10-K 1 v301314_10k.htm

 

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

(Mark One)

xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

OR

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

For the transition period from ____________to _____________

Commission file number 001-32039

 

 

 CAPLEASE, INC.
(Exact Name of Registrant as Specified in its Charter)

 

 

Maryland

(State or Other Jurisdiction of

Incorporation or Organization)

52-2414533

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

   

1065 Avenue of the Americas, New York, NY

(Address of Principal Executive Offices)

10018

(Zip code)

(212) 217-6300

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each Class

Common Stock, $0.01 par value

Name of each exchange on which registered

New York Stock Exchange

8.125% Series A Cumulative Redeemable Preferred Stock, $0.01 par value New York Stock Exchange

 

 

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨
  (Do not check if a smaller reporting company) 

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

As of June 30, 2011, the aggregate market value of the common stock, $0.01 par value per share, of CapLease, Inc. (“Common Stock”), held by non-affiliates (outstanding shares, excluding shares held by executive officers and directors) of the registrant was approximately $319 million, based upon the closing price of $4.91 on the New York Stock Exchange on such date.

As of February 23, 2012, there were 66,275,535 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive proxy statement for the registrant's 2012 Annual Meeting, to be filed within 120 days after the close of the registrant's fiscal year, are incorporated by reference into Part III of this Annual Report on Form 10-K. 

 

 
 

 

TABLE OF CONTENTS

 

PART I.      
Item 1. Business.   2
Item 1A. Risk Factors.   15
Item 1B. Unresolved Staff Comments.   28
Item 2. Properties.   28
Item 3. Legal Proceedings.   28
Item 4. Mine Safety Disclosures.   28
PART II.      
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.   29
Item 6. Selected Financial Data.   32
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.   34
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.   50
Item 8. Financial Statements and Supplementary Data.   54
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.   99
Item 9A. Controls and Procedures.   99
Item 9B. Other Information.   99
PART III.      
Item 10. Directors, Executive Officers and Corporate Governance.   100
Item 11. Executive Compensation.   100
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.   100
Item 13. Certain Relationships and Related Transactions, and Director Independence.   100
Item 14. Principal Accounting Fees and Services.   100
PART IV.      
Item 15. Exhibits and Financial Statement Schedules.   101
PART V.      
SIGNATURES     104

 

Note: Items 10, 11, 12, 13 and 14 are incorporated by reference herein from the Proxy Statement.

 

Except where otherwise indicated or where the context is clear, the portfolio statistics in Items 1 and 1A of this Form 10-K represent or are calculated from our carry value for financial reporting purposes before depreciation and amortization. With respect to our loan portfolio, we have adjusted our carry value to exclude a $0.5 million general loss reserve.

 

Throughout this Form 10-K, we disclose the credit rating of the tenants (or lease guarantors) underlying our investments and the actual rating on most of our CMBS securities. Credit ratings are one of the factors we evaluate in assessing the likelihood of receipt of expected cash flows on our investments.

 

 
 

 

PART I.

 

Item 1. Business.

 

Explanatory Note for Purposes of the “Safe Harbor Provisions” of Section 21E of the Securities Exchange Act of 1934, as amended

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Our actual results or outcomes may differ materially from those projected. Important factors that we believe might cause such differences are discussed in Item 1A (Risk Factors) of this Form 10-K or otherwise accompany the forward-looking statements contained in this Form 10-K. In assessing all forward-looking statements, readers are urged to read carefully all cautionary statements contained in this Form 10-K. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

Overview

 

We are a real estate investment trust, or REIT, that primarily owns and manages single tenant commercial real estate properties subject to long-term leases to high credit quality tenants. We focus on properties that are subject to a net lease, or a lease that requires the tenant to pay all or substantially all property operating expenses, such as utilities, real estate taxes, insurance and routine maintenance. We also have made and expect to continue to make investments in single tenant properties where the owner has exposure to property operating expenses when we determine we can sufficiently underwrite that exposure and isolate a predictable cash flow.

