|
|
 | | | |
- close
- close
- close
- close
| |||||||||
Northstar Realty Finance 10-Q 2009
Use these links to rapidly review the document
UNITED STATES FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) For the quarterly period ended June 30, 2009 Commission File Number: 001-32330 NORTHSTAR REALTY FINANCE CORP.
399 Park Avenue, 18th Floor New York, NY 10022 (212) 547-2600 Indicate by the 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 ý 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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 the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: The Company has one class of common stock, par value $0.01 per share, 68,382,300 shares outstanding as of August 4, 2009.
Table of Contents
2
See accompanying notes to condensed consolidated financial statements 3
4
See accompanying notes to condensed consolidated financial statements 5
See accompanying notes to condensed consolidated financial statements 6
See accompanying notes to condensed consolidated financial statements 7
1. Formation and Organization NorthStar Realty Finance Corp., a Maryland corporation (the "Company"), is a self-administered and self-managed real estate investment trust ("REIT"), which was formed in October 2003 in order to continue and expand the real estate debt, real estate securities and net lease businesses conducted by NorthStar Capital Investment Corp. ("NCIC"). Substantially all of the Company's assets are held by, and it conducts its operations through, NorthStar Realty Finance Limited Partnership, a Delaware limited partnership and the operating partnership of the Company (the "Operating Partnership"). On October 29, 2004, the Company closed its initial public offering pursuant to which it issued 20,000,000 shares of common stock, with proceeds to the Company of approximately $160.1 million, net of issuance costs of $19.9 million. Simultaneously with the closing of the equity offering on October 29, 2004, three majority-owned subsidiaries of NCIC contributed certain controlling and non-controlling interests in entities through which NCIC conducted its subordinate real estate debt, real estate securities and net lease businesses to the Operating Partnership in exchange for an aggregate of 4,705,915 units of limited partnership interest in the Operating Partnership (the "OP Units") and approximately $36.1 million in cash and an agreement to pay certain related transfer taxes on behalf of NCIC for approximately $1.0 million. From their inception through October 29, 2004, neither the Company nor the Operating Partnership had any operations. Joint Ventures In May 2006, the Company entered into joint venture with Chain Bridge Capital LLC to invest in senior housing and healthcare-related net leased assets, called Wakefield. In connection with the formation of the venture, Chain Bridge contributed substantially all of its assets to Wakefield for its $15.1 million membership interest in the joint venture. On July 9, 2008, Wakefield sold a $100 million convertible preferred membership interest to Inland American Real Estate Trust, Inc. ("Inland American"). The Company received approximately $87.7 million of net proceeds from the transaction. Prior to conversion, the convertible preferred investment is entitled to a 10.5% dividend per annum. The convertible preferred membership interest may be converted or redeemed, at Inland American's option, upon the sale or recapitalization of the Wakefield venture. Wakefield may, at its option, redeem the convertible preferred interests at any time following the first anniversary of the closing, subject to payment of a call premium that declines over time. In addition, at any time after the second anniversary of the closing, Inland American may convert its preferred membership interests into common equity in Wakefield. Based on the initial investment amount and capital accounts of the Wakefield members, the convertible preferred membership interests represent, upon conversion, approximately a 42% common equity ownership interest in Wakefield. Inland American will have the option of contributing additional preferred membership interest and participating in new Wakefield investment opportunities in proportion to its percentage ownership interest, assuming it was to convert its interests to common equity. In June 2009, the Company restructured its net lease relationship with one of its healthcare operators to take advantage of new REIT legislation which now allows a taxable REIT subsidiary affiliate to become the lessee of healthcare-related properties. The restructuring resulted in one of the 8
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 1. Formation and Organization (Continued) Company's unconsolidated affiliate Midwest Care Holdco TRS I LLC ("Midwest") becoming the lessee of the properties and Midwest simultaneously entering into a management contract with a third party operator. The management agreement is terminable by Midwest upon 60 days notice. This new structure allows the Company to participate in operating improvements of the underlying properties not previously available under the prior structure. The Company owns a 49% interest in Midwest and does not control the major decisions and as a result, the Company does not consolidate the operations of Midwest. The Company's investment in Midwest will be accounted for using the equity method. The Company terminated two additional leases for certain other net leased senior housing assets in its Wakefield joint venture and assumed the operations of these facilities, which are managed by an experienced third-party operator. The Company controls substantially all major decisions of the joint venture. Accordingly, the joint venture's financial statements are consolidated into the Company's consolidated financial statements and Inland American's and Chain Bridge's capital are treated as non-controlling interests. In March 2007, the Company entered into a joint venture with Monroe Capital Holdco, LLC ("Monroe"), which served as a platform for originating middle-market loans. The joint venture ("Monroe Capital") originated, structured and syndicated middle-market corporate loans, including middle-market loans to highly leveraged borrowers. On May 7, 2008, the Company completed a recapitalization of this middle-market corporate lending venture. As part of the recapitalization, an institutional money-manager invested approximately $87.2 million of cash equity into the business and the Company contributed $6.8 million of new equity capital and its CLO equity interests. The lender under two consolidated revolving credit facilities totaling $800.0 million of capacity and having $378.0 million outstanding at May 7, 2008, which the Company refers to as the MC Facility and the MC VFCC Facility, extinguished a portion of the outstanding debt balance and refinanced the remaining indebtedness in the form of a private CLO which match funded the underlying assets. The venture was also permitted to sell a portion of the loan collateral and to use the cash to make new corporate loan investments. The new investor became the controlling manager of the entity and the Company deconsolidated the venture. Additionally, as part of this recapitalization, the Company terminated its joint venture with Monroe Management. 2. Summary of Significant Accounting Policies Basis of Quarterly Presentation The accompanying condensed consolidated financial statements and related notes of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of the Company's financial position, results of operations and cash flows have been included and are of a 9
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 2. Summary of Significant Accounting Policies (Continued) normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2008, which was filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in the Company's December 31, 2008 consolidated financial statements included in its annual report on Form 10-K. Principles of Consolidation The consolidated financial statements include the accounts of the Company, and its subsidiaries, which are either majority owned or controlled by the Company or a variable interest entity ("VIE") where the Company is the primary beneficiary in accordance with the provision of FASB Staff Position No. FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)," ("FSP FIN 46(R)-6"). All significant intercompany balances have been eliminated in consolidation. Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that could affect the amounts reported in the condensed consolidated financial statements. Actual results could differ from these estimates. Reclassifications On January 1, 2009, the Company adopted FASB Staff Position APB 14-1, "Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)" ("FSP APB 14-1"). FSP APB 14-1 applies to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement of the conversion option. FSP APB 14-1 requires bifurcation of the instrument into a debt component that is initially recorded at fair value and an equity component. The difference between the fair value of the debt component and the initial proceeds from issuance of the instrument is recorded as a component of equity. The liability component of the debt instrument is accreted to par using the effective interest method; accretion is reported as a component of interest expense. The equity component is not subsequently re-valued as long as it continues to qualify for equity treatment. Additionally, FSP APB 14-1 precludes the use of the fair value option pursuant to SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." The adoption of FSP APB 14-1 resulted in the Company recognizing additional non-cash interest expense of approximately $0.6 million and $0.6 million and $1.3 million and $1.2 million in the statements of operations for the three and six months ended June 30, 2009 and 2008, respectively. The financial statements for 2008 have been restated for the effects of the retroactive application of FSP APB 14-1. 10
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 2. Summary of Significant Accounting Policies (Continued) The following tables present the cumulative effects of the change in accounting principle as of December 31, 2008 and for the three and six months ended June 30, 2008:
As of June 30, 2009 and December 31, 2008, the total carrying amount of the equity components of the exchangeable senior notes was $6.0 million and $9.2 million, respectively. The principal amount of the exchangeable senior notes liabilities was $158.2 million and $240.8 million as of June 30, 2009 and December 31, 2008, respectively. The unamortized discount of the liability components was $4.3 million and $7.5 million at June 30, 2009 and December 31, 2008, respectively. The net carrying amount of the liability components was $153.9 million and $233.3 million at June 30, 2009 and December 31, 2008, respectively. Interest expense for the three and six months ended June 30, 2009 and 2008 related to the exchangeable senior notes was $5.1 million and $9.7 million and $4.6 million and $8.3 million, respectively, of which $4.5 million and $8.4 million and $4.0 million and $7.1 million 11
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 2. Summary of Significant Accounting Policies (Continued) was related to contractual interest, respectively, and $0.6 million and $1.3 million and $0.6 million and $1.2 million was attributable to amortization of the debt discount and deferred financing costs, respectively. On January 1, 2009, the Company adopted SFAS 160, "Non-controlling Interests in Consolidated Financial Statements" ("SFAS 160"). SFAS 160 clarifies that a non-controlling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. SFAS 160 also changes the way the consolidated income statement is presented by requiring consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. The adoption of SFAS 160 does not affect prior periods reported net income or retained earnings; however, the presentation and disclosure requirements have been applied retrospectively for all periods presented. Recent Accounting Pronouncements In January 2009, the FASB issued FSP EITF 99-20-1, which amends the impairment guidance in EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets" ("FSP EITF 99-20-1") to achieve more consistent determination of whether an other-than-temporary impairment has occurred. FSP EITF 99-20-1 also retains and emphasizes the objective of an other-than-temporary impairment assessment and the related disclosure requirements in SFAS 115 and other related guidance. FSP EITF 99-20-1 is effective and should be applied prospectively for financial statements issued for fiscal years and interim periods ending after December 15, 2008. The Company's adoption of FSP EITF 99-20-1 did not have a material effect on its financial condition, results of operations, or cash flows. In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 ("FSP FAS 115-2 and FAS 124-2") which is intended to provide greater clarity to investors about the credit and noncredit component of an other-than-temporary event and to more effectively communicate when an other-than-temporary event has occurred. FSP FAS 115-2 and FAS 124-2 applies to debt securities and requires that the total other-than-temporary impairment be presented in the statement of income with an offset for the amount of impairment that is recognized in other comprehensive income, which is the noncredit component. Noncredit component losses are to be recorded in other comprehensive income if an investor can assess that (a) it does not have the intent to sell or (b) it is not more likely than not that it will have to sell the security prior to its anticipated recovery. FSP FAS 115-2 and FAS 124-2 are effective for interim and annual periods ending after June 15, 2009. FSP FAS 115-2 and FAS 124-2 will be applied prospectively with a cumulative effect transition adjustment as of the beginning of the period in which it is adopted. The Company's adoption of FSP FAS 115-2 and FAS 124-2 did not have a material effect on its financial condition, results of operations, or cash flows. In April 2009, FASB issued FSP FAS 157-4 "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That 12
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 2. Summary of Significant Accounting Policies (Continued) Are Not Orderly" ("FSP FAS 157-4"), which provides additional guidance on determining whether a market for a financial asset is not active and a transaction is not distressed for fair value measurements under FASB Statement No. 157, "Fair Value Measurements" ("SFAS 157"). FSP FAS 157-4 will be applied prospectively and retrospective application is not permitted. FSP FAS 157-4 is effective for interim and annual periods ending after June 15, 2009. The Company's adoption of FSP FAS 157-4 did not have a material effect on its financial condition, results of operations, or cash flows. In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1 ("FSP FAS 107-1 and APB 28-1 ") which will amend FASB Statement No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS 107"). FSP FAS 107-1 and APB 28-1 will require an entity to provide disclosures about the fair value of financial instruments in interim financial information. FSP FAS 107-1 and APB 28-1 would apply to all financial instruments within the scope of SFAS 107 and will require entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments, in both interim financial statements as well as annual financial statements. FSP FAS 107-1 and APB 28-1 is effective for interim and annual periods ending after June 15, 2009. The Company's adoption of FSP FAS 107-1 and APB 28-1 did not have a material effect on its financial condition, results of operations, or cash flows. In May 2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"), which establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The Company adopted the provisions of SFAS 165 for the quarter ended June 30, 2009. The Company's adoption of these provisions did not have a material effect on its financial condition, results of operations, or cash flows. In June 2009, the FASB issued SFAS No. 166, "Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140" ("SFAS 166"), which requires additional information regarding transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. SFAS 166 eliminates the concept of a "qualifying special-purpose entity," changes the requirements for derecognizing financial assets, and requires additional disclosures. SFAS 166 is effective for fiscal years beginning after November 15, 2009. The Company is currently evaluating the impact that the adoption of SFAS 166 will have on its financial condition, results of operations, and disclosures. In June 2009, the FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R)" ("SFAS 167"), which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. SFAS 167 clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. SFAS 167 requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. SFAS 167 also requires additional disclosures about a company's involvement in variable interest entities and any significant changes in risk exposure due to that involvement. SFAS 167 is effective for 13
