Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2017
OR
☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-34436
Starwood Property Trust, Inc.
(Exact name of registrant as specified in its charter)
Maryland
27-0247747
(State or Other Jurisdiction ofIncorporation or Organization)
(I.R.S. EmployerIdentification No.)
591 West Putnam Avenue
Greenwich, Connecticut
06830
(Address of Principal Executive Offices)
(Zip Code)
Registrant’s telephone number, including area code:
(203) 422-7700
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 ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ☒
Accelerated filer ☐
Non-accelerated filer ☐
Smaller reporting company ☐
(Do not check if a smaller reporting company)
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of May 3, 2017 was 260,283,904.
Special Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain forward-looking statements, including without limitation, statements concerning our operations, economic performance and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are developed by combining currently available information with our beliefs and assumptions and are generally identified by the words “believe,” “expect,” “anticipate” and other similar expressions. Forward-looking statements do not guarantee future performance, which may be materially different from that expressed in, or implied by, any such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates.
These forward-looking statements are based largely on our current beliefs, assumptions and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or within our control, and which could materially affect actual results, performance or achievements. Factors that may cause actual results to vary from our forward-looking statements include, but are not limited to:
·
factors described in our Annual Report on Form 10-K for the year ended December 31, 2016 and this Quarterly Report on Form 10-Q, including those set forth under the captions “Risk Factors” and “Business”;
defaults by borrowers in paying debt service on outstanding indebtedness;
impairment in the value of real estate property securing our loans or in which we invest;
availability of mortgage origination and acquisition opportunities acceptable to us;
potential mismatches in the timing of asset repayments and the maturity of the associated financing agreements;
national and local economic and business conditions;
general and local commercial and residential real estate property conditions;
changes in federal government policies;
changes in federal, state and local governmental laws and regulations;
increased competition from entities engaged in mortgage lending and securities investing activities;
changes in interest rates; and
the availability of, and costs associated with, sources of liquidity.
In light of these risks and uncertainties, there can be no assurances that the results referred to in the forward-looking statements contained in this Quarterly Report on Form 10-Q will in fact occur. Except to the extent required by applicable law or regulation, we undertake no obligation to, and expressly disclaim any such obligation to, update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, changes to future results over time or otherwise.
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TABLE OF CONTENTS
Page
Part I
Financial Information
Item 1.
Financial Statements
Condensed Consolidated Balance Sheets
Condensed Consolidated Statements of Operations
Condensed Consolidated Statements of Comprehensive Income
Condensed Consolidated Statements of Equity
Condensed Consolidated Statements of Cash Flows
Notes to Condensed Consolidated Financial Statements
Note 1 Business and Organization
Note 2 Summary of Significant Accounting Policies
Note 3 Acquisitions
Note 4 Loans
Note 5 Investment Securities
Note 6 Properties
Note 7 Investment in Unconsolidated Entities
Note 8 Goodwill and Intangibles
Note 9 Secured Financing Agreements
Note 10 Unsecured Senior Notes
Note 11 Loan Securitization/Sale Activities
Note 12 Derivatives and Hedging Activity
Note 13 Offsetting Assets and Liabilities
Note 14 Variable Interest Entities
Note 15 Related-Party Transactions
Note 16 Stockholders’ Equity
Note 17 Earnings per Share
Note 18 Accumulated Other Comprehensive Income
Note 19 Fair Value
Note 20 Income Taxes
Note 21 Commitments and Contingencies
Note 22 Segment Data
Note 23 Subsequent Events
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
Part II
Other Information
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Item 6.
Exhibits
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Starwood Property Trust, Inc. and Subsidiaries
(Unaudited, amounts in thousands, except share data)
As of
March 31, 2017
December 31, 2016
Assets:
Cash and cash equivalents
$
222,518
615,522
Restricted cash
40,016
35,233
Loans held-for-investment, net
6,230,819
5,847,995
Loans held-for-sale, at fair value
340,266
63,279
Loans transferred as secured borrowings
35,000
Investment securities ($277,446 and $297,638 held at fair value)
730,171
807,618
Properties, net
1,937,968
1,944,720
Intangible assets ($46,649 and $55,082 held at fair value)
202,094
219,248
Investment in unconsolidated entities
201,823
204,605
Goodwill
140,437
Derivative assets
71,040
89,361
Accrued interest receivable
32,759
28,224
Other assets
107,979
101,763
Variable interest entity (“VIE”) assets, at fair value
60,185,851
67,123,261
Total Assets
70,478,741
77,256,266
Liabilities and Equity
Liabilities:
Accounts payable, accrued expenses and other liabilities
151,405
198,134
Related-party payable
25,997
37,818
Dividends payable
126,048
125,075
Derivative liabilities
1,567
3,904
Secured financing agreements, net
4,414,917
4,154,126
Unsecured senior notes, net
2,033,384
2,011,544
Secured borrowings on transferred loans
VIE liabilities, at fair value
59,147,068
66,130,592
Total Liabilities
65,935,386
72,696,193
Commitments and contingencies (Note 21)
Equity:
Starwood Property Trust, Inc. Stockholders’ Equity:
Preferred stock, $0.01 per share, 100,000,000 shares authorized, no shares issued and outstanding
—
Common stock, $0.01 per share, 500,000,000 shares authorized, 264,834,330 issued and 260,227,445 outstanding as of March 31, 2017 and 263,893,806 issued and 259,286,921 outstanding as of December 31, 2016
2,648
2,639
Additional paid-in capital
4,689,698
4,691,180
Treasury stock (4,606,885 shares)
(92,104)
Accumulated other comprehensive income
40,067
36,138
Accumulated deficit
(138,700)
(115,579)
Total Starwood Property Trust, Inc. Stockholders’ Equity
4,501,609
4,522,274
Non-controlling interests in consolidated subsidiaries
41,746
37,799
Total Equity
4,543,355
4,560,073
Total Liabilities and Equity
See notes to condensed consolidated financial statements.
4
(Unaudited, amounts in thousands, except per share data)
For the Three Months Ended
March 31,
2017
2016
Revenues:
Interest income from loans
111,883
117,532
Interest income from investment securities
15,224
19,403
Servicing fees
14,102
24,691
Rental income
57,042
32,677
Other revenues
469
1,190
Total revenues
198,720
195,493
Costs and expenses:
Management fees
24,384
24,963
Interest expense
65,860
56,520
General and administrative
30,429
32,798
Acquisition and investment pursuit costs
671
1,285
Costs of rental operations
20,878
12,655
Depreciation and amortization
22,228
18,760
Loan loss allowance, net
(305)
(761)
Other expense
758
100
Total costs and expenses
164,903
146,320
Income before other income (loss), income taxes and non-controlling interests
33,817
49,173
Other income (loss):
Change in net assets related to consolidated VIEs
69,170
(4,167)
Change in fair value of servicing rights
(8,433)
(6,739)
Change in fair value of investment securities, net
(1,171)
753
Change in fair value of mortgage loans held-for-sale, net
10,593
6,891
Earnings from unconsolidated entities
2,987
4,065
(Loss) gain on sale of investments and other assets, net
(56)
245
Loss on derivative financial instruments, net
(4,349)
(24,718)
Foreign currency gain (loss), net
4,864
(378)
Total other-than-temporary impairment (“OTTI”)
(54)
Noncredit portion of OTTI recognized in other comprehensive income
54
Net impairment losses recognized in earnings
Loss on extinguishment of debt
(5,916)
Other income, net
365
2,015
Total other income (loss)
68,054
(22,033)
Income before income taxes
101,871
27,140
Income tax benefit (provision)
983
(94)
Net income
102,854
27,046
Net income attributable to non-controlling interests
(496)
(389)
Net income attributable to Starwood Property Trust, Inc.
102,358
26,657
Earnings per share data attributable to Starwood Property Trust, Inc.:
Basic
Diluted
Dividends declared per common share
5
(Unaudited, amounts in thousands)
Other comprehensive income (loss) (net change by component):
Cash flow hedges
76
(273)
Available-for-sale securities
1,846
(3,400)
Foreign currency translation
2,007
7,401
Other comprehensive income
3,929
3,728
Comprehensive income
30,774
Less: Comprehensive income attributable to non-controlling interests
Comprehensive income attributable to Starwood Property Trust, Inc.
30,385
6
Total
Starwood
Accumulated
Property
Common stock
Additional
Other
Trust, Inc.
Non-
Par
Paid-in
Treasury Stock
Comprehensive
Stockholders’
Controlling
Shares
Value
Capital
Amount
Deficit
Income
Equity
Interests
Balance, January 1, 2017
263,893,806
4,606,885
Proceeds from DRIP Plan
8,129
183
Equity offering costs
(12)
Equity component of 2023 Convertible Senior Notes issuance
3,755
Equity component of 2018 Convertible Senior Notes repurchase
(18,105)
Share-based compensation
514,379
3,154
3,159
Manager incentive fee paid in stock
418,016
9,543
9,547
496
Dividends declared, $0.48 per share
(125,479)
Other comprehensive income, net
VIE non-controlling interests
5,177
Distributions to non-controlling interests
(1,726)
Balance, March 31, 2017
264,834,330
Balance, January 1, 2016
241,044,775
2,410
4,192,844
3,553,996
(72,381)
(12,286)
29,729
4,140,316
30,627
4,170,943
4,411
82
Common stock repurchased
1,052,889
(19,723)
563,503
7,061
7,067
606,166
10,917
10,923
389
(114,572)
(633)
Contributions from non-controlling interests
6,584
(582)
Balance, March 31, 2016
242,218,855
2,422
4,210,904
(100,201)
33,457
4,054,478
36,385
4,090,863
7
Cash Flows from Operating Activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of deferred financing costs, premiums and discounts on secured financing agreements
4,686
3,974
Amortization of discounts and deferred financing costs on senior notes
6,093
5,277
Accretion of net discount on investment securities
(4,257)
(3,373)
Accretion of net deferred loan fees and discounts
(7,519)
(8,696)
Share-based component of incentive fees
Change in fair value of fair value option investment securities
1,171
(753)
Change in fair value of consolidated VIEs
(20,677)
54,038
8,433
6,739
Change in fair value of loans held-for-sale
(10,593)
(6,891)
Change in fair value of derivatives
2,900
23,557
Foreign currency (gain) loss, net
(4,829)
402
Loss (gain) on sale of investments and other assets
56
(245)
Impairment charges
21,297
16,759
(2,987)
(4,065)
Distributions of earnings from unconsolidated entities
2,643
5,729
5,916
Origination and purchase of loans held-for-sale, net of principal collections
(445,690)
(200,433)
Proceeds from sale of loans held-for-sale
179,296
256,964
Changes in operating assets and liabilities:
Related-party payable, net
(11,821)
(16,965)
Accrued and capitalized interest receivable, less purchased interest
(19,611)
(23,350)
(1,855)
8,779
(14,686)
(30,593)
Net cash (used in) provided by operating activities
(196,021)
131,129
Cash Flows from Investing Activities:
Origination and purchase of loans held-for-investment
(621,135)
(472,237)
Proceeds from principal collections on loans
226,039
192,813
Proceeds from loans sold
37,079
97,882
Purchase of investment securities
(84,337)
Proceeds from sales of investment securities
10,434
Proceeds from principal collections on investment securities
76,050
22,344
Real estate business combinations, net of cash acquired
(73,639)
Additions to properties and other assets
(2,435)
(2,846)
(11)
Distribution of capital from unconsolidated entities
3,127
914
Payments for purchase or termination of derivatives
(32,700)
(12,611)
Proceeds from termination of derivatives
17,331
7,910
Return of investment basis in purchased derivative asset
62
69
Net cash used in investing activities
(286,148)
(323,749)
8
Condensed Consolidated Statements of Cash Flows (Continued)
Cash Flows from Financing Activities:
Proceeds from borrowings
1,205,691
991,192
Principal repayments on and repurchases of borrowings
(957,529)
(626,462)
Payment of deferred financing costs
(5,967)
(5,969)
Proceeds from common stock issuances
Payment of equity offering costs
(647)
Payment of dividends
(124,506)
(114,624)
Purchase of treasury stock
Issuance of debt of consolidated VIEs
4,759
596
Repayment of debt of consolidated VIEs
(57,445)
(55,729)
Distributions of cash from consolidated VIEs
30,956
7,545
Net cash provided by financing activities
93,769
182,910
Net decrease in cash, cash equivalents and restricted cash
(388,400)
(9,710)
Cash, cash equivalents and restricted cash, beginning of period
650,755
391,884
Effect of exchange rate changes on cash
179
1,420
Cash, cash equivalents and restricted cash, end of period
262,534
383,594
Supplemental disclosure of cash flow information:
Cash paid for interest
51,023
50,254
Income taxes paid
268
922
Supplemental disclosure of non-cash investing and financing activities:
Dividends declared, but not yet paid
125,479
114,572
Consolidation of VIEs (VIE asset/liability additions)
1,127,952
15,103,275
Deconsolidation of VIEs (VIE asset/liability reductions)
1,528,137
2,591,268
Fair value of assets acquired, net of cash
221,125
Fair value of liabilities assumed
147,486
Net assets acquired from consolidated VIEs
42,513
9
As of March 31, 2017
(Unaudited)
1. Business and Organization
Starwood Property Trust, Inc. (“STWD” and, together with its subsidiaries, “we” or the “Company”) is a Maryland corporation that commenced operations in August 2009, upon the completion of our initial public offering. We are focused primarily on originating, acquiring, financing and managing commercial mortgage loans and other commercial real estate debt investments, commercial mortgage-backed securities (“CMBS”), and other commercial real estate investments in both the U.S. and Europe. We refer to the following as our target assets: commercial real estate mortgage loans, preferred equity interests, CMBS and other commercial real estate-related debt investments. Our target assets may also include residential mortgage-backed securities (“RMBS”), certain residential mortgage loans, distressed or non-performing commercial loans, commercial properties subject to net leases and equity interests in commercial real estate. As market conditions change over time, we may adjust our strategy to take advantage of changes in interest rates and credit spreads as well as economic and credit conditions.
We have three reportable business segments as of March 31, 2017:
Real estate lending (the “Lending Segment”)—engages primarily in originating, acquiring, financing and managing commercial first mortgages, subordinated mortgages, mezzanine loans, preferred equity, CMBS, RMBS, certain residential mortgage loans, and other real estate and real estate-related debt investments in both the U.S. and Europe.
Real estate investing and servicing (the “Investing and Servicing Segment”)—includes (i) a servicing business in the U.S. that manages and works out problem assets, (ii) an investment business that selectively acquires and manages unrated, investment grade and non-investment grade rated CMBS, including subordinated interests of securitization and resecuritization transactions, (iii) a mortgage loan business which originates conduit loans for the primary purpose of selling these loans into securitization transactions, and (iv) an investment business that selectively acquires commercial real estate assets, including properties acquired from CMBS trusts. This segment excludes the consolidation of securitization variable interest entities (“VIEs”).
Real estate property (the “Property Segment”)—engages primarily in acquiring and managing equity interests in stabilized commercial real estate properties, including multi-family properties, that are held for investment.
We are organized and conduct our operations to qualify as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, we will generally not be subject to U.S. federal corporate income tax on that portion of our net income that is distributed to stockholders if we distribute at least 90% of our taxable income to our stockholders by prescribed dates and comply with various other requirements.
We are organized as a holding company and conduct our business primarily through our various wholly-owned subsidiaries. We are externally managed and advised by SPT Management, LLC (our “Manager”) pursuant to the terms of a management agreement. Our Manager is controlled by Barry Sternlicht, our Chairman and Chief Executive Officer. Our Manager is an affiliate of Starwood Capital Group, a privately-held private equity firm founded and controlled by Mr. Sternlicht.
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2. Summary of Significant Accounting Policies
Balance Sheet Presentation of the Investing and Servicing Segment’s Variable Interest Entities
As noted above, the Investing and Servicing Segment operates an investment business that acquires unrated, investment grade and non-investment grade rated CMBS. These securities represent interests in securitization structures (commonly referred to as special purpose entities, or “SPEs”). These SPEs are structured as pass through entities that receive principal and interest on the underlying collateral and distribute those payments to the certificate holders. Under accounting principles generally accepted in the United States of America (“GAAP”), SPEs typically qualify as VIEs. These are entities that, by design, either (1) lack sufficient equity to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) have equity investors that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses, or do not have the right to receive the residual returns of the entity.
Because the Investing and Servicing Segment often serves as the special servicer of the trusts in which it invests, consolidation of these structures is required pursuant to GAAP as outlined in detail below. This results in a consolidated balance sheet which presents the gross assets and liabilities of the VIEs. The assets and other instruments held by these VIEs are restricted and can only be used to fulfill the obligations of the entity. Additionally, the obligations of the VIEs do not have any recourse to the general credit of any other consolidated entities, nor to us as the consolidator of these VIEs.
The VIE liabilities initially represent investment securities on our balance sheet (pre-consolidation). Upon consolidation of these VIEs, our associated investment securities are eliminated, as is the interest income related to those securities. Similarly, the fees we earn in our roles as special servicer of the bonds issued by the consolidated VIEs or as collateral administrator of the consolidated VIEs are also eliminated. Finally, an allocable portion of the identified servicing intangible associated with the eliminated fee streams is eliminated in consolidation.
Refer to the segment data in Note 22 for a presentation of the Investing and Servicing Segment without consolidation of these VIEs.
Basis of Accounting and Principles of Consolidation
The accompanying condensed consolidated financial statements include our accounts and those of our consolidated subsidiaries and VIEs. Intercompany amounts have been eliminated in consolidation. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows have been included.
These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (the “Form 10-K”), as filed with the Securities and Exchange Commission (“SEC”). The results of operations for the three months ended March 31, 2017 are not necessarily indicative of the operating results for the full year.
Refer to our Form 10-K for a description of our recurring accounting policies. We have included disclosure in this Note 2 regarding principles of consolidation and other accounting policies that (i) are required to be disclosed quarterly, (ii) we view as critical, or (iii) became significant since December 31, 2016 due to a corporate action or increase in the significance of the underlying business activity.
Variable Interest Entities
In addition to the Investing and Servicing Segment’s VIEs, certain other entities in which we hold interests are considered VIEs as the limited partners of these entities do not collectively possess (i) the right to remove the general partner without cause or (ii) the right to participate in significant decisions made by the partnership.
