UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2006 ------------------ OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to _____________ Commission File Number 1-14788 ------- Capital Trust, Inc. ------------------- (Exact name of registrant as specified in its charter) Maryland 94-6181186 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 410 Park Avenue, 14th Floor, New York, NY 10022 - ------------------------------------------ ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (212) 655-0220 -------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X ----- APPLICABLE ONLY TO CORPORATE ISSUERS: The number of outstanding shares of the registrant's class A common stock, par value $0.01 per share, as of October 30, 2006 was 15,397,525.
CAPITAL TRUST, INC. INDEX <TABLE> Part I. Financial Information <S> <C> Item 1: Financial Statements 1 Consolidated Balance Sheets - September 30, 2006 (unaudited) and December 31, 2005 (audited) 1 Consolidated Statements of Income - Three and Nine Months Ended September 30, 2006 and 2005 (unaudited) 2 Consolidated Statements of Changes in Shareholders' Equity - Nine Months Ended September 30, 2006 and 2005 (unaudited) 3 Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2006 and 2005 (unaudited) 4 Notes to Consolidated Financial Statements (unaudited) 5 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations 23 Item 3: Quantitative and Qualitative Disclosures about Market Risk 29 Item 4: Controls and Procedures 30 Part II. Other Information Item 1: Legal Proceedings 31 Item 1A: Risk Factors 31 Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 32 Item 3: Defaults Upon Senior Securities 32 Item 4: Submission of Matters to a Vote of Security Holders 32 Item 5: Other Information 32 Item 6: Exhibits 33 Signatures 34 </TABLE>
Capital Trust, Inc. and Subsidiaries Consolidated Balance Sheets September 30, 2006 and December 31, 2005 (in thousands) <TABLE> <CAPTION> September 30, December 31, 2006 2005 -------------------- -------------------- (unaudited) (audited) <S> <C> <C> Assets Cash and cash equivalents $ 26,720 $ 24,974 Restricted cash 8,210 1,264 Commercial mortgage-backed securities 845,452 487,970 Loans receivable 1,334,014 990,142 Total return swaps 3,000 4,000 Equity investment in unconsolidated subsidiaries 11,185 14,301 Deposits and other receivables 6,664 5,679 Accrued interest receivable 10,431 9,437 Interest rate hedge assets 959 2,273 Deferred income taxes 5,630 3,979 Prepaid and other assets 17,400 13,511 -------------------- -------------------- Total assets $ 2,269,665 $ 1,557,530 ==================== ==================== Liabilities and Shareholders' Equity Liabilities: Accounts payable and accrued expenses $ 23,474 $ 24,957 Repurchase obligations 351,433 369,751 Collateralized debt obligations ("CDOs") 1,241,949 823,744 Junior subordinated debentures 51,550 -- Participations sold 248,137 -- Deferred origination fees and other revenue 5,529 228 -------------------- -------------------- Total liabilities 1,922,072 1,218,680 -------------------- -------------------- Commitments and contingencies Shareholders' equity: Class A common stock, $0.01 par value, 100,000 shares authorized, 14,912 and 14,870 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively ("class A common stock") 149 149 Restricted class A common stock, $0.01 par value 485 and 404 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively ("restricted class A common stock" and together with class A common stock, 5 4 "common stock") Additional paid-in capital 329,564 326,299 Accumulated other comprehensive gain 13,246 14,879 Retained earnings/(deficit) 4,629 (2,481) -------------------- -------------------- Total shareholders' equity 347,593 338,850 -------------------- -------------------- Total liabilities and shareholders' equity $ 2,269,665 $ 1,557,530 ==================== ==================== </TABLE> See accompanying notes to unaudited consolidated financial statements. - 1 -
Capital Trust, Inc. and Subsidiaries Consolidated Statements of Income Three and Nine Months Ended September 30, 2006 and 2005 (in thousands, except share and per share data) (unaudited) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------------------ ------------------------------------ 2006 2005 2006 2005 ----------------- ----------------- ----------------- ----------------- <S> <C> <C> <C> <C> Income from loans and other investments: Interest and related income $ 46,011 $ 22,751 $ 123,862 $ 57,359 Less: Interest and related expenses 28,838 10,325 72,374 23,709 ----------------- ----------------- ----------------- ----------------- Income from loans and other investments, net 17,173 12,426 51,488 33,650 ----------------- ----------------- ----------------- ----------------- Other revenues: Management and advisory fees 748 1,517 2,196 12,144 Income/(loss) from equity investments 328 467 1,050 (835) Other interest income 440 137 790 374 ----------------- ----------------- ----------------- ----------------- Total other revenues 1,516 2,121 4,036 11,683 ----------------- ----------------- ----------------- ----------------- Other expenses: General and administrative 5,879 5,316 16,706 16,384 Depreciation and amortization 357 278 2,696 837 ----------------- ----------------- ----------------- ----------------- Total other expenses 6,236 5,594 19,402 17,221 ----------------- ----------------- ----------------- ----------------- Income before income taxes 12,453 8,953 36,122 28,112 (Benefit)/provision for income taxes (984) (846) (2,455) 315 ----------------- ----------------- ----------------- ----------------- Net income allocable to common stock $ 13,437 $ 9,799 $ 38,577 $ 27,797 ================= ================= ================= ================= Per share information: Net earnings per share of common stock: Basic $ 0.88 $ 0.65 $ 2.52 $ 1.84 ================= ================= ================= ================= Diluted $ 0.86 $ 0.64 $ 2.48 $ 1.81 ================= ================= ================= ================= Weighted average shares of common stock outstanding: Basic 15,337,325 15,125,443 15,327,855 15,110,227 ================= ================= ================= ================= Diluted 15,585,880 15,358,943 15,542,306 15,339,533 ================= ================= ================= ================= Dividends declared per share of common stock $ 0.75 $ 0.55 $ 2.05 $ 1.65 ================= ================= ================= ================= </TABLE> See accompanying notes to unaudited consolidated financial statements. - 2 -
Capital Trust, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders' Equity For the Nine Months Ended September 30, 2006 and 2005 (in thousands) (unaudited) <TABLE> <CAPTION> Restricted Accumulated Class A Class A Additional Other Retained Comprehensive Common Common Paid-In Comprehensive Earnings Income/(Loss) Stock Stock Capital Income/(Loss) (Deficit) Total ------------- -------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> Balance at January 1, 2005 $ 148 $ 3 $ 321,937 $ 3,815 $ (9,406) $ 316,497 Net income $ 27,797 -- -- -- -- 27,797 27,797 Unrealized loss on derivative financial instruments 876 -- -- -- 876 -- 876 Unrealized gain on available-for-sale securities 8,393 -- -- -- 8,393 -- 8,393 Sale of shares of class A common stock under stock option agreements -- -- -- 1,121 -- -- 1,121 Deferred gain on settlement of swap, net of amortization -- -- -- -- 1,011 -- 1,011 Restricted class A common stock earned -- -- -- 1,936 -- -- 1,936 Restricted class A common stock forfeited upon resignation by holder -- -- -- (57) -- -- (57) Dividends declared on class A common stock -- -- -- -- -- (24,967) (24,967) ------------- -------------------------------------------------------------------------- Balance at September 30, 2005 $ 37,066 $ 148 $ 3 $ 324,937 $ 14,095 $ (6,576) $ 332,607 ============= ========================================================================== Balance at January 1, 2006 $ 149 $ 4 $ 326,299 $ 14,879 $ (2,481) $ 338,850 Net income $ 38,577 -- -- -- -- 38,577 38,577 Unrealized loss on derivative financial instruments (1,315) -- -- -- (1,315) -- (1,315) Unrealized loss on available for sale security (96) -- -- -- (96) (96) Amortization of unrealized gain on securities (1,226) -- -- -- (1,226) -- (1,226) Currency translation adjustments 1 -- -- -- 1 -- 1 Sale of shares of class A common stock under stock option agreements -- -- -- 368 -- -- 368 Deferred gain on settlement of swap, net of amortization -- -- -- -- 1,003 -- 1,003 Reimbursement of offering expenses -- -- -- 124 -- -- 124 Restricted class A common stock earned -- -- -- 2,818 -- -- 2,818 Restricted class A common stock forfeited upon resignation by holder -- -- -- (45) -- -- (45) Issuance of restricted stock -- -- 1 -- -- -- 1 Dividends declared on class A common stock -- -- -- -- -- (31,467) (31,467) ------------- -------------------------------------------------------------------------- Balance at September 30, 2006 $ 35,941 $ 149 $ 5 $ 329,564 $ 13,246 $ 4,629 $ 347,593 ============= ========================================================================== </TABLE> See accompanying notes to unaudited consolidated financial statements. -3-
Capital Trust, Inc. and Subsidiaries Consolidated Statements of Cash Flows Nine months ended September 30, 2006 and 2005 (in thousands) (unaudited) <TABLE> <CAPTION> 2006 2005 ---------------- ----------------- <S> <C> <C> Cash flows from operating activities: Net income $ 38,577 $ 27,797 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,696 837 (Income)/loss from equity investments (1,050) 835 Distributions from equity investments 1,009 -- Restricted class A common stock earned 2,818 -- Amortization of premiums and accretion of discounts on loans and investments, net (1,131) (2,158) Amortization of deferred gains on interest rate hedges (182) -- Stock based compensation (45) 1,899 Changes in assets and liabilities, net: Deposits and other receivables 5,237 279 Accrued interest receivable (994) (3,954) Deferred income taxes (1,651) 1,889 Prepaid and other assets 2,261 886 Accounts payable and accrued expenses (814) (354) Deferred origination fees and other revenue 5,301 (97) ---------------- ----------------- Net cash provided by operating activities 52,032 27,859 ---------------- ----------------- Cash flows from investing activities: Purchases of commercial mortgage-backed securities (384,732) (205,565) Principal collections on and proceeds from sale of commercial mortgage-backed securities 26,548 8,787 Origination and purchase of loans receivable (771,200) (510,015) Principal collections on loans receivable 421,617 261,787 Equity investments (3,208) (4,660) Return of capital 3,752 7,950 Purchase of total return swaps (4,138) (4,000) Proceeds from total return swaps 5,138 -- Increase in restricted cash (6,946) (1,478) Purchases of equipment and leasehold improvements -- (23) ---------------- ----------------- Net cash used in investing activities (713,169) (447,217) ---------------- ----------------- Cash flows from financing activities: Proceeds from repurchase obligations 878,534 436,393 Repayment of repurchase obligations (896,852) (503,710) Proceeds from credit facilities -- 104,704 Repayment of credit facilities -- (169,880) Issuance of junior subordinated debentures 51,550 -- Purchase of common equity in CT Preferred Trust I (1,550) -- Proceeds from CDOs 429,399 571,039 Repayments of CDOs (11,194) -- Proceeds from participations sold 248,137 -- Settlement of interest rate hedge 1,186 1,410 Payment of deferred financing costs (4,681) (7,734) Reimbursement of offering expenses 124 -- Dividends paid on class A common stock (32,138) (24,156) Sale of shares of class A common stock under stock option agreements 368 1,121 ---------------- ----------------- Net cash provided by financing activities 662,883 409,187 ---------------- ----------------- Net decrease in cash and cash equivalents 1,746 (10,171) Cash and cash equivalents at beginning of year 24,974 24,583 ---------------- ----------------- Cash and cash equivalents at end of period $ 26,720 $ 14,412 ================ ================= </TABLE> See accompanying notes to unaudited consolidated financial statements -4-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 1. Organization References herein to "we," "us" or "our" refer to Capital Trust, Inc. and its subsidiaries unless the context specifically requires otherwise. We are a fully integrated, self-managed finance and investment management company that specializes in credit-sensitive structured financial products. To date, our investment programs have focused on loans and securities backed by commercial real estate assets. We invest for our own account and for private equity funds that we manage on behalf of third parties. From the commencement of our finance business in 1997 through September 30, 2006, we have completed $7.2 billion of investments both directly and on behalf of our managed funds. We conduct our operations as a real estate investment trust, or REIT, for federal income tax purposes and we are headquartered in New York City. 2. Summary of Significant Accounting