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 2. Summary of Significant Accounting Policies (Continued) fiscal years beginning after November 15, 2009. The Company is currently evaluating the impact that the adoption of SFAS 167 will have on its financial condition, results of operations, and disclosures. In June 2009, the FASB approved the "FASB Accounting Standards Codification" ("Codification") as the single source of authoritative nongovernmental U.S. GAAP to be launched on July 1, 2009. The Codification does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all the authoritative literature related to a particular topic in one place. All existing accounting standard documents will be superseded and all other accounting literature not included in the Codification will be considered nonauthoritative. The Codification is effective for interim and annual periods ending after September 15, 2009. The Codification will not have an impact on the Company's financial condition or results of operations. 3. Fair Value of Financial Instruments The Company has elected to apply the fair value option in accordance with SFAS No. 159 "The Fair Value Option" ("SFAS 159") to the following financial assets and liabilities existing at the time of adoption or at the time the Company recognizes the eligible item:
The Company has elected the fair value option for the above financial instruments for the purpose of enhancing the transparency of its financial condition. Fair Value Measurements SFAS 157 "Fair Value Measurement" ("SFAS 157") defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements. In addition, SFAS 157 requires an issuer to incorporate changes in its own credit spreads when determining the fair value of its liabilities. Fair Value Hierarchy In accordance with SFAS 157, the Company has categorized its financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument. 14
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 3. Fair Value of Financial Instruments (Continued) Financial assets and liabilities recorded on the condensed consolidated balance sheets are categorized based on the inputs to the valuation techniques as follows:
As required by SFAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following table sets forth the 15
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 3. Fair Value of Financial Instruments (Continued) Company's financial assets and liabilities that were accounted for at fair value on a recurring basis as of June 30, 2009 by level within the fair value hierarchy:
The following table presents additional information about the Company's available for sale securities, corporate lending investment, bonds payable and liabilities to subsidiary trusts issuing 16
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 3. Fair Value of Financial Instruments (Continued) preferred securities which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value: Fair Value Measurements Using Significant Unobservable Inputs (Level 3):
Fair Value Option SFAS 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attributable to certain financial assets and liabilities. Changes in fair value for assets and liabilities for which the election is made will be recognized in earnings as they occur. SFAS 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of 17
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 3. Fair Value of Financial Instruments (Continued) accounting for that instrument. The following table sets forth the Company's financial instruments for which the fair value option was elected:
The following table presents the difference between fair values and the aggregate contractual amounts of available for sale securities and liabilities, for which the fair value option has been elected:
At June 30, 2009, the basis in the Company's corporate lending investment was $73.9 million. The Company has elected the fair market value option pursuant to SFAS 159 for this investment which is 18
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 3. Fair Value of Financial Instruments (Continued) accounted for under the equity method of accounting. The fair market value of the Company's investment at June 30, 2009 was $14.1 million. For the three and six months ended June 30, 2009 and 2008, the Company recognized a net loss of $6.7 million and $73.9 million and a net gain of $82.5 million and $169.2 million, respectively, as the result of the change in fair value of financial assets and liabilities for which the fair value option was elected, which is recorded as unrealized gain (loss) on investments and other in the Company's condensed consolidated statement of operations. The impact of changes in instrument-specific credit spreads on N-Star bonds payable, liability to subsidiary trusts issuing preferred securities and derivatives for which the fair value option was elected was a net gain of $115.9 million for the six months ended June 30, 2009. The Company attributes changes in the fair value of floating rate liabilities to changes in instrument-specific credit spreads. For fixed rate liabilities, the firm allocates changes in fair value between interest rate-related changes and credit spread-related changes based on changes in interest rates. 4. Operating Real Estate Chatsworth Property One of the Company's net lease investments is comprised of three office buildings totaling 257,000 square feet located in Chatsworth, CA and was 100% leased to Washington Mutual Bank, FA ("WaMu"). The tenant vacated the building as of March 23, 2009, and the lease was terminated. The assets are financed with a non-recourse $42.9 million first mortgage loan. The assets are also refinanced with a $9.2 million mezzanine loan which is collateral for one of the Company's securities term financings. In the fourth quarter of 2008, the Company took an impairment charge relating to these properties and is in the process of transferring title to the first mortgage special servicer. The net book value in the assets currently is approximately equal to the mortgage debt, and the Company therefore does not expect the transfer to materially impact its income statement. 19
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 5. Available for Sale Securities The following is a summary of the Company's available for sale securities at June 30, 2009 and December 31, 2008:
At June 30, 2009, the maturities of the available for sale securities ranged from one to 44 years. During the three and six months ended June 30, 2009, proceeds from the sale and redemption of available for sale securities was $47.2 million and $63.7 million, respectively and the realized gain on sale was $15.2 million and $17.7 million, respectively.
At December 31, 2008, the maturities of the available for sale securities ranged from two to 44 years. 20
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 6. Real Estate Debt Investments At June 30, 2009 and December 31, 2008, the Company held the following real estate debt investments:
21
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 6. Real Estate Debt Investments (Continued)
Contractual maturities of real estate debt investments at June 30, 2009 are as follows:
22
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 6. Real Estate Debt Investments (Continued) $28.5 million, and a whole loan with an initial maturity of April 1, 2009 and a principal balance of $13.8 million that remain outstanding as of June 30, 2009. Actual maturities may differ from contractual maturities because certain borrowers have the right to prepay with or without prepayment penalties. The contractual amounts differ from the carrying amounts due to unamortized origination fees and costs and unamortized premiums and discounts being reported as part of the carrying amount of the investment. Maturity Including Extensions assumes that all loans with extension options will qualify for extension at initial maturity according to the conditions stipulated in the related loan agreements. On June 30, 2009, the Company received $23.6 million of cash proceeds relating to the repayment of a $27.4 million first mortgage loan backed by a data center property bearing interest at LIBOR + 4.5% and having a February 2012 final maturity date. The Company agreed to the discounted payoff of its loan on this niche asset for the economic and credit risk benefits. Accordingly, for the second quarter 2009, the Company recorded a $3.8 million credit loss relating to this discounted payoff. Non-Performing Loans and Provision for Loan Losses As of June 30, 2009, the Company had four non-performing loans totaling $73.0 million which consisted of a first mortgage having a principal balance of $21.3 million and a maturity date of October 1, 2008, a junior participation in a first mortgage having a principal balance of $28.5 million and a maturity date of March 1, 2009, a first mortgage having a principal balance of $13.8 million and a maturity date of April 1, 2009 and a mezzanine loan having a principal balance of $9.4 million and a maturity date of August 1, 2009, representing approximately 3.5% of the Company's total commercial real estate debt investments. The Company's maximum exposure to loss related to these loans would be equal to the outstanding principal balance less reserves taken. 23
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 6. Real Estate Debt Investments (Continued) For the three and six months ending June 30, 2009, the Company recorded a $17.0 million and $38.5 million credit loss provision relating to eight and 13 loans, respectively. As of June 30, 2009, the loan loss reserves totaled $49.7 million. 7. Investment in and Advances to Unconsolidated Ventures The Company has non-controlling, unconsolidated ownership interests in entities that are accounted for using the equity method. Capital contributions, distributions, and profits and losses of the real estate entities are allocated in accordance with the terms of the applicable partnership and limited liability company agreements. Such allocations may differ from the stated percentage interests, if any, in such entities as a result of preferred returns and allocation formulas as described in such agreements. CS/Federal Venture In February 2006, the Company, through a joint venture with an institutional investor, acquired a portfolio of three adjacent class A office/flex buildings located in Colorado Springs, Colorado for $54.3 million. The joint venture financed the transaction with two non-recourse, first mortgage loans totaling $38.0 million and the balance in cash. The loans mature on February 11, 2016 and bear fixed interest rates of 5.51% and 5.46%. The Company contributed $8.4 million for a 50% interest in the joint venture and incurred $0.3 million in costs related to its acquisition, which are capitalized to the investment account. These costs will be amortized over the useful lives of the assets held by the joint venture. The Company accounts for its investment under the equity method of accounting. At June 30, 2009 and December 31, 2008, the Company had an investment in CS/Federal of approximately $7.0 million and $7.3 million, respectively. The Company recognized equity in earnings of $0.1 million and $0.2 million for each of the three and six months ended June 30, 2009 and June 30, 2008, respectively. Monroe Capital Management Advisors, LLC In March 2007, the Company entered into a joint venture with Monroe Management, a Chicago-based firm, and acquired a 49.9% non-controlling interest in Monroe Management. Monroe Management originated, structured and syndicated middle-market corporate loans for Monroe Capital and provided asset management services. On May 7, 2008, the Company terminated its joint venture with Monroe Management upon the completion of the recapitalization of Monroe Capital. See Note 1 for additional information. G-NRF, LTD On May 7, 2008, the Company completed a recapitalization of Monroe Capital, its middle-market corporate lending platform. Upon completion of the recapitalization transaction, the new investor became the controlling manager of the assets and the Company deconsolidated the joint venture. The Company currently uses the equity method of accounting to account for the recapitalized joint venture and has elected the fair value option under SFAS 159 for its equity investment. As of June 30, 2009, 24
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 7. Investment in and Advances to Unconsolidated Ventures (Continued) the fair market value of the Company's investment in the corporate lending venture was $14.1 million. For the three and six months ended June 30, 2009, the Company recognized an unrealized loss of $4.6 million and $29.9 million related to the fair value adjustment on its equity investment, respectively. The company conducted its quarterly comprehensive credit review of this investment and as a result, concluded that due to the uncertainty of the underlying cash flows, the Company will utilize the cost recovery method of accounting for income recognition on this investment. NorthStar Real Estate Securities Opportunity Fund In July 2007, the Company closed on $109.0 million of equity capital for its Securities Fund, an investment vehicle in which the Company conducts most of its real estate securities investment business. The Company is the manager and general partner of the Securities Fund. The Company receives base management fees ranging from 1.0% to 2.0% per annum on third-party capital and is entitled to annual incentive management fees ranging from 20% to 25% of the increase in the Securities Fund's net asset value in excess of an 8.0% per annum return. Base and incentive fees vary depending on the investor capital lockup periods. At June 30, 2009 and December 31, 2008, the Company's investment in the Securities Fund was $19.4 million and $29.3 million, respectively, representing a 49.2% and 53.1% interest in the Securities Fund, respectively. For the three and six months ended June 30, 2009 and 2008, the Company recognized equity in losses of $3.1 million and $5.0 million and $5.4 million and $5.6 million, respectively. The Company also earned $0.1 million and $0.2 million and $0.1 million and $0.3 million in management fees from the Securities Fund for the three and six months ended June 30, 2009 and 2008, respectively. LandCap Investment On October 5, 2007, the Company entered into a joint venture with Whitehall Street Global Real Estate Limited Partnership 2007 ("Whitehall"), to form LandCap Partners, which is referred to as LandCap. LandCap was established to opportunistically invest in single family residential land through land loans, lot option agreements and select land purchases. The venture is managed by professionals who have extensive experience in the single family housing sector. During the first quarter 2009, the Company and Whitehall agreed to provide no additional new investment capital in the LandCap joint venture. The joint venture was subsequently restructured, all employees were terminated and the joint venture entered into an asset management agreement with Solus Management Company ("Solus"). Solus was formed by the former Chief Executive Officer and several other key employees of LandCap, and will manage the existing investments of the venture. At June 30, 2009 and December 31, 2008 the Company's investment in LandCap is carried at $10.5 million and $12.9 million, respectively. For the three and six months ended June 30, 2009 and 2008, the Company recognized equity in loss of $0.4 million and $1.1 million and $2.8 million and $1.6 million, respectively, which consisted primarily of general and administrative expenses. At June 30, 2009 and December 31, 2008, LandCap has made investments totaling $39.1 million. In addition, the Company advanced approximately $4.9 million 25