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We evaluate all of our interests in VIEs for consolidation. When our interests are determined to be variable interests, we assess whether we are deemed to be the primary beneficiary of the VIE. The primary beneficiary of a VIE is required to consolidate the VIE. Accounting Standards Codification (“ASC”) 810, Consolidation, defines the primary beneficiary as the party that has both (i) the power to direct the activities of the VIE that most significantly impact its economic performance, and (ii) the obligation to absorb losses and the right to receive benefits from the VIE which could be potentially significant. We consider our variable interests as well as any variable interests of our related parties in making this determination. Where both of these factors are present, we are deemed to be the primary beneficiary and we consolidate the VIE. Where either one of these factors is not present, we are not the primary beneficiary and do not consolidate the VIE.
To assess whether we have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, we consider all facts and circumstances, including our role in establishing the VIE and our ongoing rights and responsibilities. This assessment includes, (i) identifying the activities that most significantly impact the VIE’s economic performance; and (ii) identifying which party, if any, has power over those activities. In general, the parties that make the most significant decisions affecting the VIE or have the right to unilaterally remove those decision makers are deemed to have the power to direct the activities of a VIE. The right to remove the decision maker in a VIE must be exercisable without cause for the decision maker to not be deemed the party that has the power to direct the activities of a VIE.
To assess whether we have the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE, we consider all of our economic interests, including debt and equity investments, servicing fees, and other arrangements deemed to be variable interests in the VIE. This assessment requires that we apply judgment in determining whether these interests, in the aggregate, are considered potentially significant to the VIE. Factors considered in assessing significance include: the design of the VIE, including its capitalization structure; subordination of interests; payment priority; relative share of interests held across various classes within the VIE’s capital structure; and the reasons why the interests are held by us.
Our purchased investment securities include CMBS which are unrated and non-investment grade rated securities issued by CMBS trusts. In certain cases, we may contract to provide special servicing activities for these CMBS trusts, or, as holder of the controlling class, we may have the right to name and remove the special servicer for these trusts. In our role as special servicer, we provide services on defaulted loans within the trusts, such as foreclosure or work-out procedures, as permitted by the underlying contractual agreements. In exchange for these services, we receive a fee. These rights give us the ability to direct activities that could significantly impact the trust’s economic performance. However, in those instances where an unrelated third party has the right to unilaterally remove us as special servicer without cause, we do not have the power to direct activities that most significantly impact the trust’s economic performance. We evaluated all of our positions in such investments for consolidation.
For securitization VIEs in which we are determined to be the primary beneficiary, all of the underlying assets, liabilities and equity of the structures are recorded on our books, and the initial investment, along with any associated unrealized holding gains and losses, are eliminated in consolidation. Similarly, the interest income earned from these structures, as well as the fees paid by these trusts to us in our capacity as special servicer, are eliminated in consolidation. Further, an allocable portion of the identified servicing intangible asset associated with the servicing fee streams, and the corresponding allocable amortization or change in fair value of the servicing intangible asset, are also eliminated in consolidation.
We perform ongoing reassessments of: (i) whether any entities previously evaluated under the majority voting interest framework have become VIEs, based on certain events, and therefore subject to the VIE consolidation framework, and (ii) whether changes in the facts and circumstances regarding our involvement with a VIE causes our consolidation conclusion regarding the VIE to change.
We elect the fair value option for initial and subsequent recognition of the assets and liabilities of our consolidated securitization VIEs. Interest income and interest expense associated with these VIEs are no longer relevant on a standalone basis because these amounts are already reflected in the fair value changes. We have elected to present these items in a single line on our condensed consolidated statements of operations. The residual difference shown on
12
our condensed consolidated statements of operations in the line item “Change in net assets related to consolidated VIEs” represents our beneficial interest in the VIEs.
We separately present the assets and liabilities of our consolidated securitization VIEs as individual line items on our condensed consolidated balance sheets. The liabilities of our consolidated securitization VIEs consist solely of obligations to the bondholders of the related CMBS trusts, and are thus presented as a single line item entitled “VIE liabilities.” The assets of our consolidated securitization VIEs consist principally of loans, but at times, also include foreclosed loans which have been temporarily converted into real estate owned (“REO”). These assets in the aggregate are likewise presented as a single line item entitled “VIE assets.”
Loans comprise the vast majority of our securitization VIE assets and are carried at fair value due to the election of the fair value option. When an asset becomes REO, it is due to nonperformance of the loan. Because the loan is already at fair value, the carrying value of an REO asset is also initially at fair value. Furthermore, when we consolidate a CMBS trust, any existing REO would be consolidated at fair value. Once an asset becomes REO, its disposition time is relatively short. As a result, the carrying value of an REO generally approximates fair value under GAAP.
In addition to sharing a similar measurement method as the loans in a CMBS trust, the securitization VIE assets as a whole can only be used to settle the obligations of the consolidated VIE. The assets of our securitization VIEs are not individually accessible by the bondholders, which creates inherent limitations from a valuation perspective. Also creating limitations from a valuation perspective is our role as special servicer, which provides us very limited visibility, if any, into the performing loans of a CMBS trust.
REO assets generally represent a very small percentage of the overall asset pool of a CMBS trust. In a new issue CMBS trust there are no REO assets. We estimate that REO assets constitute approximately 4% of our consolidated securitization VIE assets, with the remaining 96% representing loans. However, it is important to note that the fair value of our securitization VIE assets is determined by reference to our securitization VIE liabilities as permitted under Accounting Standards Update (“ASU”) 2014-13, Consolidation (Topic 810): Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity. In other words, our VIE liabilities are more reliably measurable than the VIE assets, resulting in our current measurement methodology which utilizes this value to determine the fair value of our securitization VIE assets as a whole. As a result, these percentages are not necessarily indicative of the relative fair values of each of these asset categories if the assets were to be valued individually.
Due to our accounting policy election under ASU 2014-13, separately presenting two different asset categories would result in an arbitrary assignment of value to each, with one asset category representing a residual amount, as opposed to its fair value. However, as a pool, the fair value of the assets in total is equal to the fair value of the liabilities.
For these reasons, the assets of our securitization VIEs are presented in the aggregate.
Fair Value Option
The guidance in ASC 825, Financial Instruments, provides a fair value option election that allows entities to make an irrevocable election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The decision to elect the fair value option is determined on an instrument by instrument basis and must be applied to an entire instrument and is irrevocable once elected. Assets and liabilities measured at fair value pursuant to this guidance are required to be reported separately in our consolidated balance sheets from those instruments using another accounting method.
We have elected the fair value option for eligible financial assets and liabilities of our consolidated securitization VIEs, loans held-for-sale originated or acquired for future securitization, purchased CMBS issued by VIEs we could consolidate in the future and certain investments in marketable equity securities. The fair value elections for VIE and securitization related items were made in order to mitigate accounting mismatches between the carrying value of the instruments and the related assets and liabilities that we consolidate at fair value. The fair value elections for
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mortgage loans held-for-sale were made due to the short-term nature of these instruments. The fair value elections for investments in marketable equity securities were made because the shares are listed on an exchange, which allows us to determine the fair value using a quoted price from an active market.
Fair Value Measurements
We measure our mortgage‑backed securities, derivative assets and liabilities, domestic servicing rights intangible asset and any assets or liabilities where we have elected the fair value option at fair value. When actively quoted observable prices are not available, we either use implied pricing from similar assets and liabilities or valuation models based on net present values of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors.
As discussed above, we measure the assets and liabilities of consolidated securitization VIEs at fair value pursuant to our election of the fair value option. The securitization VIEs in which we invest are “static”; that is, no reinvestment is permitted, and there is no active management of the underlying assets. In determining the fair value of the assets and liabilities of the securitization VIE, we maximize the use of observable inputs over unobservable inputs. We also acknowledge that our principal market for selling CMBS assets is the securitization market where the market participant is considered to be a CMBS trust or a collateralized debt obligation (“CDO”). This methodology results in the fair value of the assets of a static CMBS trust being equal to the fair value of its liabilities. Refer to Note 19 for further discussion regarding our fair value measurements.
Loans Held-for-Investment and Provision for Loan Losses
Loans that are held for investment are carried at cost, net of unamortized acquisition premiums or discounts, loan fees, and origination costs as applicable, unless the loans are deemed impaired. We evaluate each loan classified as held-for-investment for impairment at least quarterly. In connection with this evaluation, we assess the performance of each loan and assign a risk rating based on several factors, including risk of loss, loan-to-collateral value ratio (“LTV”), collateral performance, structure, exit plan, and sponsorship. Loans are rated “1” through “5”, from less risk to greater risk, in connection with this review.
Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, we record an allowance through the provision for loan losses to reduce the carrying value of the loan to the present value of expected future cash flows discounted at the loan’s contractual effective rate or the fair value of the collateral, if repayment is expected solely from the collateral. Actual losses, if any, could ultimately differ from these estimates.
Earnings Per Share
We present both basic and diluted earnings per share (“EPS”) amounts in our financial statements. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the maximum potential dilution that could occur from (i) our share-based compensation, consisting of unvested restricted stock (“RSAs”) and restricted stock units (“RSUs”), (ii) shares contingently issuable to our Manager, and (iii) the “in-the-money” conversion options associated with our outstanding convertible senior notes (see further discussion in Notes 10 and 17). Potential dilutive shares are excluded from the calculation if they have an anti-dilutive effect in the period.
Nearly all of the Company’s unvested RSUs and RSAs contain rights to receive non-forfeitable dividends and thus are participating securities. Due to the existence of these participating securities, the two-class method of computing EPS is required, unless another method is determined to be more dilutive. Under the two-class method, undistributed earnings are reallocated between shares of common stock and participating securities. For the three months ended March 31, 2017 and 2016, the two-class method resulted in the most dilutive EPS calculation.
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Restricted Cash
Restricted cash includes cash and cash equivalents that are legally or contractually restricted as to withdrawal or usage and primarily includes cash collateral associated with derivative financial instruments and funds held on behalf of borrowers and tenants. Effective January 1, 2017, we early adopted ASU 2016-18, Statement of Cash Flows (Topic 230) – Restricted Cash, which requires that restricted cash be included with cash and cash equivalents when reconciling the beginning and end-of-period total amounts shown on the statement of cash flows. As required by this ASU, we applied this change retrospectively to our prior period condensed consolidated statement of cash flows for the three months ended March 31, 2016.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The most significant and subjective estimate that we make is the projection of cash flows we expect to receive on our loans, investment securities and intangible assets, which has a significant impact on the amounts of interest income, credit losses (if any), and fair values that we record and/or disclose. In addition, the fair value of financial assets and liabilities that are estimated using a discounted cash flows method is significantly impacted by the rates at which we estimate market participants would discount the expected cash flows.
Recent Accounting Developments
On May 28, 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers, which establishes key principles by which an entity determines the amount and timing of revenue recognized from customer contracts. At issuance, the ASU was effective for the first interim or annual period beginning after December 15, 2016. On August 12, 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers – Deferral of the Effective Date, which delayed the effective date of ASU 2014-09 by one year, resulting in the ASU becoming effective for the first interim or annual period beginning after December 15, 2017. Though we have not completed our assessment of this ASU, we expect to identify similar performance obligations as currently identified, and we therefore do not expect the application of this ASU to materially impact the Company.
On January 5, 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) – Recognition and Measurement of Financial Assets and Financial Liabilities, which impacts the accounting for equity investments, financial liabilities under the fair value option, and disclosure requirements for financial instruments. The ASU shall be applied prospectively and is effective for annual periods, and interim periods therein, beginning after December 15, 2017. Early application is not permitted. We do not expect the application of this ASU to materially impact the Company.
On February 25, 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which establishes a right-of-use model for lessee accounting which results in the recognition of most leased assets and lease liabilities on the balance sheet of the lessee. Lessor accounting was not significantly changed by the ASU. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2018 by applying a modified retrospective approach. Early application is permitted. We are in the process of assessing the impact this ASU will have on the Company.
On March 17, 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606) – Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which amends the principal-versus-agent implementation guidance and illustrations in the FASB’s revenue recognition standard issued in ASU 2014-09. The ASU provides further guidance to assist an entity in determining whether the nature of its promise to its customer is to provide the underlying goods or services, meaning the entity is a principal, or to arrange for a third party to provide the underlying goods or services, meaning the entity is an agent. The ASU is effective for the first interim or annual period beginning after December 15, 2017. Early application is permitted though no earlier than the first interim or annual period beginning after December 15, 2016. We do not expect the application of this ASU to materially impact the Company.
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On April 14, 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606) – Identifying Performance Obligations and Licensing, which amends guidance and illustrations in the FASB’s revenue recognition standard issued in ASU 2014-09 regarding the identification of performance obligations and the implementation guidance on licensing arrangements. The ASU is effective for the first interim or annual period beginning after December 15, 2017. Early application is permitted. We do not expect the application of this ASU to materially impact the Company.
On June 16, 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments, which mandates use of an “expected loss” credit model for estimating future credit losses of certain financial instruments instead of the “incurred loss” credit model that current GAAP requires. The “expected loss” model requires the consideration of possible credit losses over the life of an instrument as opposed to only estimating credit losses upon the occurrence of a discrete loss event in accordance with the current “incurred loss” methodology. The ASU is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2019. Early application is permitted though no earlier than the first interim or annual period beginning after December 15, 2018. Though we have not completed our assessment of this ASU, we expect the ASU to result in our recognition of higher levels of allowances for loan losses. Our assessment of the estimated amount of such increases remains in process.
On August 26, 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments, which seeks to reduce diversity in practice regarding how various cash receipts and payments are reported within the statement of cash flows. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2017. Early application is permitted in any interim or annual period. We do not expect the application of this ASU to materially impact the Company.
On October 24, 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740) – Intra-Entity Transfers of Assets Other Than Inventory, which requires that an entity recognize the income tax consequences of intra-entity transfers of assets other than inventory at the time of the transfer instead of deferring the tax consequences until the asset has been sold to an outside party, as current GAAP requires. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2017. Early application is permitted in any interim or annual period. We do not expect the application of this ASU to materially impact the Company.
On January 5, 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805) – Clarifying the Definition of a Business, which amends the definition of a business to exclude acquisitions of groups of assets where substantially all of the fair value of the assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2017 and is applied prospectively. Early application is permitted. We expect most real estate acquired by the Company subsequent to the ASU’s effective date will no longer be accounted for as business combinations and instead be accounted for as asset acquisitions.
On January 26, 2017, the FASB issued ASU 2017-04, Goodwill and Other (Topic 350) – Simplifying the Test for Goodwill Impairment, which simplifies the method applied for measuring impairment in cases where goodwill is impaired. The ASU specifies that goodwill impairment will be measured as the excess of the reporting unit’s carrying value (inclusive of goodwill) over its fair value, eliminating the requirement that all assets and liabilities of the reporting unit be remeasured individually in connection with measurement of goodwill impairment. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2019 and is applied prospectively. Early application is permitted though no earlier than January 1, 2017. We do not expect the application of this ASU to materially impact the Company.
On February 22, 2017, the FASB issued ASU 2017-05, Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets (Topic 610-20), which requires that all entities account for the derecognition of a business in accordance with ASC 810, including instances in which the business is considered in substance real estate. The ASU is effective for annual periods, and interim periods therein, beginning after December 15, 2017. Early application is permitted. We do not expect the application of this ASU to materially impact the Company.
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3. Acquisitions
The Company had no real estate business combinations during the three months ended March 31, 2017. However, the following business combinations occurred in prior years and continue to have disclosure relevance:
Medical Office Portfolio
The Medical Office Portfolio is comprised of 34 medical office buildings acquired for a purchase price of $758.8 million during the year ended December 31, 2016. These properties, which collectively comprise 1.9 million square feet, are geographically dispersed throughout the U.S. and primarily affiliated with major hospitals or located on or adjacent to major hospital campuses. No goodwill or bargain purchase gains were recognized in connection with the Medical Office Portfolio acquisition as the purchase price equaled the fair value of the net assets acquired.
Woodstar Portfolio
The Woodstar Portfolio is comprised of 32 affordable housing communities with 8,948 units concentrated primarily in the Tampa, Orlando and West Palm Beach metropolitan areas. During the year ended December 31, 2015, we acquired 18 of the 32 affordable housing communities of the Woodstar Portfolio with the final 14 communities acquired during the year ended December 31, 2016 for an aggregate acquisition price of $421.5 million. We assumed federal, state and county sponsored financing and other debt in connection with this acquisition.
No goodwill was recognized in connection with the Woodstar Portfolio acquisition as the purchase price did not exceed the fair value of the net assets acquired. A bargain purchase gain of $8.4 million was recognized within other income, net in our consolidated statement of operations for the year ended December 31, 2016 as the fair value of the net assets acquired exceeded the purchase price due to favorable changes in net asset fair values occurring between the date the purchase price was negotiated and the closing date.
Investing and Servicing Segment Property Portfolio
The Investing and Servicing Segment Property Portfolio (the “REO Portfolio”) is comprised of controlling interests in 24 commercial real estate properties acquired from CMBS trusts. During the year ended December 31, 2015, we acquired 14 of these properties with the remaining 10 properties acquired during the year ended December 31, 2016 for an aggregate acquisition price of $268.5 million. When the properties are acquired from CMBS trusts that are consolidated as VIEs on our balance sheet, the acquisitions are reflected as repayment of debt of consolidated VIEs in our condensed consolidated statements of cash flows.
No goodwill was recognized in connection with the REO Portfolio acquisitions as the purchase prices did not exceed the fair values of the net assets acquired. A bargain purchase gain of $8.8 million was recognized within change in net assets related to consolidated VIEs in our consolidated statement of operations for the year ended December 31, 2016 as the fair value of the net assets acquired for certain properties exceeded the purchase price.
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During the three months ended March 31, 2017, in accordance with ASU 2015-16, Business Combinations (Topic 805) – Simplifying the Accounting for Measurement-Period Adjustments, we adjusted our initial provisional estimates of the acquisition date fair values of the identified assets acquired and liabilities assumed for a certain property acquired within the REO Portfolio during the year ended December 31, 2016 to reflect new information obtained regarding facts and circumstances that existed at the acquisition date. The following table summarizes the measurement period adjustment applied to this property’s initial provisional acquisition date balance sheet (amounts in thousands):
Measurement
Initial
Period
Adjusted
Assets acquired:
Amounts
Adjustments
Properties
12,087
660
12,747
Intangible assets
4,270
(802)
3,468
97
Total assets acquired
16,454
(142)
16,312
Liabilities assumed:
1,539
1,397
Total liabilities assumed
Non-controlling interests
3,084
Net assets acquired
11,831
The net income effect associated with this measurement period adjustment during the three months ended March 31, 2017 was immaterial.