Policies The accompanying unaudited consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The accompanying unaudited consolidated interim financial statements should be read in conjunction with the financial statements and the related management discussion and analysis of financial condition and results of operations filed with our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. In our opinion, all adjustments (consisting only of normal, recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. Our accounting and reporting policies conform in all material respects to accounting principles generally accepted in the United States. Principles of Consolidation The accompanying unaudited consolidated interim financial statements include, on a consolidated basis, our accounts, the accounts of our wholly-owned subsidiaries and our interests in variable interest entities in which we are the primary beneficiary. All significant intercompany balances and transactions have been eliminated in consolidation. Our interest in CT Preferred Trust I is accounted for using the equity method and its assets and liabilities are not consolidated into our financial statements due to our determination that CT Preferred Trust I is a variable interest entity in which we are not the primary beneficiary under Financial Accounting Standards Board, or FASB, Interpretation No. 46, or FIN 46. We account for our co-investment interests in two of the private equity funds we have co-sponsored and continue to manage, CT Mezzanine Partners II LP and CT Mezzanine Partners III, Inc., or Fund II and Fund III, respectively, under the equity method of accounting. We also account for our investment in Bracor Investimentos Imobiliarios Ltda., or Bracor, under the equity method of accounting. As such, we report a percentage of the earnings of Fund II, Fund III and Bracor equal to our ownership percentage on a single line item in the consolidated statement of operations as income from equity investments. Revenue Recognition Interest income from our loans receivable is recognized over the life of the investment using the effective interest method and recorded on the accrual basis. Fees, premiums, discounts and direct costs in connection with these investments are deferred until the loan is advanced and are then recognized over the term of the loan as an adjustment to yield. Fees on commitments that expire unused are recognized at expiration. For loans where we have unfunded commitments, we amortize the appropriate items on a straight line basis. Income recognition is generally suspended for loans at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. Fees from special servicing and asset management services are recognized as services are rendered. We account for incentive fees we can potentially earn from our investment management business in accordance with Method 1 of Emerging Issues Task Force Topic D-96. Under Method 1, no incentive income is recorded until all contingencies have been eliminated. -5-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) Restricted Cash Restricted cash of $8.2 million at September 30, 2006 is on deposit with the trustee for our CDOs and is expected to be used to pay contractual interest and principal and to purchase replacement collateral for our reinvesting CDOs during their respective reinvestment periods. Commercial Mortgage Backed Securities From time to time we purchase commercial mortgage-backed securities, or CMBS, and other investments in which we have a level of control over the issuing entity; we refer to these investments as controlling class investments, or Controlling Class Investments. The presentation of Controlling Class Investments in our financial statements is governed in part by FIN 46. FIN 46 could require that certain Controlling Class Investments be presented on a consolidated basis. Based upon the specific circumstances of certain of our CMBS investments that are Controlling Class Investments and our interpretation of FIN 46, specifically the exemption for qualifying special purpose entities as defined under FASB Statements of Financial Accounting Standard No. 140, or FAS 140, we have concluded that the entities that have issued the Controlling Class Investments should not be presented on a consolidated basis. We are aware that FAS 140 is currently under review by standard setters and that, as a result of this review, our current interpretation of FIN 46 and FAS 140 may change. We classify our CMBS investments pursuant to FAS No. 115 on the date of acquisition of the investment. On August 4, 2005, we made a decision to change the accounting classification of our CMBS investments from available-for-sale to held-to-maturity. Held-to-maturity investments are stated at cost plus the amortization of any premiums or discounts and any premiums or discounts will be amortized through the consolidated statements of income using the level yield method. Other than in the instance of impairment, these held-to-maturity investments will be shown in our financial statements at their adjusted values pursuant to the methodology described above. We may from time to time invest in CMBS and certain other securities which may be classified as available-for-sale. Available-for-sale securities are carried at estimated fair value with the net unrealized gains or losses reported as a component of accumulated other comprehensive income/(loss) in shareholders' equity. Many of these investments are relatively illiquid and management must estimate their values. In making these estimates, management utilizes market prices provided by dealers who make markets in these securities, but may, under certain circumstances, adjust these valuations based on management's judgment. Changes in the valuations do not affect our reported income or cash flows, but impact shareholders' equity and, accordingly, book value per share. Income on these securities is recognized based upon a number of assumptions that are subject to uncertainties and contingencies. Examples include, among other things, the rate and timing of principal payments, including prepayments, repurchases, defaults and liquidations, the pass-through or coupon rate and interest rates. Additional factors that may affect our reported interest income on our mortgage-backed securities include interest payment shortfalls due to delinquencies on the underlying mortgage loans and the timing and magnitude of credit losses on the mortgage loans underlying the securities that are impacted by, among other things, the general condition of the real estate market, including competition for tenants and their related credit quality, and changes in market rental rates. These uncertainties and contingencies are difficult to predict and are subject to future events that may alter the assumptions. We account for CMBS under Emerging Issues Task Force 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets", or EITF 99-20. Under EITF 99-20, when significant changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience and the present value of the revised cash flows using the current expected yield is less than the present value of the previously estimated remaining cash flows, adjusted for cash receipts during the intervening period, an other-than-temporary impairment is deemed to have occurred. Accordingly, the security is written down to fair value with the resulting change being included in income and a new cost basis established with the original discount or premium written off when the new cost basis is established. In accordance with this guidance, on a quarterly basis, when significant changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience, we calculate a revised yield based upon the current amortized cost of the investment, including any other-than-temporary impairments recognized to date, and the revised cash flows. The revised yield is then applied prospectively to recognize interest income. Management must also assess whether unrealized losses on securities reflect a decline in value that is other-than-temporary, and, accordingly, write down the impaired security to its fair value, through a charge to earnings. Significant judgment of management is required in this analysis that includes, but is not limited to, making -6-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) assumptions regarding the collectibility of the principal and interest, net of related expenses, on the underlying loans. Loans Receivable and Reserve for Possible Credit Losses We purchase and originate commercial real estate debt and related instruments, or Loans, to be held as long term investments at amortized cost. Management must periodically evaluate each of these loans for possible impairment. Impairment is indicated when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan were determined to be permanently impaired, we would write down the loan through a charge to the reserve for possible credit losses. Given the nature of our loan portfolio and the underlying commercial real estate collateral, significant judgment of management is required in determining the permanent impairment and the resulting charge to the reserve, which includes but is not limited to making assumptions regarding the value of the real estate that secures the loan. Each loan in our portfolio is evaluated at least quarterly using our loan risk rating system which considers loan-to-value, debt yield, cash flow stability, exit plan, loan sponsorship, loan structure and other factors deemed necessary by management to assess the likelihood of delinquency or default. If we believe that there is a potential for delinquency or default, a downside analysis is prepared to estimate the value of the collateral underlying our loan, and this potential loss is multiplied by the default likelihood to determine the size of the reserve. Actual losses, if any, could ultimately differ from these estimates. Repurchase Obligations In certain circumstances, we have financed the purchase of investments from a counterparty through a repurchase agreement with that same counterparty. We currently record these investments in the same manner as other investments financed with repurchase agreements, with the investment recorded as an asset and the related borrowing under any repurchase agreement as a liability on our consolidated balance sheet. Interest income earned on the investments and interest expense incurred on the repurchase obligations are reported separately on the consolidated statements of income. There is a position under consideration by standard setters, based upon a technical interpretation of FAS 140, that these transactions will not qualify as a purchase by us. We believe, consistent with industry practice, that we are accounting for these transactions in an appropriate manner; however, if these investments do not qualify as a purchase under FAS 140, we would be required to present the net investment (asset balance less the repurchase obligation balance) on our balance sheet together with an embedded derivative with the corresponding change in fair value of the derivative being recorded in the consolidated statements of income. The value of the derivative would reflect not only changes in the value of the underlying investment, but also changes in the value of the underlying credit provided by the counterparty. Income from these arrangements would be presented on a net basis. Furthermore, hedge instruments related to these assets and liabilities, currently deemed effective, may no longer be effective and may have to be accounted for as non-hedge derivatives. As of September 30, 2006 we had entered into thirteen such transactions, with a book value of the associated assets of $310.1 million financed with repurchase obligations of $198.0 million. Adoption of the aforementioned treatment would result in a reduction in total assets and liabilities on our consolidated balance sheet of $198.0 million and $118.2 million at September 30, 2006 and December 31, 2005, respectively. Interest Rate Derivative Financial Instruments In the normal course of business, we use interest rate derivative financial instruments to manage, or hedge, cash flow variability caused by interest rate fluctuations. Specifically, we currently use interest rate swaps to effectively convert variable rate liabilities, that are financing fixed rate assets, to fixed rate liabilities. The differential to be paid or received on these agreements is recognized on the accrual basis as an adjustment to the interest expense related to the attendant liability. The swap agreements are generally accounted for on a held-to-maturity basis, and, in cases where they are terminated early, any gain or loss is generally amortized over the remaining life of the hedged item. These swap agreements must be effective in reducing the variability of cash flows of the hedged items in order to qualify for the aforementioned hedge accounting treatment. Changes in value of effective cash flow hedges are reflected in our financial statements through accumulated other comprehensive income/(loss) and do not affect our net income. To the extent a derivative does