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 7. Investment in and Advances to Unconsolidated Ventures (Continued) under a loan agreement to LandCap, which bears interest at a fixed rate of 12% and was included in other assets in the condensed consolidated balance sheets. Midwest Care Holdco TRS I LLC In June 2009, the Company restructured its net lease relationship with one of its healthcare operators to take advantage of new REIT legislation which now allows a taxable REIT subsidiary affiliate to become the lessee of healthcare-related properties. The restructuring resulted Midwest becoming the lessee of the properties and Midwest simultaneously entering into a management contract with a third party operator. This new structure allows the Company to participate in operating improvements of the underlying properties not previously available under the prior structure. The Company owns a 49% interest in Midwest and does not control the major decisions and as a result, the Company does not consolidate the operations of Midwest. The Company recognized equity in earnings of $3.3 million for the three and six months ended June 30, 2009. 8. Variable Interest Entities The Company has created and manages portfolios of primarily investment grade commercial real estate securities and real estate debt investments, which were financed in term debt transactions. The collateral securities include CMBS, fixed income securities issued by REITs and term debt transactions backed primarily by real estate securities. These securities are primarily investment grade and generally are not insured by the Federal Housing Administration or guaranteed by the Veterans Administration or otherwise guaranteed or insured. The collateral debt investments include whole loans, subordinate mortgage interests, mezzanine loans and other loans. By financing these securities with long-term debt through the issuance of term debt transactions, the Company expects to generate attractive risk-adjusted equity returns and to match the term of its assets and liabilities. FASB Interpretation No. 46 (revised December 2003),"Consolidation of Variable Interest Entities," ("Fin 46(R)") requires a variable interest entity ("VIE") to be consolidated by its primary beneficiary. The primary beneficiary is the party that absorbs a majority of the VIEs anticipated losses and or a majority of the expected returns. The Company has evaluated its real estate debt investments, liability to subsidiary trusts issuing preferred securities and its investments in each of its eight term debt transaction issuers to determine whether they are VIEs. For each of these investments, the Company has evaluated: (1) the sufficiency of the fair value of the entity's equity investment at risk to absorb losses; (2) whether as a group the holders of the equity investment at risk have: (a) the direct or indirect ability through voting rights to make decisions about the entity's significant activities; (b) the obligation to absorb the expected losses of the entity and their obligations are not protected directly or indirectly; and (c) the right to receive the expected residual return of the entity and their rights are not capped; (3) whether the voting rights of these investors are proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected returns of their equity, or both; and (4) whether substantially all of the entity's activities involve or are conducted on behalf of an investor that has disproportionately fewer voting rights. 26
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 8. Variable Interest Entities (Continued) FSP FIN 46(R)-6 addresses how a reporting enterprise should determine the variability to be considered and provides guidance in applying Fin 46(R). As of June 30, 2009 and December 31, 2008, the Company identified interests in 17 entities which were determined to be VIEs under FSP FIN 46(R)-6. Based on management's analysis, the Company is not the primary beneficiary of 13 of the identified VIEs since it does not absorb a majority of the expected residual losses, or is entitled to a majority of the expected residual returns. Accordingly, these VIEs are not consolidated into the Company's financial statements as of June 30, 2009 or December 31, 2008. Real Estate Debt Investments The Company has identified one real estate debt investment as a variable interest in a VIE in accordance with the provisions of Fin 46(R) and has determined that the Company is not the primary beneficiary of this VIE and as such the VIE should not be consolidated in the Company's consolidated financial statements. The Company's maximum exposure to loss would not exceed the carrying amount of its investment of $23.9 million. For all other investments, the Company has determined that these investments are not VIEs and, as such, the Company has continued to account for all real estate debt investments as loans. NorthStar Realty Finance Trusts The Company owns all of the common stock of NorthStar Realty Finance Trusts I through VIII (collectively, the "Trusts"). The Trusts were formed to issue preferred securities. Under the provisions of FIN 46(R)-6, the Company determined that the holders of the trust preferred securities were the primary beneficiaries of the Trusts. As a result, the Company did not consolidate the Trusts and has accounted for the investment in the common stock of the Trusts under the equity method of accounting. Term Debt Transactions The Company has interests in eight collateralized debt obligations, also referred to as term debt transactions, whose term notes are primarily collateralized by investment grade real estate securities or real estate debt investments. The Company generally purchases the preferred equity or the income notes of each term debt transaction, which are the equity securities of the term debt issuances, and, with the exception of N-Star I, all of the below investment grade term debt notes of each term debt transaction. In addition, the Company earns a fee of 0.35% of the outstanding principal balance of the assets backing each of these term debt issuances as an annual collateral management fee. The Company's interests in each of the term debt transactions is accounted for as a single debt security available for sale pursuant to EITF 99-20. During the first quarter, two of the Company's term debt transactions experienced a credit loss on a security whose issuer filed for bankruptcy. The Company reviewed the equity notes for impairment and determined base upon its analysis that no impairment existed at June 30, 2009. The Company will use the cost recovery method of income recognition for the term notes because of the uncertainty of the income streams of these two term debt transactions. Any 27
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 8. Variable Interest Entities (Continued) potential losses in the Company's off balance sheet term debt transactions is limited to the amortized cost of its investment of $108.9 million at June 30, 2009. Consolidated Term Debt Transactions N-Star IV, VI, VII and VIII are consolidated term debt transactions in accordance with the guidance provided in FSP FIN 46(R)-6. The following tables describe certain terms of the collateral for, and the notes issued by, N-Star IV, N-Star VI, N-Star VII and N-Star VIII at June 30, 2009 and December 31, 2008:
Unconsolidated term debt transactions N-Star I, II, III and V are unconsolidated term debt transactions in accordance with the provisions of FIN 46(R). 28
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 8. Variable Interest Entities (Continued) The following tables describe certain terms of the collateral for, and the notes issued by, N-Star I, N-Star II, N-Star III and N-Star V at June 30, 2009 and December 31, 2008:
29
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 9. Borrowings The following is a table of the Company's outstanding borrowings as of June 30, 2009 and December 31, 2008:
30
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 9. Borrowings (Continued)
31
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 9. Borrowings (Continued) Scheduled principal payment requirements on the Company's borrowings based on initial maturity dates are as follows as of June 30, 2009:
At June 30, 2009, the Company was in compliance with all covenants under its borrowings. During the three and six months ended June 30, 2009, the Company repurchased approximately $21.6 million and $82.6 million of its 7.25% exchangeable senior notes for a total of $9.4 million and $35.2 million, respectively, The Company recorded a net realized gain of $11.9 million and $46.2 million in connection with the repurchase of its notes for the three and six months ended June 30, 2009, respectively. The repurchases for the three and six months ended June 30, 2009 represented a $12.2 million and $47.4 million discount to the par value of the debt, respectively. 10. Related Party Transactions Advisory Fees The Company has agreements with each of N-Star I, N-Star II, N-Star III, N-Star V and N-Star IX to perform certain advisory services. The Company earned total fees on these agreements of approximately $1.8 million and $6.4 million and $3.4 million and $8.6 million for the three and six months ended June 30, 2009 and 2008, respectively. The Company has an agreement with the Securities Fund to receive base management fees ranging from 1.0% to 2.0% per year on third-party capital. For the three months ended June 30, 2008, the Company earned $0.1 million in management fees. For the six months ended June 30, 2009 and 2008, the Company earned $0.1 million and $0.3 million, respectively, in management fees. 32
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 10. Related Party Transactions (Continued) Asset Management Fees The Company entered into a management agreement in April 2006 with Wakefield Capital Management Inc., an affiliate of Chain Bridge, to perform certain management services. The Company incurred $0.9 million and $1.7 million in management fees for each of the three and six months ended June 30, 2009 and 2008, which are recorded in asset management fees-related parties in the condensed consolidated statement of operations. The Company entered into a management agreement in March 2007 with Monroe Management to perform certain management services. On May 7, 2008, the Company terminated its management agreement with Monroe Management. The Company incurred $1.3 million in management fees for the six months ended June 30, 2008, which are recorded in asset management fees-related parties in the condensed consolidated statement of operations. 11. Equity-Based Compensation Omnibus Stock Incentive Plan On September 14, 2004, the Board of Directors of the Company adopted the NorthStar Realty Finance Corp. 2004 Omnibus Stock Incentive Plan (the "Stock Incentive Plan"). The Stock Incentive Plan provides for the issuance of stock-based incentive awards, including incentive stock options, non-qualified stock options, and stock appreciation rights, shares of common stock of the Company, including restricted shares, and other equity-based awards, including OP Units which are structured as profits interests ("LTIP Units") or any combination of the foregoing. The eligible participants in the Stock Incentive Plan include directors, officers and employees of the Company and, prior to October 29, 2005, employees pursuant to the shared facilities and services agreement. An aggregate of 8,933,038 shares of common stock of the Company are currently reserved and authorized for issuance under the Stock Incentive Plan, subject to equitable adjustment upon the occurrence of certain corporate events. As of June 30, 2008, the Company has issued an aggregate of 8,283,340 LTIP Units, net of forfeitures of 60,368 LTIP Units. An aggregate of 898,343 LTIP Units were converted to commons stock and 468,064 shares of common stock were issued pursuant to the Stock Incentive Plan. Of the 8,283,340 LTIP Units, so long as the recipient continues to be an eligible recipient, 5,015,942 will vest to the individual recipient at a rate of one-twelfth of the total amount granted as of the end of each quarter, beginning with the first quarter after the date of grant ended either January 29, April 29, July 29, or October 29 for the three-year vesting period, 2,252,437 will vest over 16 consecutive quarters with the first quarter being January 29, 2008, 701,058 will cliff vest on December 31, 2010, and 170,801 are subject to no vesting requirements. The Company accelerated the vesting of 143,102 LTIP Units as part of the termination agreements provided to employees. In addition, the LTIP Unit holders are entitled to dividends on the entire grant beginning on the date of the grant. The Company has recognized compensation expense of $4.9 million and $5.2 million and $9.9 million and $10.1 million for the three and six months ended June 30, 2009 and 2008, respectively. As of June 30, 2009, there were approximately 4,221,723 unvested LTIP Units and 170 LTIP Units were forfeited during the period. The related compensation expense to be recognized over the remaining 33
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 11. Equity-Based Compensation (Continued) vesting period of the Omnibus Incentive Plan LTIP grants is $29.9 million, provided there are no forfeitures. 2006 Outperformance Plan In January 2006, the Compensation Committee of the Board of Directors approved the NorthStar Realty Finance Corp. 2006 Outperformance Plan (the "2006 Outperformance Plan"), a long-term compensation program to further align the interests of the Company's stockholders and management. The Company did not meet the performance hurdles under the 2006 Outperformance Plan as of the conclusion of the 2006 Outperformance Plan on December 31, 2008. The Company recorded the compensation expense for the 2006 Outperformance Plan in accordance with SFAS 123 (R) "Stock Based Compensation" of $0.1 million and $0.3 million for the three months ended June 30, 2009 and 2008, respectively, and $0.2 million and $0.6 million for the three and six months ended June 30, 2009 and 2008, respectively. The remaining compensation expense to be recognized over the next six quarters is $0.4 million. The status of all of the LTIP grants as June 30, 2009 and December 31, 2008 is as follows:
12. Stockholders' Equity Common Stock In May 2009, the Company issued 94,045 shares of common stock with a fair value at the date of grant of $0.3 million to its Board of Directors as part of their annual grants. In April 2007, the Company implemented a Dividend Reinvestment and Stock Purchase Plan (the "Plan"), pursuant to which it registered with the Securities and Exchange Commission and reserved for issuance 15,000,000 shares of its common stock. Under the terms of the Plan, stockholders who participate in the Plan may purchase shares of the Company's common stock directly from it, in cash investments up to $10,000. At the Company's sole discretion, it may accept optional cash investments in excess of $10,000 per month, which may qualify for a discount from the market price of 0% to 5%. 34