Ireland Portfolio
The Ireland Portfolio is comprised of 12 net leased fully occupied office properties and one multi-family property all located in Dublin, Ireland, which the Company acquired during the year ended December 31, 2015. The Ireland Portfolio, which collectively is comprised of approximately 600,000 square feet, included total assets of $518.2 million and assumed debt of $283.0 million at acquisition. Following our acquisition, all assumed debt was immediately extinguished and replaced with new financing of $328.6 million from the Ireland Portfolio Mortgage (as set forth in Note 9). No goodwill or bargain purchase gain was recognized in connection with the Ireland Portfolio acquisition as the purchase price equaled the fair value of the net assets acquired.
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4. Loans
Our loans held-for-investment are accounted for at amortized cost and our loans held-for-sale are accounted for at the lower of cost or fair value, unless we have elected the fair value option. The following tables summarize our investments in mortgages and loans by subordination class as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Weighted
Average Life
Carrying
Face
Average
(“WAL”)
Coupon
(years)(1)
First mortgages (2)
5,212,199
5,228,599
5.6
%
2.1
Subordinated mortgages (3)
294,754
310,085
8.9
3.1
Mezzanine loans (2)
733,349
733,965
9.7
1.6
Total loans held-for-investment
6,240,302
6,272,649
Loans held-for-sale, fair value option
336,197
7.2
6.2
0.2
Total gross loans
6,615,568
6,643,846
Loan loss allowance (loans held-for-investment)
(9,483)
Total net loans
6,606,085
4,865,994
4,881,656
5.7
2.2
278,032
293,925
3.3
713,757
714,608
9.6
1.8
5,857,783
5,890,189
63,065
5.3
10.0
0.4
5,956,062
5,988,254
(9,788)
5,946,274
(1)
Represents the WAL of each respective group of loans as of the respective balance sheet date. The WAL of each individual loan is calculated using amounts and timing of future principal payments, as projected at origination or acquisition.
(2)
First mortgages include first mortgage loans and any contiguous mezzanine loan components because as a whole, the expected credit quality of these loans is more similar to that of a first mortgage loan. The application of this methodology resulted in mezzanine loans with carrying values of $1.1 billion and $964.1 million being classified as first mortgages as of March 31, 2017 and December 31, 2016, respectively.
(3)
Subordinated mortgages include B-Notes and junior participation in first mortgages where we do not own the senior A-Note or senior participation. If we own both the A-Note and B-Note, we categorize the loan as a first mortgage loan.
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As of March 31, 2017, approximately $5.7 billion, or 91.6%, of our loans held-for-investment were variable rate and paid interest principally at LIBOR plus a weighted-average spread of 5.5%. The following table summarizes our investments in floating rate loans (dollars in thousands):
Index
Base Rate
One-month LIBOR USD
0.9828
879,641
0.7717
880,357
LIBOR floor
0.15 - 3.00
% (1)
4,836,995
4,449,861
5,716,636
5,330,218
The weighted-average LIBOR floor was 0.39% and 0.36% as of March 31, 2017 and December 31, 2016, respectively.
Our loans are typically collateralized by real estate. As a result, we regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower. Specifically, a property’s operating results and any cash reserves are analyzed and used to assess (i) whether cash flow from operations is sufficient to cover the debt service requirements currently and into the future, (ii) the ability of the borrower to refinance the loan at maturity, and/or (iii) the property’s liquidation value. We also evaluate the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, we consider the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates. Such impairment analyses are completed and reviewed by asset management and finance personnel who utilize various data sources, including (i) periodic financial data such as property operating statements, occupancy, tenant profile, rental rates, operating expenses, the borrower’s exit plan, and capitalization and discount rates, (ii) site inspections, and (iii) current credit spreads and discussions with market participants.
Our evaluation process, as described above produces an internal risk rating between 1 and 5, which is a weighted average of the numerical ratings in the following categories: (i) sponsor capability and financial condition, (ii) loan and collateral performance relative to underwriting, (iii) quality and stability of collateral cash flows, and (iv) loan structure. We utilize the overall risk ratings as a concise means to monitor any credit migration on a loan as well as on the whole portfolio. While the overall risk rating is generally not the sole factor we use in determining whether a loan is impaired, a loan with a higher overall risk rating would tend to have more adverse indicators of impairment, and therefore would be more likely to experience a credit loss.
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The rating categories generally include the characteristics described below, but these are utilized as guidelines and therefore not every loan will have all of the characteristics described in each category:
Rating
Characteristics
1
Sponsor capability and financial condition—Sponsor is highly rated or investment grade or, if private, the equivalent thereof with significant management experience.
Loan collateral and performance relative to underwriting—The collateral has surpassed underwritten expectations.
Quality and stability of collateral cash flows—Occupancy is stabilized, the property has had a history of consistently high occupancy, and the property has a diverse and high quality tenant mix.
Loan structure—LTV does not exceed 65%. The loan has structural features that enhance the credit profile.
Sponsor capability and financial condition—Strong sponsorship with experienced management team and a responsibly leveraged portfolio.
Loan collateral and performance relative to underwriting—Collateral performance equals or exceeds underwritten expectations and covenants and performance criteria are being met or exceeded.
Quality and stability of collateral cash flows—Occupancy is stabilized with a diverse tenant mix.
Loan structure—LTV does not exceed 70% and unique property risks are mitigated by structural features.
Sponsor capability and financial condition—Sponsor has historically met its credit obligations, routinely pays off loans at maturity, and has a capable management team.
Loan collateral and performance relative to underwriting—Property performance is consistent with underwritten expectations.
Quality and stability of collateral cash flows—Occupancy is stabilized, near stabilized, or is on track with underwriting.
Loan structure—LTV does not exceed 80%.
Sponsor capability and financial condition—Sponsor credit history includes missed payments, past due payment, and maturity extensions. Management team is capable but thin.
Loan collateral and performance relative to underwriting—Property performance lags behind underwritten expectations. Performance criteria and loan covenants have required occasional waivers. A sale of the property may be necessary in order for the borrower to pay off the loan at maturity.
Quality and stability of collateral cash flows—Occupancy is not stabilized and the property has a large amount of rollover.
Loan structure—LTV is 80% to 90%.
Sponsor capability and financial condition—Credit history includes defaults, deeds‑in‑lieu, foreclosures, and/or bankruptcies.
Loan collateral and performance relative to underwriting—Property performance is significantly worse than underwritten expectations. The loan is not in compliance with loan covenants and performance criteria and may be in default. Sale proceeds would not be sufficient to pay off the loan at maturity.
Quality and stability of collateral cash flows—The property has material vacancy and significant rollover of remaining tenants.
Loan structure—LTV exceeds 90%.
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As of March 31, 2017, the risk ratings for loans subject to our rating system, which excludes loans for which the fair value option has been elected, by class of loan were as follows (dollars in thousands):
Balance Sheet Classification
Loans Held-For-Investment
Loans
Transferred
% of
Risk Rating
First
Subordinated
Mezzanine
Loans Held-
As Secured
Category
Mortgages
For-Sale
Borrowings
868
27,280
210,815
22.9
463,491
64.4
383,639
59,043
442,682
6.7
56,857
0.9
N/A
5.1
100.0
As of December 31, 2016, the risk ratings for loans subject to our rating system, which excludes loans for which the fair value option has been elected, by class of loan were as follows (dollars in thousands):
921
1,092,731
27,069
194,803
1,349,603
22.6
3,348,874
250,963
425,972
4,025,809
67.6
365,151
92,982
458,133
7.7
58,317
1.0
1.1
After completing our impairment evaluation process as of March 31, 2017, we concluded that none of our loans were impaired and therefore no individual loan impairment charges were required on any individual loans, as we expect to collect all outstanding principal and interest. None of our loans were 90 days or greater past due as of March 31, 2017.
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In accordance with our policies, we record an allowance for loan losses equal to (i) 1.5% of the aggregate carrying amount of loans rated as a “4,” plus (ii) 5% of the aggregate carrying amount of loans rated as a “5, ” plus (iii) impaired loan reserves, if any. The following table presents the activity in our allowance for loan losses (amounts in thousands):
Allowance for loan losses at January 1
9,788
6,029
Provision for loan losses
Charge-offs
Recoveries
Allowance for loan losses at March 31
9,483
5,268
Recorded investment in loans related to the allowance for loan loss
499,539
351,220
The activity in our loan portfolio was as follows (amounts in thousands):
Balance at January 1
Acquisitions/originations/additional funding
1,067,021
674,712
Capitalized interest (1)
15,079
21,290
Basis of loans sold (2)
(216,431)
(354,601)
Loan maturities/principal repayments
(230,931)
(195,073)
Discount accretion/premium amortization
7,519
8,696
Changes in fair value
Unrealized foreign currency remeasurement loss
6,053
(12,984)
Change in loan loss allowance, net
305
761
Transfer to/from other asset classifications
603
17,182
Balance at March 31
Represents accrued interest income on loans whose terms do not require current payment of interest.
See Note 11 for additional disclosure on these transactions.
Primarily represents commercial mortgage loans acquired from CMBS trusts which are consolidated as VIEs on our balance sheet. Refer to Note 3 for further discussion.
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5. Investment Securities
Investment securities were comprised of the following as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Carrying Value as of
RMBS, available-for-sale
249,419
253,915
CMBS, fair value option (1)
1,015,146
990,570
Held-to-maturity (“HTM”) securities
452,725
509,980
Equity security, fair value option
12,555
12,177
Subtotal—Investment securities
1,729,845
1,766,642
VIE eliminations (1)
(999,674)
(959,024)
Total investment securities
Certain fair value option CMBS are eliminated in consolidation against VIE liabilities pursuant to ASC 810.
Purchases, sales and principal collections for all investment securities were as follows (amounts in thousands):
RMBS,
CMBS, fair
HTM
available-for-sale
value option
Securities
Security
Three Months Ended March 31, 2017
Purchases (1)
Sales (2)
Principal collections
10,228
5,766
60,056
Three Months Ended March 31, 2016
41,470
33,173
9,694
84,337
6,811
12,303
3,230
During the three months ended March 31, 2017 and 2016, we purchased $57.4 million and $46.6 million of CMBS, respectively, for which we elected the fair value option. Due to our consolidation of securitization VIEs, $57.4 million and $13.4 million, respectively, of this amount is eliminated and reflected as repayment of debt of consolidated VIEs in our condensed consolidated statements of cash flows.
During the three months ended March 31, 2017 and 2016, we sold $15.2 million and $0.6 million of CMBS, respectively, for which we had previously elected the fair value option. Due to our consolidation of securitization VIEs, $4.8 million and $0.6 million, respectively, of this amount is eliminated and reflected as issuance of debt of consolidated VIEs in our condensed consolidated statements of cash flows.
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RMBS, Available-for-Sale
The Company classified all of its RMBS as available-for-sale as of March 31, 2017 and December 31, 2016. These RMBS are reported at fair value in the balance sheet with changes in fair value recorded in accumulated other comprehensive income (“AOCI”).
The tables below summarize various attributes of our investments in available-for-sale RMBS as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Unrealized Gains or (Losses)
Recognized in AOCI
Purchase
Recorded
Gross
Net
Amortized
Credit
Non-Credit
Unrealized
Fair Value
Cost
OTTI
Gains
Losses
Adjustment
RMBS
212,829
(10,185)
202,644
(85)
46,860
46,775
219,171
208,986
45,113
(90)
44,929
Weighted Average Coupon (1)
Weighted Average Rating
WAL (Years) (2)
B
6.5
6.1
Calculated using the March 31, 2017 and December 31, 2016 one-month LIBOR rate of 0.983% and 0.772%, respectively, for floating rate securities.
Represents the WAL of each respective group of securities as of the respective balance sheet date. The WAL of each individual security is calculated using projected amounts and projected timing of future principal payments.
As of March 31, 2017, approximately $208.3 million, or 83.5%, of RMBS were variable rate and paid interest at LIBOR plus a weighted average spread of 1.22%. As of December 31, 2016, approximately $211.1 million, or 83.2%, of RMBS were variable rate and paid interest at LIBOR plus a weighted average spread of 1.22%. We purchased all of the RMBS at a discount that will be accreted into income over the expected remaining life of the security. The majority of the income from this strategy is earned from the accretion of these discounts.
The following table contains a reconciliation of aggregate principal balance to amortized cost for our RMBS as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Principal balance
388,204
399,883
Accretable yield
(60,818)
(64,290)
Non-accretable difference
(124,742)
(126,607)
Total discount
(185,560)
(190,897)
Amortized cost
The principal balance of credit deteriorated RMBS was $361.6 million and $371.5 million as of March 31, 2017 and December 31, 2016, respectively. Accretable yield related to these securities totaled $53.2 million and $55.9 million as of March 31, 2017 and December 31, 2016, respectively.
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The following table discloses the changes to accretable yield and non-accretable difference for our RMBS during the three months ended March 31, 2017 (amounts in thousands):
Non-Accretable
Accretable Yield
Difference
Balance as of January 1, 2017
64,290
126,607
Accretion of discount
(3,886)
Principal write-downs, net
(1,451)
Purchases
Sales
Transfer to/from non-accretable difference
414
(414)
Balance as of March 31, 2017
60,818
124,742
We have engaged a third party manager who specializes in RMBS to execute the trading of RMBS, the cost of which was $0.5 million and $0.4 million for the three months ended March 31, 2017 and 2016, respectively, which has been recorded as management fees in the accompanying condensed consolidated statements of operations.
The following table presents the gross unrealized losses and estimated fair value of any available-for-sale securities that were in an unrealized loss position as of March 31, 2017 and December 31, 2016, and for which OTTIs (full or partial) have not been recognized in earnings (amounts in thousands):
Estimated Fair Value
Unrealized Losses
Securities with a
loss less than
loss greater than
12 months
1,601
954
(17)
(68)
As of December 31, 2016
8,819
957
As of both March 31, 2017 and December 31, 2016, there were three securities with unrealized losses reflected in the table above. After evaluating these securities and recording adjustments for credit-related OTTI, we concluded that the remaining unrealized losses reflected above were noncredit-related and would be recovered from the securities’ estimated future cash flows. We considered a number of factors in reaching this conclusion, including that we did not intend to sell the securities, it was not considered more likely than not that we would be forced to sell the securities prior to recovering our amortized cost, and there were no material credit events that would have caused us to otherwise conclude that we would not recover our cost. Credit losses, which represent most of the OTTI we record on securities, are calculated by comparing (i) the estimated future cash flows of each security discounted at the yield determined as of the initial acquisition date or, if since revised, as of the last date previously revised, to (ii) our amortized cost basis. Significant judgment is used in projecting cash flows for our non-agency RMBS. As a result, actual income and/or impairments could be materially different from what is currently projected and/or reported.
CMBS, Fair Value Option
As discussed in the “Fair Value Option” section of Note 2 herein, we elect the fair value option for the Investing and Servicing Segment’s CMBS in an effort to eliminate accounting mismatches resulting from the current or potential consolidation of securitization VIEs. As of March 31, 2017, the fair value and unpaid principal balance of CMBS where we have elected the fair value option, before consolidation of securitization VIEs, were $1.0 billion and $4.3 billion, respectively. The $1.0 billion fair value balance represents our economic interests in these assets. However, as a result of our consolidation of securitization VIEs, the vast majority of this fair value ($999.7 million at March 31, 2017) is eliminated against VIE liabilities before arriving at our GAAP balance for fair value option CMBS.
As of March 31, 2017, none of our CMBS where we have elected the fair value option were variable rate.
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HTM Securities
The table below summarizes unrealized gains and losses of our investments in HTM securities as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Net Carrying Amount
Gross Unrealized
(Amortized Cost)
Holding Gains
Holding Losses
CMBS
432,734
3,069
(8,564)
427,239
Preferred interests
19,991
493
20,484
3,562
447,723
490,107
2,106
(8,648)
483,565
19,873
727
20,600
2,833
504,165
The table below summarizes the maturities of our HTM CMBS and our HTM preferred equity interests in limited liability companies that own commercial real estate as of March 31, 2017 (amounts in thousands):
Preferred
Less than one year
150,346
One to three years
89,939
Three to five years
192,449
Thereafter
Equity Security, Fair Value Option
During 2012, we acquired 9,140,000 ordinary shares from a related-party in Starwood European Real Estate Finance Limited (“SEREF”), a debt fund that is externally managed by an affiliate of our Manager and is listed on the London Stock Exchange. We have elected to report the investment using the fair value option because the shares are listed on an exchange, which allows us to determine the fair value using a quoted price from an active market, and also due to potential lags in reporting resulting from differences in the respective regulatory requirements. The fair value of the investment remeasured in USD was $12.6 million and $12.2 million as of March 31, 2017 and December 31, 2016, respectively. As of March 31, 2017, our shares represent an approximate 2% interest in SEREF.
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6. Properties
Our properties include the Medical Office Portfolio, Woodstar Portfolio, REO Portfolio and Ireland Portfolio as discussed in Note 3. The table below summarizes our properties held as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Depreciable Life
Property Segment
Land and land improvements
0 – 12 years
387,863
385,860
Buildings and building improvements
5 – 40 years
1,295,175
1,291,531
Furniture & fixtures
3 – 7 years
23,677
23,035
Investing and Servicing Segment
0 – 15 years
87,245
89,425
3 – 40 years
199,513
195,178
3 – 5 years
1,303
1,256
Properties, cost
1,994,776
1,986,285
Less: accumulated depreciation
(56,808)
(41,565)
There were no properties sold during the three months ended March 31, 2017 and 2016.
7. Investment in Unconsolidated Entities
The table below summarizes our investments in unconsolidated entities as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Participation /
Carrying value as of
Ownership % (1)
Equity method:
Retail Fund
33%
124,977
Investor entity which owns equity in an online real estate company
50%
21,566
21,677
Equity interests in commercial real estate
16% - 50%
23,301
23,297
Various
25% - 50%
6,762
6,640
176,936
176,591
Cost method:
Equity interest in a servicing and advisory business
6%
12,234
Investment funds which own equity in a loan servicer and other real estate assets
4% - 6%
9,225
2% - 3%
3,428
6,555
24,887
28,014
None of these investments are publicly traded and therefore quoted market prices are not available.
There were no differences between the carrying value of our equity method investments and the underlying equity in the net assets of the investees as of March 31, 2017.