not qualify for hedge accounting, and is deemed a non-hedge derivative, the changes in its value are included in net income. To determine the fair value of derivative instruments, we use third parties to periodically value our interests. Income Taxes Our financial results generally do not reflect provisions for current or deferred income taxes on our REIT taxable income. Management believes that we have and intend to continue to operate in a manner that will continue to allow -7-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) us to be taxed as a REIT and, as a result, do not expect to pay substantial corporate-level taxes (other than taxes payable by our taxable REIT subsidiaries which are accounted for in accordance with Statement of Financial Accounting Standards No. 109). Many of these requirements, however, are highly technical and complex. If we were to fail to meet these requirements, we may be subject to Federal income tax on current and past income and may be subject to penalties. Use of 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 affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may ultimately differ from those estimates. Reclassifications Certain reclassifications have been made in the presentation of the prior periods consolidated financial statements to conform to the September 30, 2006 presentation. -8-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 3. Commercial Mortgage-Backed Securities Activity relating to our commercial mortgage-backed securities, or CMBS, for the nine months ended September 30, 2006 was as follows ($ values in thousands): <TABLE> <CAPTION> Weighted Average ------------------------------------------ Number Number Face Book of of Maturity Asset Type Value Value Securities Issues Rating(1) Coupon(2) Yield(2) (Years)(3) - ---------------------------------------------- ------------ ---------- ------- ---------- ---------- --------- ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> December 31, 2005 Floating Rate $ 106,666 $ 105,032 11 9 BBB- 6.89% 6.99% 2.3 Fixed Rate 419,885 382,938 34 21 B+ 6.97% 7.72% 10.1 ------------- ------------ ------------------ ---------- ---------- --------- ---------- Total/Average 526,551 487,970 45 30 BB- 6.95% 7.57% 8.4 Originations- Nine Months Floating Rate 25,448 25,451 4 2 BB+ 7.18% 7.21% 3.0 ------------- ------------ ------------------ ---------- ---------- --------- ---------- Fixed Rate 361,255 359,280 34 28 BBB- 6.35% 6.33% 8.0 ------------- ------------ ------------------ ---------- ---------- --------- ---------- Total/Average 386,703 384,731 38 30 BBB- 6.41% 6.39% 7.6 Repayments & Other(4)-Nine Months Floating Rate 18,748 18,737 3 2 N/A N/A N/A N/A Fixed Rate 9,059 8,512 1 1 N/A N/A N/A N/A ------------- ------------ ------------------ ---------- ---------- --------- ---------- Total/Average 27,807 27,249 4 3 N/A N/A N/A N/A September 30, 2006 Floating Rate 113,366 111,747 12 9 BBB- 7.66% 7.79% 2.0 Fixed Rate 772,081 733,705 67 48 BB 6.70% 7.35% 8.7 ------------- ------------ ------------------ ---------- ---------- --------- ---------- Total/Average $ 885,447 $ 845,452 79 57 BB 6.82% 7.41% 7.8 ============ ============ ========= ======= ========== ========== ========= ========= </TABLE> (1) Rating is the lowest rating from Fitch Ratings, Standard & Poor's and/or Moody's Investors Service and the weighted average is calculated using the Fitch Ratings methodology. (2) Calculations based on LIBOR of 5.32% as of September 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (3) Represents the maturity of the investment assuming all extension options are executed. (4) Includes full repayments, sale, partial repayments, mark-to-market adjustments, and the impact of premium and discount amortization and losses, if any. The figures shown in "Number of Securities" and "Number of Issues" represent the full repayments/sales, if any. While we typically account for our CMBS investments on a held-to-maturity basis, under certain circumstances we will account for CMBS on an available-for-sale basis. At September 30, 2006, we had one CMBS investment that we designated and account for on an available-for-sale basis with a face value of $10.0 million. The security earns interest at a rate of 8.00%. As of September 30, 2006, the security was carried at its fair market value of $10.5 million. The investment matures in February 2010. Quarterly, we reevaluate our CMBS portfolio to determine if there has been an other-than-temporary impairment based upon our assessment of future cash flow receipts. For the nine months ended September 30, 2006, we believe that there has not been any adverse change in cash flows for our CMBS portfolio and, therefore, did not recognize any other-than-temporary impairments. During the fourth quarter of 2004, we concluded that two of our CMBS investments had incurred other-than-temporary impairment and we incurred a charge of $5.9 million through the consolidated statements of income. Significant judgment of management is required in this analysis that includes, but is not limited to, making assumptions regarding the collectibility of the principal and interest, net of related expenses, on the underlying loans. -9-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 4. Loans Receivable Activity relating to our loans receivable for the nine months ended September 30, 2006 was as follows ($ values in thousands): <TABLE> <CAPTION> Weighted Average(1) --------------------------------------- Invest- Maturity Asset Type Face Value(1) Book Value(1) ments(1) LTV(2) Coupon(3) Yield(3) (Years)(4) - ---------------------------------- ---------------------------------------------- ------------------- --------- <S> <C> <C> <C> <C> <C> <C> <C> December 31, 2005 - ----------------- Floating rate Mortgage loans $ 66,471 $ 66,471 3 71.8% 6.90% 6.85% 2.8 Subordinate mortgage interests 527,497 526,435 51 64.3% 7.75% 7.82% 3.7 Mezzanine loans 230,174 229,998 14 70.4% 8.56% 8.59% 3.5 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 824,142 822,904 68 66.6% 7.91% 7.96% 3.6 Fixed rate Mortgage loans - - Subordinate mortgage interests 49,390 48,435 4 71.6% 7.78% 8.15% 16.9 Mezzanine loans 119,543 115,764 4 70.5% 9.00% 9.54% 5.9 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 168,933 164,199 8 70.8% 8.65% 9.13% 9.2 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average - December 31, 2005 993,075 987,103 76 67.1% 8.01% 8.13% 4.5 ============= ============= ========= ======== ========== ======== ========= Originations - Nine Months(5) - ----------------------------- Floating rate Mortgage loans 146,027 146,027 10 75.8% 8.76% 8.85% 3.9 Subordinate mortgage interests 206,280 206,280 4 77.5% 9.22% 9.37% 4.0 Mezzanine loans 392,480 392,480 8 74.8% 9.98% 10.18% 4.3 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 744,787 744,787 22 75.7% 9.53% 9.69% 4.1 Fixed rate Mortgage loans -- -- -- -- -- -- -- Subordinate mortgage interests -- -- -- -- -- -- -- Mezzanine loans 25,700 26,413 4 80.0% 11.49% 10.98% 4.6 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 25,700 26,413 4 80.0% 11.49% 10.98% 4.6 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 770,487 771,200 26 75.9% 9.60% 9.74% 4.1 ============= ============= ========= ======== ========== ======== ========= Repayments & Other(6) - Nine Months - ----------------------------------- Floating rate Mortgage loans 61,569 61,569 3 N/A N/A N/A N/A Subordinate mortgage interests 296,450 296,255 30 N/A N/A N/A N/A Mezzanine loans 68,795 68,763 4 N/A N/A N/A N/A ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 426,814 426,587 37 N/A N/A N/A N/A Fixed rate Mortgage loans -- -- -- N/A N/A N/A N/A Subordinate mortgage interests 159 61 -- N/A N/A N/A N/A Mezzanine loans 578 392 -- N/A N/A N/A N/A ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 737 453 -- N/A N/A N/A N/A ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 427,551 427,040 37 N/A N/A N/A N/A ============= ============= ========= ======== ========== ======== ========= September 30, 2006 - ------------------ Floating rate Mortgage loans 150,929 150,929 10 74.9% 8.64% 8.98% 3.8 Subordinate mortgage interests 437,327 436,460 25 69.0% 8.92% 9.01% 3.5 Mezzanine loans 553,859 553,715 18 72.7% 9.85% 10.01% 4.0 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 1,142,115 1,141,104 53 71.5% 9.34% 9.49% 3.8 Fixed rate Mortgage loans -- -- -- -- -- -- -- Subordinate mortgage interests 49,231 48,374 4 70.2% 7.78% 7.86% 16.2 Mezzanine loans 144,665 141,785 8 69.5% 9.30% 9.59% 5.1 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average 193,896 190,159 12 69.7% 8.91% 9.15% 7.9 ------------- ------------- --------- -------- ---------- -------- --------- Total/Average - September 30, 2006 $ 1,336,011 $ 1,331,263 65 71.2% 9.27% 9.44% 4.4 ============= ============= ========= ======== ========== ======== ========= </TABLE> (1) Does not include one non-performing loan with a face value of $8,000 and a book value of $2,751 and $3,039 on September 30, 2006 and December 31, 2005, respectively. (2) Loan to value is based upon appraised values determined by third parties. (3) Calculations based on LIBOR of 5.32% as of September 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (4) Represents the maturity of the investment assuming all extension options are executed. (5) Includes additional fundings on prior period originations. The figures shown in "Investments" represents the actual number of originations during the period. (6) Includes full repayments, sale, partial repayments and the impact of premium and discount amortization and losses, if any. The figures shown in "Investments" represents the full repayments/sales, if any. -10-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) We continue to have one defaulted loan, an $8.0 million first mortgage at September 30, 2006. We received $288,000 in cash on the loan during the nine months ended September 30, 2006. The cash collections reduced the carrying value to $2.8 million at September 30, 2006. In some instances, we have a further obligation to fund additional amounts under our loan arrangements, or Unfunded Commitments. At September 30, 2006, we had five such Unfunded Commitments for a total future funding obligation of $218.9 million. At September 30, 2006, we had $6.2 million included in deposits and other receivables which represented loans that were satisfied and repaid prior to September 30, the proceeds of which had not been remitted to us by our servicers. Quarterly, we reevaluate the reserve for possible credit losses based upon our current portfolio of loans. At September 30, 2006, a detailed review of the entire portfolio was completed, and we concluded that a reserve for possible credit losses was not warranted. 5. Total Return Swaps Total return swaps are derivative contracts in which one party agrees to make payments that replicate the total return of a defined underlying asset, typically in return for another party agreeing to bear the risk of performance of the defined underlying asset. Under our current total return swaps, we bear the risk of performance of the underlying asset and receive payments from our counterparty as compensation. In effect, these total return swaps allow us to receive the leveraged economic benefits of asset ownership without our acquiring, or our counterparty selling, the actual underlying asset. Our total return swaps reference commercial real estate loans and contain a put provision whereby our counterparty has the right to require us to buy the reference loan at its par value under certain reference loan performance scenarios. The put obligation imbedded in these arrangements constitutes a recourse obligation for us to perform under the terms of the contract. Activity relating to our total return swaps for the nine months ended September 30, 2006 was as follows ($ values in thousands): <TABLE> <CAPTION> Weighted Average ------------------------ Asset Type Fair Market Cash Reference Number Maturity Value Loan/ of (Book Value) Collateral Participation Investments Yield(1) (Years) - ----------------------------------------- --------------- ------------- ----------- ------------ ------------ <S> <C> <C> <C> <C> <C> <C> December 31, 2005 $ 4,000 $ 4,000 $ 20,000 1 18.14% 0.6 Originations- Nine Months(2) 4,138 4,138 40,000 2 19.55% 1.9 Repayments- Nine Months 5,138 5,138 20,000 1 N/A N/A ------------ --------------- ------------- ----------- ------------ ------------ September 30, 2006(2) $ 3,000 $ 3,000 $ 40,000 2 20.55% 1.0 ============ =============-- ============= =========== ============ ============ </TABLE> (1) Calculations based on LIBOR of 5.32% as of September 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (2) One total return swap currently has no outstanding balance and a $3.0 million Unfunded Commitment exists. The total return swaps are treated as non-hedge derivatives for accounting purposes and, as such, changes in their market value are recorded through the consolidated statements of income. At September 30, 2006, our total return swaps were valued at par and no such consolidated statement of income impact was recorded. -11-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 