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 12. Stockholders' Equity (Continued) Plan participants may also automatically reinvest all or a portion of their dividends for additional shares of the Company's stock. The Company expects to use the proceeds from any dividend reinvestments or stock purchases for general corporate purposes. For the three and six months ended June 30, 2009, the Company issued a total of approximately 27,062 and 32,030 common shares, respectively, pursuant to the Plan. Equity Distribution Agreements In May 2009, the Company entered into an equity distribution agreement with JMP Securities LLC ("JMP"). In accordance with the terms of the agreement, the Company may offer and sell up to 10,000,000 shares of its common stock from time to time through JMP. JMP will receive a commission from the Company of up to 2.5% of the gross sales price of all shares sold through it under the equity distribution agreement. As of June 30, 2009, the Company sold 1,251,628 common shares and received $4.0 million of cash proceeds pursuant to its equity distribution agreement with JMP. For the six months ending June 30, 2009, the Company did not sell any common shares pursuant to its May 2008 equity distribution agreement with Wachovia. Stock Repurchase Program On October 8, 2008, the Company's Board of Directors authorized a stock repurchase program of up to 10,000,000 shares of its outstanding common stock, or approximately 16% of its outstanding common stock. Stock repurchases under this program will be made from time to time through the open market or in privately negotiated transactions. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. For the six months ended June 30, 2009, the Company did not repurchase any common shares pursuant to its stock repurchase program. Dividends On January 20, 2009, the Company declared a dividend of $0.25 per share of common stock. The dividends were paid on February 27, 2009 to the stockholders of record as of January 28, 2009. The common stock dividends were paid in a combination of 40% cash and 60% common stock which totaled approximately 3,715,869 shares of common stock. On January 20, 2009, the Company declared a cash dividend of $0.54688 per share of Series A preferred stock and $0.51563 per share of Series B preferred stock. The dividends were paid on February 16, 2009 to the stockholders of record as of the close of business on February 6, 2009. On April 21, 2009, the Company declared a cash dividend of $0.10 per share of common stock, $0.54688 per share of Series A preferred stock and $0.51563 per share of Series B preferred stock. The dividends were paid on May 15, 2009 to the stockholders of record as of the close of business on May 5, 2009. 35
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 12. Stockholders' Equity (Continued) Earnings Per Share Earnings per share for the three and six months ended June 30, 2009 and 2008 is computed as follows:
The earnings per share calculation takes into account the conversion of LTIP units into common shares. The LTIPS convert on a one-for-one basis into commons shares and share equally in the Company's earnings. Depending on the timing of LTIP conversions and the amount of LTIPS converted, relative to the timing of the Company's earnings allocated to the LTIP non-controlling interest, and the weighting of the common shares, the LTIP conversions may result in an anti-dilutive effect on earnings per share. For the six months ended June 30, 2009 the LTIP conversion were anti-dilutive.. 13. Non-controlling Interest Operating Partnership Non-controlling interest represents the aggregate limited partnership interests or OP Units in the Operating Partnership held by limited partners (the "Unit Holders"). Income allocated to the non-controlling interest is based on the Unit Holders ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the numbers of OP Units held by the Unit Holders by the total number of dilutive shares. The issuance of additional shares of beneficial interest (the "Common Shares" or "Share") or OP Units changes the percentage ownership of both the Unit Holders and the Company. Since a unit is generally redeemable for cash or Shares at the option of the Company, it is deemed to be equivalent to a Share. Therefore, such transactions are treated as 36
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 13. Non-controlling Interest (Continued) capital transactions and result in an allocation between shareholders' equity and non-controlling interest in the accompanying condensed consolidated balance sheet to account for the change in the ownership of the underlying equity in the Operating Partnership. As of June 30, 2009 and December 31, 2008, non-controlling interest related to the aggregate limited partnership units of 7,696,093 and 8,067,211, represented a 10.12% and 11.37% interest in the Operating Partnership, respectively. Income/(loss) allocated to the operating partnership non-controlling interest for the three and six months ended June 30, 2009 and 2008 was a loss of $0.5 million and a loss of $3.0 million and $9.9 million and $19.9 million, respectively. Joint Ventures On July 9, 2008, Wakefield sold a $100 million convertible preferred membership interest to Inland American Real Estate Trust, Inc. The Wakefield joint venture is consolidated in the condensed consolidated financial statements with Inland American's and Chain Bridge's equity treated as non-controlling interests. Income allocated to the joint venture's non-controlling interest for the three months and six ended June 30, 2009 and 2008 was $2.0 million and a loss of $0.4 million and $4.4 million and a loss of $0.2 million, respectively. 14. Risk Management and Derivative Activities Derivatives The Company uses derivatives primarily to manage interest rate risk exposure. These derivatives are typically in the form of interest rate swap agreements and the primary objective is to minimize interest rate risks associated with the Company's investment and financing activities. The counterparties of these arrangements are major financial institutions with which the Company may also have other financial relationships. The Company is exposed to credit risk in the event of non-performance by these counterparties and it monitors their financial condition; however, the Company currently does not anticipate that any of the counterparties will fail to meet their obligations because of their high credit ratings and financial support from the U.S. Government. The objective in using interest rate derivatives is to add stability to interest expense and to manage exposure to interest rate movements. 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. During 2009, such derivatives were used to hedge the variable cash flows associated with certain variable-rate debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and six months ended June 30, 2009 and 2008, the Company recorded immaterial amounts of 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 Company's variable-rate debt. During the remainder of 2009, the Company estimates that an additional $5.6 million will be reclassified as an increase to interest expense. 37
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 14. Risk Management and Derivative Activities (Continued) The following tables summarize the Company's derivative financial instruments that were designated as cash flow hedges of interest rate risk as of June 30, 2009 and December 31, 2008:
In January 2008, the Company adopted SFAS 159 and elected the fair value option for its bonds payable and its liability to subsidiary trusts issuing preferred securities. Under SFAS 159, the changes in fair value of these financial instruments are now recorded in earnings. As a result of this election, the interest rate swap agreements associated with these debt instruments no longer qualify for hedge accounting, in accordance with SFAS 133 "Derivatives and Hedging Activity", since the underlying debt is remeasured with changes in the fair value recorded in earnings. The unrealized gains or losses accumulated in other comprehensive income, related to these interest rate swaps, will be reclassified into earning over the shorter of either the life of the swap or the associated debt with current mark-to-market unrealized gains or losses recorded in earnings. Derivatives not designated as hedges are not speculative and are used to manage the Company's exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of SFAS 133. For the three months ended June 30, 2009 and 2008, the Company recorded, in earnings, a mark-to-market unrealized gain of $7.4 million and $33.4 million and a $1.4 million and $1.4 million reclassification from accumulated other comprehensive income for the non-qualifying interest rate swaps, respectively. For the six months ended June 30, 2009 and 2008, the Company recorded, in earnings, a mark-to-market unrealized gain of $10.4 million and $3.1 million and a $2.8 million and $2.6 million reclassification from accumulated other comprehensive income for the non-qualifying interest rate swaps, respectively. The following tables summarize the Company's derivative financial instruments that were not designated as hedges in qualifying hedging relationships as of June 30, 2009 and December 31, 2008:
38
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 14. Risk Management and Derivative Activities (Continued) The following table presents the fair value of the Company's derivative financial instruments as well as their classification on its balance sheet as of June 30, 2009 and December 31, 2008.
39
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 14. Risk Management and Derivative Activities (Continued) The following tables present the effect of the Company's derivative financial instruments on its statement of operations for the three and six months ended June 30, 2009 and 2008: Derivatives is SFAS 133 Cash Flow Hedging Relationships
Derivatives Not Designated as Hedging Instruments Under SFAS 133
At June 30, 2009, the Company's counterparties hold approximately $26.5 million of cash margin as collateral against its swap contracts. Credit Risk Concentrations Concentrations of credit risk arise when a number of borrowers, tenants or issuers related to the Company's investments are engaged in similar business activities or located in the same geographic location to be similarly affected by changes in economic conditions. The Company monitors its portfolio to identify potential concentrations of credit risks. The Company has no one borrower or one tenant that generates 10% or more of its total revenue. However, approximately 51.2% and 51.4%, respectively of the Company's rental and escalation revenue for the three and six months ended June 30, 2009 is generated from two tenants in the Company's healthcare net lease portfolio. The 40
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 14. Risk Management and Derivative Activities (Continued) Company believes the remainder of its net lease portfolio is reasonably well diversified and does not contain any unusual concentration of credit risks. 15. Segment Reporting The Company's real estate debt segment is focused on originating, structuring and acquiring senior and subordinate debt investments secured primarily by commercial real estate properties. The Company generates revenues from this segment by earning interest income from its debt investments and its operating expenses consist primarily of interest costs from financing the assets. This segment generates income from operations by earning a positive spread between the yield on its assets and the interest cost of its debt. The Company evaluates performance and allocates resources to this segment based upon its contribution to income from continuing operations. The Company's operating real estate segment is focused on acquiring commercial real estate facilities located throughout the U.S. that are primarily leased under long-term triple-net leases to corporate tenants. Triple-net leases generally require the lessee to pay all costs of operating the facility, including taxes and insurance and maintenance of the facility. The Company's net-leased facilities are currently located in New York, Ohio, California, Utah, Pennsylvania, New Jersey, Indiana, Illinois, New Hampshire, Massachusetts, Kansas, Maine, South Carolina, Michigan, Colorado, North Carolina, Florida, Washington, Oregon, Wisconsin, Georgia, Oklahoma, Nebraska, Tennessee, Texas and Kentucky. Revenues from these assets are generated from rental income received from lessees of the facilities, and operating expenses, which include interest costs related to financing the assets, operating expenses, real estate taxes, insurance, ground rent and repairs and maintenance. The segment generates income from operations by leasing these facilities at a higher rate than the costs of owning and financing the assets. The Company's real estate securities segment is focused on investing in a wide range of commercial real estate debt securities, including commercial mortgage- backed securities ("CMBS"), REIT unsecured debt, credit tenant loans and unsecured subordinate securities of commercial real estate companies. The Company generates revenues from this segment by earning interest income and advisory fees from owning and managing these investments. Its operating expenses consist primarily of interest costs from financing its securities. The segment generates income from operations by earning advisory fees and a positive spread between the yield on its assets and the interest cost of its debt. 41
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 15. Segment Reporting (Continued) The following table summarizes segment reporting for the three and six months ended June 30, 2009 and 2008:
42
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 16. Supplemental Disclosure of Non-Cash Investing and Financing Activities A summary of non-cash investing and financing activities for the six months ended June 30, 2009 and 2008 is presented below:
17. Fair Value of Financial Instruments The following disclosures of estimated fair value were determined by the Company, using available market information and appropriate valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. As of June 30, 2009 cash equivalents, accounts receivable, accounts payable, repurchase agreements with major banks and securities firms and the master repurchase agreement balances reasonably approximate their fair values due to the short-term maturities of these items. The available for sale securities and securities sold, not yet purchased are carried on the balance sheet at their estimated fair value. For the real estate debt investments the fair value of the fixed and floating rate investments was approximated comparing yields at which the investments are held to estimated yields at which loans originated with similar credit risks or market yields at which a third party might require to purchase the investment by discounting future cash flows at such market yields. Prices were calculated to the "worst" assuming fully extended maturities regardless of if structural or economic tests required to achieve such extended maturities. At June 30, 2009 the fair market value was $1.7 billion with a gross carrying amount of $2.1 billion. For the exchangeable senior notes the Company uses available market information, which includes quoted market prices or recent transactions, if available to estimate their fair value. At June 30, 2009 the fair market value of the 7.25% exchangeable senior notes was $36.3 million with a carrying amount 43
