0.2 million was payable as of September 30, 2010.

 

Termination Fee.    After the initial three-year term, we can terminate the management agreement without cause, as defined in the management agreement, with an affirmative two-thirds vote by our independent directors and 180 days written notice to the Manager. Upon termination without cause, the Manager is due a termination fee equal to three times the sum of the average annual base management fee and incentive fee earned by the Manager over the preceding eight calendar quarters. No termination fee is payable if the Manager is terminated for cause, as defined in the management agreement, which can be done at any time with 30 days written notice from our Board of Directors.

 

10. Stockholders’ Equity

 

Our authorized capital stock consists of 100,000,000 shares of preferred stock, $0.01 par value per share, and 500,000,000 shares of common stock, $0.01 par value per share.

 

On August 17, 2009, we sold 47,575,000 shares of our common stock (including 1,000,000 shares sold to an entity controlled by Starwood Capital Group pursuant to a simultaneous private placement) in our IPO at an offering price of $20 per share.

 

In December 2010, we completed a follow-on offering of 23,000,000 shares of our common stock at a price of $19.73 per share.

 

In May 2011, we completed another follow-on offering of 22,000,000 shares of our common stock at a price of $21.67 per share.

 

On August 2, 2011, our Board of Directors declared a dividend of $0.44 per share of common stock for the quarter ended September 30, 2011.  The dividend was paid on October 15, 2011 to common stockholders of record on September 30, 2011.

 

In August 2011, our Board of Directors authorized us to repurchase up to $100 million of our outstanding common shares over a one-year period.  Purchases made pursuant to the program are to be made in either the open market or in privately negotiated transactions from time to time as permitted by federal securities laws and other legal requirements. The timing, manner, price and amount of any repurchases are determined by us and are subject to economic and market conditions, stock price, applicable legal requirements and other factors. The program may be suspended or discontinued at any time.  Through September 30, 2011, we purchased 342,000 common shares on the open market at an aggregate cost of approximately $6.0 million, resulting in a weighted average share cost of $17.49.

 

Equity Incentive Plans

 

We have reserved an aggregate of 3,112,500 shares of common stock for issuance under the Starwood Property Trust, Inc. Equity Plan and Starwood Property Trust, Inc. Manager Equity Plan and an additional 100,000 shares of common stock for issuance under the Starwood Property Trust, Inc. Non-Executive Director Stock Plan. These plans provide for the issuance of restricted stock or restricted stock units. The holders of awards of restricted stock or restricted stock units will be entitled to receive dividends or “distribution equivalents,” which will be payable at such time dividends are paid on our outstanding common shares.

 

We granted each of our four independent directors 2,200 restricted shares concurrently with our IPO, with a total fair value of approximately $175,000. The grants vest ratably in three annual installments on each of the first, second, and third anniversaries of the grant date, respectively, subject to the director’s continued service. Effective August 19, 2010, we granted each of our four independent directors an additional 1,000 restricted shares, with a total fair value of approximately $75,000. The grants vested in

 

23



 

one annual installment on the first anniversary of the grant.  Effective August 19, 2011, we granted each of our four independent directors an additional 2,877 restricted shares, with a total fair value of approximately $200,000. The grant will vest in one annual installment on the first anniversary of the grant, subject to the director’s continued service.   For the three and nine months ended September 30, 2011, approximately $48,000 and $114,000 was included in general and administrative expense, respectively, related to the grants.  For the three and nine months ended September 30, 2010, approximately $30,000 and $52,000 was included in general and administrative expense, respectively, related to the grants.

 

In August 2009, we granted 1,037,500 restricted stock units with a fair value of approximately $20.8 million at the grant date to the Manager under the Manager Equity Plan. The grants vest ratably in quarterly installments over three years beginning on October 1, 2009, with 86,458 shares vesting each quarter, respectively. In connection with the supplemental equity offering in December 2010, we granted 1,075,000 restricted stock units with a fair value of approximately $21.8 million at the grant date to the Manager under the Manager Equity Plan. The grants vest ratably in quarterly installments over three years beginning on March 31, 2011, with 89,583 shares vesting each quarter. For the three and nine months ended September 30, 2011, approximately 176,041 and 528,123 shares have vested, respectively, and approximately $2.9 million and $10.3 million has been included in management fees related to these grants, respectively.  For the three and nine months ended September 30, 2010, approximately $1.7 million and $4.6 million has been included in management fees related to these grants, respectively.

 

In May 2011, we issued 9,021 shares of common stock to the Manager at a price of $22.08 per share. The shares were issued to the Manager as part of the incentive compensation due to the Manager under the Management Agreement.  See Note 9.

 

We granted 5,000 restricted stock units with a fair value of $100,000 to an employee under the Starwood Property Trust, Inc. Equity Plan in August 2009. The award was scheduled to vest ratably in quarterly installments over three years beginning on October 1, 2009. Upon the departure of this employee in July, 2010, we issued 1,250 shares of our common stock relating to the vested portion of the award, while the remaining 3,750 unvested units were forfeited.  In February 2011, we granted 11,082 restricted stock units with a fair value of $250,000 to an employee under the Starwood Property Trust, Inc. Equity Plan.  The award vests ratably in quarterly installments over three years beginning on March 31, 2011.  For the three and nine months ended September 30, 2011, 924 and 2,771 shares have vested, respectively, and approximately $21,000 and $50,000, respectively, was included in general and administrative expense related to the grants.  For the three and nine months ended September 30, 2010, approximately $0 and $16,000 was included in general and administrative expense related to these grants.