6. Equity Investment in Unconsolidated Subsidiaries Pursuant to a venture agreement with Citigroup Alternative Investments, LLC, or the Venture Agreement, entered into in 2000 and subsequently amended in 2003, we have co-sponsored two funds: CT Mezzanine Partners II LP and CT Mezzanine Partners III, Inc., or Fund II and Fund III. We are an investor in the funds and our wholly-owned subsidiary, CT Investment Management Co., LLC, serves as the investment manager to the funds. Both funds have concluded their respective investment periods and are liquidating in the ordinary course. In connection with entering into the Venture Agreement and the formation of the funds, we capitalized certain costs. These costs are being amortized over the expected life of each fund with respect to each of the funds. During the second quarter, management concluded that it no longer intends to co-sponsor investment management vehicles pursuant to the Venture Agreement. Accordingly, the costs related to the Venture Agreement were accelerated and fully amortized during the quarter ended June 30, 2006. Included in depreciation and amortization for the quarter ended June 30, 2006, was $1.8 million of the accelerated amortization of these costs. In September of 2006, we made a founding investment in Bracor Investimentos Imobiliarios Ltda., or Bracor, a newly formed net lease commercial real estate company located and operating in Brazil. Our total commitment is $15.0 million and at September 30, 2006, we funded $3.2 million. Bracor is owned 24% by us, 47% by Equity International Properties, Ltd., or EIP, and 29% by third parties. Our Chairman, Sam Zell, is the Chairman of EIP and has an ownership position in EIP. Bracor's operations will be conducted in Brazilian Reais and changes in the USD/Reais exchange rate will impact the carrying value of our investment. At September 30, 2006, the currency valuation adjustment for our investment was $1,000 and was recorded as an adjustment to accumulated other comprehensive income/(loss) in shareholders' equity. Our share of profits and losses from Bracor will be reported one quarter subsequent to the period earned by Bracor. Activity relating to our equity investment in unconsolidated subsidiaries for the nine months ended September 30, 2006 was as follows ($ values in thousands): <TABLE> <CAPTION> Venture Fund II Fund II Fund III Bracor Total Agrmt. GP(1) ----------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Equity Investment Beginning Balance $ -- $1,278 $692 $7,754 $ -- $9,724 Equity investment -- -- -- -- 3,209 3,209 Company portion of fund income -- 410 (70) 804 -- 1,144 Amortization of capitalized costs -- (93) -- -- -- (93) Investment/(Distributions) from funds -- (106) -- (4,656) -- (4,762) ----------- ---------- ---------- ---------- ---------- ---------- Ending Balance $ -- $1,489 $622 $3,902 $3,209 $9,222 =========== ========== ========== ========== ========== ========== Capitalized Costs Beginning Balance $2,020 $2,036 $ -- $521 $ -- $4,577 Amortization of capitalized costs (2,020) (481) -- (113) -- (2,614) ----------- ---------- ---------- ---------- ---------- ---------- Ending Balance $ -- $1,555 $ -- $408 $ -- $1,963 =========== ========== ========== ========== ========== ========== Total Beginning Balance $2,020 $3,314 $692 $8,275 $ -- $ 14,301 Equity investment -- -- -- -- 3,209 3,209 Company portion of fund income -- 410 (70) 804 -- 1,144 Amortization of capitalized costs (2,020) (574) -- (113) -- (2,707) Distributions from funds -- (106) -- (4,656) -- (4,762) ----------- ---------- ---------- ---------- ---------- ---------- Ending Balance $ -- $3,044 $622 $4,310 $3,209 $11,185 =========== ========== ========== ========== ========== ========== </TABLE> (1) $420,000 of the equity investment consists of capitalized costs at Fund II GP which are being amortized over the expected life of the Fund. -12-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 7. Debt At September 30, 2006 and December 31, 2005 we had approximately $1.6 billion and $1.2 billion, respectively, of total debt outstanding. The balances of each category of debt and their respective all-in effective cost, including the amortization of fee and expenses, as of September 30, 2006 and December 31, 2005 were as follows ($ values in thousands): <TABLE> <CAPTION> September 30, 2006 December 31, 2005 ---------------------------------------------- ----------------------------------------------- All-In All-In Face Value Book Value Coupon(1) Cost Face Value Book Value Coupon(1) Cost ----------- ----------- ---------- ----- ---------- ---------- --------- ---- <S> <C> <C> <C> <C> <C> <C> <C> <C> Repurchase Obligations $351,433 $351,433 6.51% 6.81% $369,751 $369,751 5.33% 5.57% Collateralized Debt Obligations CDO I (Floating) 252,778 252,778 5.94% 6.36% 252,778 252,778 5.01% 5.43% CDO II (Floating) 298,913 298,913 5.81% 6.03% 298,913 298,913 4.88% 5.10% CDO III (Fixed) 269,594 271,830 5.22% 5.25% 269,594 272,053 5.22% 5.25% CDO IV(Floating)(2) 418,428 418,428 5.52% 5.62% -- -- -- -- ----------- ----------- ---------- ----- ---------- ---------- --------- ---- Total CDOs 1,239,713 1,241,949 5.61% 5.79% 821,285 823,744 5.03% 5.25% Junior subordinated debentures 51,550 51,550 7.45% 7.53% -- -- -- -- ----------- ----------- ---------- ----- ---------- ---------- --------- ---- Total $1,642,696 $1,644,932 5.86% 6.06% $1,191,036 $1,193,495 5.12% 5.35% =========== =========== ========== ===== ========== ========== ========= ===== </TABLE> (1) Calculations based on LIBOR of 5.32% as of September 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (2) Comprised of $402.2 million of floating rate notes sold and $16.2 million of fixed rate notes sold. Repurchase Obligations At September 30, 2006, we were a party to eight repurchase agreements with six counterparties that provide total commitments of $950.0 million. At September 30, 2006, we borrowed $351.4 million under these agreements and had the ability to borrow $77.5 million without pledging additional collateral. In February 2006, we amended and restated our repurchase agreements with Bear Stearns increasing the combined commitment by $75 million to $200 million. The agreements expire in August 2008 and are designed to finance, on a recourse basis, our general investment activity as well as assets designated for one or more of our CDOs. Under the agreements, advance rates are up to 85.0% and cash costs of funds range from LIBOR plus 0.55% to LIBOR plus 2.00%. At September 30, 2006, we had incurred borrowings under the agreements of $88.3 million and had the ability to borrow an additional $31.6 million against the assets collateralizing the borrowings under the agreement. In March 2006, we extended our $200 million repurchase agreement with Liquid Funding, LTD., an affiliate of Bear Stearns. The agreement, which we originally entered into in February 2002, is designed to provide us with non-recourse financing for our general securities investment activity. Under the agreement, advance rates are up to 85.0% and cash costs of funds range from LIBOR plus 0.40% to LIBOR plus 1.70%. At September 30, 2006, we had incurred borrowings under the agreement of $25.7 million. In March 2006, we entered into a loan-specific repurchase obligation representing borrowings of $6.0 million with Lehman Brothers. The obligation is non-recourse, has a term of one year and the advance rate is 60.0% with a cash cost of LIBOR plus 2.50%. In June 2006, we extended our $100 million repurchase agreement with Goldman Sachs Mortgage Company to June 2009 and in August we amended and restated the agreement to increase the commitment to $150 million. The agreement, which we originally entered into in May 2003, is designed to finance, on a recourse basis, our general -13-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) investment activity. Under the agreement, advance rates are up to 88.0% and cash costs of funds range from LIBOR plus 0.60% to LIBOR plus 1.95%. At September 30, 2006, we had incurred borrowings under the agreement of $71.0 million and had the ability to borrow an additional $24.6 million against the assets collateralizing the borrowings under the agreement. Collateralized Debt Obligations At September 30, 2006, we had collateralized debt obligations, or CDOs, outstanding from four separate issuances with a total face value of $1.2 billion. Our existing CDOs are financing vehicles for our assets and, as such, are consolidated on our balance sheet at $1.2 billion, representing the amortized sales price of the securities sold to third parties. In total, our two floating rate reinvesting CDOs provide us with $551.7 million of debt financing at a cash cost of LIBOR plus 0.55% (5.87% at September 30, 2006) and an all-in effective interest rate (including the amortization of issuance costs) of LIBOR plus 0.87% (6.19% at September 30, 2006). Our two fixed rate static CDOs provide us with $690.3 million of financing with a cash cost of 5.40% and an all-in effective interest rate of 5.47%. On a combined basis, our CDOs provide us with $1.2 billion of non-recourse, non-mark-to-market, index matched financing at a weighted average cash cost of 0.49% over the applicable index (5.61% at September 30, 2006) and a weighted average all-in cost of 0.69% over the applicable index (5.79% at September 30, 2006). Junior Subordinated Debentures In February 2006, we sold $50 million of trust preferred securities through a subsidiary, CT Preferred Trust I. The trust preferred securities have a 30-year term, maturing in April 2036, are redeemable at par on or after April 30, 2011 and pay distributions at a fixed rate of 7.45% for the first ten years ending April 2016, and thereafter, at a floating rate of three month LIBOR plus 2.65%. The all-in cost of the junior subordinated debentures is 7.53%. Our interest in CT Preferred Trust I is accounted for using the equity method and the assets and liabilities are not consolidated into our financial statements due to our determination that CT Preferred Trust I is a variable interest entity under FIN 46 and that we are not the primary beneficiary of the entity. Interest on the junior subordinated debentures is included in interest expense on our consolidated statements of income while the junior subordinated notes are presented as a separate item in our consolidated balance sheet. 8. Participations Sold Participations sold represent interests in loans that we originated and subsequently sold to third parties. We present these sold interests as secured borrowings in conformity with GAAP on the basis that these arrangements do not qualify as sales under FAS 140. At September 30, 2006, we had three such participations sold with a total book balance of $248.1 million at a weighted average yield of LIBOR plus 3.64% (8.96% at September 30, 2006). The income earned on the loans is recorded as interest income and an identical amount is recorded as interest expense on the consolidated statements of income. -14-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 9. Derivative Financial Instruments To manage interest rate risk, we typically employ interest rate swaps or other arrangements, to convert a portion of our floating rate debt to fixed rate debt in order to index match our assets and liabilities. The net payments due under these swap contracts are recognized as interest expense over the life of the contracts. During the nine month period ended September 30, 2006, we entered into nine new cash flow hedge agreements with a total current notional balance of $404.1 million. Additionally, during the nine months ended September 30, 2006, we received $1.2 million from counterparties in settlement of seven interest rate swaps. Recognition of these settlements has been deferred and is being amortized over the remaining life of the previously hedged item using an approximation of the level yield basis. The following table summarizes the notional and fair values of our derivative financial instruments as of September 30, 2006. The notional value provides an indication of the extent of our involvement in the instruments at that time, but does not represent exposure to credit or interest rate risk ($ values in thousands): <TABLE> <CAPTION> Hedge Type Notional Value Interest Rate Maturity Fair Value ---------- --------------------- -------------------- ------------------ ------------- ------------- <S> <C> <C> <C> <C> Swap Cash Flow Hedge $340,895 5.10% 2015 ($662) Swap Cash Flow Hedge 74,094 4.58% 2014 1,495 Swap Cash Flow Hedge 19,037 3.95% 2011 794 Swap Cash Flow Hedge 16,894 4.83% 2014 181 Swap Cash Flow Hedge 16,377 5.52% 2018 (635) Swap Cash Flow Hedge 15,278 5.05% 2016 (29) Swap Cash Flow Hedge 8,007 4.77% 2011 44 Swap Cash Flow Hedge 7,410 5.31% 2011 (124) Swap Cash Flow Hedge 7,062 5.10% 2016 (48) Swap Cash Flow Hedge 6,328 4.78% 2007 26 Swap Cash Flow Hedge 5,384 3.12% 2007 82 Swap Cash Flow Hedge 5,104 5.18% 2016 (62) Swap Cash Flow Hedge 4,134 4.76% 2007 18 Swap Cash Flow Hedge 3,325 5.45% 2015 (104) Swap Cash Flow Hedge 2,870 5.08% 2011 (17) -------------------- ------------------ ------------- ------------- Total/Weighted