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 17. Fair Value of Financial Instruments (Continued) of $76.4 million and the fair market value of the 11.50% exchangeable senior notes was $39.2 million with a carrying amount of $77.4 million. For fixed rate mortgage loans payable the Company uses rates currently available to them with similar terms and remaining maturities to estimate their fair value. At June 30, 2009 the fair market value was $919.2 million with a carrying amount of $906.7 million. Disclosure about fair value of financial instruments is based on pertinent information available to management as of June 30, 2009. Although management is not aware of any factors that would significantly affect the fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and current estimates of fair value may differ significantly from the amounts presented herein. 18. Subsequent Events The Company has evaluated subsequent events through August 4, 2009, which is the date these financial statements were issued. Dividends On July 21, 2009, the Company declared a dividend of $0.10 per share of common stock, $0.54688 per share of Series A preferred stock and $0.51563 per share of Series B preferred stock. The dividends will be paid on August 14, 2009 to the stockholders of record as of the close of business on August 4, 2009. Debt Repurchases During July 2009, the Company repurchased $10.0 million of its 7.25% exchangeable senior notes and $18.3 million of its 11.50% exchangeable senior notes for a total purchase price of $14.4 million. The Company recorded a realized gain of approximately $12.9 million in connection with the repurchase of its notes. Incentive Compensation Plan On July 21, 2009, the Compensation Committee of the Board of Directors (the "Committee") of the Company approved the material terms of a new Incentive Compensation Plan for the Company's executive officers and other employees (the "Plan"). Under the Plan, a potential incentive compensation pool will be established each calendar year. The size of the incentive pool will be calculated as the sum of (a) 1.75% of the Company's "adjusted equity capital" and (b) 25% of the Company's adjusted funds from operations, as adjusted ("AFFO"), above a 9% return hurdle on adjusted equity capital. Payout from the incentive pool is subject to achievement of additional performance goals summarized below. The incentive pool will be divided into the following three separate incentive compensation components: (1) an annual cash bonus, tied to annual performance of the Company and paid after year end at or around completion of the year end audit; (2) a deferred cash bonus, determined based on the 44
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) Amount in Thousands, Except per Share Data (Unaudited) 18. Subsequent Events (Continued) same year's performance, but paid 50% following the close of each of the first and second years after such incentive pool is determined, subject to the participant's continued employment through each payment date; and (3) a long-term incentive, paid at the end of a three-year period based on the Company's achievement of cumulative performance goals for the three-year period, subject to the participant's continued employment through the payment date. Performance goals for each component will be set by the Committee initially upon the adoption of the Plan and at the beginning of each subsequent calendar year for each new cycle. The goals will generally be divided into five distinct ranges of performance, each of which will correspond to a pay-out level equal to a percentage (0%, 25%, 50%, 75% or 100%) of a participant's pool allocation for such component. The annual bonus component for 2009 will be calculated based on AFFO and liquidity targets (weighted 50% and 25%, respectively) with the remaining 25% of the 2009 annual bonus determined in the Committee's discretion. The deferred bonus component will be calculated based on the same performance measures as the annual bonus, but paid as described above. For the long-term incentive component, each participant will initially be granted a number of restricted stock units determined by dividing the value of the participant's pool allocation for this component by the 20-day average closing price of the Company's common stock at the end of the first year of the grant cycle (such amount, the "Initial Long-Term Allocation"). Upon the conclusion of the three-year performance period, the participant will receive a payout equal to the value of one share of common stock at the time of such payout, with respect to a share of common stock during the three-year performance period, for each unit actually earned based on the Company's achievement of cumulative AFFO and/or a stock price goal during the performance period (the "Long-Term Payout"). The Long-Term Payout will be made in the form of shares of common stock to the extent available under the Company's equity compensation plans or, if all or a portion of such shares are not available, in cash; provided, that the amount of cash paid to any participant with respect to the 2009 long-term incentive component shall not exceed such participant's Initial Long-Term Allocation. For the three-year performance period ending December 31, 2011, the stock price goal is $8.21 per share. 45
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our financial statements and notes thereto included in this report. Forward-Looking Statements This report contains information that may constitute "forward-looking statements." Such forward-looking statements relate to, among other things, the operating performance of our investments and financing needs. Forward-looking statements are generally identifiable by use of forward-looking terminology such as "may," "will," "should," "potential," "intend," "expect," "seek," "anticipate," "estimate," "believe," "could," "project," "predict," "continue" or other similar words or expressions. Forward-looking statements are not guarantees of performance and are based on certain assumptions, discuss future expectations, describe plans and strategies, contain projections of results of operations or of financial condition or state other forward-looking information. Our ability to predict results or the actual effect of plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward-looking statements. These forward-looking statements involve risks, uncertainties and other factors that may cause our actual results in future periods to differ materially from those forward looking statements. We are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results. Factors that could have a material adverse effect on our operations and future prospects are set forth in "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2008, and those described from time to time in our future reports filed with the Securities and Exchange Commission. The factors set forth in the Risk Factors section could cause our actual results to differ significantly from those contained in any forward- looking statement contained in this report. Introduction We primarily derive revenues from interest income on the real estate debt investments that we originate with borrowers or acquire from third parties and our real estate securities in which we invest. We generate rental income from our net lease investments. We also generate interest revenues from our ownership interest in non-consolidated securities term debt transaction issuances and advisory fee income and income from our unconsolidated ventures. Other income comprises a much smaller and more variable source of revenues and is generated principally from fees associated with early loan repayments and gains/losses from sales of securities. We primarily derive income through the difference between the interest and rental income we are able to generate from our investments and the cost at which we are able to obtain financing for our investments. In order to protect this difference, or "spread", we seek to match-fund our investments using secured sources of long-term financing such as term debt transaction financings, mortgage financings and long-term unsecured subordinate debt. Match-funding means that we try to obtain debt with maturities equal to our asset maturities and borrow funds at interest rate benchmarks similar to our assets. Match-funding results in minimal impact to spread when interest rates are rising and falling and minimizes refinancing risk since our asset maturities match those of our debt. Profitability and Performance Metrics We calculate several metrics to evaluate the profitability and performance of our business.
46
Credit risk management is our ability to manage our assets in a manner that preserves principal and income and minimizes credit losses that would decrease income. Corporate expense management influences the profitability of our business. We must balance making appropriate investments in our infrastructure and employees with a recognition that our accounting, finance, legal and risk management infrastructure does not directly generate quantifiable revenues for us. We frequently refer to general and administrative expenses, excluding stock-based compensation expense, divided by total revenues as a measure of our efficiency in managing expenses. For 2008, a much higher percentage of our performance compensation was awarded in cash rather than stock equivalents compared to prior years, resulting in an unfavorable efficiency ratio compared to prior years. Availability and cost of capital will impact our profitability and earnings since we must raise new capital to fund a majority of our AUM growth. Outlook and Recent Trends In early 2007, the subprime residential lending and single family housing markets began to experience significant default rates, declining real estate values and increasing backlog of housing supply. Other lending markets also experienced higher volatility and decreased liquidity resulting from the poor credit performance in the residential lending markets. The residential sector capital markets issues quickly spread more broadly into the asset-backed commercial real estate, corporate and other credit and equity markets. During 2008, financial institutions curtailed their lending to peer institutions, even on a very short-term basis, as lack of transparency regarding asset quality reduced confidence in counterparty creditworthiness. Despite liquidity infusions from government-sponsored central banks worldwide, the cost of capital increased dramatically, and even the most liquid markets such as the commercial paper market experienced enormous outflows of capital. Those institutions deemed by the market to be most at risk for credit issues, principally those with large real estate and mortgage portfolios, experienced massive withdrawals from customer brokerage and deposit accounts. These institutions also became unable to transact in the capital markets because few participants were willing to take their counterparty risk, thereby resulting in their insolvency (most notably Bear, Stearns & Co. and Lehman Brothers Holdings, Inc.). The U.S. Government reacted to the rapid deterioration in the financial system by passing the Emergency Economic Stabilization Act of 2008, or the EESA, in early October. The EESA authorized and provided funds to the U.S. Treasury Department to acquire financial assets from institutions as a buyer of last resort in order to enable these institutions to reduce their exposure to troubled assets and to regain market confidence. During the fourth quarter of 2008, the U.S. abandoned the direct asset purchase strategy, committed to make up to $250 billion of direct equity investments through the Troubled Asset Relief Program, or TARP, into banking institutions and purchased commercial paper from corporations. 47 In February 2009, the U.S. Government ratified a nearly $800 billion economic stimulus package and in March announced the Public-Private Investment Program, or PPIP, to introduce up to $1 trillion of leverage into the financial system to purchase and finance high quality securities, including CMBS, and to acquire "legacy" loans from banks. The goal of the PPIP is to draw private capital into the market by providing government equity co-investment and attractive public financing, and the CMBS market initially responded positively to the announcement with credit spreads for the highest quality securities decreasing by several hundred basis points after the program's announcement. We, as well as a reported nearly 100 other potential PPIP managers filed an application with the U.S. Government to be one of its approved fund managers, but NorthStar was not one of the initial handful selected. In June 2009, the Term Asset Lending Facility ("TALF"), a financing facility for asset-backed securities established by the U.S. Federal Reserve in late 2008, began accepting commercial real estate securities as assets eligible for financing. The Federal Reserve indicated that securities issued in 2009 and having a AAA rating would be considered eligible for financing, subject to the Fed's final approval of individual assets. To-date, it appears that several banks may be working on new loans whose AAA rated securities would be eligible for TALF financing, but none have yet been completed. During the second quarter 2009, several banks were permitted by the U.S. Government to repay their TARP equity investments, but other very large institutions (e.g., Bank of America and Citigroup, among others) were not deemed healthy enough to repay their TARP capital. Although repayment of the government investment was considered a sign of financial strength, those who repaid their TARP funds remain cautious in committing new capital to real estate in an uncertain economic environment. Despite the TARP repayments, the overall U.S. banking sector remains under stress, with 69 banks seized by the FDIC in 2009 to date. In addition, neither the legacy loans nor securities programs formed under the PPIP have resulted in any material investment activity and the legacy loans program has been put on hold. As a result, capital for commercial real estate remains extremely scarce and continued declines in macroeconomic conditions and employment are resulting in worsening credit performance across commercial real estate and many other sectors. Virtually all commercial real estate property types have been adversely impacted by this prolonged economic recession and liquidity crisis. Property types that were most directly and immediately impacted by these weaker conditions include residential condominium projects in markets which experienced a high level of development during the residential market boom, such as in South Florida, Las Vegas and areas of California. Multi-family properties located in nearby areas have generally been impacted by the oversupply of condominiums because many of these projects are being converted into competing rental properties. Also, hotels were immediately impacted by changing economic conditions because revenues are generated on a nightly basis, based on room rates and occupancy. Business and leisure travel continues to decline as macroeconomic conditions worsen. The next most sensitive real estate class to changing economic conditions is retail, followed by office and industrial properties. Office, industrial and retail property types have longer-term, multi-year leases and therefore reset to market on a lagging basis. Business and retailer failures have become more frequent and are expected to negatively impact occupancy rates in the future. Our credit loss provisioning levels are higher than in the past due to the impact of these conditions on the cash flow performance of the collateral properties underlying our loans. The degree to which commercial real estate values are impacted by weaker economic conditions and the level of credit losses in our asset base will be determined primarily by the length that such conditions persist and the severity of the economic contraction. Most of our real estate loans bear interest rates based on a spread to one-month LIBOR, a floating rate index based on rates that banks charge each other to borrow. One-month LIBOR as of June 30, 2009 is 0.3%, well below its 3.5% average over the past five years. Lower LIBOR means lower debt service costs for our borrowers which should partially offset decreasing cash flows caused by the 48 economic recession, and extend the life of interest reserves for those loans that require interest reserves to service debt while the collateral properties are being repositioned by our borrowers. Lower interest rates also theoretically support real estate valuations because a lower discount rate is applied to underlying future real estate cash flow assumptions in valuing a property. Currently, a lack of readily available