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8. Goodwill and Intangibles
Goodwill at March 31, 2017 and December 31, 2016 represented the excess of consideration transferred over the fair value of net assets of LNR Property LLC (“LNR”) acquired on April 19, 2013. The goodwill recognized is attributable to value embedded in LNR’s existing platform, which includes an international network of commercial real estate asset managers, work-out specialists, underwriters and administrative support professionals as well as proprietary historical performance data on commercial real estate assets.
Intangible Assets
Servicing Rights Intangibles
In connection with the LNR acquisition, we identified domestic and European servicing rights that existed at the purchase date, based upon the expected future cash flows of the associated servicing contracts. During the year ended December 31, 2016, we contributed our European servicing and advisory business to an unrelated entity in exchange for a non-controlling equity interest in that entity and therefore no longer have any European servicing rights as of December 31, 2016.
At March 31, 2017 and December 31, 2016, the balance of the domestic servicing intangible was net of $33.0 million and $34.2 million, respectively, which was eliminated in consolidation pursuant to ASC 810 against VIE assets in connection with our consolidation of securitization VIEs. Before VIE consolidation, as of March 31, 2017 and December 31, 2016, the domestic servicing intangible had a balance of $79.7 million and $89.3 million, respectively, which represents our economic interest in this asset.
Lease Intangibles
In connection with our acquisitions of commercial real estate, we recognized in-place lease intangible assets and favorable lease intangible assets associated with certain noncancelable operating leases of the acquired properties.
The following table summarizes our intangible assets, which are comprised of servicing rights intangibles and lease intangibles, as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Gross Carrying
Net Carrying
Amortization
Domestic servicing rights, at fair value
46,649
55,082
In-place lease intangible assets
174,226
(45,223)
129,003
175,409
(38,532)
136,877
Favorable lease intangible assets
30,621
(4,179)
26,442
30,459
(3,170)
27,289
Total net intangible assets
251,496
(49,402)
260,950
(41,702)
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The following table summarizes the activity within intangible assets for the three months ended March 31, 2017 (amounts in thousands):
Domestic
In-place Lease
Favorable Lease
Servicing
Intangible
Rights
Assets
(6,733)
(983)
(7,716)
Foreign exchange (loss) gain
438
117
555
Impairment (1)
(758)
Changes in fair value due to changes in inputs and assumptions
Measurement period adjustments
(821)
Impairment of intangible lease assets is recognized within other expense in our condensed consolidated statements of operations.
The following table sets forth the estimated aggregate amortization of our in-place lease intangible assets and favorable lease intangible assets for the next five years and thereafter (amounts in thousands):
2017 (remainder of)
22,050
2018
26,317
2019
19,961
2020
14,960
2021
12,784
59,373
155,445
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9. Secured Financing Agreements
The following table is a summary of our secured financing agreements in place as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Carrying Value at
Current
Extended
Pledged Asset
Maximum
December 31,
Maturity
Maturity (a)
Pricing
Carrying Value
Facility Size
Lender 1 Repo 1
(b)
LIBOR + 1.75% to 5.75%
1,775,380
(c)
944,712
Lender 2 Repo 1
Oct 2017
Oct 2020
LIBOR + 1.75% to 2.75%
366,942
500,000
94,349
132,941
Lender 3 Repo 1
May 2018
May 2019
LIBOR + 2.50% to 2.85%
110,076
78,017
78,288
Lender 4 Repo 2
Dec 2018
Dec 2020
LIBOR + 2.00% to 2.50%
514,725
(d)
135,161
166,394
Lender 6 Repo 1
Aug 2019
LIBOR + 2.50% to 2.75%
339,964
218,728
182,586
Lender 6 Repo 2
Nov 2019
Nov 2020
GBP LIBOR + 2.75%
176,686
123,568
121,509
Lender 9 Repo 1
Dec 2017
LIBOR + 1.65%
378,607
283,575
Lender 10 Repo 1
Mar 2020
Mar 2022
LIBOR + 2.00% to 2.75%
125,000
Lender 7 Secured Financing
Jul 2018
Jul 2019
LIBOR + 2.75%
(e)
85,127
650,000
(f)
Lender 8 Secured Financing
LIBOR + 4.00%
66,578
75,000
43,647
43,555
Conduit Repo 2
Nov 2017
LIBOR + 2.25%
43,368
150,000
33,050
14,944
Conduit Repo 3
Feb 2018
LIBOR + 2.10%
8,683
6,525
Conduit Repo 4
100,000
MBS Repo 1
(g)
LIBOR + 1.90%
31,250
20,838
21,052
MBS Repo 2
Jun 2020
LIBOR/EURIBOR + 2.00% to 2.95%
331,800
240,892
239,434
MBS Repo 3
(h)
LIBOR + 1.32% to 2.00%
389,540
260,933
285,209
MBS Repo 4
(i)
LIBOR + 1.20% to 1.90%
185,435
225,000
8,146
5,633
Investing and Servicing Segment Property Mortgages
Feb 2018 to Jun 2026
238,193
192,703
172,981
164,611
Ireland Portfolio Mortgage
May 2020
EURIBOR + 1.69%
452,360
313,266
309,246
Woodstar Portfolio Mortgages
Nov 2025 to Oct 2026
3.72% to 3.97%
373,957
276,748
Woodstar Portfolio Government Financing
Mar 2026 to Jun 2049
1.00% to 5.00%
312,316
135,050
135,584
Medical Office Portfolio Mortgages
Dec 2021 to Feb 2022
Dec 2023 to Feb 2024
LIBOR + 2.50%
(j)
758,684
531,815
497,613
491,197
Term Loan A
Dec 2021
884,780
300,000
Revolving Secured Financing
7,824,451
4,197,218
Unamortized net premium
2,619
2,640
Unamortized deferred financing costs
(44,049)
(45,732)
(a)
Subject to certain conditions as defined in the respective facility agreement.
Maturity date for borrowings collateralized by loans is September 2018 before extension options and September 2021 assuming exercise of extension options. Borrowings collateralized by loans existing at maturity may remain outstanding until such loan collateral matures, subject to certain specified conditions and not to exceed September 2025.
The initial maximum facility size of $1.8 billion may be increased to $2.0 billion at our option, subject to certain conditions.
The initial maximum facility size of $600.0 million may be increased to $1.0 billion at our option, subject to certain conditions.
Subject to borrower’s option to choose alternative benchmark based rates pursuant to the terms of the credit agreement.
The initial maximum facility size of $450.0 million may be increased to $650.0 million at our option, subject to certain conditions.
Facility carries a rolling 11 month term which may reset monthly with the lender’s consent not to exceed December 2018. This facility carries no maximum facility size. Amounts reflect the outstanding balance as of March 31, 2017.
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Facility carries a rolling 12 month term which may reset monthly with the lender’s consent. Current maturity is March 2018. This facility carries no maximum facility size. Amounts reflect the outstanding balance as of March 31, 2017.
The date that is 270 days after the buyer delivers notice to seller, subject to a maximum date of May 2018.
Subject to a 25 basis point floor.
In the normal course of business, the Company is in discussions with its lenders to extend or amend any financing facilities which contain near term expirations.
In February 2017, we entered into a mortgage loan with maximum borrowings of $24.0 million to finance commercial real estate previously acquired by our Investing and Servicing Segment. This facility carries a term of 5.0 years with an annual interest rate of LIBOR + 2.00%.
In February 2017, we entered into a mortgage loan with maximum borrowings of $7.3 million as part of the Medical Office Portfolio Mortgages. This loan carries a five year initial term with two 12 month extension options and an annual interest rate of LIBOR + 2.50%.
In March 2017, we entered into a $125.0 million repurchase facility (“Lender 10 Repo 1”) that carries a three year initial term with two one-year extension options and an annual interest rate of LIBOR + 2.00% to 2.75%.
In March 2017, we amended the Lender 3 Repo 1 facility to extend the maturity from May 2017 to May 2018.
Our secured financing agreements contain certain financial tests and covenants. As of March 31, 2017, we were in compliance with all such covenants.
The following table sets forth our five‑year principal repayments schedule for secured financings assuming no defaults and excluding loans transferred as secured borrowings. Our credit facilities generally require principal to be paid down prior to the facilities’ respective maturities if and when we receive principal payments on, or sell, the investment collateral that we have pledged. The amount reflected in each period includes principal repayments on our credit facilities that would be required if (i) we received the repayments that we expect to receive on the investments that have been pledged as collateral under the credit facilities, as applicable, and (ii) the credit facilities that are expected to have amounts outstanding at their current maturity dates are extended where extension options are available to us (amounts in thousands):
Repurchase
Other Secured
Agreements
Financing
518,557
20,452
539,009
1,136,466
51,484
490,476
47,438
537,914
290,722
326,719
617,441
126,586
315,687
442,273
154,235
977,525
2,717,042
For the three months ended March 31, 2017 and 2016, approximately $4.7 million and $3.9 million, respectively, of amortization of deferred financing costs from secured financing agreements was included in interest expense on our condensed consolidated statements of operations.
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The following table sets forth our outstanding balance of repurchase agreements related to the following asset collateral classes as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Class of Collateral
Loans held-for-investment
2,114,914
1,890,925
Loans held-for-sale
71,319
34,024
Investment securities
530,809
551,328
2,476,277
We seek to mitigate risks associated with our repurchase agreements by managing risk related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value. The margin call provisions under the majority of our repurchase facilities, consisting of 58% of these agreements, do not permit valuation adjustments based on capital markets activity. Instead, margin calls on these facilities are limited to collateral-specific credit marks. To monitor credit risk associated with the performance and value of our loans and investments, our asset management team regularly reviews our investment portfolios and is in regular contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary. For repurchase agreements containing margin call provisions for general capital markets activity, approximately 18% of these pertain to our loans held-for-sale, for which we manage credit risk through the purchase of credit index instruments. We further seek to manage risks associated with our repurchase agreements by matching the maturities and interest rate characteristics of our loans with the related repurchase agreements.
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10. Unsecured Senior Notes
The following table is a summary of our unsecured senior notes outstanding as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Remaining
Effective
Period of
Rate
Rate (1)
Date
2017 Convertible Notes
3.75
5.86
10/15/2017
years
411,885
2018 Convertible Notes
4.55
6.10
3/1/2018
369,981
599,981
2019 Convertible Notes
4.00
5.35
1/15/2019
341,363
2021 Senior Notes
5.00
5.32
12/15/2021
700,000
2023 Convertible Notes
4.38
4.86
4/1/2023
250,000
Total principal amount
2,073,229
2,053,229
Unamortized discount—Convertible Notes
(23,907)
(26,135)
Unamortized discount—Senior Notes
(9,297)
(9,728)
(6,641)
(5,822)
Carrying amount of debt components
Carrying amount of conversion option equity components recorded in additional paid-in capital
31,638
45,988
Effective rate includes the effects of underwriter purchase discount and the adjustment for the conversion option on our convertible notes, the value of which reduced the initial liability and was recorded in additional paid‑in‑capital.
Senior Notes Due 2021
On December 16, 2016, we issued $700.0 million of 5.00% Senior Notes due 2021 (the “2021 Notes”). The 2021 Notes mature on December 15, 2021. Prior to September 15, 2021, we may redeem some or all of the 2021 Notes at a price equal to 100% of the principal amount thereof, plus the applicable “make-whole” premium as of the applicable date of redemption. On and after September 15, 2021, we may redeem some or all of the 2021 Notes at a price equal to 100% of the principal amount thereof. In addition, we may redeem up to 35% of the 2021 Notes at the applicable redemption prices using the proceeds of certain equity offerings.
Convertible Senior Notes
On March 29, 2017, we issued $250.0 million of 4.375% Convertible Senior Notes due 2023 (the “2023 Notes”) resulting in gross proceeds of $247.5 million. At issuance, we allocated $243.7 million and $3.8 million of the carrying value of the 2023 Notes to its debt and equity components, respectively. Also on March 29, 2017, the proceeds from the issuance of the 2023 Notes were used to repurchase $230.0 million of the 4.55% Convertible Senior Notes due 2018 (the “2018 Notes”) for $250.7 million. The repurchase price was allocated between the fair value of the liability component and the fair value of the equity component of the 2018 Notes at the repurchase date. The portion of the repurchase price attributable to the equity component totaled $18.1 million and was recognized as a reduction of additional paid-in capital during the three months ended March 31, 2017. The portion of the repurchase price attributable to the liability component exceeded the net carrying amount of the liability component by $5.9 million, which was recognized as a loss on extinguishment of debt in our condensed consolidated statement of operations during the three months ended March 31, 2017. The repurchase of the 2018 Notes was not considered part of the repurchase program approved by our board of directors (refer to Note 16) and therefore does not reduce our available capacity for future
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repurchases under the repurchase program. There were no repurchases of Convertible Notes during the three months ended March 31, 2016.
On October 8, 2014, we issued $431.3 million of 3.75% Convertible Senior Notes due 2017 (the “2017 Notes”). On February 15, 2013, we issued $600.0 million of 4.55% Convertible Senior Notes due 2018 (the “2018 Notes”). On July 3, 2013, we issued $460.0 million of 4.00% Convertible Senior Notes due 2019 (the “2019 Notes”).
The following table details the conversion attributes of our Convertible Notes outstanding as of March 31, 2017 (amounts in thousands, except rates):
Conversion Spread Value - Shares (3)
Conversion
For the Three Months Ended March 31,
Price (2)
2017 Notes
41.7397
23.96
2018 Notes
47.5317
21.04
1,200
2019 Notes
50.2114
19.92
2,020
2023 Notes
38.5959
25.91
3,220
The conversion rate represents the number of shares of common stock issuable per $1,000 principal amount of Convertible Notes converted, as adjusted in accordance with the indentures governing the Convertible Notes (including the applicable supplemental indentures) as a result of the spin-off of our former single family residential segment to our stockholders in January 2014 and cash dividend payments.
As of March 31, 2017 and 2016, the market price of the Company’s common stock was $22.58 and $18.93 per share, respectively.
The conversion spread value represents the portion of the convertible senior notes that are “in-the-money”, representing the value that would be delivered to investors in shares upon an assumed conversion.
The if-converted value of the 2018 Notes and 2019 Notes exceeded their principal amount by $27.1 million and $45.6 million, respectively, at March 31, 2017 as the closing market price of the Company’s common stock of $22.58 per share exceeded the implicit conversion prices of $21.04 and $19.92 per share, respectively. However, the if‑converted value of the 2017 Notes and 2023 Notes was less than their principal amount by $23.7 million and $32.1 million, respectively, at March 31, 2017 as the closing market price of the Company’s common stock was less than the implicit conversion prices of $23.96 and $25.91 per share, respectively.
The Company has asserted its intent and ability to settle the principal amount of the Convertible Notes in cash. As such, only the conversion spread value, if any, is included in the computation of diluted EPS.
Conditions for Conversion
Prior to April 15, 2017 for the 2017 Notes, September 1, 2017 for the 2018 Notes, July 15, 2018 for the 2019 Notes and October 1, 2022 for the 2023 Notes, the Convertible Notes will be convertible only upon satisfaction of one or more of the following conditions: (1) the closing market price of the Company’s common stock is at least 110%, in the case of the 2017 Notes and the 2023 Notes, or 130%, in the case of the 2018 Notes and the 2019 Notes, of the conversion price of the respective Convertible Notes for at least 20 out of 30 trading days prior to the end of the preceding fiscal quarter, (2) the trading price of the Convertible Notes is less than 98% of the product of (i) the conversion rate and (ii) the closing price of the Company’s common stock during any five consecutive trading day period, (3) the Company issues certain equity instruments at less than the 10-day average closing market price of its common stock or the per-share value of certain distributions exceeds the market price of the Company’s common stock by more than 10% or (4) certain other specified corporate events (significant consolidation, sale, merger, share exchange, fundamental change, etc.) occur.
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On or after April 15, 2017, in the case of the 2017 Notes, September 1, 2017, in the case of the 2018 Notes, July 15, 2018, in the case of the 2019 Notes, and October 1, 2022, in the case of the 2023 Notes, holders may convert each of their Convertible Notes at the applicable conversion rate at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date.
11. Loan Securitization/Sale Activities
As described below, we regularly sell loans and notes under various strategies. We evaluate such sales as to whether they meet the criteria for treatment as a sale—legal isolation, ability of transferee to pledge or exchange the transferred assets without constraint, and transfer of control.
Within the Investing and Servicing Segment, we originate commercial mortgage loans with the intent to sell these mortgage loans to VIEs for the purposes of securitization. These VIEs then issue CMBS that are collateralized in part by these assets, as well as other assets transferred to the VIE. In certain instances, we retain a subordinated interest in the VIE and serve as special servicer for the VIE. The following summarizes the fair value and par value of loans sold from our conduit platform, as well as the amount of sale proceeds used in part to repay the outstanding balance of the repurchase agreements associated with these loans for the three months ended March 31, 2017 and 2016 (amounts in thousands):
Fair value of loans sold
Par value of loans sold
168,564
252,172
Repayment of repurchase agreements
126,518
189,207
Within the Lending Segment, we originate or acquire loans and then subsequently sell a portion, which can be in various forms including first mortgages, A-Notes, senior participations and mezzanine loans. Typically, our motivation for entering into these transactions is to effectively create leverage on the subordinated position that we will retain and hold for investment. In certain instances, we continue to service the loan following its sale. The following table summarizes our loans sold and loans transferred as secured borrowings by the Lending Segment net of expenses (amounts in thousands):
Loan Transfers
Loan Transfers Accounted
Accounted for as Secured
for as Sales
Face Amount
Proceeds
38,750
98,537
During the three months ended March 31, 2017 and 2016, gains (losses) recognized by the Lending Segment on sales of loans were not material.
12. Derivatives and Hedging Activity
Risk Management Objective of Using Derivatives
We are exposed to certain risks arising from both our business operations and economic conditions. Refer to Note 13 to the consolidated financial statements included in our Form 10-K for further discussion of our risk management objectives and policies.
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Designated Hedges
In connection with our repurchase agreements, we have entered into six outstanding interest rate swaps that have been designated as cash flow hedges of the interest rate risk associated with forecasted interest payments. As of March 31, 2017, the aggregate notional amount of our interest rate swaps designated as cash flow hedges of interest rate risk totaled $53.0 million. Under these agreements, we will pay fixed monthly coupons at fixed rates ranging from 0.60% to 1.52% of the notional amount to the counterparty and receive floating rate LIBOR. Our interest rate swaps designated as cash flow hedges of interest rate risk have maturities ranging from August 2017 to May 2021.