Average $532,199 4.96% 2014 $959 ==================== ================== ============= ============= </TABLE> As of September 30, 2006, the derivative financial instruments were reported at their fair value of $959,000 as interest rate hedge assets. Income and expense associated with these instruments is recorded as interest expense on the company's consolidated statements of income. -15-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 10. Earnings Per Share The following table sets forth the calculation of Basic and Diluted EPS for the nine months ended September 30, 2006 and 2005 (in thousands, except share and per share amounts): <TABLE> <CAPTION> Nine months Ended September 30, 2006 Nine months Ended September 30, 2005 ----------------------------------------------------------------------------------------- Per Share Per Share Net Income Shares Amount Net Income Shares Amount ---------------- ------------- -------------- ------------- ----------------- ----------- <S> <C> <C> <C> <C> <C> <C> Basic EPS: Net earnings per share of common stock $ 38,577 15,327,855 $ 2.52 $ 27,797 15,110,227 $ 1.84 ============== =========== Effect of Dilutive Securities: Options outstanding for the purchase of common stock -- 147,643 -- 172,744 Stock units outstanding convertible to shares of common stock -- 66,808 -- 56,562 ---------------- -------------- -------------- ----------------- Diluted EPS: Net earnings per share of common stock and assumed conversions $ 38,577 15,542,306 $ 2.48 $ 27,797 15,339,533 $ 1.81 ================ ============== ============= ============= ================= =========== </TABLE> The following table sets forth the calculation of Basic and Diluted EPS for the three months ended September 30, 2006 and 2005 (in thousands, except share and per share amounts): <TABLE> <CAPTION> Three months Ended September 30, 2006 Three months Ended September 30, 2005 ----------------------------------------------------------------------------------------- Per Share Per Share Net Income Shares Amount Net Income Shares Amount ---------------- ------------- -------------- ------------- ----------------- ----------- <S> <C> <C> <C> <C> <C> <C> Basic EPS: Net earnings per share of common stock $ 13,437 15,337,325 $ 0.88 $ 9,799 15,125,443 $ 0.65 ============== =========== Effect of Dilutive Securities: Options outstanding for the purchase of common stock -- 178,748 -- 173,900 Stock units outstanding convertible to shares of common stock -- 69,807 -- 59,600 ------------------------------- -------------- ----------------- Diluted EPS: Net earnings per share of common stock and assumed conversions $ 13,437 15,585,880 $ 0.86 $ 9,799 15,358,943 $ 0.64 ================ ============== ============= ============= ================= =========== </TABLE> -16-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 11. Income Taxes We made an election to be taxed as a REIT under Section 856(c) of the Internal Revenue Code of 1986, as amended, commencing with the tax year ended December 31, 2003. As a REIT, we are generally not subject to federal income tax. To maintain qualification as a REIT, we must distribute at least 90% of our REIT taxable income to our shareholders and meet certain other requirements. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on taxable income at regular corporate rates. Under certain circumstances, federal income and excise taxes may be due on our undistributed taxable income. At September 30, 2006, we were in compliance with all REIT requirements. During the three and nine months ended September 30, 2006, we recorded $984,000 and $2.5 million of income tax benefit for losses of $2.2 million and $5.3 million, respectively, attributable to our taxable REIT subsidiary. Our effective tax rate for the three and nine months ended September 30, 2006 attributable to the taxable REIT subsidiary was 44.4% and 46.2%, respectively. 12. Shareholders' Equity On September 15, 2006, we declared a dividend of approximately $11.5 million, or $0.75 per share of common stock applicable to the three-month period ended September 30, 2006, which was paid on October 15, 2006 to shareholders of record on September 30, 2006. All dividends paid during the period presented were ordinary income. 13. Employee Benefit Plans We had three benefit plans in effect at September 30, 2006: (1) the Second Amended and Restated 1997 Long-Term Incentive Stock Plan, or 1997 Employee Plan, (2) the Amended and Restated 1997 Non-Employee Director Stock Plan, or 1997 Director Plan, and (3) the Amended and Restated 2004 Long-Term Incentive Plan, or 2004 Employee Plan. Activity under these three plans for the nine month period ended September 30, 2006 is summarized in the chart below in share and share equivalents: <TABLE> <CAPTION> 1997 Employee 1997 Director 2004 Employee Plan Plan Plan Total ------------------ -------------------- ------------------- -------------------- <S> <C> <C> <C> <C> Options(1) Beginning Balance 352,960 85,002 -- 437,962 Granted 2006 -- -- -- -- Exercised 2006 (13,169) (8,334) -- (21,503) Canceled 2006 -- -- -- -- ------------------ -------------------- ------------------- -------------------- Ending Balance 339,791 76,668 -- 416,459 Restricted Stock(2) Beginning Balance -- -- 405,790 405,790 Granted 2006 -- -- 119,504 119,504 Vested 2006 -- -- (23,366) (23,366) Forfeited 2006 -- -- (16,929) (16,929) ------------------ -------------------- ------------------- -------------------- Ending Balance -- -- 484,999 484,999 Stock Units(3) Beginning Balance 62,384 -- 62,384 Granted 2006 9,047 -- 9,047 Converted 2006 -- -- -- ------------------ -------------------- ------------------- -------------------- Ending Balance 71,431 -- 71,431 ------------------ -------------------- ------------------- -------------------- Total Outstanding Shares 339,791 148,099 484,999 972,889 ================== ==================== =================== ==================== </TABLE> (1) All options are fully vested as of September 30, 2006. (2) Comprised of both performance based awards that vest upon the attainment of certain common equity return thresholds and time based awards that vest based upon an employee's continued employment on vesting dates. (3) Stock units are given to certain members of our board of directors in lieu of cash compensation for services and in lieu of dividends earned on previously granted stock units. -17-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) Compensation expense for stock awards is recognized on the accelerated attribution method under FASB Interpretation No. 28. The following table summarizes the outstanding options as of September 30, 2006: <TABLE> <CAPTION> Exercise Price Options Weighted Average Weighted per Share Outstanding Exercise Price per Share Average Remaining Life --------------------- ----------------------------- ----------------------------- -------------------------------- 1997 1997 Employee Director 1997 Employee 1997 1997 Employee 1997 Director Plan Plan Plan Director Plan Plan Plan --------------- ------------- -------------- -------------- --------------- ---------------- <S> <C> <C> <C> <C> <C> <C> $10.00 - $15.00 55,939 -- $ 13.34 $ -- 4.20 -- $15.00 - $20.00 197,184 8,334 16.85 18.00 3.72 0.79 $20.00 - $25.00 -- -- -- -- -- -- $25.00 - $30.00 86,668 68,334 28.85 30.00 1.54 1.33 --------------- ------------- -------------- -------------- --------------- ---------------- Total/W. Average 339,791 76,668 $ 19.33 $ 28.70 3.24 1.27 =============== ============= ============== ============== =============== ================ </TABLE> In addition to the equity interests detailed above, we have granted percentage interests in the incentive compensation received by us from the Funds. At September 30, 2006, we had granted, net of forfeitures, 24% and 43% of the Fund II and fund III incentive compensation received by us, respectively. 14. Supplemental Disclosures for Consolidated Statements of Cash Flows Interest paid on our outstanding debt during the nine months ended September 30, 2006 and 2005 was $70.6 million and $21.7 million, respectively. We paid income taxes during the nine months ended September 30, 2006 and 2005 of $197,000 and $5,000, respectively. At September 30, 2006, we had $6.2 million included in deposits and other receivables which represented loans that were satisfied and repaid prior to September 30, 2006, the proceeds of which had not been remitted to us by our servicers. The reclassification from loans receivable to deposits and other receivables resulted in a non-cash investing activity. -18-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 15. Segment Reporting We operate two reportable segments. We have an internal information system that produces performance and asset data for the two segments along business lines. The Balance Sheet Investment segment includes all activities related to direct investment activities (including direct investments in Funds) and the financing thereof. The Investment Management segment includes all activities related to investment management services provided to us and third-party funds under management and includes our taxable REIT subsidiary, CT Investment Management Co., LLC and its subsidiaries. The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the nine months ended, and as of, September 30, 2006, respectively (in thousands): <TABLE> <CAPTION> Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ------------------ ------------------- ------------------- <S> <C> <C> <C> <C> Income from loans and other investments: Interest and related income $ 123,862 $ -- $ -- $ 123,862 Less: Interest and related expenses 72,374 -- -- 72,374 ------------------- ------------------ ------------------- ------------------- Income from loans and other investments, net 51,488 -- -- 51,488 ------------------- ------------------ ------------------- ------------------- Other revenues: Management and advisory fees -- 8,058 (5,862) 2,196 Income/(loss) from equity investments in Funds 1,120 (70) -- 1,050 Other interest income 830 (7) (33) 790 ------------------- ------------------ ------------------- ------------------- Total other revenues 1,950 7,981 (5,895) 4,036 ------------------- ------------------ ------------------- ------------------- Other expenses: General and administrative 9,467 13,101 (5,862) 16,706 Other interest expense 33 -- (33) -- Depreciation and amortization 2,501 195 -- 2,696 ------------------- ------------------ ------------------- ------------------- Total other expenses 12,001 13,296 (5,895) 19,402 ------------------- ------------------ ------------------- ------------------- Income (loss) before income taxes 41,437 (5,315) -- 36,122 Benefit for income taxes -- (2,455) -- (2,455) ------------------- ------------------ ------------------- ------------------- Net (loss) income allocable to $ 41,437 $ (2,860) $ -- $ 38,577 class A common stock =================== ================== =================== =================== Total Assets $ 2,269,723 $ 6,481 $ (6,539) $ 2,269,665 =================== ================== =================== =================== </TABLE> All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $5.9 million for management of the segment for the nine months ended September 30, 2006, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -19-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the nine months ended, and as of, September 30, 2005, respectively (in thousands): <TABLE> <CAPTION> Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ------------------ ------------------- ------------------- <S> <C> <C> <C> <C> Income from loans and other investments: Interest and related income $ 57,359 $ -- $ -- $ 57,359 Less: Interest and related expenses 23,709 -- -- 23,709 ------------------- ------------------ ------------------- ------------------- Income from loans and other investments, net 33,650 -- -- 33,650 ------------------- ------------------ ------------------- ------------------- Other revenues: Management and advisory fees -- 15,718 (3,574) 12,144 Income/(loss) from equity investments in Funds 628 (1,463) -- (835) Other interest income 318 64 (8) 374 ------------------- ------------------ ------------------- ------------------- Total other revenues 946 14,319 (3,582) 11,683 ------------------- ------------------ ------------------- ------------------- Other expenses: General and administrative 6,710 13,248 (3,574) 16,384 Other interest expense 8 -- (8) -- Depreciation and amortization 633 204 -- 837 ------------------- ------------------ ------------------- ------------------- Total other expenses 7,351 13,452 (3,582) 17,221 ------------------- ------------------ ------------------- ------------------- Income before income taxes 27,245 867 -- 28,112 Provision for income taxes -- 315 -- 315 ------------------- ------------------ ------------------- ------------------- Net income allocable to class A common stock $ 27,245 $ 552 $ -- $ 27,797 =================== ================== =================== =================== Total Assets $ 1,331,130 $ 11,469 $ (9,844) $ 1,332,755 =================== ================== =================== =================== </TABLE> All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $3.6 