financing, economic uncertainty and higher returning alternative investment opportunities have increased investor return expectations resulting in much higher risk premiums and, despite the lower interest rate, lower valuations for commercial real estate properties. The conditions are adversely impacting the performance of our real estate loans and the related collateral properties. The deep economic recession combined with a crippled banking sector has resulted in weakening cash flows from collateral properties and extreme difficulties in obtaining repayments at maturity. For existing loans, when credit spreads widen, the fair value of these existing loans decreases. If a lender were to originate a similar loan today, such loan would carry a greater credit spread than the existing loan. Even though a loan may be performing in accordance with its loan agreement and the underlying collateral has not changed, the fair value of the loan may be negatively impacted by the incremental interest foregone from the widened credit spread. Accordingly, when a lender wishes to sell or finance the loan, the reduced value of the loan will impact the total proceeds that the lender will receive. Our real estate securities investments are also negatively impacted by weaker real estate market and economic conditions. Within the underlying loan pools, slowdown in economic conditions is reducing tenants' ability to make rent payments in accordance with the terms of their leases. Additionally, to the extent that market rental rates are reduced, property-level cash flows are negatively affected as existing leases renew at lower rates. Finally, declining occupancy rates also impact cash flow and reduce borrowers' ability to service their outstanding loans. Real estate securities values are also influenced by credit ratings assigned to the securities by accredited rating agencies. The rating agencies have changed their ratings methodologies for all securitized asset classes, including commercial real estate, in light of questionable ratings previously assigned to residential mortgage portfolios. Their reviews have resulted in, and are continuing to result in, large amounts of ratings downgrade actions for CMBS, negatively impacting market values of CMBS and in some cases negatively impacting the term debt transaction financing structures used by us and others to leverage these investments. Our net leased assets are also adversely impacted by a weaker economy as well. Corporate space needs are contracting resulting in lower lease renewal rates and longer releasing periods when leases are not renewed. Poor economic conditions may negatively impact the creditworthiness of our tenants which could result in their inability to meet the contractual terms of their leases. We responded to these difficult conditions by decreasing investment activity when we observed deteriorating market conditions. We expect credit to continue to be challenging throughout the remainder of 2009 and into 2010 and have focused our company resources on portfolio management activities to preserve our invested capital and liquidity. We anticipate that most of our investment activity and uses of available unrestricted cash liquidity for the foreseeable future will be focused on discounted repurchases of our previously issued debt securities which generally have been available in the market at very attractive prices, and for amortization of bank debt. Our business plan assumes that the gains from repurchasing our debt securities at discounts to par more than offsets credit losses during the same period. Approximately $4.0 billion of our collateralized debt obligations, also referred to as our term debt transaction liabilities (including the off-balance sheet and on-balance sheet term debt transaction financings) currently permit reinvestment of capital proceeds which means when the underlying assets 49 repay we are able to reinvest the proceeds in new assets without having to repay the liabilities. We also have assets financed on a bank term loan with an outstanding balance of $379.7 million at June 30, 2009, which has a final maturity in October 2010. Rather than making new investments with loan repayment proceeds in our term debt transactions, in certain instances we have been amortizing the bank term loan by transferring performing assets financed by the bank loan into our term debt transactions, providing match funded financing for these assets. Approximately $553.6 million of our funded loan commitments have their initial maturity date in the remainder of 2009; however, most of the loans contain extension options of at least nine months (many subject to performance criteria). It is therefore difficult to estimate how much capital, if any, from initial maturities or prepayments will be generated in our term debt transactions from loan repayments during 2009 to create availability to further amortize the bank loan. Our term debt structures do not have corporate financial covenants but require that the underlying loans and securities meet debt service and collateral value coverage (as defined by the indentures) in order for us to receive regular cash flow distributions. If the tests are not met cash flow is diverted from us to repay the liabilities until the tests are back into compliance. In some cases, our ability to reinvest can be adversely impacted if these tests are not in compliance. Ratings downgrades of CMBS and other securities can reduce the deemed value of the security in measuring collateral coverage, depending on the level of the downgrade. Also, defaults in our loans can reduce the collateral coverage of the defaulted loan in our term debt structures. As economic conditions continue to weaken and capital for commercial real estate remains scarce, we expect credit quality in our assets and across the commercial real estate sector to weaken. While we have devoted a majority of our resources to managing our existing asset base, a continued weak environment and additional credit ratings downgrades will make maintaining compliance with the term debt structures more difficult, jeopardizing regular cash flow distributions to our company. We believe that in the longer term, liquidity could eventually return to the commercial real estate finance markets but that in the near term, new financing sources must be developed in order to attractively finance new investment activity. We believe these sources could include financing from U.S. Government sponsored programs such as PPIP and TARP, term loans from financial institutions and life insurance companies, more restrictive commercial real estate finance structures, which may not permit reinvestment from asset repayments, and financing provided by motivated sellers of assets. Risk Management We use many methods to actively manage our asset base to preserve our income and capital. Generally, for loans and net lease assets, frequent dialogue with borrowers/tenants and inspections of our collateral and owned properties have proven to be an effective process for identifying issues early and prior to missed debt service and lease payments. Many of our loans also require borrowers to replenish cash reserves for items such as taxes, insurance and future debt service costs. Late replenishments also may be an early indicator there could be a problem with the borrower or collateral property. We also may negotiate modifications to loan terms if we believe such modification improves our ability to maximize principal recovery. Modifications may include changes to contractual interest rates, maturity dates and other borrower obligations. Generally, when we make a concession such as reducing an interest rate or extending a maturity date, we seek to get additional collateral and/or fees in return for the modification. In some cases we may issue default notices and begin foreclosure proceedings when the borrower is not complying with the loan terms and we believe taking control of the collateral is the best course of action to protect our capital. For net leases, we may seek to obtain up-front or accelerated payment in return for an early cancelation of the lease if we believe the tenant's creditworthiness has significantly deteriorated and that taking control of the property and re-leasing it maximizes value. 50 In certain circumstances, we may pursue loan sales and payoffs at discounts to our book value. Generally, we may agree to discounted payoffs where we believe there is an economic benefit from monetizing the asset in advance of its contractual maturity date. For example, we may accept a discounted payoff where we believe the cash proceeds can be reinvested at a much higher rate of return (including the capital loss from the payoff), where we believe there is significant risk of collateral value or cash flow erosion through maturity, or where we believe refinancing risk at maturity is very high. When evaluating sales and payoffs at discounts to book value, we must also consider the impact such transactions have on our financing structures, corporate debt covenants and earnings. Securities investments generally have a more liquid market than loans and net lease assets, but we typically have very little control over restructuring decisions when there are problems with the underlying collateral. Generally, we manage risk in the securities portfolio by selling the asset when we can obtain a price that is attractive relative to its risk. In certain situations, we may sell an asset because there is an opportunity to reinvest the capital into a new asset with a more attractive risk/return profile. We conduct a quarterly comprehensive credit review which is designed to enable management to evaluate and proactively manage asset-specific credit issues and identify credit trends on a portfolio-wide basis as an "early warning system." Nevertheless, we cannot be certain that our review will identify all issues within our portfolio due to, among other things, adverse economic conditions or events adversely affecting specific assets; therefore, potential future losses may also stem from assets that are not identified by our credit reviews. Based on the quarterly reviews, loans and net lease assets are put on an internal "watch list" if we believe there is greater near-term risk that we could lose invested capital and/or there is a situation at the underlying collateral which requires intensive risk management and portfolio management resources. During the quarterly reviews, assets are also put on non-performing status and identified for possible impairment based upon several factors, including missed or late contractual payments, significant declines in collateral performance, and other data which may indicate a potential issue in our ability to recover our capital from the investment. We believe the watch list is a useful internal tool for prioritizing management resources but delinquencies, realized losses, non-performing loans and actual credit loss reserves are the appropriate basis in which our investors should compare our credit performance to other financial services companies. As of June 30, 2009, our loan portfolio had the following credit statistics:
As of June 30, 2009, our loan portfolio principal and interest aging is as follows (inclusive of our non-performing loans):
During the three and six month period ending June 30, 2009, we recorded $17.0 million and $38.5 million of credit loss provisions relating to eight and 13 loans, respectively, and had no foreclosures or (reversals of prior period reserves). As of June 30, 2009, loan loss reserves totaled $49.7 million. At June 30, 2009, we had three loans totaling $63.6 million on non-performing status due to maturity defaults and one loan totaling $9.4 million on non-performing status due to a payment 51 delinquency of greater than 90 days. A $21.3 million first mortgage loan secured by a condo/hotel development site in Manhattan was on the non-performing loan list at December 31, 2008 and the maturity default is not yet resolved. At June 30, 2009, we have a $5.0 million loan loss reserve for this loan, and continue to negotiate a potential assumption of our loan by new sponsors, who have significant hotel development and operating track records and intend to develop a full service hotel on the site, as well as pursuing legal remedies against the borrower. The second non-performing loan is a $28.5 million B-note secured by a large mixed use development located near Orlando, FL. Our note is subordinate to a $127 million A-note and senior to a $28.0 million C-note. The borrower did not meet the requirements for a March 2009 extension, and the A-Note holder is leading restructuring discussions with the borrower. The borrower also has existing recourse obligations to make scheduled amortization payment. At June 30, 2009, we have a $8.0 million loan loss reserve for this loan. The third non-performing loan which we fully reserved against, is a $9.4 million mezzanine loan backed by a multi-family development site in Washington D.C. The fourth non-performing loan is a $13.8 million first mortgage loan secured by a condo development site in Manhattan which has the same sponsor as the $21.3 million non-performing loan previously discussed. There is a $2.0 million reserve for this loan at June 30, 2009. There can be no assurance that acceptable assumption and modification agreements can be reached with the respective borrowers under our non-performing loans, and if agreements cannot be reached we may determine that more reserves are required for these loans. On June 30, 2009, we received $23.8 million of cash proceeds relating to the repayment of a $27.4 million first mortgage loan backed by a data center property bearing interest at LIBOR + 4.5% and having a February 2012 final maturity date. We agreed to the discounted payoff of our loan on this niche asset for the economic and credit risk benefits discussed herein. Accordingly, for the second quarter 2009 we recorded a $3.6 million credit loss relating to this discounted payoff. Overall, the prolonged financial sector crisis and economic recession is resulting in increasing stress levels for commercial real estate credit. A shrinking economy generally results in decreasing real estate cash flows as corporations and consumers reduce their real estate needs, travel and spending. Because the commercial real estate asset-backed markets remain closed, and banks and life companies have drastically curtailed new lending activity, real estate owners are having difficulty refinancing their assets at maturity. Many owners are also having trouble achieving their business plans to the extent they acquired a property to reposition it or otherwise invest capital to increase the property's cash flows. Property values have also generally decreased over the past year because of scarcity of financing, which when it is available the terms generally are at much lower leverage and higher cost than available in prior years, uncertainty regarding future economic conditions and higher returning investment opportunities available in other asset classes. Decreasing values make it difficult for real estate investors to sell their properties and to recoup their capital. As a result of the weak commercial real estate market, many lenders, including us, are concluding that extending loans at original maturity, rather than foreclosure and sale, may be the most attractive path for maximizing value. Many of our loans were made to borrowers who had a business plan to improve the collateral property and who therefore needed a flexible balance sheet lender. In many cases we required the borrowers to pre-fund reserves to cover interest and operating expenses until the property cash flows increased sufficiently to cover debt service costs. We also generally required the investor to refill these reserves if they became deficient due to underperformance and if the borrower wanted to exercise extension options under the loan. Despite low interest rates, we expect that in the future some of our borrowers may have difficulty servicing our debt because they cannot achieve their business plan in this economic environment. If any of our borrowers are unable to replenish reserves and otherwise ultimately achieve their business plans, the related loans may become non-performing. In addition, even if a borrower's business plan is achieved, current real estate valuations and the financing environment may result in a borrower being unable to recoup its invested capital and a default under the loan causing a partial or full loss of our loan principal. 