 

Schedule of Non-Vested Share and Share Equivalents

 

 

 

Restricted Stock
Grants to
Independent
Directors

 

Restricted Stock
Unit
Grants to
Employees

 

Restricted Stock
Unit
Grants to
Manager

 

Total

 

Balance as of December 31, 2010

 

10,601

 

 

1,680,208

 

1,690,809

 

Granted

 

11,508

 

11,082

 

 

22,590

 

Vested

 

(6,933

)

(2,771

)

(528,123

)

(537,827

)

Forfeited

 

 

 

 

 

Balance as of September 30, 2011

 

15,176

 

8,311

 

1,152,085

 

1,175,572

 

 

Vesting Schedule

 

 

 

Restricted Stock
Grants to
Independent
Directors

 

Restricted Stock
Unit
Grants to
Employees

 

Restricted Stock
Unit
Grants to
Manager

 

Total

 

2011 (remainder of)

 

 

923

 

176,043

 

176,966

 

2012

 

2,935

 

3,694

 

617,709

 

624,338

 

2013

 

12,241

 

3,694

 

358,333

 

374,268

 

Total

 

15,176

 

8,311

 

1,152,085

 

1,175,572

 

 

11. Net Income per Share

 

Net income per share for the three and nine month periods ended September 30, 2011, is computed as follows (amounts in thousands except share and per share):

 

24



 

 

 

Three-Months
Ended
September 30, 2011

 

Nine-Months
Ended
September 30, 2011

 

Basic and Diluted:

 

 

 

 

 

Net income attributable to Starwood Property Trust, Inc.

 

$

14,478

 

$

78,349

 

Weighted average number of shares of common stock outstanding

 

93,249,249

 

82,234,976

 

Basic net income (loss) per share

 

$

0.16

 

$

0.95

 

Weighted average number of diluted shares outstanding (1)

 

94,596,978

 

83,755,295

 

Diluted net income per share

 

$

0.15

 

$

0.94

 

 


(1) The weighted average number of diluted shares outstanding includes the impact of unvested restricted stock units totaling 1,175,572 and 702,268 as of September 30, 2011 and 2010, respectively.

 

Net income per share for the three and nine month periods ended September 30, 2010, is computed as follows (amounts in thousands except share and per share):

 

 

 

Three-Months
Ended
September 30, 2010

 

Nine-Months
Ended
September 30, 2010

 

Basic and Diluted:

 

 

 

 

 

Net income attributable to Starwood Property Trust, Inc.

 

$

22,683

 

$

39,473

 

Weighted average number of shares of common stock outstanding

 

47,837,616

 

47,750,058

 

Basic net income (loss) per share

 

$

0.47

 

$

0.83

 

Weighted average number of diluted shares outstanding (1)

 

48,626,550

 

48,626,550

 

Diluted net income per share

 

$

0.47

 

$

0.81

 

 


(1) The weighted average number of diluted shares outstanding includes the impact of unvested restricted stock units totaling 1,175,572 and 702,268 as of September 30, 2011 and 2010, respectively.

 

12. Fair Value of Financial Instruments

 

GAAP establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial instruments 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 a security. These may include quoted prices for similar securities, interest rates, prepayment speeds, 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.

 

Any changes to the valuation methodology will be reviewed by our management to ensure the changes are appropriate. The methods used may produce a fair value calculation that is not indicative of net realizable value or reflective of future fair values. Furthermore, while we anticipate that our valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. We use inputs that are current as of the measurement date, which may fall within periods of market dislocation, during which price transparency may be reduced.

 

The following table presents the Company’s financial instruments carried at fair value on a recurring basis in the consolidated balance sheet as of September 30, 2011 (amounts in thousands):

 

25



 

 

 

Fair Value at Reporting Date Using Inputs:

 

 

 

September 30, 2011

 

 

 

Total

 

Level I

 

Level II

 

Level III

 

 

 

 

 

 

 

 

 

 

 

Loans held-for-sale at fair value

 

$

121,229

 

 

 

 

 

$

121,229

 

Available-for-sale debt securities:

 

 

 

 

 

 

 

 

 

Residential-mortgage-backed securities

 

164,393

 

 

 

 

 

 

164,393

 

Commercial-mortgage-backed securities

 

187,707

 

 

 

 

 

187,707

 

 

 

 

 

 

 

 

 

 

 

Total available-for-sale debt securities

 

352,100

 

 

 

352,100

 

Available-for-sale equity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Real estate industry

 

9,985

 

$

9,985

 

 

 

 

 

 

 

 

 

 

 

 

 

Total available-for-sale equity securities:

 

9,985

 

9,985

 

 

 

Total investments:

 

483,314

 

9,985

 

 

473,329

 

Derivative Assets:

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

3,588

 

 

 

3,588

 

 

 

Credit contracts

 

61

 

 

 

61

 

 

 

Derivatives Liabilities:

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

(12,765

)

 

 

(12,765

)

 

 

Foreign exchange contracts

 

(8,297

)

 

 

(8,297

)

 

 

 

 

 

 

 

 

 

 

 

 

Total Derivatives:

 

(17,413

)

 

(17,413

)

 

Total:

 

$

465,901

 

$

9,985

 

$

(17,413

)

$

473,329

 

 

The changes in investments classified as Level III are as follows for the nine-months ended September 30, 2011 (amounts in thousands):

 

Fair Value Measurements Using Significant Unobservable Inputs

(Level III)

 

 

 

Loans held-for-sale, at
fair value

 

MBS available-
for-sale at fair
value

 

Total

 

Beginning balance, January 1, 2011

 

$

144,163