million for management of the segment for the nine months ended September 30, 2005, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -20-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the three months ended, and as of, September 30, 2006, respectively (in thousands): <TABLE> <CAPTION> Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ------------------ ------------------- ------------------- <S> <C> <C> <C> <C> Income from loans and other investments: Interest and related income $ 46,011 $ -- $ -- $ 46,011 Less: Interest and related expenses 28,838 -- -- 28,838 ------------------- ------------------ ------------------- ------------------- Income from loans and other investments, net 17,173 -- -- 17,173 ------------------- ------------------ ------------------- ------------------- Other revenues: Management and advisory fees -- 2,604 (1,856) 748 Income/(loss) from equity investments in Funds 348 (20) -- 328 Other interest income 500 (27) (33) 440 ------------------- ------------------ ------------------- ------------------- Total other revenues 848 2,557 (1,889) 1,516 ------------------- ------------------ ------------------- ------------------- Other expenses: General and administrative 3,027 4,708 (1,856) 5,879 Other interest expense 33 -- (33) -- Depreciation and amortization 292 65 -- 357 ------------------- ------------------ ------------------- ------------------- Total other expenses 3,352 4,773 (1,889) 6,236 ------------------- ------------------ ------------------- ------------------- Income before income taxes 14,669 (2,216) -- 12,453 Benefit for income taxes -- (984) -- (984) ------------------- ------------------ ------------------- ------------------- Net income allocable to class A common stock $ 14,669 $ (1,232) $ -- $ 13,437 =================== ================== =================== =================== Total Assets $ 2,269,723 $ 6,481 $ (6,539) $ 2,269,665 =================== ================== =================== =================== </TABLE> All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $1.9 million for management of the segment for the three months ended September 30, 2006, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -21-
Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the three months ended, and as of, September 30, 2005, respectively (in thousands): <TABLE> <CAPTION> Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ------------------ ------------------- ------------------- <S> <C> <C> <C> <C> Income from loans and other investments: Interest and related income $ 22,751 $ -- $ -- $ 22,751 Less: Interest and related expenses 10,325 -- -- 10,325 ------------------- ------------------ ------------------- ------------------- Income from loans and other investments, net 12,426 -- -- 12,426 ------------------- ------------------ ------------------- ------------------- Other revenues: Management and advisory fees -- 2,711 (1,194) 1,517 Income/(loss) from equity investments in Funds 528 (61) -- 467 Other interest income 111 26 -- 137 ------------------- ------------------ ------------------- ------------------- Total other revenues 639 2,676 (1,194) 2,121 ------------------- ------------------ ------------------- ------------------- Other expenses: General and administrative 2,026 4,484 (1,194) 5,316 Other interest expense -- -- -- -- Depreciation and amortization 211 67 -- 278 ------------------- ------------------ ------------------- ------------------- Total other expenses 2,237 4,551 (1,194) 5,594 ------------------- ------------------ ------------------- ------------------- Income before income taxes 10,828 (1,875) -- 8,953 Benefit for income taxes -- (846) -- (846) ------------------- ------------------ ------------------- ------------------- Net income allocable to class A common stock $ 10,828 $ (1,029) $ -- $ 9,799 =================== ================== =================== =================== Total Assets $ 1,331,130 $ 11,469 $ (9,844) $ 1,332,755 =================== ================== =================== =================== </TABLE> All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $1.2 million for management of the segment for the three months ended September 30, 2005, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -22-
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Historical results set forth are not necessarily indicative of our future financial position and results of operations. Introduction We are a fully integrated, self-managed finance and investment management company that specializes in credit-sensitive structured financial products. To date, our investment programs have focused on loans and securities backed by commercial real estate assets. We invest for our own account and for private equity funds that we manage on behalf of third parties. From the commencement of our finance business in 1997 through September 30, 2006 we have completed $7.2 billion of investments both directly and on behalf of our managed funds. We conduct our operations as a real estate investment trust, or REIT, for federal income tax purposes and we are headquartered in New York City. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Actual results could differ from these estimates. There have been no material changes to our Critical Accounting Policies described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 10, 2006. Balance Sheet Overview At September 30, 2006, total assets were $2.3 billion, an increase of $712.1 million or 46% from year end 2005. Asset growth was driven predominantly by growth in CMBS, Loans and total return swaps, which we refer to collectively as Interest Earning Assets. Interest Earning Assets grew by $700.4 million or 47% from $1.5 billion at year end 2005 to $2.2 billion at September 30, 2006. At September 30, 2006, Interest Earning Assets had a weighted average yield of 8.67% (based upon LIBOR of 5.32% as of September 30, 2006). During the nine months ended September 30, 2006, we made 38 investments in CMBS, with a total purchase price of $384.7 million ($386.7 million face value) with a weighted average yield of 6.39%. Four investments with a purchase price of $25.5 million ($25.5 million face value) bear interest at floating rates with a yield of LIBOR plus 1.89% (7.21% at September 30, 2006). Thirty four investments with a purchase price of $359.3 million ($361.3 million face value) bear interest at fixed rates with a yield of 6.33%. At September 30, 2006, we held 79 investments in 57 separate issues of CMBS with an aggregate book value of $845.5 million that yield 7.41%. Floating rate CMBS with a book value of $111.7 million yields LIBOR plus 2.47% (7.79% at September 30, 2006). The remaining CMBS, $733.7 million book value, earns interest at fixed rates and yields 7.35%. At September 30, 2006, the expected average life for the CMBS portfolio was 94 months. During the nine months ended September 30, 2006, we originated $771.2 million of Loans with a weighted average yield of 9.74%. Originations were comprised of ten mortgage loans for $146.0 million, four subordinate mortgage interests for $206.3 million and twelve mezzanine loans for $418.9 million. Twenty two of the loans we originated with a balance of $744.8 million bear interest at floating rates with a yield of LIBOR plus 4.37% (9.69% at September 30, 2006). Four loans with a balance of $26.4 million bear interest at fixed rates with a yield of 10.98%. At September 30, 2006, we had 65 performing loans with a current book value of $1.3 billion and a yield of 9.44%. Twelve of the loans totaling $190.2 million bear interest at fixed rates with a yield of 9.15%. The 53 remaining loans, totaling $1.1 billion, bear interest at variable rates with a yield of LIBOR plus 4.17% (9.49% at September 30, 2006). One mortgage loan with an original principal balance of $8.0 million matured on July 15, 2000 but has not been repaid with respect to principal and interest, all other loans were performing in accordance with their terms. At September 30, 2006, we had five outstanding unfunded loan commitments for $218.9 million. -23-
At September 30, 2006, we had two total return swaps with total market value of $3.0 million that earned interest at floating rates with a yield of LIBOR plus 15.24% (20.55% at September 30, 2006). The total return swaps are treated as non-hedge derivatives for accounting purposes and, as such, changes in their market value are recorded through the consolidated statements of income. At September 30, 2006, we had $3.0 million of unfunded commitments on our total return swaps. At September 30, 2006, equity investments in unconsolidated subsidiaries consisted of our co-investments in Fund II and Fund III, associated capitalized costs and a new investment in Bracor Investimentos Imobiliarios Ltda., or Bracor. Bracor is a newly formed net lease commercial real estate company located and operating in Brazil. Our total commitment to Bracor is $15.0 million and, at September 30, 2006, we had funded $3.2 million of that commitment. Bracor's operations will be conducted in local currency and, as such, changes in local currency value will impact the carrying value of our investment. At quarter end, the currency valuation adjustment for our investment was $1,000 and was recorded as an adjustment to accumulated other comprehensive income/(loss) in shareholders' equity. At quarter end, total equity investments were $11.2 million, including $2.0 million of unamortized costs capitalized in connection with raising Fund II and Fund III. These costs are being amortized over the expected lives of the funds. At September 30, 2006, we had $11.8 million of unfunded commitments associated with our equity investments in unconsolidated subsidiaries. We were party to 15 cash flow interest rate swaps with a total notional value of $532.2 million as of September 30, 2006. These cash flow interest rate swaps effectively convert floating rate debt to fixed rate debt, which is utilized to finance assets that earn interest at fixed rates. Under these swaps, we receive a rate equal to LIBOR (5.32% at September 30, 2006) and pay a weighted average rate of 4.96%. The market value of the swaps at September 30, 2006 was $959,000, which is recorded as an interest rate hedge asset and as a component of accumulated other comprehensive income/(loss) in shareholders' equity. At September 30, 2006, total liabilities were $1.9 billion, an increase of $703.4 million or 58% from year end 2005. Liability growth, the vast majority of which was in the form of repurchase obligations, CDOs and junior subordinated debentures which we refer to collectively as Interest Bearing Liabilities, was the primary source of funds used to finance new originations. At September 30, 2006, Interest Bearing Liabilities had a weighted average all-in cost of 6.06% (based upon LIBOR of 5.32% as of September 30, 2006). At September 30, 2006 we were a party to eight repurchase agreements with six counterparties that provide for total commitments of $950.0 million. At quarter end we borrowed $351.4 million under these agreements and had the ability to borrow an additional $77.5 million without pledging additional collateral. The weighted average cash borrowing cost for all the repurchase agreements outstanding at September 30, 2006 was LIBOR plus 1.19% (6.51% at September 30, 2006). Assuming no additional utilization under the repurchase agreements and including the amortization of all fees paid and capitalized over the remaining term of the repurchase agreements, the all-in effective borrowing cost was LIBOR plus 1.49% (6.81% at September 30, 2006). At September 30, 2006, we had CDOs outstanding from four separate issuances with a total face value of $1.2 billion. Our existing CDOs are financing vehicles for our assets and, as such, are consolidated on our balance sheet at $1.2 billion, representing the amortized sales price of the securities sold to third parties. In total, our two floating rate reinvesting CDOs provide us with $551.7 million of debt financing at a cash cost of LIBOR plus 0.55% (5.87% at September 30, 2006) and an all-in effective interest rate (including the amortization of issuance costs) of LIBOR plus 0.87% (6.19% at September 30, 2006). Our two fixed rate static CDOs provide us with $690.3 million of financing with a cash cost of 5.40% and an all-in effective interest rate of 5.47%. On a combined basis, our CDOs provide us with $1.2 billion of non-recourse, non-mark-to-market, index matched financing at a weighted average cash cost of 0.49% over the applicable index (5.61% at September 30, 2006) and a weighted average all-in cost of 0.69% over the applicable index (5.79% at September 30, 2006). In February 2006, we sold $50.0 million of trust preferred securities through a subsidiary, CT Preferred Trust I. The trust preferred securities have a 30-year term ending April 2036, are redeemable at par on or after April 30, 2011 and pay distributions at a fixed rate of 7.45% for the first ten years ending April 2016, and thereafter, at a floating rate of three month LIBOR plus 2.65%. The all-in cost of the junior subordinated debentures is 7.53%. At September 30, 2006, total shareholders' equity was $347.6 million, an increase of $8.7 million or 3% from the year ended 2005. The increase in shareholders' equity was primarily due to an increase in retained earnings as our net income exceeded our dividends declared which was offset by a decrease in accumulated other comprehensive income/(loss) as the value of our interest rate swaps decreased by $1.3 million. -24-