52 Our net leased assets are generally leased to a single tenant and we typically financed these assets with non-recourse first mortgage loans. In the event a tenant goes out of business, we must decide whether to continue to pay debt service and property operating costs until we find a new tenant, or we may give the property to the mortgage lender and lose our invested equity capital. One of our net lease investments is comprised of three office buildings totaling 257,000 square feet located in Chatsworth, CA and was 100% leased to Washington Mutual Bank, FA, or WaMu. The assets are financed with a non-recourse $43.0 million first mortgage loan. The assets are also financed with a $9.2 million mezzanine loan which is collateral for one of our securities term financings. The tenant vacated the building as of March 23, 2009 and terminated its lease. In the fourth quarter of 2008, we took an impairment charge relating to these properties and we are currently in the process of transferring title to the first mortgage special servicer. Our net book value in the assets currently is approximately equal to the mortgage debt, and we therefore do not expect the transfer to materially impact our income statement. Critical Accounting Policies Refer to the section of our Annual Report on Form 10-K for the year ended December 31, 2008 entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting policies" for a full discussion of our critical accounting policies. Recent Accounting Pronouncements In January 2009, the FASB issued FSP EITF 99-20-1, which amends the impairment guidance in EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets" ("FSP EITF 99-20-1") to achieve more consistent determination of whether an other-than-temporary impairment has occurred. FSP EITF 99-20-1 also retains and emphasizes the objective of an other-than-temporary impairment assessment and the related disclosure requirements in SFAS 115 and other related guidance. FSP EITF 99-20-1 is effective and should be applied prospectively for financial statements issued for fiscal years and interim periods ending after December 15, 2008. The adoption of FSP EITF 99-20-1 did not have a material effect on our financial condition, results of operations, or cash flows. In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 ("FSP FAS 115-2 and FAS 124-2") which is intended to provide greater clarity to investors about the credit and noncredit component of an other-than-temporary event and to more effectively communicate when an other-than-temporary event has occurred. FSP FAS 115-2 and FAS 124-2 applies to debt securities and requires that the total other-than-temporary impairment be presented in the statement of income with an offset for the amount of impairment that is recognized in other comprehensive income, which is the noncredit component. Noncredit component losses are to be recorded in other comprehensive income if an investor entity can assess that (a) it does not have the intent to sell or (b) it is not more likely than not that it will have to sell the security prior to its anticipated recovery. FSP FAS 115-2 and FAS 124-2 is effective for interim and annual periods ending after June 15, 2009. FSP FAS 115-2 and FAS 124-2 will be applied prospectively with a cumulative effect transition adjustment as of the beginning of the period in which it is adopted. The adoption of FSP FAS 115-2 and FAS 124-2 did not have a material effect on our financial statements. In April 2009, FASB issued FSP FAS 157-4 "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly" ("FSP FAS 157-4"), which provides additional guidance on determining whether a market for a financial asset is not active and a transaction is not distressed for fair value measurements under FASB Statement No. 157, "Fair Value Measurements" (SFAS 157). FSP FAS 157-4 will be applied prospectively and retrospective application is not permitted. FSP FAS 157-4 is effective for interim and 53 annual periods ending after June 15, 2009. The adoption of FSP FAS 157-4 did not have a material effect on our financial statements. In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1 ("FSP FAS 107-1 and APB 28-1") which will amend FASB Statement No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS 107"). FSP FAS 107-1 and APB 28-1 will require an entity to provide disclosures about the fair value of financial instruments in interim financial information. FSP FAS 107-1 and APB 28-1 would apply to all financial instruments within the scope of SFAS 107 and will require entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments, in both interim financial statements as well as annual financial statements. FSP FAS 107-1 and APB 28-1 is effective for interim and annual periods ending after June 15, 2009. The adoption of FSP FAS 107-1 and APB 28-1did not have a material effect our financial statement disclosures. In May 2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"), which establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. We adopted the provisions of SFAS 165 for the quarter ended June 30, 2009. Our adoption of these provisions did not have a material effect on our financial condition, results of operations, or cash flows. In June 2009, the FASB issued SFAS No. 166, "Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140" ("SFAS 166"), which requires additional information regarding transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. SFAS 166 eliminates the concept of a "qualifying special-purpose entity," changes the requirements for derecognizing financial assets, and requires additional disclosures. SFAS 166 is effective for fiscal years beginning after November 15, 2009. We are currently evaluating the impact that the adoption of SFAS 166 will have on our financial condition, results of operations, and disclosures. In June 2009, the FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R)" ("SFAS 167"), which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar) rights, should be consolidated. SFAS 167 clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. SFAS 167 requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. SFAS 167 also requires additional disclosures about a company's involvement in variable interest entities and any significant changes in risk exposure due to that involvement. SFAS 167 is effective for fiscal years beginning after November 15, 2009. We are currently evaluating the impact that the adoption of SFAS 167 will have on our financial condition, results of operations, and disclosures. In June 2009, the FASB approved the "FASB Accounting Standards Codification" ("Codification") as the single source of authoritative nongovernmental U.S. GAAP to be launched on July 1, 2009. The Codification does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all the authoritative literature related to a particular topic in one place. All existing accounting standard documents will be superseded and all other accounting literature not included in the Codification will be considered nonauthoritative. The Codification is effective for interim and annual periods ending after September 15, 2009. The Codification will not have an impact on our financial condition or results of operations. 54 Comparison of the Three Months Ended June 30, 2009 to the Three Months Ended June 30, 2008 Revenues Interest income for the three months ended June 30, 2009 totaled $35.7 million, representing a decrease of $14.2 million, or 28%, compared to $49.9 million for the three months ended June 30, 2008. The decrease consisted of a $14.1 million decrease attributable to an approximately 225 basis points lower average one-month LIBOR rate during the second quarter 2009 compared to second quarter 2008, and a $1.1 million decrease in interest income attributable to the recapitalization and deconsolidation of Monroe Capital in 2008. The decrease was partially offset by a net increase to interest income of approximately $1.9 million resulting from the origination and acquisition of commercial real estate debt and commercial real estate securities with a net book value of $389.3 million subsequent to June 30, 2008 offset by approximately $357.7 million of investment dispositions and repayments during 2008. Interest income from related parties for the three months ended June 30, 2009 totaled $4.4 million, representing an increase of $0.8 million, or 22%, compared to $3.6 million for the three months ended June 30, 2008. The increase is attributable to securities purchases within our non-consolidated term debt financings in which we own the non-investment grade note classes. We are generally earning higher yields on securities purchased during the past 12 months due to credit spread widening. All of our real estate securities term debt transactions completed since 2006, in which we retain the equity notes, have been accounted for as on-balance sheet financings. Rental and escalation income for the three months ended June 30, 2009 totaled $24.4 million, representing a decrease of $4.6 million, or 16%, compared to $29.0 million for the three months ended June 30, 2008. The decrease of $4.6 million was primarily attributable to the following; i) Reading, PA and Chatsworth, CA property lease terminations, ii) the Cincinnati, OH lease renewal and iii) during the second quarter 2009, we restructured our net lease relationship with one of our healthcare operators to take advantage of new REIT legislation which now allows a taxable REIT subsidiary affiliate to become the lessee of healthcare-related properties. The restructuring resulted in one of our unconsolidated affiliates becoming the lessee of the properties and our unconsolidated affiliate simultaneously entering into a management contract with a third party operator. This new structure allows us to participate in operating improvements of the underlying properties not previously available under the prior structure. Advisory fees from related parties for the three months ended June 30, 2009 totaled $1.8 million, representing a decrease of approximately $4.7 million, or 72%, compared to $6.5 million for the three months ended June 30, 2008. The decrease was primarily attributable to the sale of 67% of the advisory fee income stream from one of our term debt transactions to the Securities Fund which resulted in the recognition of an additional $4.8 million in advisory fee income during the second quarter 2008. The sale resulted in $0.2 million of lower advisory fees and a decrease of $0.1 million as a result of the decline in the net asset value of our Securities Fund and our term debt transactions which generate advisory fees, also contributed to the lower advisory fees. 55 Other revenue for the three months ended June 30, 2009 totaled $0.2 million, representing a decrease of $3.8 million, or 95%, compared to $4.0 million the three months ended June 30, 2008. Other revenue for three months ended June 30, 2009 consisted primarily of $0.1 million in exit fees and $0.1 million in unused credit line fees. Other revenue for the three months ended June 30, 2008 consisted primarily of the sale of our profit participation in a real estate debt investment for $3.7 million, $0.1 million unused credit line fees and $0.1million in draw fees and $0.1 million miscellaneous other revenue. Expenses Interest expense for the three months ended June 30, 2009 totaled $31.9 million, representing a decrease of $14.6 million, or 31%, compared to $46.5 million for the three months ended June 30, 2008. The decrease in interest was primarily the result of: (i) $9.5 million lower interest on N-Star IV, VI, VII and VIII bonds payable and trust preferred debt due to lower average LIBOR rates, debt repurchases and repayments; (ii) $2.5 million lower interest on our 7.25% exchangeable senior notes due to repurchases; (iii) $0.9 million lower interest as a result of the recapitalization, termination and de-consolidation of our corporate lending venture in 2008; (iv) $0.9 million lower interest relating to lower average balances and lower LIBOR rates on our WA Term Loan; (v) $1.1 million in lower interest rates on our Euro-note; (vi) $0.8 million lower interest related to the Chatsworth, CA lease termination (vii) $0.5 million lower interest related to the termination of our unsecured revolving credit line in May 2008; and (viii) $0.2 million lower interest related to lower average balances on repurchase obligations. The decrease in interest expense was partially offset by: (i) $1.7 million in additional expense from our $80.0 million 11.50% exchangeable senior notes issued in May 2008 and (ii) $0.1 million in additional expense from our LB term loan which closed in June 2008. Real estate property operating expenses for three months ended June 30, 2009 totaled $2.8 million, representing an increase of $0.8 million, or 40%, compared to $2.0 million for three months ended June 30, 2008. The increase was primarily attributable to expenses of $0.3 million that are no longer reimbursed related to the Reading, PA facility that in now vacant and $0.8 million related to the restructuring and termination of our leases with two of our operators in our healthcare portfolio, partially offset by $0.3 million in lower expenses as a result of Chatsworth, CA lease termination. Advisory fees for related parties for the three months ended June 30, 2009 totaled $0.9 million, which was flat, compared to $0.9 million for the three months ended June 30, 2008. We incurred advisory fees to Wakefield Capital Management for the three months ended June 30, 2009 and 2008. Provision for loan losses for the three months ended June 30, 2009 totaled $17.0 million and was specifically identified for eight loans. The second quarter 2009 expense includes $7.5 million for first mortgage whole loans, $5.0 million for subordinated mortgage interests and $4.5 million for mezzanine loans. Provision for loan losses for the three months ended June 30, 2008 totaled $2.5 million and was specifically identified for two loans. The second quarter 2008 expense includes $0.5 million for a first mortgage whole loan and $2.0 million for a mezzanine loan. 56 General and administrative expenses for the three months ended June 30, 2009 totaled $17.0 million, representing an increase of $2.3 million, or 16%, compared to $14.7 million for the three months ended June 30, 2008. The primary components of our general and administrative expenses were the following: Salaries and equity-based compensation for the three months ended June 30, 2009 totaled $11.2 million, representing an increase of approximately $1.3 million, or 13%, compared to $9.9 million, for the three months ended June 30, 2008. The increase was attributable to a $1.9 million increase related to salaries and accrued cash incentive compensation costs offset partially by a $0.7 million decrease related to equity-based compensation. The 2008 cash incentive compensation costs were weighted towards the fourth quarter in anticipation of a greater mix of equity than cash awards than was actually paid. The 2009 quarterly cash incentive compensation accruals assume the equity/cash mix will be consistent with actual 2008 payments. The $0.7 million decrease in equity-based compensation expense was attributable to 2008 grants of $0.1 million in connection with employee separation agreements and a decrease of approximately $0.5 million in vesting of equity-based awards issued under our 2004 Omnibus Stock Incentive Plan and our 2006 Outperformance Plan relating to grants fully vesting and a $0.1 million decrease in our Annual Directors grants. Auditing and professional fees for the three months ended June 30, 2009 totaled $2.3 