The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in AOCI and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three months ended March 31, 2017 and 2016, we did not recognize any hedge ineffectiveness in earnings.
Amounts reported in AOCI related to derivatives will be reclassified to interest expense as interest payments are made on the associated variable-rate debt. Over the next 12 months, we estimate that an immaterial amount will be reclassified as a decrease to interest expense. We are hedging our exposure to the variability in future cash flows for forecasted transactions over a maximum period of 50 months.
Non-designated Hedges
We have entered into a series of forward contracts whereby we agreed to sell an amount of foreign currency for an agreed upon amount of USD at various dates through July 2020. These forward contracts were entered into to economically fix the USD amounts of foreign denominated cash flows expected to be received by us related to certain foreign denominated loan investments and properties.
The following table summarizes our non-designated foreign exchange (“Fx”) forwards, interest rate swaps, interest rate caps and credit index instruments as of March 31, 2017 (notional amounts in thousands):
Type of Derivative
Number of Contracts
Aggregate Notional Amount
Notional Currency
Fx contracts – Buy Danish Krone ("DKK")
5,947
DKK
September 2017
Fx contracts – Buy Euros ("EUR")
1,728
EUR
Fx contracts – Buy Norwegian Krone ("NOK")
836
NOK
Fx contracts – Buy Swedish Krona ("SEK")
1,138
SEK
Fx contracts – Sell DKK
5,960
Fx contracts – Sell EUR (1)
293,552
May 2017 – June 2020
Fx contracts – Sell Pounds Sterling ("GBP")
130
215,690
GBP
April 2017 – July 2020
Fx contracts – Sell NOK
Fx contracts – Sell SEK
1,317
Interest rate swaps – Paying fixed rates
37
780,033
USD
April 2019 – April 2027
Interest rate swaps – Receiving fixed rates
8,000
July 2017
Interest rate caps
294,000
60,138
June 2018 – October 2021
Credit index instruments
34,000
September 2058 – November 2059
244
Includes 39 Fx contracts entered into to hedge our Euro currency exposure created by our acquisition of the Ireland Portfolio. As of March 31, 2017, these contracts have an aggregate notional amount of €236.7 million and varying maturities through June 2020.
The table below presents the fair value of our derivative financial instruments as well as their classification on the condensed consolidated balance sheets as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Fair Value of Derivatives
in an Asset Position (1) as of
in a Liability Position (2) as of
Derivatives designated as hedging instruments:
Interest rate swaps
Total derivatives designated as hedging instruments
Derivatives not designated as hedging instruments:
Interest rate swaps and caps
27,487
26,591
338
3,484
Foreign exchange contracts
42,461
62,295
1,215
364
1,030
445
Total derivatives not designated as hedging instruments
70,978
89,331
1,553
3,848
Total derivatives
Classified as derivative assets in our condensed consolidated balance sheets.
Classified as derivative liabilities in our condensed consolidated balance sheets.
The tables below present the effect of our derivative financial instruments on the condensed consolidated statements of operations and of comprehensive income for the three months ended March 31, 2017 and 2016 (amounts in thousands):
Gain (Loss)
Reclassified
Recognized
from AOCI
Derivatives Designated as Hedging Instruments
in OCI
into Income
in Income
Location of Gain (Loss)
(effective portion)
(ineffective portion)
Recognized in Income
47
(29)
(368)
(95)
Amount of Gain (Loss)
Recognized in Income for the
Derivatives Not Designated
Three Months Ended March 31,
as Hedging Instruments
Gain (loss) on derivative financial instruments
1,468
(18,000)
(5,742)
(6,550)
(75)
(168)
38
13. Offsetting Assets and Liabilities
The following tables present the potential effects of netting arrangements on our financial position for financial assets and liabilities within the scope of ASC 210-20, Balance Sheet—Offsetting, which for us are derivative assets and liabilities as well as repurchase agreement liabilities (amounts in thousands):
(iv)
Gross Amounts Not
Offset in the Statement
(ii)
(iii) = (i) - (ii)
of Financial Position
Gross Amounts
Net Amounts
Cash
Offset in the
Presented in
Collateral
Statement of
the Statement of
Financial
Received /
(v) = (iii) - (iv)
Financial Position
Instruments
Pledged
Net Amount
1,323
69,717
Repurchase agreements
2,718,609
2,718,365
491
88,870
3,413
2,480,181
2,476,768
14. Variable Interest Entities
Investment Securities
As discussed in Note 2, we evaluate all of our investments and other interests in entities for consolidation, including our investments in CMBS and our retained interests in securitization transactions we initiated, all of which are generally considered to be variable interests in VIEs.
Securitization VIEs consolidated in accordance with ASC 810 are structured as pass through entities that receive principal and interest on the underlying collateral and distribute those payments to the certificate holders. The assets and other instruments held by these securitization entities are restricted and can only be used to fulfill the obligations of the entity. Additionally, the obligations of the securitization entities do not have any recourse to the general credit of any other consolidated entities, nor to us as the primary beneficiary. The VIE liabilities initially represent investment securities on our balance sheet (pre-consolidation). Upon consolidation of these VIEs, our associated investment securities are eliminated, as is the interest income related to those securities. Similarly, the fees we earn in our roles as special servicer of the bonds issued by the consolidated VIEs or as collateral administrator of the consolidated VIEs are also eliminated. Finally, an allocable portion of the identified servicing intangible associated with the eliminated fee streams is eliminated in consolidation.
VIEs in which we are the Primary Beneficiary
The inclusion of the assets and liabilities of securitization VIEs in which we are deemed the primary beneficiary has no economic effect on us. Our exposure to the obligations of securitization VIEs is generally limited to our investment in these entities. We are not obligated to provide, nor have we provided, any financial support for any of these consolidated structures.
We also hold controlling interests in certain other entities that are considered VIEs, which were established to facilitate the purchase of certain properties acquired with third party minority interest partners. We are the primary beneficiaries of these VIEs as we possess both the power to direct the activities of the VIEs that most significantly
39
impact their economic performance and hold significant economic interests. These VIEs had assets of $180.9 million and liabilities of $117.5 million as of March 31, 2017.
VIEs in which we are not the Primary Beneficiary
In certain instances, we hold a variable interest in a VIE in the form of CMBS, but either (i) we are not appointed, or do not serve as, special servicer or (ii) an unrelated third party has the rights to unilaterally remove us as special servicer without cause. In these instances, we do not have the power to direct activities that most significantly impact the VIE’s economic performance. In other cases, the variable interest we hold does not obligate us to absorb losses or provide us with the right to receive benefits from the VIE which could potentially be significant. For these structures, we are not deemed to be the primary beneficiary of the VIE, and we do not consolidate these VIEs.
As of March 31, 2017, one of our CDO structures was in default, which, pursuant to the underlying indentures, changes the rights of the variable interest holders. Upon default of a CDO, the trustee or senior note holders are allowed to exercise certain rights, including liquidation of the collateral, which at that time, is the activity which would most significantly impact the CDO’s economic performance. Further, when the CDO is in default, the collateral administrator no longer has the option to purchase securities from the CDO. In cases where the CDO is in default and we do not have the ability to exercise rights which would most significantly impact the CDO’s economic performance, we do not consolidate the VIE. As of March 31, 2017, this CDO structure was not consolidated.
As noted above, we are not obligated to provide, nor have we provided, any financial support for any of our securitization VIEs, whether or not we are deemed to be the primary beneficiary. As such, the risk associated with our involvement in these VIEs is limited to the carrying value of our investment in the entity. As of March 31, 2017, our maximum risk of loss related to securitization VIEs in which we were not the primary beneficiary was $15.5 million on a fair value basis.
As of March 31, 2017, the securitization VIEs which we do not consolidate had debt obligations to beneficial interest holders with unpaid principal balances of $8.5 billion. The corresponding assets are comprised primarily of commercial mortgage loans with unpaid principal balances corresponding to the amounts of the outstanding debt obligations.
We also hold passive non-controlling interests in certain unconsolidated entities that are considered VIEs. We are not the primary beneficiaries of these VIEs as we do not possess the power to direct the activities of the VIEs that most significantly impact their economic performance and therefore report our interests, which totaled $134.5 million as of March 31, 2017, within investment in unconsolidated entities on our condensed consolidated balance sheet. Our maximum risk of loss is limited to our carrying value of the investments of $134.5 million plus $15.5 million of unfunded commitments related to one of these VIEs.
15. Related-Party Transactions
Management Agreement
We are party to a management agreement (the “Management Agreement”) with our Manager. Under the Management Agreement, our Manager, subject to the oversight of our board of directors, is required to manage our day to day activities, for which our Manager receives a base management fee and is eligible for an incentive fee and stock awards. Our Manager’s personnel perform certain due diligence, legal, management and other services that outside professionals or consultants would otherwise perform. As such, in accordance with the terms of our Management Agreement, our Manager is paid or reimbursed for the documented costs of performing such tasks, provided that such costs and reimbursements are in amounts no greater than those which would be payable to outside professionals or consultants engaged to perform such services pursuant to agreements negotiated on an arm’s-length basis. Refer to Note 16 to the consolidated financial statements included in our Form 10-K for further discussion of this agreement.
Base Management Fee. For the three months ended March 31, 2017 and 2016, approximately $16.9 million and $15.1 million, respectively, was incurred for base management fees. As of March 31, 2017 and December 31, 2016,
40
there were $16.9 million and $15.7 million, respectively, of unpaid base management fees included in related-party payable in our condensed consolidated balance sheets.
Incentive Fee. For the three months ended March 31, 2017 and 2016, approximately $5.5 million and $4.6 million, respectively, was incurred for incentive fees. As of March 31, 2017 and December 31, 2016, approximately $5.4 million and $19.0 million, respectively, of unpaid incentive fees were included in related-party payable in our condensed consolidated balance sheets.
Expense Reimbursement. For the three months ended March 31, 2017 and 2016, approximately $1.6 million and $1.1 million, respectively, was incurred for executive compensation and other reimbursable expenses and recognized within general and administrative expenses in our condensed consolidated statements of operations. As of March 31, 2017 and December 31, 2016, approximately $3.7 million and $3.0 million, respectively, of unpaid reimbursable executive compensation and other expenses were included in related-party payable in our condensed consolidated balance sheets.
Equity Awards. In certain instances, we issue RSAs to certain employees of affiliates of our Manager who perform services for us. During the three months ended March 31, 2017 and 2016, we granted 138,264 and 162,546 RSAs, respectively, at grant date fair values of $3.1 million for both periods. Expenses related to the vesting of awards to employees of affiliates of our Manager were $0.6 million and $0.4 million during the three months ended March 31, 2017 and 2016, respectively, and are reflected in general and administrative expenses in our condensed consolidated statements of operations. These shares generally vest over a three-year period.
Manager Equity Plan
In March 2017, we granted 1,000,000 RSUs to our Manager under the Starwood Property Trust, Inc. Manager Equity Plan (“Manager Equity Plan”). In May 2015, we granted 675,000 RSUs to our Manager under the Manager Equity Plan. In connection with these grants and prior similar grants, we recognized share-based compensation expense of $1.5 million and $4.8 million within management fees in our condensed consolidated statements of operations for the three months ended March 31, 2017 and 2016, respectively. Refer to Note 16 for further discussion of these grants.
Investments in Loans and Securities
In March 2017, we were fully repaid $59.0 million upon the maturity of a subordinate single-borrower CMBS that we acquired in March 2015. The bond was secured by 85 U.S. hotel properties, and the borrower was an affiliate of Starwood Distressed Opportunity Fund IX, an affiliate of our Manager.
Refer to Note 16 to the consolidated financial statements included in our Form 10-K for further discussion of related-party agreements.
41
16. Stockholders’ Equity
During the three months ended March 31, 2017, our board of directors declared the following dividend:
Declaration Date
Record Date
Ex-Dividend Date
Payment Date
Frequency
2/23/17
3/31/17
3/29/17
4/14/17
0.48
Quarterly
During the three months ended March 31, 2017 and 2016, there were no shares issued under our At-The-Market Equity Offering Sales Agreement. During the three months ended March 31, 2017 and 2016, shares issued under the Starwood Property Trust, Inc. Dividend Reinvestment and Direct Stock Purchase Plan (the “DRIP Plan”) were not material.
In February 2017, our board of directors extended the term of our $500.0 million common stock and Convertible Note repurchase program through January 2019. Refer to Note 17 to the consolidated financial statements included in our Form 10-K for further information regarding the repurchase program. During the three months ended March 31, 2016, we repurchased 1,052,889 shares of common stock for $19.7 million and no Convertible Notes under our repurchase program. There were no share repurchases or Convertible Note repurchases under the repurchase program during the three months ended March 31, 2017. The repurchase of the 2018 Notes discussed in Note 10 was not considered part of the repurchase program and therefore does not reduce our available capacity for future repurchases under the repurchase program. As of March 31, 2017, we had $262.2 million of remaining capacity to repurchase common stock and/or Convertible Notes under the repurchase program through January 2019.
Equity Incentive Plans
The Company currently maintains the Manager Equity Plan, the Starwood Property Trust, Inc. Equity Plan (the “Equity Plan”), and the Starwood Property Trust, Inc. Non-Executive Director Stock Plan (“Non-Executive Director Stock Plan”). Refer to Note 17 to the consolidated financial statements included in our Form 10-K for further information regarding these plans.
The table below summarizes our share awards granted or vested under the Manager Equity Plan during the three months ended March 31, 2017 and 2016 (dollar amounts in thousands):
Grant Date
Type
Amount Granted
Grant Date Fair Value
Vesting Period
March 2017
RSU
1,000,000
22,240
3 years
May 2015
675,000
16,511
January 2014
489,281
14,776
2,000,000
55,420
As of March 31, 2017, there were 0.8 million shares available for future grants under the Manager Equity Plan, the Equity Plan and the Non-Executive Director Stock Plan.
Schedule of Non-Vested Shares and Share Equivalents
Non-Executive
Weighted Average
Director
Manager
Stock Plan
Equity Plan
(per share)
17,788
521,336
281,250
820,374
22.34
Granted
470,469
1,470,469
22.25
Vested
(178,136)
(56,250)
(234,386)
21.56
Forfeited
(12,340)
23.32
801,329
1,225,000
2,044,117
22.36
42
17. Earnings per Share
The following table provides a reconciliation of net income and the number of shares of common stock used in the computation of basic EPS and diluted EPS (amounts in thousands, except per share amounts):
Basic Earnings
Income attributable to STWD common stockholders
Less: Income attributable to participating shares
(899)
(708)
Basic earnings
101,459
25,949
Diluted Earnings
Basic — Income attributable to STWD common stockholders
Add: Undistributed earnings to participating shares
Less: Undistributed earnings reallocated to participating shares
Diluted earnings
Number of Shares:
Basic — Average shares outstanding
258,997
236,556
Effect of dilutive securities — Convertible Notes
Effect of dilutive securities — Contingently issuable shares
121
Effect of dilutive securities — Unvested non-participating shares
103
Diluted — Average shares outstanding
262,441
236,759
Earnings Per Share Attributable to STWD Common Stockholders:
0.39
0.11
As of March 31, 2017 and 2016, participating shares of 1.9 million and 1.5 million, respectively, were excluded from the computation of diluted shares as their effect was already considered under the more dilutive two-class method used above.
Additionally, as of March 31, 2017, there were 61.6 million potential shares of common stock contingently issuable upon the conversion of the Convertible Notes. The Company has asserted its intent and ability to settle the principal amount of the Convertible Notes in cash. As a result, this principal amount, representing 58.4 million shares at March 31, 2017, was not included in the computation of diluted EPS. However, as discussed in Note 10, the conversion options associated with the 2018 Notes and 2019 Notes are “in-the-money” as the if-converted values of the 2018 Notes and 2019 Notes exceeded their principal amounts by $27.1 million and $45.6 million, respectively, at March 31, 2017. The dilutive effect to EPS is determined by dividing this “conversion spread value” by the average share price. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the Convertible Notes, upon an assumed conversion. In calculating the dilutive effect of these shares, the treasury stock method was used and resulted in a dilution of 3.2 million shares for the three months ended March 31, 2017. The conversion options associated with the 2017 Notes and 2023 Notes are “out-of-the-money” because the if-converted values of the 2017 Notes and 2023 Notes were less than their principal amount by $23.7 million and $32.1 million, respectively, at March 31, 2017; therefore, there was no dilutive effect to EPS for the 2017 Notes and 2023 Notes.
43
18. Accumulated Other Comprehensive Income
The changes in AOCI by component are as follows (amounts in thousands):
Cumulative
Unrealized Gain
Effective Portion of
(Loss) on
Foreign
Cumulative Loss on
Available-for-
Currency
Cash Flow Hedges
Sale Securities
Translation
Balance at January 1, 2017
(26)
(8,765)
OCI before reclassifications
1,931
3,985
Amounts reclassified from AOCI
Net period OCI
Balance at March 31, 2017
50
(6,758)
Balance at January 1, 2016
(65)
37,307
(7,513)
3,633
95
Balance at March 31, 2016
(338)
33,907
(112)
The reclassifications out of AOCI impacted the condensed consolidated statements of operations for the three months ended March 31, 2017 and 2016 as follows (amounts in thousands):
Amounts Reclassified from
AOCI during the Three Months
Affected Line Item
Ended March 31,
in the Statements
Details about AOCI Components
of Operations
Losses on cash flow hedges:
Interest rate contracts
Unrealized gains on available-for-sale securities:
Interest realized upon collection
85
Total reclassifications for the period
19. Fair Value
GAAP establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial assets and liabilities at fair value. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below:
Level I—Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
Level II—Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.
Level III—Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
44
Valuation Process
We have valuation control processes in place to validate the fair value of the Company’s financial assets and liabilities measured at fair value including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. Refer to Note 20 to the consolidated financial statements included in our Form 10-K for further discussion of our valuation process.
We determine the fair value of our assets and liabilities measured at fair value on a recurring and nonrecurring basis in accordance with the methodology described in our Form 10-K.