At September 30, 2006, we had 15,397,525 shares of our class A common stock outstanding including unearned restricted stock. Investment Management Overview In addition to our balance sheet investment activities, we act as an investment advisor for third parties. The purpose of the investment management business is to create additional revenue sources for us and to broaden our platform to include investment activities complimentary to those executed directly on our balance sheet. We currently manage three private equity funds through our wholly-owned, taxable, investment management subsidiary, CT Investment Management Co., LLC, or CTIMCO. Two of these funds, CT Mezzanine Partners II LP and CT Mezzanine Partners III, Inc., were co-sponsored vehicles under a joint venture with Citigroup Alternative Investments, or CAI. We have a co-investment in each of these vehicles. The third fund, CT Large Loan 2006, Inc., or the Large Loan Fund, is exclusively sponsored by us and we do not have a co-investment in this vehicle. At September 30, 2006, Fund II had one investment, total assets of $47.9 million and invested equity of $27.7 million. Our equity co-investment at quarter end totaled $2.1 million (5.88%). CTIMCO earns base management fees of 1.29% per annum on invested capital and is entitled to incentive compensation payments on a 50/50 basis with our co-sponsor. We have agreed to pay up to 25% of the incentive compensation we receive to employees. If Fund II's assets were sold and liabilities were settled on October 1, 2006 at the recorded book value, and the fund's equity and income were distributed, we would record approximately $2.3 million of additional gross incentive fees. At September 30, 2006, Fund III had six investments, total assets of $216.3 million and invested equity of $71.5 million. Our equity co-investment at quarter end totaled $3.9 million (4.71%). CTIMCO earns base management fees of 1.42% per annum on invested capital and is entitled to incentive compensation payments on a 62.5/37.5 basis with our co-sponsor. We have agreed to pay up to 43% of the incentive compensation we receive to employees. If Fund III's assets were sold and liabilities were settled on October 1, 2006 at the recorded book value, and the fund's equity and income were distributed, we would record approximately $7.1 million of additional gross incentive fees. At September 30, 2006, Large Loan Fund had two investments, total assets of $195.2 million and invested equity of $98.0 million. Large Loan Fund's investment mandate is to co-invest with us in large mezzanine transactions that exceed the appetite of the balance sheet. Large Loan Fund has a one year investment period that expires in May 2007. CTIMCO earns management fees of 0.75% per annum of invested assets. Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005 We reported net income of $13.4 million for the three months ended September 30, 2006, an increase of $3.6 million, or 37%, from net income of $9.8 million for the three months ended September 30, 2005. The increase was primarily the result of an increase in net interest income from Interest Earning Assets (due to both higher levels of aggregate investments and increases in average LIBOR). Interest and related income from Interest Earning Assets amounted to $46.0 million for the three months ended September 30, 2006, an increase of $23.3 million or 102.2% from the $22.8 million for the three months ended September 30, 2005. The increase in interest income was due to the growth in Interest Earning Assets and a higher average LIBOR rate, which increased by 1.75% from 3.60% for the three months ended September 30, 2005 to 5.35% for the three months ended September 30, 2006. Interest and related expenses on Interest Bearing Liabilities amounted to $28.8 million for the three months ended September 30, 2006, an increase of $18.5 million from the $10.3 million for the three months ended September 30, 2005. The increase in expense was due to an increase in the amount of Interest Bearing Liabilities outstanding in connection with our asset growth as well as an increase in LIBOR. The increase in interest expense was partially offset by the increased use of lower cost collateralized debt obligations and more favorable terms under our repurchase agreements. Other revenues decreased $605,000 from $2.1 million for the three months ended September 30, 2005 to $1.5 million for the three months ended September 30, 2006. The decrease was primarily due to the lower level of fund management fees received during the three months ended September 30, 2006. -25-
General and administrative expenses increased $563,000 to $5.9 million for the three months ended September 30, 2006 from approximately $5.3 million for the three months ended September 30, 2005. The increase in general and administrative expenses was primarily due to increased employee compensation expense and professional fees. We have made an election to be taxed as a REIT under Section 856(c) of the Internal Revenue Code of 1986, as amended, commencing with the tax year ended December 31, 2003. As a REIT, we generally are not subject to federal income tax. To maintain qualification as a REIT, we must distribute at least 90% of our REIT taxable income to our shareholders and meet certain other requirements. If we fail to qualify as a REIT in any taxable three months, we will be subject to federal income tax on our taxable income at regular corporate rates. We may also be subject to certain state and local taxes on our income and property. Under certain circumstances, federal income and excise taxes may be due on our undistributed taxable income. At September 30, 2006 and 2005, we were in compliance with all REIT requirements and, therefore, have not provided for income tax expense on our REIT taxable income for the three months ended September 30, 2006 and 2005. We also have taxable REIT subsidiaries which are subject to tax at regular corporate rates. During the three months ended September 30, 2006 and 2005, we recorded a $984,000 and $846,000 income tax benefit, respectively. The income tax benefits resulted from a net operating loss for the period in our taxable REIT subsidiaries. Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005 We reported net income of $38.6 million for the nine months ended September 30, 2006, an increase of $10.8 million, or 39%, from net income of $27.8 million for the nine months ended September 30, 2005. The increase was primarily the result of an increase in net interest income from Interest Earning Assets (due to both higher levels of aggregate investments and increases in average LIBOR), partially offset by decreases in fund base management and incentive management fees. Interest and related income from Interest Earning Assets amounted to $123.9 million for the nine months ended September 30, 2006, an increase of $66.5 million or 115.9% from the $57.4 million for the nine months ended September 30, 2005. The increase in interest income was due to the growth in Interest Earning Assets and a higher average LIBOR rate, which increased by 1.89% from 3.13% for the nine months ended September 30, 2005 to 5.02% for the nine months ended September 30, 2006. Interest and related expenses on Interest Bearing Liabilities amounted to $72.4 million for the nine months ended September 30, 2006, an increase of $48.7 million from the $23.7 million for the nine months ended September 30, 2005. The increase in expense was due to an increase in the amount of Interest Bearing Liabilities outstanding in connection with our asset growth as well as an increase in LIBOR. The increase in interest expense was partially offset by the increased use of lower cost collateralized debt obligations and more favorable terms under our repurchase agreements. Other revenues decreased $7.6 million from $11.7 million for the nine months ended September 30, 2005 to $4.0 million for the nine months ended September 30, 2006. The decrease was primarily due to the receipt of $7.8 million of incentive management fees from Fund II during the nine months ended September 30, 2005 offset by the acceleration of $1.0 million of previously capitalized fund related expenses in that same period as well as the lower level of fund management fees received during the nine months ended September 30, 2006. General and administrative expenses increased $322,000 to $16.7 million for the nine months ended September 30, 2006 from approximately $16.4 million for the nine months ended September 30, 2005. The increase in general and administrative expenses was primarily due to generally higher employee compensation expense and professional fees offset by the allocation in March 2005 of Fund II incentive management fees for payment to employees (representing 25% of the total received by us, or $2.0 million). Depreciation and amortization increased by $1.9 million from $837,000 to $2.7 million for the nine months ended September 30, 2006 as a result of our expensing an additional $1.8 million of the capitalized costs relating to the Venture Agreement. At September 30, 2006 and 2005, we were in compliance with all REIT requirements and, therefore, have not provided for income tax expense on our REIT taxable income for the nine months ended September 30, 2006 and 2005. We also have taxable REIT subsidiaries which are subject to tax at regular corporate rates. During the nine months ended September 30, 2006 and 2005, we recorded a $2.5 million income tax benefit and a $315,000 income -26-
tax expense, respectively. The income tax benefit resulted from a net operating loss for the period in our taxable REIT subsidiaries. Liquidity and Capital Resources We expect that during the balance of 2006, we will use a significant amount of our available capital resources to originate or purchase new loans and investments for our balance sheet. We intend to continue to employ leverage on our balance sheet assets to enhance our return on equity. At September 30, 2006, we had $26.7 million in cash, $8.2 million in restricted cash and $77.5 million of immediately available liquidity from our repurchase agreements. Our primary sources of liquidity for the remainder of 2006 are expected to be cash on hand, cash generated from operations, principal and interest payments received on loans and investments, additional borrowings under our repurchase agreements, and capital raised through CDO issuances, stock offerings, junior subordinated debenture issuances and other capital raising activities. We believe these sources of capital will be adequate to meet future cash requirements. We experienced a net increase in cash of $1.7 million for the nine months ended September 30, 2006, compared to a net decrease of $10.2 million for the nine months ended September 30, 2005. Cash provided by operating activities during the nine months ended September 30, 2006 was $52.0 million, compared to cash provided by operating activities of $27.9 million during the same period of 2005. The change was primarily due to increased net interest income due to our increased investment originations. For the nine months ended September 30, 2006, cash used in investing activities was $713.2 million, compared to $447.2 million during the same period in 2005. The change was primarily due to our increased investment originations. For the nine months ended September 30, 2006, cash provided by financing activities was $662.9 million, compared to $409.2 million during the same period in 2005. The change was primarily due to our increased investment originations. At September 30, 2006, we had outstanding repurchase obligations totaling $351.4 million. At September 30, 2006, we had pledged assets that enable us to obtain an additional $77.5 million of financing under our repurchase agreements without pledging additional collateral. At September 30, 2006, we had $598.6 million of credit available for the financing of new and existing unpledged assets pursuant to our repurchase agreements. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Impact of Inflation Our operating results depend in part on the difference between the interest income earned on our interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities. Changes in the general level of interest rates prevailing in the economy in response to changes in the rate of inflation or otherwise can affect our income by affecting the spread between our interest-earning assets and interest-bearing liabilities, as well as, among other things, the value of our interest-earning assets and our ability to realize gains from the sale of assets and the average life of our interest-earning assets. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. We employ the use of correlated hedging strategies to limit the effects of changes in interest rates on our operations, including engaging in interest rate swaps and interest rate caps to minimize our exposure to changes in interest rates. There can be no assurance that we will be able to adequately protect against the foregoing risks or that we will ultimately realize an economic benefit from any hedging contract into which we enter. -27-