million, representing an increase of $1.1 million, or 92%, compared to $1.2 million for the three months ended June 30, 2008. The increase was primarily attributable to increased legal fees for general corporate work, investment activities and lease restructuring expenses in our healthcare portfolio. Other general and administrative expenses for the three months ended June 30, 2009 totaled $3.4 million, representing a decrease of approximately $0.1 million, or 3%, compared to $3.5 million for the three months ended June 30, 2008. The decrease was primarily attributable to a decrease in overhead resulting from lower staffing levels during the three months ended June 30, 2009. Depreciation and amortization expense for the three months ended June 30, 2009 totaled $17.4 million, representing an increase of $7.4 million, or 74%, compared to $10.0 million for the three months ended June 30, 2008. This increase was primarily attributable to the write-off of $7.7 million of certain costs associated with the lease restructuring and termination of one of our operators in our healthcare portfolio, partially offset by lower depreciation and amortization of $0.3 million as a result of the write of the Reading, PA and Chatsworth, CA properties. Equity in (loss) earnings for the three months ended June 30, 2009 was a net $0.2 million in earnings, representing an increase of $5.6 million, compared to a loss of $5.4 million for the three months ended June 30, 2008. For the three months ended June 30, 2009, we recognized equity in earnings of $3.4 million on a new joint venture related to the restructured net lease relationship with one of our healthcare operators which resulted in one of our unconsolidated affiliates becoming the lessee of the properties and the unconsolidated affiliate simultaneously entering into a management contract with a third party operator and equity in earnings of $0.1 million in connection with another net lease joint venture. The equity in earnings were partially offset by equity in losses $3.0 million from the Securities Fund (which includes both realized and unrealized gains from asset sales and mark-to-market adjustments) and equity in losses $0.3 million from the LandCap joint venture. For the three months ended June 30, 2008, we recognized equity in losses of $4.9 million from the Securities Fund, of which $5.3 million was an unrealized loss related to the mark-to-market adjustment on the securities in the Securities Fund, and equity in loss of $1.1 million on the LandCap joint venture. The 57 losses were partially offset by equity in earnings of $0.1 million in connection with our net lease joint venture and $0.5 million equity in earning from our corporate lending venture. Unrealized gain (loss) on investments and other increased by approximately $40.7 million for the three months ended June 30, 2009 to a loss of $0.6 million, compared to a loss of $41.3 million for the three months ended June 30, 2008. The unrealized loss on investments for the three months ended June 30, 2009 consisted primarily of unrealized losses related to SFAS 159 mark-to-market adjustments of $28.0 million on liability to subsidiary trusts issuing preferred securities and unrealized losses of $4.6 million on our corporate lending joint venture (which is an equity investment that is marked to market). The unrealized losses were partially offset by unrealized gains related to SFAS 159 mark-to-market adjustments of $19.5 million on various available for sale securities, unrealized gains of $6.5 million on various N-Star bonds payable and net gains of $6.0 million on interest rate swap derivatives no longer qualifying, or not designated as, hedging instruments under SFAS 133. The unrealized loss on investment for the three months ended June 30, 2008 consisted of unrealized losses related to SFAS 159 mark-to-market adjustments of $13.5 million on various N-Star bonds payable, $2.8 million on liability to subsidiary trusts issuing preferred securities, $25.1 million on various available for sale securities and unrealized losses of $32.5 million on our corporate lending joint venture offset partially by unrealized gains $32.0 million on interest rate swaps as a result of these swaps no longer qualifying for hedge accounting under SFAS 133 and $0.6 million on securities sold, not yet purchased. The realized gain of $23.3 million for the three months ended June 30, 2009 consisted primarily of net realized gains of $11.9 million on the repurchase of $21.6 million of our 7.25% exchangeable senior notes and net realized gains of $15.5 million on the sale of certain debt securities available for sale, offset partially by realized losses of $3.8 million related to the discounted payoff of a first mortgage. The realized gain on investments and other of $7.1 million for the three months ended June 30, 2008, was attributable to the recapitalization of our corporate lending venture in which we recognized a $46.0 million realized gain upon the extinguishment of a portion of the debt, a simultaneous $27.1 million cost basis reduction of our investment in the recapitalized venture and a realized loss of $18.9 million related to the sale of certain corporate loans within the portfolio. In addition we recognized a $7.1 million gain on the repurchase of various N-Star bonds. Comparison of the Six Months Ended June 30, 2009 to the Six Months Ended June 30, 2008 Revenues Interest income for the six months ended June 30, 2009 totaled $72.5 million, representing a decrease of $41.1 million, or 36%, compared to $113.6 million for the six months ended June 30, 2008. The decrease consisted of a $32.5 million decrease attributable to an approximately 273 basis points lower average one-month LIBOR rate and lower asset balances during the six month period ending June 30, 2009 compared to the six month period ending June 30 2008, and a $11.7 million decrease in interest income attributable to the recapitalization and deconsolidation of Monroe Capital in 2008. The decrease was partially offset by a net increase to interest income of approximately $4.0 million resulting from the origination and acquisition of commercial real estate debt and commercial real estate securities with a net book value of $389.3 million subsequent to June 30, 2008 offset by approximately $357.7million of investment dispositions and repayments during 2008. 58 Interest income from related parties for the six months ended June 30, 2009 totaled $9.0 million, representing an increase of $1.7 million, or 23%, compared to $7.3 million for the six months ended June 30, 2008. The increase is attributable to securities purchases within our non-consolidated term debt financings in which we own the non-investment grade note classes. We are generally earning higher yields on securities purchased during the past 12 months due to credit spread widening. All of our real estate securities term debt transactions completed since 2006, in which we retain the equity notes, have been accounted for as on-balance sheet financings. Rental and escalation income for the six months ended June 30, 2009 totaled $51.6 million, representing a decrease of $6.4 million, or 11%, compared to $58.0 million for the six months ended June 30, 2008. The decrease of $6.4 million was attributable to the following; i) Reading, PA and Chatsworth, CA property lease terminations, ii) the Cincinnati, OH lease renewal and iii) during the second quarter 2009, we restructured our net lease relationship with one of our healthcare operators to take advantage of new REIT legislation which now allows a taxable REIT subsidiary affiliate to become the lessee of healthcare-related properties. The restructuring resulted in one of our unconsolidated affiliates becoming the lessee of the properties and our unconsolidated affiliate simultaneously entering into a management contract with a third party operator. This new structure allows us to participate in operating improvements of the underlying properties not previously available under the prior structure. Advisory fees from related parties for the six months ended June 30, 2009 totaled $3.5 million, representing a decrease of approximately $5.4 million, or 61%, compared to $8.9 million for the six months ended June 30, 2008. The decrease was primarily attributable to the sale of 67% of the advisory fee income stream from one of our term debt transactions to the Securities Fund which resulted in the recognition of an additional $4.8 million in advisory fee income during the second quarter 2008. The sale resulted in $0.4 million of lower advisory fees and a decrease of $0.2 million as a result of the decline in net asset value of our Securities Fund and our term debt transactions which generate the advisory fees. Other revenue for the six months ended June 30, 2009 totaled $0.3 million, representing a decrease of $4.7 million, or 94%, compared to $5.0 million the six months ended June 30, 2008. Other revenue for six months ended June 30, 2009 consisted primarily of $0.2 million in late fees and $0.1 million in unused credit line fees. Other revenue for the six months ended June 30, 2008 consisted primarily of $3.7 million in profit participation proceeds from the modification of a real estate debt investment, $0.3 million in prepayment penalties, $0.3 million of exit fees, $0.3 million in unused credit line fees, $0.1 million in draw fees and $0.2 million miscellaneous other revenue. Expenses Interest expense for the six months ended June 30, 2009 totaled $66.0 million, representing a decrease of $36.0 million, or 35%, compared to $102.0 million for the six months ended June 30, 2008. The decrease in interest was primarily the result of: (i) $23.6 million lower interest on N-Star IV, VI, VII and VIII bonds payable and trust preferred debt due to lower average LIBOR rates, debt repurchases and repayments; (ii) $3.7 million lower interest on our 7.25% exchangeable senior notes due to repurchases; (iii) $5.9 million lower interest as a result of the recapitalization, termination and 59 de-consolidation of our corporate lending venture in 2008; (iv) $2.7 million lower interest relating to lower average balances and lower LIBOR rates on our WA Term Loan; (v) $1.8 million in lower interest rates on our Euro-note; (vi) $0.8 million lower interest related to the Chatsworth, CA lease termination; (vii) $1.2 million lower interest related to the termination of our unsecured revolving credit line in May 2008; and (viii) $0.6 million lower interest related to lower average balances on repurchase obligations. The decrease in interest expense was partially offset by: (i) $4.2 million in additional expense from our $80.0 million 11.50% exchangeable senior notes issued in May 2008 and (ii) $0.3 million in additional expense from our LB term loan which closed in June 2008. Real estate property operating expenses for six months ended June 30, 2009 totaled $4.9 million, representing an increase of $0.8 million, or 20%, compared to $4.1 million for six months ended June 30, 2008. The increase was primarily related to expenses of $0.5 million that are no longer reimbursed related to the Reading, PA facility that is now vacant and $0.8 million related to the restructuring and termination of our leases with two of our operators in our healthcare portfolio partially offset by $0.3 million in lower expenses as a result of Chatsworth, CA lease termination and lower expenses of $0.2 million at various properties. Advisory fees for related parties for the six months ended June 30, 2009 totaled $1.7 million, representing a decrease of $1.3 million, or 43%, compared to $3.0 million for the six months ended June 30, 2008. The decrease was primarily attributable to the termination of the corporate lending joint venture agreement. We incurred $1.7 million of advisory fees to Wakefield Capital Management and no advisory fees to the corporate lending joint venture for the six months ended June 30, 2009, respectively. We incurred $1.7 million of advisory fees to Wakefield Capital Management and $1.3 million of advisory fees to our former corporate lending venture for the six months ended June 30, 2008, respectively. Provision for loan losses for the six months ended June 30, 2009 totaled $38.5 million and was specifically identified for 13 loans. The provision for loan losses for the six months ended June 30, 2009 included $14.0 million for first mortgage whole loans, $8.0 million for subordinated mortgage interests and $16.5 million for mezzanine loans. Provision for loan losses for the six months ended June 30, 2008 totaled $3.3 million and included $1.3 million for first mortgage whole loans and $2.0 million for a mezzanine loan. General and administrative expenses for the six months ended June 30, 2009 totaled $34.4 million, representing an increase of $1.7 million, or 5%, compared to $32.7 million for the six months ended June 30, 2008. The primary components of our general and administrative expenses were the following: Salaries and equity-based compensation for the six months ended June 30, 2009 totaled $22.9 million, representing an increase of approximately $1.2 million, or 5%, compared to $21.7 million, for the six months ended June 30, 2008. The increase was attributable to a $3.6 million increase related to salaries and accrued cash incentive compensation costs offset partially by a $2.5 million decrease related to equity-based compensation. The 2008 cash incentive compensation costs were weighted towards the fourth quarter in anticipation of a greater mix of equity than cash awards than was actually paid. The 2009 quarterly cash incentive compensation accruals assume the equity/cash mix will be consistent with actual 2008 payments. The $2.5 million decrease in equity-based compensation expense 60 was attributable to the one-time 2008 grants of $0.7 million in connection with employee compensation arrangements and $1.2 million in connection with employee separation agreements. In addition, approximately $0.5 million of the decrease was attributable to a decrease of vesting of equity-based awards issued under our 2004 Omnibus Stock Incentive Plan and our 2006 Outperformance Plan relating to awards fully vesting and a $0.1 million decrease in our Annual Directors grants. Auditing and professional fees for the six months ended June 30, 2009 totaled $4.5 million, representing an increase of $0.8 million, or 22%, compared to $3.7 million for the six months ended June 30, 2008. The increase was primarily attributable to increased legal fees for general corporate work, investment activities and lease restructuring expense in our healthcare portfolio. Other general and administrative expenses for the six months ended June 30, 2009 totaled $7.0 million, representing a decrease of approximately $0.4 million, or 5%, compared to $7.4 million for the six months ended June 30, 2008. The decrease was primarily attributable to decreases costs related to decrease in overhead resulting from lower staffing levels during the six months ended June 30, 2009. Depreciation and amortization expense for the six months ended June 30, 2009 totaled $32.2 million, representing an increase of $12.3 million, or 62%, compared to $19.9 million for the six months ended June 30, 2008. This increase was primarily attributable to the write-off of $7.7 million of certain costs associated with the lease restructuring and termination of one of our operators in our healthcare portfolio and the write-off of $4.6 million of various costs as a result of the Chatsworth, CA property lease termination. Equity in (loss) earnings for the six months ended June 30, 2009 was a net $4.3 million loss, representing a decrease of $1.3 million, compared to a loss of $5.6 million for the six months ended June 30, 2008. For the six months ended June 30, 2009, we recognized equity in losses of $2.7 million from the LandCap joint venture and equity in losses of $5.2 million from the Securities Fund (which includes both realized and unrealized gains from asset sales and mark-to-market adjustments). The losses were partially offset by equ | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||