Fair Value Disclosures
The following tables present our financial assets and liabilities carried at fair value on a recurring basis in the condensed consolidated balance sheets by their level in the fair value hierarchy as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Level I
Level II
Level III
Financial Assets:
15,472
Equity security
Domestic servicing rights
VIE assets
60,921,252
60,837,657
Financial Liabilities:
VIE liabilities
56,985,773
2,161,295
59,148,635
56,987,340
31,546
67,628,621
67,527,083
63,545,223
2,585,369
66,134,496
63,549,127
45
The changes in financial assets and liabilities classified as Level III are as follows for the three months ended March 31, 2017 and 2016 (amounts in thousands):
VIE
Held‑for‑sale
VIE Assets
Liabilities
January 1, 2017 balance
(2,585,369)
64,941,714
Total realized and unrealized gains (losses):
Included in earnings:
Change in fair value / gain on sale
(1,343)
(6,537,225)
384,981
(6,151,427)
Net accretion
3,886
Included in OCI
Purchases / Originations
445,887
(179,296)
(10,434)
(189,730)
Issuances
(4,759)
Cash repayments / receipts
(197)
(10,228)
(5,766)
(30,796)
(46,987)
Transfers into Level III
(63,970)
Transfers out of Level III
129,452
Consolidation of VIEs
Deconsolidation of VIEs
1,469
(1,528,137)
9,166
(1,517,502)
March 31, 2017 balance
(2,161,295)
58,676,362
Amount of total (losses) gains included in earnings attributable to assets still held at March 31, 2017
(6)
3,795
248
(6,156,640)
January 1, 2016 balance
203,865
176,224
212,981
119,698
76,675,689
(2,552,448)
74,836,009
Impact of ASU 2015-02 adoption (1)
(17,467)
17,467
967
(4,089,501)
236,123
(3,852,259)
3,415
200,570
275,213
(256,964)
(596)
(137)
(6,811)
(12,303)
5,850
(13,401)
(415,044)
110,965
(138,342)
(430,653)
14,534,280
(2,591,268)
7,269
(2,583,751)
March 31, 2016 balance
154,225
210,898
96,724
95,492
85,115,662
(3,038,534)
82,634,467
Amount of total gains (losses) included in earnings attributable to assets still held at March 31, 2016
2,162
1,499
(3,853,041)
Our implementation of ASU 2015-02 resulted in the consolidation of certain CMBS trusts effective January 1, 2016, which required the elimination of $17.5 million of domestic servicing rights associated with these newly consolidated trusts.
Amounts were transferred from Level II to Level III due to a decrease in the observable relevant market activity and amounts were transferred from Level III to Level II due to an increase in the observable relevant market activity.
46
The following table presents the fair values, all of which are classified in Level III of the fair value hierarchy, of our financial instruments not carried at fair value on the condensed consolidated balance sheets (amounts in thousands):
Fair
Financial assets not carried at fair value:
Loans held-for-investment and loans transferred as secured borrowings
6,265,819
6,320,782
5,882,995
5,934,219
HTM securities
Financial liabilities not carried at fair value:
Secured financing agreements and secured borrowings on transferred loans
4,449,917
4,446,571
4,189,126
4,198,136
Unsecured senior notes
2,092,717
2,088,374
The following is quantitative information about significant unobservable inputs in our Level III measurements for those assets and liabilities measured at fair value on a recurring basis (dollars in thousands):
Valuation
Unobservable
Range as of (1)
Technique
Input
Discounted cash flow
Yield (b)
4.7% - 5.5%
5.0% - 5.7%
Duration (c)
1.7 - 11.3 years
10.0 years
Constant prepayment rate (a)
2.3% - 20.1%
2.8% - 17.0%
Constant default rate (b)
1.0% - 7.3%
1.1% - 8.1%
Loss severity (b)
23% - 83% (e)
12% - 79% (e)
Delinquency rate (c)
4% - 32%
2% - 29%
Servicer advances (a)
18% - 83%
23% - 94%
Annual coupon deterioration (b)
0% - 0.8%
0% - 0.6%
Putback amount per projected total collateral loss (d)
0% - 15%
0% - 147.9%
0% - 172.0%
0 - 8.9 years
0 - 18.7 years
Debt yield (a)
7.75%
Discount rate (b)
15%
Control migration (b)
0% - 80%
0% - 578.7%
0% - 960.4%
0 - 11.8 years
0 - 12.0 years
The ranges of significant unobservable inputs are represented in percentages and years.
Sensitivity of the Fair Value to Changes in the Unobservable Inputs
Significant increase (decrease) in the unobservable input in isolation would result in a significantly higher (lower) fair value measurement.
Significant increase (decrease) in the unobservable input in isolation would result in a significantly lower (higher) fair value measurement.
Significant increase (decrease) in the unobservable input in isolation would result in either a significantly lower or higher (higher or lower) fair value measurement depending on the structural features of the security in question.
Any delay in the putback recovery date leads to a decrease in fair value for the majority of securities in our RMBS portfolio.
86% and 57% of the portfolio falls within a range of 45%-80% as of March 31, 2017 and December 31, 2016, respectively.
20. Income Taxes
Certain of our subsidiaries have elected to be treated as taxable REIT subsidiaries (“TRSs”). TRSs permit us to participate in certain activities from which REITs are generally precluded, as long as these activities meet specific criteria, are conducted within the parameters of certain limitations established by the Code, and are conducted in entities which elect to be treated as taxable subsidiaries under the Code. To the extent these criteria are met, we will continue to maintain our qualification as a REIT.
Our TRSs engage in various real estate related operations, including special servicing of commercial real estate, originating and securitizing commercial mortgage loans, and investing in entities which engage in real estate related operations. The majority of our TRSs are held within the Investing and Servicing Segment. As of March 31, 2017 and December 31, 2016, approximately $621.1 million and $634.4 million, respectively, of the Investing and Servicing Segment’s assets, including $23.6 million and $181.0 million in cash, respectively, were owned by TRS entities. Our TRSs are not consolidated for U.S. federal income tax purposes, but are instead taxed as corporations. For financial reporting purposes, a provision for current and deferred taxes is established for the portion of earnings recognized by us with respect to our interest in TRSs.
The following table is a reconciliation of our U.S. federal income tax determined using our statutory federal tax rate to our reported income tax (benefit) provision for the three months ended March 31, 2017 and 2016 (dollars in thousands):
Federal statutory tax rate
35,655
35.0
9,499
REIT and other non-taxable income
(36,425)
(35.8)
(8,964)
(33.0)
State income taxes
(139)
(0.1)
(0.4)
Federal benefit of state tax deduction
49
0.1
Valuation allowance
(123)
(379)
(1.4)
Effective tax rate
(1.0)
94
0.3
21. Commitments and Contingencies
As of March 31, 2017, we had future funding commitments on 55 loans totaling $1.5 billion, of which we expect to fund $1.3 billion. These future funding commitments primarily relate to construction projects, capital improvements, tenant improvements and leasing commissions. Generally, funding commitments are subject to certain conditions that must be met, such as customary construction draw certifications, minimum debt service coverage ratios or executions of new leases before advances are made to the borrower.
Management is not aware of any other contractual obligations, legal proceedings, or any other contingent obligations incurred in the normal course of business that would have a material adverse effect on our condensed consolidated financial statements.
22. Segment Data
In its operation of the business, management, including our chief operating decision maker, who is our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis prior to the impact of consolidating securitization VIEs under ASC 810. The segment information within this note is reported on that basis.
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The table below presents our results of operations for the three months ended March 31, 2017 by business segment (amounts in thousands):
Investing
Lending
and Servicing
Segment
Corporate
Subtotal
VIEs
109,046
2,837
12,719
34,836
47,555
(32,331)
210
30,081
30,291
(16,189)
12,189
44,853
79
464
588
(119)
122,054
80,407
44,898
247,359
(48,639)
454
23,862
24,334
19,957
4,358
10,207
31,607
66,129
(269)
4,211
22,580
1,381
2,170
30,342
87
515
(16)
172
5,487
15,391
5,054
17,157
24,849
38,239
44,308
57,639
165,035
(132)
Income (loss) before other income (loss), income taxes and non-controlling interests
97,205
42,168
590
(57,639)
82,324
(48,507)
(9,637)
1,204
19,045
19,217
(20,388)
470
1,017
2,461
3,948
(961)
Loss on sale of investments and other assets, net
(Loss) gain on derivative financial instruments, net
(4,535)
697
(511)
Foreign currency gain, net
4,863
22,081
1,950
19,029
49,025
Income (loss) before income taxes
98,119
64,249
2,540
(63,555)
101,353
518
Income tax (provision) benefit
(215)
1,198
Net income (loss)
97,904
65,447
102,336
Net (income) loss attributable to non-controlling interests
(354)
376
(518)
Net income (loss) attributable to Starwood Property Trust, Inc.
97,550
65,823
The table below presents our results of operations for the three months ended March 31, 2016 by business segment (amounts in thousands):
114,658
2,874
9,628
47,626
57,254
(37,851)
159
36,218
36,377
(11,686)
6,475
26,202
1,342
1,371
(181)
124,468
94,535
26,208
245,211
(49,718)
375
24,528
24,921
22,335
3,238
4,949
25,998
3,922
25,294
2,850
32,621
177
355
592
3,062
9,593
3,051
15,709
26,209
35,118
31,398
53,376
146,101
219
Income (loss) before other (loss) income, income taxes and non-controlling interests
98,259
59,417
(5,190)
(53,376)
99,110
(49,937)
Other (loss) income:
(8,670)
(214)
(51,528)
(51,742)
52,495
468
1,377
2,429
4,274
(209)
Gain on sale of investments and other assets, net
(3,026)
(11,245)
(10,447)
Foreign currency (loss) gain, net
(1,822)
1,460
422
1,550
Total other (loss) income
(61,672)
(7,612)
(72,083)
50,050
93,910
(2,255)
(12,802)
(51,826)
27,027
113
Income tax provision
(19)
93,835
(2,274)
26,933
(350)
74
(276)
(113)
93,485
(2,200)
The table below presents our condensed consolidated balance sheet as of March 31, 2017 by business segment (amounts in thousands):
654
46,711
15,048
158,869
221,282
1,236
19,784
10,349
9,883
6,210,717
20,102
189,334
150,932
714,699
277,253
1,660,715
111,728
123,399
235,127
(33,033)
31,125
53,974
125,307
210,406
(8,583)
26,594
1,713
42,733
31,950
809
17,775
51,043
40,373
1,497
110,688
(2,709)
VIE assets, at fair value
7,277,632
1,880,197
2,017,458
160,366
11,335,653
59,143,088
23,132
43,985
57,615
25,750
150,482
923
25,903
1,113
2,485,056
450,181
1,207,281
296,099
4,438,617
(23,700)
2,544,301
494,714
1,264,896
2,507,184
6,811,095
59,124,291
2,391,134
917,208
713,255
668,101
Treasury stock
Accumulated other comprehensive income (loss)
46,825
(396)
(6,362)
Retained earnings (accumulated deficit)
2,284,352
456,742
45,669
(2,925,463)
4,722,311
1,373,554
752,562
(2,346,818)
11,020
11,929
22,949
18,797
4,733,331
1,385,483
4,524,558
51
The table below presents our condensed consolidated balance sheet as of December 31, 2016 by business segment (amounts in thousands):
7,085
38,798
7,701
560,790
614,374
1,148
17,885
8,202
9,146
5,827,553
20,442
776,072
277,612
1,667,108
125,327
128,159
253,486
(34,238)
30,874
56,376
212,227
(7,622)
45,282
1,186
42,893
25,831
2,393
13,470
59,503
29,569
1,866
104,408
(2,645)
6,779,052
1,784,125
2,009,553
562,656
11,135,386
66,120,880
20,769
68,603
81,873
26,003
197,248
886
440
37,378
3,388
516
2,258,462
426,683
1,196,830
295,851
4,177,826
2,317,619
496,242
1,278,703
2,495,851
6,588,415
66,107,778
2,218,671
883,761
696,049
892,699
44,903
(437)
(8,328)
2,186,727
390,994
43,129
(2,736,429)
4,450,301
1,274,318
730,850
(1,933,195)
11,132
13,565
24,697
13,102
4,461,433
1,287,883
4,546,971
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23. Subsequent Events
Our significant events subsequent to March 31, 2017 were as follows:
2017 Equity Plans
In May 2017, the Company’s shareholders approved the 2017 Manager Equity Plan and 2017 Equity Plan (collectively, the “2017 Plans”) which allow for the issuance of up to 11,000,000 stock options, stock appreciation rights, RSAs, RSUs or other equity-based awards or any combination thereof to the Manager, directors, employees, consultants or any other party providing services to the Company. The 2017 Plans replace the Manager Equity Plan, Equity Plan and Non-Executive Director Stock Plan.
Dividend Declaration
On May 9, 2017, our board of directors declared a dividend of $0.48 per share for the second quarter of 2017, which is payable on July 14, 2017 to common stockholders of record as of June 30, 2017.
53
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with the information included elsewhere in this Quarterly Report on Form 10-Q and in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (the “Form 10-K”). This discussion contains forward-looking statements that involve risks and uncertainties. Actual results could differ significantly from the results discussed in the forward-looking statements. See “Special Note Regarding Forward-Looking Statements” at the beginning of this Quarterly Report on Form 10-Q.
Overview
Refer to Note 1 of our condensed consolidated financial statements included herein (the “Condensed Consolidated Financial Statements”) for further discussion of our business and organization.
Developments During the First Quarter of 2017
The Lending Segment originated or acquired the following loans during the quarter:
o
$250.0 million first mortgage and mezzanine loan for the refinancing and renovation of two adjoined 12-floor office buildings located in Washington, D.C., of which the Company funded $135.7 million.
$223.6 million first mortgage and mezzanine loan for the development of a waterfront residential community located in Glen Cove, New York. The $160.0 million first mortgage was subsequently sold during the quarter and the mezzanine loan was unfunded as of March 31, 2017.
$175.0 million first mortgage and mezzanine loan for the acquisition of a portfolio of four office buildings located in Tysons Corner, Virginia, of which the Company funded $171.0 million.
$100.0 million first mortgage and mezzanine loan for the acquisition of a 23-building predominantly office property located in Alhambra, California, of which the Company funded $84.5 million.
$73.0 million first mortgage and mezzanine loan for the final stage development of a 347-key full-service hotel and conference center located in Renton, Washington, of which the Company funded $40.0 million.
Funded $141.6 million of previously originated loan commitments.
Received proceeds of $268.0 million from maturities, sales and principal repayments on loans held-for-investment.
Added conduit loans of $256.5 million and received proceeds of $179.3 million from sales of conduit loans.
Purchased one new issue B-piece for $57.4 million, representing the first horizontal risk retention deal.
Named special servicer on two new issue CMBS deals, one of which we retained the related B-piece, with a total unpaid principal balance of $1.7 billion at issuance.
Issued $250.0 million of 4.375% Convertible Senior Notes due 2023 (the “2023 Notes”) and utilized the proceeds to repurchase $230.0 million aggregate principal amount of our 2018 Notes for $250.7 million, recognizing a loss on extinguishment of debt of $5.9 million.
Subsequent Events
Refer to Note 23 to the Condensed Consolidated Financial Statements for disclosure regarding significant transactions that occurred subsequent to March 31, 2017.
55
Results of Operations
The discussion below is based on accounting principles generally accepted in the United States of America (“GAAP”) and therefore reflects the elimination of certain key financial statement line items related to the consolidation of securitization variable interest entities (“VIEs”), particularly within revenues and other income, as discussed in Note 2 to the Condensed Consolidated Financial Statements. For a discussion of our results of operations excluding the impact of Accounting Standards Codification (“ASC”) Topic 810 as it relates to the consolidation of securitization VIEs, refer to the Non-GAAP Financial Measures section herein.
The following table compares our summarized results of operations for the three months ended March 31, 2017 and 2016 by business segment (amounts in thousands):
Change
Lending Segment
(2,414)
(14,128)
18,690
Investing and Servicing VIEs
1,079
3,227
(1,360)
3,121
12,910
4,263
(351)
18,583
5,263
83,753
9,562
(7,466)
(1,025)
90,087
Income (loss) before income taxes:
4,209
66,504
15,342
(11,729)
405
74,731
1,077
(107)
75,701
Three Months Ended March 31, 2017 Compared to the Three Months Ended March 31, 2016
Revenues
For the three months ended March 31, 2017, revenues of our Lending Segment decreased $2.4 million to $122.1 million, compared to $124.5 million for the three months ended March 31, 2016. This decrease was primarily due to (i) a
$5.6 million decrease in interest income from loans principally reflecting a gradual decline of interest rate spreads on new loans versus loans repaid during the preceding twelve months, partially offset by (ii) a $3.1 million increase in interest income from investment securities reflecting an increase in CMBS and RMBS investments between March 31, 2016 and 2017.
Costs and Expenses
For the three months ended March 31, 2017, costs and expenses of our Lending Segment decreased $1.4 million to $24.8 million, compared to $26.2 million for the three months ended March 31, 2016. This decrease was primarily due to a decrease in interest expense associated with the various secured financing facilities used to fund a portion of our investment portfolio.
Net Interest Income (amounts in thousands)
(5,612)
3,091
(19,957)
(22,335)
2,378
Net interest income
101,808
101,951
(143)
For the three months ended March 31, 2017, net interest income of our Lending Segment decreased $0.1 million to $101.8 million, compared to $101.9 million for the three months ended March 31, 2016. This decrease reflects the net decrease in interest income explained in the Revenues discussion above and the decrease in interest expense on our secured financing facilities.
During the three months ended March 31, 2017 and 2016, the weighted average unlevered yields on the Lending Segment’s loans and investment securities were 7.1% and 7.3%, respectively. The slight decrease in the weighted average unlevered yield is primarily due to a gradual decline of interest rate spreads over the last twelve months.
During the three months ended March 31, 2017 and 2016, the Lending Segment’s weighted average secured borrowing rates, inclusive of interest rate hedging costs and the amortization of deferred financing fees, were 3.6% and 3.4%, respectively, and 3.5% and 3.2%, respectively, excluding the impact of bridge financing. The increases in borrowing rates primarily reflects increases in LIBOR.
Other Income (Loss)
For the three months ended March 31, 2017, other income (loss) of our Lending Segment increased $5.3 million to income of $0.9 million, compared to a loss of $4.4 million for the three months ended March 31, 2016. The increase was primarily due to a $6.7 million favorable change in foreign currency gain (loss), partially offset by a $1.5 million increased loss on derivatives. The increase in loss on derivatives reflects an $8.0 million unfavorable change on foreign currency hedges, partially offset by a $6.5 million favorable change in interest rate swaps. The foreign currency hedges are used to fix the U.S. dollar amounts of cash flows (both interest and principal payments) we expect to receive from our foreign currency denominated loans and CMBS investments. The favorable change in foreign currency gain (loss) and the unfavorable change on the foreign currency hedges reflect the overall weakening of the U.S. dollar against the pound sterling (“GBP”) in the first quarter of 2017 versus a strengthening of the U.S. dollar in the first quarter of 2016. The interest rate swaps are used primarily to fix our interest rate payments on certain variable rate borrowings which fund fixed rate investments.