Note on Forward-Looking Statements Except for historical information contained herein, this quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Section 21E of the Securities and Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements are included with respect to, among other things, the our current business plan, business and investment strategy and portfolio management. These forward-looking statements are identified by their use of such terms and phrases as "intends," "intend," "intended," "goal," "estimate," "estimates," "expects," "expect," "expected," "project," "projected," "projections," "plans," "anticipates," "anticipated," "should," "designed to," "foreseeable future," "believe," "believes" and "scheduled" and similar expressions. Our actual results or outcomes may differ materially from those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We assume no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Important factors that we believe might cause actual results to differ from any results expressed or implied by these forward-looking statements are discussed in the cautionary statements contained in Exhibit 99.1 to this Form 10-Q, which are incorporated herein by reference. In assessing forward-looking statements contained herein, readers are urged to read carefully all cautionary statements contained in this Form 10-Q. -28-
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk The principal objective of our asset/liability management activities is to maximize net interest income, while managing levels of interest rate risk. Net interest income and interest expense are subject to the risk of interest rate fluctuations. In certain instances, to mitigate the impact of fluctuations in interest rates, we use interest rate swaps to effectively convert variable rate liabilities to fixed rate liabilities for proper matching with fixed rate assets. The swap agreements are generally held-to-maturity and we do not use interest rate derivative financial instruments for trading purposes. The differential to be paid or received on these agreements is recognized as an adjustment to the interest expense related to debt and is recognized on the accrual basis. Our loans and investments, including our fund investments, are also subject to credit risk. The ultimate performance and value of our loans and investments depends upon the owner's ability to operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due us. To monitor this risk, our asset management team continuously reviews the investment portfolio and in certain instances is in constant contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary. The following table provides information about our financial instruments that are sensitive to changes in interest rates at September 30, 2006. For financial assets and debt obligations, the table presents cash flows (in certain cases, face adjusted for expected losses) to the expected maturity and weighted average interest rates based upon the current carrying values of the remaining assets and liabilities. For interest rate swaps, the table presents notional amounts and weighted average fixed pay and variable receive interest rates by contractual maturity dates. Notional amounts are used to calculate the contractual cash flows to be exchanged under the contract. Weighted average variable rates are based on rates in effect as of the reporting date. <TABLE> <CAPTION> Expected Maturity Dates ----------------------------------------------------------------------------------------------------- 2006 2007 2008 2009 2010 Thereafter Total Fair Value ---- ---- ---- ---- ---- ---------- ----- ----------- Assets: (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> Commercial Mortgage-backed Securities Fixed Rate $ 1,509 $ 21,745 $ 48,802 $ 7,784 $ 17,639 $ 653,988 $ 751,467 $ 724,205 Average interest rate 6.66% 6.66% 6.67% 6.71% 6.70% 6.50% 6.52% Variable Rate $ 146 $ 34,752 $ 57,689 $ 19,195 -- $ 1,583 $ 113,365 $ 112,301 Average interest rate 7.62% 7.54% 7.42% 7.20% -- 11.26% 7.47% Loans receivable Fixed Rate $ 404 $ 15,890 $ 61,102 $ 1,538 $ 1,671 $ 113,291 $ 193,896 $ 194,198 Average interest rate 8.91% 8.79% 8.30% 7.75% 7.74% 7.34% 7.77% Variable Rate $ 80,505 $ 264,897 $ 515,197 $ 106,863 $ 87,261 $ 90,142 $ 1,144,865 $ 1,145,082 Average interest rate 9.37% 9.49% 9.40% 9.91% 10.56% 11.16% 9.69% Total Return Swaps Variable Rate -- $ 3,000 -- -- -- -- $ 3,000 $ 3,000 Average interest rate -- 20.55% -- -- -- -- 20.55% Interest rate swaps Notional amounts $ 6,694 $ 36,343 $ 41,375 $ 37,425 $ 14,107 $ 396,255 $ 532,199 $ 959 Average fixed pay rate 5.07% 4.68% 5.08% 4.69% 5.04% 5.00% 4.96% Average variable receive rate 5.32% 5.32% 5.32% 5.32% 5.32% 5.32% 5.32% Liabilities: Repurchase obligations Variable Rate $ 56,161 $ 71,021 $ 224,251 -- -- -- $ 351,433 $ 351,433 Average interest rate 6.08% 6.40% 6.64% -- -- -- 6.49% Collateralized debt obligations Fixed Rate $ 324 $ 5,976 $ 5,030 $ 4,396 $ 2,603 $ 267,460 $ 285,789 $ 265,082 Average interest rate 6.82% 5.37% 5.65% 5.69% 5.28% 5.29% 5.31% Variable Rate $ 8,052 $ 24,255 $ 121,225 $201,424 $ 151,803 $ 453,524 $ 960,283 $ 960,283 Average interest rate 5.69% 5.69% 5.34% 5.55% 5.74% 5.83% 5.69% </TABLE> -29-
ITEM 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures An evaluation of the effectiveness of the design and operation of our "disclosure controls and procedures" (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (a) are effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act is timely recorded, processed, summarized and reported and (b) include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Changes in Internal Controls There have been no significant changes in our "internal control over financial reporting" (as defined in Rule 13a-15(f) under the Securities Exchange Act) that occurred during the period covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. -30-
PART II. OTHER INFORMATION ITEM 1: Legal Proceedings None ITEM 1A: Risk Factors There have been no material changes to the risk factors previously disclosed in Item 1A of our annual report on Form 10-K for the year ended December 31, 2005, filed on March 10, 2006 with the Securities and Exchange Commission, except that the Company has determined to add the following risk factors: We are subject to risks related to our international investments. We make investments in foreign countries. Investing in foreign countries involves certain risks that may not exist when investing in the United States. The risks involved in foreign investments include: o exposure to local economic conditions, foreign exchange restrictions and restrictions on the withdrawal of foreign investment and earnings, investment restrictions or requirements, expropriations of property and changes in foreign taxation structures; o potential adverse changes in the diplomatic relations of foreign countries with the United States and government policies against investments by foreigners; o changes in foreign regulations; o hostility from local populations, potential instability of foreign governments and risks of insurrections, terrorist attacks, war or other military action; o fluctuations in foreign exchange rates; o changes in social, political, legal and other conditions affecting our international investment; o logistical barriers to our timely receiving the financial information relating to our international investments that may need to be included in our periodic reporting obligations as a public company; and o lack of uniform accounting standards (including availability of information in accordance with U.S. generally accepted accounting principles). Unfavorable legal, regulatory, economic or political changes such as those described above could adversely affect our financial condition and results of operations. There are increased risks involved with construction lending activities. We originate loans for the construction of commercial and residential use properties. Construction lending generally is considered to involve a higher degree of risk than to other types of lending due to a variety of factors, including generally larger loan balances, the dependency on successful completion or operation of the project for repayment, the difficulties in estimating construction costs and loan terms which often do not require full amortization of the loan over its term and, instead, provide for a balloon payment at stated maturity. Some of our investments and investment opportunities are in synthetic form. Synthetic investments are contracts between parties whereby payments are exchanged based upon the performance of an underlying reference obligation. These investments can take the form of either a total return swap, contracts in which one party agrees to make payments that replicate the total return of a defined underlying asset, typically in return for an upfront payment from the counterparty who essentially bears the risk of performance of the referenced asset, or a credit default swap, where one counterparty receives payments in return for assuming the risk of defaults and losses corresponding to the reference obligation. In addition to the performance of the reference obligation, these synthetic interests carry the risk of the counterparty not performing its contractual obligations. Market standards, the GAAP accounting methodology and tax regulations related to these investments are evolving, and we cannot be certain that their evolution will not adversely impact the value or sustainability of these investments. Furthermore, our ability to invest in synthetic investments, other than through a taxable REIT subsidiary, may be severely limited by the REIT qualification requirements because total return swaps and other synthetic investment contracts generally are not qualifying assets and do not produce qualifying income for purposes of the REIT asset and income tests. -31-
ITEM 2: Unregistered Sales of Equity Securities and Use of Proceeds None ITEM 3: Defaults Upon Senior Securities None ITEM 4: Submission of Matters to a Vote of Security Holders None ITEM 5: Other Information None -32-
ITEM 6: Exhibits 3.1 Charter of Capital Trust, Inc. (filed as Exhibit 3.1.a to the Company's Current Report on Form 8-K (File No. 1-14788) filed on April 2, 2003 and incorporated herein by reference). 3.2 Amended and Restated Bylaws of Capital Trust, Inc. (filed as Exhibit 3.2 to the Company's Current Report on Form 8-K (File No. 1-14788) filed on January 29, 1999 and incorporated herein by reference). 3.3 First Amendment to Amended and Restated Bylaws of Capital Trust, Inc. (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q (File No. 1-14788) filed on August 16, 2004 and incorporated herein by reference). o10.1.a Amended and Restated Master Repurchase Agreement, dated as of August 15, 2006, by and between Goldman Sachs Mortgage Company and Capital Trust, Inc. o10.1.b Annex I to Amended and Restated Master Repurchase Agreement, dated as of August 15, 2006, by and between Goldman Sachs Mortgage Company and Capital Trust, Inc. o10.1.c Letter, dated as of August 15, 2006, by and between Goldman Sachs Mortgage Company and Capital Trust, Inc. +10.2 Employment Agreement, dated as of August 4, 2006, by and among Capital Trust, Inc., CT Investment Management Co., LLC and Thomas C. Ruffing (filed as Exhibit 10.2 to Capital Trust, Inc.'s Quarterly Report on Form 10-Q (File No. 1-14788) filed on August 8, 2006 and incorporated herein by reference). o+10.3 Employment Agreement, dated as of September 29, 2006, by and among Capital Trust, Inc., CT Investment Management Co., LLC and Geoffrey G. Jervis. 11.1 Statements regarding Computation of Earnings per Share (Data required by Statement of Financial Accounting Standard No. 128, Earnings per Share, is provided in Note 10 to the consolidated financial statements contained in this report). o31.1 Certification of John R. Klopp, Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. o31.2 Certification of Geoffrey G. Jervis, Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. o32.1 Certification of John R. Klopp, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. o32.2 Certification of Geoffrey G. Jervis, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. o99.1 Risk Factors ------------------------ o Filed herewith + Represents a management contract or compensatory plan or arrangement -33-
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CAPITAL TRUST, INC. October 30, 2006 /s/ John R. Klopp - ---------------- ----------------- Date John R. Klopp Chief Executive Officer October 30, 2006 /s/ Geoffrey G. Jervis - ---------------- ----------------------- Date Geoffrey G. Jervis Chief Financial Officer -34-