57
Investing and Servicing Segment and VIEs
For the three months ended March 31, 2017, revenues of our Investing and Servicing Segment decreased $13.0 million to $31.8 million after consolidated VIE eliminations of $48.6 million, compared to $44.8 million after consolidated VIE eliminations of $49.7 million for the three months ended March 31, 2016. The VIE eliminations are merely a function of the number of CMBS trusts consolidated in any given period, and as such, are not a meaningful indicator of the operating results for this segment. The decrease in revenues in the first quarter of 2017 was primarily due to decreases of $10.6 million in servicing fees and $7.3 million in interest income from CMBS investments, partially offset by a $5.7 million increase in rental income on our expanded REO Portfolio (see Note 3 to the Condensed Consolidated Financial Statements). The $7.3 million decrease in CMBS interest income reflects a $5.5 million decrease in VIE eliminations related to the CMBS trusts we consolidate. Excluding the effect of these eliminations, CMBS interest income decreased by $12.8 million, reflecting a lower level of CMBS interest recoveries due to fewer asset liquidations by CMBS trusts.
For the three months ended Mach 31, 2017, costs and expenses of our Investing and Servicing Segment increased $2.8 million to $38.1 million, compared to $35.3 million for the three months ended March 31, 2016, inclusive of VIE eliminations which were nominal for both periods. The increase in costs and expenses was primarily due to increases of $2.4 million in costs of rental operations and $2.0 million in depreciation and amortization, partially offset by a $2.8 million decrease in general and administrative (“G&A”) expenses reflecting lower compensation costs.
For the three months ended March 31, 2017 other income (loss) of our Investing and Servicing Segment increased $82.7 million to income of $71.1 million including additive net VIE eliminations of $49.0 million, from a loss of $11.6 million including additive net VIE eliminations of $50.0 million for the three months ended March 31, 2016. The increase in other income in the first quarter of 2017 compared to the first quarter of 2016 was primarily due to (i) a $73.3 million increase in the change in value of net assets related to consolidated VIEs and (ii) an $11.9 million favorable change in gain (loss) on derivatives which principally hedge our interest rate risk on conduit loans. The change in net assets related to consolidated VIEs reflects amounts associated with the Investing and Servicing Segment’s variable interests in CMBS trusts it consolidates, including special servicing fees, interest income, and changes in fair value of CMBS and servicing rights. As noted above, this number is merely a function of the number of CMBS trusts consolidated in any given period, and as such, is not a meaningful indicator of the operating results for this segment. Before VIE eliminations, there was an increase in fair value of CMBS securities of $19.0 million and a decrease of $51.5 million in the three months ended March 31, 2017 and 2016, respectively.
Income Tax Benefit (Provision)
Historically, our consolidated income tax provision principally relates to the taxable nature of the Investing and Servicing Segment’s loan servicing and loan conduit businesses which are housed in TRSs. For the three months ended March 31, 2017 we had a tax benefit of $1.0 million compared to a provision of $0.1 million in the three months ended March 31, 2016. The change primarily reflects a decrease in the taxable income of our TRSs.
For the three months ended March 31, 2017, revenues of our Property Segment increased $18.7 million to $44.9 million, compared to $26.2 million for the three months ended March 31, 2016. The increase in revenues in the first quarter of 2017 was primarily due to the full period inclusion of rental income for the Medical Office Portfolio, which was acquired in December 2016, and the Woodstar Portfolio, which was acquired from October 2015 through April 2016 (see Note 3 to the Condensed Consolidated Financial Statements).
58
For the three months ended March 31, 2017, costs and expenses of our Property Segment increased $12.9 million to $44.3 million, compared to $31.4 million for the three months ended March 31, 2016. The increase in costs and expenses was primarily due to the full period inclusion of the Medical Office and Woodstar Portfolios and reflected increases of $1.4 million in depreciation and amortization, $5.8 million in other rental related costs and $5.3 million in interest expense primarily on the secured financing for the Medical Office Portfolio.
For the three months ended March 31, 2017, other income (loss) of our Property Segment increased $9.6 million to income of $2.0 million, compared to a loss of $7.6 million for the three months ended March 31, 2016. The increase in other income (loss) was primarily due to a decreased loss on derivatives primarily related to foreign exchange contracts which economically hedge our Euro currency exposure with respect to the Ireland Portfolio (see Note 3 to the Condensed Consolidated Financial Statements).
For the three months ended March 31, 2017, corporate expenses increased $4.2 million to $57.6 million, compared to $53.4 million for the three months ended March 31, 2016. The increase was primarily due to interest expense on our 2021 Senior Notes issued in December 2016, partially offset by a decrease in interest expense on our reduced term loan borrowings.
Other (Loss) Income
For the three months ended March 31, 2017, corporate other loss was $5.9 million, compared to income of $1.5 million for the three months ended March 31, 2016. Corporate other loss of $5.9 million in the first quarter of 2017 represents a loss on repurchase of $230.0 million of our 2018 Convertible Notes (see Note 10 to the Condensed Consolidated Financial Statements). Corporate other income of $1.5 million in the first quarter of 2016 represents a reimbursement received related to a partnership guarantee arrangement.
Non-GAAP Financial Measures
Core Earnings is a non-GAAP financial measure. We calculate Core Earnings as GAAP net income (loss) excluding the following:
non-cash equity compensation expense;
incentive fees due under our management agreement;
(iii)
depreciation and amortization of real estate and associated intangibles;
acquisition costs associated with successful acquisitions; and
(v)
any unrealized gains, losses or other non-cash items recorded in net income for the period, regardless of whether such items are included in other comprehensive income or loss, or in net income.
The repurchase of our 2018 Notes was considered to be an unrealized event for Core Earnings purposes because the 2018 Notes were effectively exchanged for the 2023 Notes, thereby simply extending the term of this debt. As such, consistent with the above definition, we have deferred the $5.9 million GAAP loss on extinguishment of debt included in our GAAP results for the three months ended March 31, 2017 and will amortize this loss over the term of our 2023 Notes.
59
We believe that Core Earnings provides an additional measure of our core operating performance by eliminating the impact of certain non-cash expenses and facilitating a comparison of our financial results to those of other comparable REITs with fewer or no non-cash adjustments and comparison of our own operating results from period to period. Our management uses Core Earnings in this way, and also uses Core Earnings to compute the incentive fee due under our management agreement. The Company believes that its investors also use Core Earnings or a comparable supplemental performance measure to evaluate and compare the performance of the Company and its peers, and as such, the Company believes that the disclosure of Core Earnings is useful to (and expected by) its investors.
However, the Company cautions that Core Earnings does not represent cash generated from operating activities in accordance with GAAP and should not be considered as an alternative to net income (determined in accordance with GAAP), or an indication of our cash flows from operating activities (determined in accordance with GAAP), a measure of our liquidity, or an indication of funds available to fund our cash needs, including our ability to make cash distributions. In addition, our methodology for calculating Core Earnings may differ from the methodologies employed by other REITs to calculate the same or similar supplemental performance measures, and accordingly, our reported Core Earnings may not be comparable to the Core Earnings reported by other REITs.
In assessing the appropriate weighted average diluted share count to apply to Core Earnings for purposes of determining Core Earnings per share (“EPS”), management considered the following attributes of our current GAAP diluted share methodology: (i) our unvested stock awards representing participating securities were determined to be anti-dilutive and were thus excluded from the denominator of the EPS calculation; and (ii) the portion of the convertible senior notes that are “in-the-money” (referred to as the “conversion spread value”), representing the value that would be delivered to investors in shares upon an assumed conversion, is included in the denominator. Because compensation expense related to unvested stock awards is added back for Core Earnings purposes pursuant to the definition above, there is no dilution to Core Earnings resulting from the associated expense recognition. As a result, for purposes of determining Core EPS, our GAAP EPS methodology was adjusted to include (instead of exclude) such unvested awards. Further, conversion of the convertible senior notes is an event that is contingent upon numerous factors, none of which are in our control, and is an event that may or may not occur. Consistent with the treatment of other unrealized adjustments to Core Earnings, our GAAP EPS methodology was adjusted to exclude (instead of include) the conversion spread value in determining Core EPS until a conversion actually occurs. The following table presents our diluted weighted average shares used in our GAAP EPS calculation reconciled to our diluted weighted average shares used in our Core EPS calculation (amounts in thousands):
Diluted weighted average shares - GAAP
Add: Unvested stock awards
913
1,793
Less: Conversion spread value
(3,220)
Diluted weighted average shares - Core
260,134
238,552
The definition of Core Earnings allows management to make adjustments, subject to the approval of a majority of our independent directors, in situations where such adjustments are considered appropriate in order for Core Earnings to be calculated in a manner consistent with its definition and objective. No adjustments to the definition of Core Earnings occurred during the three months ended March 31, 2017.
60
The following table presents our summarized results of operations and reconciliation to Core Earnings for the three months ended March 31, 2017, by business segment (amounts in thousands, except per share data):
Costs and expenses
(24,849)
(38,239)
(44,308)
Other income (loss)
(Income) loss attributable to non-controlling interests
Add / (Deduct):
Non-cash equity compensation expense
749
629
1,752
3,151
Management incentive fee
5,470
65
4,474
17,371
21,862
Interest income adjustment for securities
(248)
2,069
1,821
Other non-cash items
773
(580)
6,109
Reversal of unrealized (gains) / losses on:
(172)
(19,045)
(19,217)
Derivatives
4,021
(1,111)
(10)
Foreign currency
(4,863)
(4,864)
(470)
(1,017)
(2,461)
(3,948)
Recognition of realized gains / (losses) on:
10,732
14,923
2,318
158
17,399
(13,581)
(830)
(14,411)
450
466
1,772
2,688
Core Earnings (Loss)
98,071
65,285
18,871
(50,417)
131,810
Core Earnings (Loss) per Weighted Average Diluted Share
0.38
0.25
0.07
(0.19)
0.51
61
The following table presents our summarized results of operations and reconciliation to Core Earnings for the three months ended March 31, 2016, by business segment (amounts in thousands, except per share data):
(26,209)
(35,118)
(31,398)
(146,101)
Other (loss) income
582
1,086
5,383
7,084
4,599
589
558
1,147
2,206
15,720
17,926
(261)
889
628
(1,608)
214
51,528
51,742
2,347
10,763
10,447
1,822
(1,460)
378
(468)
(1,377)
(2,429)
(4,274)
4,792
(3,323)
554
(6,712)
(70)
(6,228)
(67)
1,354
(15)
1,272
1,072
1,125
2,197
98,519
52,369
9,850
(41,844)
118,894
0.41
0.22
0.04
(0.17)
0.50
The Lending Segment’s Core Earnings decreased by $0.4 million, from $98.5 million during the first quarter of 2016 to $98.1 million in the first quarter of 2017. After making adjustments for the calculation of Core Earnings, revenues were $121.8 million, costs and expenses were $24.4 million and other income was $1.2 million.
Core revenues, consisting principally of interest income on loans, decreased by $2.4 million in the first quarter of 2017 primarily due to (i) a $5.6 million decrease in interest income from loans principally reflecting a gradual decline of interest rate spreads on new loans versus loans repaid during the preceding twelve months, partially offset by (ii) a $3.1 million increase in interest income from investment securities reflecting an increase in CMBS and RMBS investments between March 31, 2016 and 2017.
Core costs and expenses decreased by $2.0 million in the first quarter of 2017 primarily due to a decrease in interest expense associated with the various secured financing facilities used to fund a portion of our investment portfolio.
Core other income increased by $0.1 million, principally due to increased gains on foreign currency derivatives partially offset by increased foreign currency losses.
The Investing and Servicing Segment’s Core Earnings increased by $12.9 million, from $52.4 million during the first quarter of 2016 to $65.3 million in the first quarter of 2017. After making adjustments for the calculation of Core Earnings, revenues were $82.4 million, costs and expenses were $32.2 million, other income was $13.6 million and income tax benefit was $1.2 million.
Core revenues decreased by $13.1 million in the first quarter of 2017, primarily due to decreases of $11.6 million in interest income from our CMBS portfolio and $6.1 million in servicing fees, partially offset by a $5.6 million increase in rental income on our expanded REO Portfolio.
Core costs and expenses increased by $0.9 million in the first quarter of 2017, primarily due to increases of $2.4 million in costs of rental operations and $1.1 million in interest expense on secured financings for CMBS and the REO Portfolio, partially offset by a $2.3 million decrease in G&A expenses reflecting lower compensation costs.
Core other income increased by $25.4 million principally due to increases in realized gains on sales of CMBS investments and conduit loans.
Income taxes, which principally relate to the operating results of our servicing and conduit businesses which are held in TRSs, decreased $1.2 million to a benefit due to a decrease in the taxable income of our TRSs.
The Property Segment’s Core Earnings increased by $9.1 million, from $9.8 million during the first quarter of 2016 to $18.9 million in the first quarter of 2017. After making adjustments for the calculation of Core Earnings, revenues were $44.5 million, costs and expenses were $27.0 million and other income was $1.4 million.
Core revenues increased by $19.9 million in the first quarter of 2017, primarily due to the full period inclusion of rental income for the Medical Office Portfolio and the Woodstar Portfolio.
Core costs and expenses increased by $11.9 million in the first quarter of 2017, primarily due to increases in rental related costs of $5.8 million and interest expense of $5.3 million primarily on the secured financing for the Medical Office Portfolio.
Core other income increased by $1.1 million in the first quarter of 2017, primarily due to an increase in equity in earnings recognized from our investment in the Retail Fund.
Core corporate costs and expenses increased by $8.6 million, from $41.8 million in the first quarter of 2016 to $50.4 million in the first quarter of 2017, primarily due to increases in interest expense of $5.6 million and base management fees of $1.8 million as well as the absence of a $1.5 million reimbursement received related to a partnership guarantee arrangement in the first quarter of 2016.
63
Liquidity and Capital Resources
Liquidity is a measure of our ability to meet our cash requirements, including ongoing commitments to repay borrowings, fund and maintain our assets and operations, make new investments where appropriate, pay dividends to our stockholders, and other general business needs. We closely monitor our liquidity position and believe that we have sufficient current liquidity and access to additional liquidity to meet our financial obligations for at least the next 12 months. Our strategy for managing liquidity and capital resources has not changed since December 31, 2016. Refer to our Form 10-K for a description of these strategies.
Cash Flows for the Three Months Ended March 31, 2017 (amounts in thousands)
Excluding Investing
GAAP
and Servicing VIEs
Net cash used in operating activities
(88)
(196,109)
Proceeds from principal collections and sale of loans
263,118
Proceeds from sales and collections of investment securities
86,484
35,715
122,199
Net cash flows from other investments and assets
(14,615)
(21,730)
(307,878)
Proceeds from common stock issuances, net of offering costs
(464)
57,445
(30,956)
21,730
115,499
(388,488)
(1,148)
649,607
(1,236)
261,298
The discussion below is on a non-GAAP basis, after removing adjustments principally resulting from the consolidation of the Investing and Servicing Segment’s VIEs under ASC 810. These adjustments principally relate to (i) purchase of CMBS, loans and real estate from consolidated VIEs, which are reflected as repayments of VIE debt on a GAAP basis and (ii) principal collections of CMBS related to consolidated VIEs, which are reflected as VIE distributions on a GAAP basis. There is no significant net impact to cash flows from operations or to overall cash resulting from these consolidations. Refer to Note 2 of our Condensed Consolidated Financial Statements for further discussion.
Cash and cash equivalents decreased by $388.5 million during the three months ended March 31, 2017, reflecting net cash used in operating activities of $196.1 million and net cash used in investing activities of $307.9 million, partially offset by net cash provided by financing activities of $115.5 million.
Net cash used in operating activities of $196.1 million for the three months ended March 31, 2017 related primarily to $266.4 million of originations and purchases of loans held-for-sale, net of proceeds from principal collections and sales, cash interest expense of $51.0 million, management fees of $26.2 million, a net change in operating assets and liabilities of $24.7 million and general and administrative expenses of $22.7 million. Offsetting these cash outflows were cash interest income of $82.1 million from our loan origination and conduit programs, plus
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cash interest income on investment securities of $45.4 million. Net rental income provided cash of $35.8 million and servicing fees provided cash of $30.3 million.
Net cash used in investing activities of $307.9 million for the three months ended March 31, 2017 related primarily to the origination and acquisition of new loans held-for-investment of $621.1 million and the purchase of investment securities of $57.4 million, partially offset by proceeds received from principal collections and sales of loans of $263.1 million and investment securities of $122.2 million
Net cash provided by financing activities of $115.5 million for the three months ended March 31, 2017 related primarily to net borrowings after repayments of our secured debt of $251.4 million and the issuance of the 2023 Notes which resulted in gross proceeds of $247.5 million, partially offset by the repurchase of the 2018 Notes for $250.7 million and dividend distributions of $124.5 million.
Our Investment Portfolio
The following table sets forth the amount of each category of investments we owned across various property types within our Lending Segment as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Unlevered
Asset Specific
Return on
Investment
Vintage
Asset
First mortgages (1)
5,208,497
5,192,097
2,135,308
3,056,789
1989-2017
Subordinated mortgages
290,733
1998-2015
Mezzanine loans (1)
2006-2017
185,339
2013-2017
Loan loss allowance
43,399
206,020
2003-2007
HTM securities (2)
457,609
302,328
150,397
2013-2015
11,466
Investments in unconsolidated entities
7,330,165
7,180,875
2,520,056
4,660,819
4,861,214
4,845,552
1,910,078
2,935,474
1989-2016
6.4
274,011
11.5
2006-2016
10.7
38,832
215,083
10.3
515,027
305,531
204,449
6.0
11,275
6,830,932
6,669,499
2,293,462
4,376,037
CMBS held-to-maturity (“HTM”) and mandatorily redeemable preferred equity interests in commercial real estate entities.
As of March 31, 2017 and December 31, 2016, our Lending Segment’s investment portfolio, excluding loans held-for-sale, RMBS and other investments, had the following characteristics based on carrying values:
Collateral Property Type
Office
37.2
35.8
Hospitality
20.7
Mixed Use
20.0
15.1
Multi-family
15.3
Retail
7.0
Residential
3.7
1.9
Industrial
2.0
Geographic Location
North East
36.2
37.7
West
21.7
21.5
South East
11.0
11.6
South West
8.4
International
8.1
9.5
Mid Atlantic
8.0
3.5
Midwest
6.6
7.3
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The following table sets forth the amount of each category of investments we owned within our Investing and Servicing Segment as of March 31, 2017 and December 31, 2016 (amounts in thousands):
Specific
CMBS, fair value option
4,255,625
184,790
830,356
Intangible assets - servicing rights
79,682
Lease intangibles, net
26,326
Loans held-for-sale, commercial, fair value option
150,858
70,355
80,577
195,036
82,217
4,426,585
1,623,415
1,173,234
4,459,655
206,651
783,919
89,320
29,676
33,131
30,148
186,901
90,711
4,543,162
1,527,275
1,100,592
Includes $999.7 million and $959.0 million of CMBS reflected in “VIE liabilities” in accordance with ASC 810 as of March 31, 2017 and December 31, 2016, respectively.
Includes $33.0 million and $34.2 million of servicing rights intangibles reflected in “VIE assets” in accordance with ASC 810 as of March 31, 2017 and December 31, 2016, respectively.
Our Investing and Servicing Segment’s REO Portfolio, as defined in Note 3 to the Condensed Consolidated Financial Statements, had the following characteristics based on carrying values of $279.9 million and $283.5 million as of March 31, 2017 and December 31, 2016, respectively:
Property Type
45.6
45.8
23.7
23.9
18.4
18.1
7.5
Self-storage
4.8
4.7
51.0
17.3
9.3
9.4
8.2
6.9
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The following table sets forth the amount of each category of investments, which are comprised of properties, intangible lease assets and liabilities and our equity investment in four regional shopping malls (the “Retail Fund”) held within our Property Segment as of March 31, 2017 and December 31, 2016 (amounts in thousands):
117,785
122,124
1,914,209
The following table sets forth our net investment and other information regarding the Property Segment’s properties and intangible lease assets and liabilities as of March 31, 2017 (dollars in thousands):
Occupancy
Lease Term
Office—Medical Office Portfolio
767,835
486,902
280,933
95.1
6.4 years
Office—Ireland Portfolio
465,473
299,038
166,435
97.7
9.2 years
Multi-family residential—Ireland Portfolio
16,706
10,844
5,862
0.4 years
Multi-family residential—Woodstar Portfolio
610,496
410,497
199,999
0.5 years
Subtotal—undepreciated carrying value
1,860,510
653,229
Accumulated depreciation and amortization
(82,010)
Net carrying value
1,778,500
571,219
As of March 31, 2017 and December 31, 2016, our Property Segment’s investment portfolio had the following geographic characteristics based on carrying values:
Ireland
25.4
25.2
U.S. Regions:
39.7
13.0
8.6
8.7
New Credit Facilities and Amendments
Refer to Notes 9 and 10 of our Condensed Consolidated Financial Statements for a detailed discussion of new credit facilities and amendments to existing credit facilities executed since December 31, 2016.
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Borrowings under Various Secured Financing Arrangements
The following table is a summary of our secured financing facilities as of March 31, 2017 (dollars in thousands):
Approved
but
Unallocated
Facility
Outstanding
Undrawn
Size
Balance
Capacity (b)
Amount (c)
1,213,260
112,745
673,995
185,496
220,155
218,068
646,771
40,938
240,334
31,353
116,950
143,475
(k)
96,048
120,806
19,722
(l)
34,202
4,456,347
653,295
Approved but undrawn capacity represents the total draw amount that has been approved by the lender related to those assets that have been pledged as collateral, less the drawn amount.
Unallocated financing amount represents the maximum facility size less the total draw capacity that has been approved by the lender.
Maturity date for borrowings collateralized by loans is September 2018 before extension options and September 2021 assuming the exercise of extension options. Borrowings collateralized by loans existing at maturity may remain outstanding until such loan collateral matures, subject to certain specified conditions and not to exceed September 2025.
Facility carries a rolling 11 month term which may reset monthly with the lender’s consent not to exceed December 2018. This facility carries no maximum facility size. Amount herein reflects the outstanding balance as of March 31, 2017.
Facility carries a rolling 12 month term which may reset monthly with the lender’s consent. Current maturity is March 2018. This facility carries no maximum facility size. Amount herein reflects the outstanding balance as of March 31, 2017.
As of March 31, 2017, Wells Fargo Bank, N.A. is our largest creditor through two repurchase facilities (Lender 1 Repo 1 facility and mortgage-backed securities (“MBS”) Repo 4 facility).
Refer to Note 9 of our Condensed Consolidated Financial Statements for further disclosure regarding the terms of our secured financing arrangements.
Variance between Average and Quarter-End Credit Facility Borrowings Outstanding
The following table compares the average amount outstanding under our secured financing agreements during each quarter and the amount outstanding as of the end of each quarter, together with an explanation of significant variances (amounts in thousands):
Weighted-Average
Explanations
Quarter-End
Balance During
for Significant
Quarter Ended
Quarter
Variance
Variances
4,073,485
123,733
4,154,497
301,850
Variance primarily due to the following: (i) $491.2 million drawn on Medical Office Portfolio Mortgages in December 2016; (ii) $300.0 million drawn on the Term Loan A facility in December 2016; and (iii) $283.6 million drawn on the Lender 9 Repo 1 facility in December 2016; partially offset by (iv) $653.2 million pay down of the former Term Loan B facility in December 2016.
Variance primarily due to the following: (i) $336.8 million drawn on the Lender 1 Repo 1 facility in March 2017.
Borrowings under Unsecured Senior Notes
During both the three months ended March 31, 2017 and 2016, the weighted average effective borrowing rate on our unsecured senior notes was 5.7%. The effective borrowing rate includes the effects of underwriter purchase discount and the adjustment for the conversion option on the convertible notes, the initial value of which reduced the balance of the notes.
Refer to Note 10 of our Condensed Consolidated Financial Statements for further disclosure regarding the terms of our unsecured senior notes.
Scheduled Principal Repayments on Investments and Overhang on Financing Facilities
The following scheduled and/or projected principal repayments on our investments were based upon the amounts outstanding and contractual terms of the financing facilities in effect as of March 31, 2017 (amounts in thousands):
Scheduled Principal
Scheduled/Projected
Projected/Required
Repayments on Loans
Principal Repayments
Repayments of
Inflows Net of
and HTM Securities
on RMBS and CMBS
Financing Outflows
Second Quarter 2017
493,762
30,250
(162,811)
361,201
Third Quarter 2017
273,707
80,849
(159,472)
195,084
Fourth Quarter 2017
916,004
35,165
(628,611)
322,558
First Quarter 2018
638,138
28,234
(563,587)
102,785
2,321,611
174,498
(1,514,481)
981,628
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Issuances of Equity Securities
We may raise funds through capital market transactions by issuing capital stock. There can be no assurance, however, that we will be able to access the capital markets at any particular time or on any particular terms. We have authorized 100,000,000 shares of preferred stock and 500,000,000 shares of common stock. At March 31, 2017, we had 100,000,000 shares of preferred stock available for issuance and 239,772,555 shares of common stock available for issuance.
Other Potential Sources of Financing
In the future, we may also use other sources of financing to fund the acquisition of our target assets, including other secured as well as unsecured forms of borrowing and sale of certain investment securities which no longer meet our return requirements.
Repurchases of Equity Securities and Convertible Senior Notes
In September 2014, our board of directors authorized and announced the repurchase of up to $250.0 million of our outstanding common stock over a period of one year. Subsequent amendments to the repurchase program approved by our board of directors in December 2014, June 2015, January 2016 and February 2017 resulted in the program being (i) amended to increase maximum repurchases to $500.0 million, (ii) expanded to allow for the repurchase of our outstanding convertible senior notes under the program and (iii) extended through January 2019. Purchases made pursuant to the program are made in either the open market or in privately negotiated transactions from time to time as permitted by federal securities laws and other legal requirements. The timing, manner, price and amount of any repurchases are discretionary and will be subject to economic and market conditions, stock price, applicable legal requirements and other factors. The program may be suspended or discontinued at any time. During the three months ended March 31, 2017, we repurchased $230.0 million aggregate principal amount of our 2018 Notes for $250.7 million, however, this repurchase was not considered part of the repurchase program and therefore does not reduce our available capacity for future repurchases under the repurchase program. During the three months ended March 31, 2017, we did not repurchase any common stock under the repurchase program. As of March 31, 2017, we have $262.2 million of remaining capacity to repurchase common stock and/or convertible senior notes under the repurchase program.
Off-Balance Sheet Arrangements
We have relationships with unconsolidated entities and financial partnerships, such as entities often referred to as VIEs. Our maximum risk of loss associated with our involvement in VIEs is limited to the carrying value of our investment in the entity and any unfunded capital commitments. Refer to Note 14 of our Condensed Consolidated Financial Statements for further discussion.
Dividends
We intend to continue to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its net taxable income. We intend to continue to pay regular quarterly dividends to our stockholders in an amount approximating our net taxable income, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating and debt service requirements. If our cash available for distribution is less than our net taxable income, we could be required to sell assets or borrow funds to make cash distributions or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities. Refer to our Form 10-K for a detailed dividend history.
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The Company’s board of directors declared the following dividends during the three months ended March 31, 2017:
Declare Date
On May 9, 2017, our board of directors declared a dividend of $0.48 per share for the second quarter of 2017, which is payable on July 14, 2017 to common stockholders of record as of June 30, 2016.
Leverage Policies
Our strategies with regards to use of leverage have not changed significantly since December 31, 2016. Refer to our Form 10-K for a description of our strategies regarding use of leverage.
Contractual Obligations and Commitments
Contractual obligations as of March 31, 2017 are as follows (amounts in thousands):
Less than
More than
1 year
1 to 3 years
3 to 5 years
5 years
Secured financings (a)
732,615
1,656,037
1,017,183
1,050,512
781,866
Secured borrowings on transferred loans (b)
Loan funding commitments (c)
1,260,268
820,646
426,230
13,392
Future lease commitments
32,104
6,446
12,198
6,885
6,575
7,856,948
2,376,573
2,435,828
1,737,460
1,307,087
Includes available extension options.
These amounts relate to financial asset sales that were required to be accounted for as secured borrowings. As a result, the assets we sold remain on our consolidated balance sheet for financial reporting purposes. Such assets are expected to provide match funding for these liabilities.
Excludes $233.4 million of loan funding commitments in which management projects the Company will not be obligated to fund in the future due to repayments made by the borrower either earlier than, or in excess of, expectations.
The table above does not include interest payable, amounts due under our management agreement or amounts due under our derivative agreements as those contracts do not have fixed and determinable payments.
Critical Accounting Estimates
Refer to the section of our Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” for a full discussion of our critical accounting estimates. Our critical accounting estimates have not materially changed since December 31, 2016.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while, at the same time, seeking to provide an opportunity to stockholders to realize attractive risk-adjusted returns through ownership of our capital stock. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake. Our strategies for managing risk and our exposure to such risks have not changed materially since December 31, 2016. Refer to our Form 10-K, Item 7A for further discussion.
Credit Risk
Our loans and investments are subject to credit risk. The performance and value of our loans and investments depend upon the owners’ ability to operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due to us. To monitor this risk, our Manager’s asset management team reviews our investment portfolios and is in regular contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary.
We seek to further manage credit risk associated with our Investing and Servicing Segment loans held-for-sale through the purchase of credit index instruments. The following table presents our credit index instruments as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Face Value of
Aggregate Notional Value of
Number of
Loans Held-for-Sale
Credit Index Instruments
14,000
Refer to Note 5 of our Condensed Consolidated Financial Statements for a discussion of weighted average ratings of our investment securities.
Capital Market Risk
We are exposed to risks related to the equity capital markets, and our related ability to raise capital through the issuance of our common stock or other equity instruments. We are also exposed to risks related to the debt capital markets, and our related ability to finance our business through borrowings under repurchase obligations or other debt instruments. As a REIT, we are required to distribute a significant portion of our taxable income annually, which constrains our ability to accumulate operating cash flow and therefore requires us to utilize debt or equity capital to finance our business. We seek to mitigate these risks by monitoring the debt and equity capital markets to inform our decisions on the amount, timing, and terms of capital we raise.
Interest Rate Risk
Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We are subject to interest rate risk in connection with our investments and the related financing obligations. In general, we seek to match the interest rate characteristics of our investments with the interest rate characteristics of any related financing obligations such as repurchase agreements, bank credit facilities, term loans, revolving facilities and securitizations. In instances where the interest rate characteristics of an investment and the related financing obligation are not matched, we mitigate such interest rate risk through the utilization of interest rate derivatives of the same duration. The following
73
table presents financial instruments where we have utilized interest rate derivatives to hedge interest rate risk and the related interest rate derivatives as of March 31, 2017 and December 31, 2016 (dollars in thousands):
Aggregate Notional
Value of Interest
Number of Interest
Hedged Instruments
Rate Derivatives
Instrument hedged as of March 31, 2017
127,000
69,000
Secured financing agreements
1,026,433
1,010,413
1,573,495
1,214,413
Instrument hedged as of December 31, 2016
50,900
1,011,067
1,003,064
1,482,015
1,130,964
The following table summarizes the estimated annual change in net investment income for our LIBOR-based investments and our LIBOR-based debt assuming increases or decreases in LIBOR and adjusted for the effects of our interest rate hedging activities (amounts in thousands, except per share data):
Variable-rate
investments and
3.0%
2.0%
1.0%
Income (Expense) Subject to Interest Rate Sensitivity
indebtedness (1)
Increase
Decrease (2)
Investment income from variable-rate investments
6,187,642
181,579
120,386
59,390
Interest expense from variable-rate debt, net of interest rate derivatives
(2,746,006)
(87,832)
(60,653)
(31,471)
29,545
Net investment income from variable rate instruments
3,441,636
93,747
59,733
27,919
(9,377)
Impact per diluted shares outstanding
0.35
0.23
(0.04)
Includes the notional value of interest rate derivatives.
Assumes LIBOR does not go below 0%.
Foreign Currency Risk
We intend to hedge our currency exposures in a prudent manner. However, our currency hedging strategies may not eliminate all of our currency risk due to, among other things, uncertainties in the timing and/or amount of payments received on the related investments, and/or unequal, inaccurate, or unavailable hedges to perfectly offset changes in future exchange rates. Additionally, we may be required under certain circumstances to collateralize our currency hedges for the benefit of the hedge counterparty, which could adversely affect our liquidity.
Consistent with our strategy of hedging foreign currency exposure on certain investments, we typically enter into a series of forwards to fix the U.S. dollar amount of foreign currency denominated cash flows (interest income, rental income and principal payments) we expect to receive from our foreign currency denominated investments. Accordingly, the notional values and expiration dates of our foreign currency hedges approximate the amounts and timing of future payments we expect to receive on the related investments.
The following table represents our current currency hedge exposure as it relates to our investments denominated in foreign currencies, along with the aggregate notional amount of the hedges in place (amounts in thousands except for number of contracts, using the March 31, 2017 GBP closing rate of 1.2545, Euro (“EUR”) closing rate of 1.0655, Swedish Krona (“SEK”) closing rate of 0.1115, Norwegian Krone (“NOK”) closing rate of .01163 and Danish Krone (“DKK”) closing rate of .01432):
Carrying Value of Net Investment
Local Currency
Number of Foreign Exchange Contracts
Aggregate Notional Value of Hedges Applied
Expiration Range of Contracts
148,047
160,236
January 2018
18,031
80
21,613
June 2017 – June 2019
26,849
33,689
June 2017 – December 2018
2,018
EUR, DKK, NOK, SEK
8,444
17,995
22,456
May 2017 – November 2018
53,118
74,327
May 2017 – July 2020
1,409
2,139
June 2017 – March 2018
142,478
252,216
June 2017 – June 2020
12,269
April 2017 – January 2018
422,500
192
587,389
These foreign exchange contracts hedge our Euro currency exposure created by our acquisition of the Ireland Portfolio.
Item 4. Controls and Procedures.
Disclosure Controls and Procedures. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer, as appropriate, to allow timely decisions regarding required disclosures.
As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control Over Financial Reporting. No change in internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) occurred during the quarter ended March 31, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II—OTHER INFORMATION
Item 1. Legal Proceedings.
Currently, no material legal proceedings are pending or, to our knowledge, threatened or contemplated against us, that could have a material adverse effect on our business, financial position or results of operations.
Item 1A. Risk Factors.
There have been no material changes to the risk factors previously disclosed in the Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
There were no unregistered sales of securities during the three months ended March 31, 2017.
Issuer Purchases of Equity Securities
There were no purchases of common stock during the three months ended March 31, 2017.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Mine Safety Disclosures.
Not applicable.
Item 5. Other Information.
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.
STARWOOD PROPERTY TRUST, INC.
Date: May 9, 2017
By:
/s/ BARRY S. STERNLICHT
Barry S. Sternlicht Chief Executive Officer Principal Executive Officer
/s/ RINA PANIRY
Rina Paniry Chief Financial Officer, Treasurer, Chief Accounting Officer and Principal Financial Officer
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Item 6. Exhibits.
(a)Index to Exhibits
INDEX TO EXHIBITS
Exhibit No.
Description
4.1
Fourth Supplemental Indenture, dated as of March 29, 2017, between the Company and The Bank of New York Mellon, as trustee (Incorporated by reference to Exhibit 4.2 of the Company’s Current Report on Form 8-K filed March 29, 2017)
4.2
Form of 4.375% Convertible Senior Notes due 2023 (Incorporated by reference to Exhibit 4.2 of the Company’s Current Report on Form 8-K filed on March 29, 2017)
10.1
Fifth Amended and Restated Master Repurchase and Securities Contract, dated as of September 16, 2016, by and among Starwood Property Trust, Inc., Starwood Property Mortgage Sub-2, L.L.C., Starwood Property Mortgage Sub-2-A, L.L.C., SPT CA Fundings 2, LLC and Wells Fargo Bank, National Association
10.2
Credit Agreement, dated as of December 16, 2016, among Starwood Property Trust, Inc., as borrower, certain subsidiaries of Starwood Property Trust, Inc. from time to time party thereto, as guarantors, the lenders from time to time party thereto, and JPMorgan Chase Bank, N.A., as administrative agent
31.1
Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
31.2
32.1
Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
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