 

In addition to our portfolio of owned properties, we have a modest portfolio of first mortgage loans and other debt investments on single tenant properties. That debt portfolio was reduced significantly during 2011 as a result of our sale of the assets and associated liabilities comprising our collateralized debt obligation, or CDO, as well as the individual sale of certain other loans and securities. While the focus of our investment activity is expected to remain the ownership of real properties, we may continue to make debt investments from time to time on an opportunistic basis in the future.

 

Our tenants are primarily large public companies or their significant operating subsidiaries and governmental entities with investment grade credit ratings, defined as a published senior unsecured credit rating of BBB-/Baa3 or above from one or both of Standard & Poor’s (“S&P”) and Moody’s Investors Service (“Moody’s”). We also imply an investment grade credit rating for tenants that are not publicly rated by S&P or Moody’s but (i) are 100% owned by an investment grade parent, (ii) for which we have obtained a private investment grade rating from either S&P or Moody’s, (iii) for which we have evaluated the creditworthiness of the tenant and estimated a credit rating that is consistent with an investment grade rating from S&P or Moody’s, or (iv) are governmental entity branches or units of another investment grade rated governmental entity.

 

Our portfolio produces stable, high quality cash flows generated by long-term leases to primarily investment grade tenants. As of December 31, 2011, we had an approximately $1.8 billion investment portfolio, including the following assets by type:

 

   Investment(1)     
   (in thousands)   Percentage 
Owned properties  $1,682,424    94.7%
Debt investments          
Loans          
Long-term mortgage loans   24,909    1.4%
Corporate credit notes   8,800    0.5%
Commercial mortgage loan securitizations   12,981    0.7%
Certificated mortgage loan investments   46,454    2.6%
Other   253    0.1%
Total  $1,775,821    100.0%

 

(1) Here and elsewhere in Item 1 of this Form 10-K, references to our “Investment” represent our carry value for financial reporting purposes before depreciation and amortization. With respect to our loan portfolio, we have adjusted our carry value to exclude a $0.5 million general loss reserve.

 

Our primary business objective is to generate stable, long-term and attractive returns based on the spread between the yields generated by our assets and the cost of financing our portfolio. We continued to grow our portfolio during 2011, as we purchased two single tenant properties for a total purchase price of $53.5 million, completed the development of a build-to-suit project with a total investment of $8.1 million, and commenced another build-to-suit project with an expected total investment of $53 million. We also continued to strengthen our balance sheet and significantly reduced the number and size of our debt investments and significantly lowered our debt liabilities, primarily through the sale of the mortgage assets and associated liabilities comprising our CDO. During 2011, we reduced our debt investments by $263 million and debt obligations by $258 million, and brought down our leverage level by 600 basis points to 66%. During 2012, we expect to continue our portfolio growth momentum and continue to reduce our leverage.

 

2
 

 

Multi-Tenant Properties

 

As described above and throughout this Annual Report on Form 10-K, we primarily own and manage single tenant commercial real estate properties. However, as a result of lease non-renewals, we have classified three properties as “multi-tenant properties,” as each is no longer leased primarily by a single tenant. We may have additional multi-tenant properties in the future. The first multi-tenant property is located in Johnston, Rhode Island, and is currently vacant. The other two multi-tenant properties are located in Omaha, Nebraska: one on West Dodge Road, which we call the “Dodge Building,” and the other on Farnam Street, which we call the “Landmark Building.” We refer to these three properties as the “Multi-Tenant Properties” in this Form 10-K and have excluded them from certain of our statistical measures. When we refer to our “Single Tenant Portfolio” in this Form 10-K, we mean our entire portfolio (e.g., all owned properties, loans and securities) other than the three Multi-Tenant Properties, and when we refer to our “Single Tenant Owned Property Portfolio,” we mean our owned property portfolio other than the three Multi-Tenant Properties. See “Our Portfolio—Owned Properties—Multi-Tenant Properties” for additional information about the Multi-Tenant Properties.

 

Investment Strategy

 

We focus on the following core business strategies:

 

·High Credit Quality Tenants. We primarily own and manage commercial real estate properties where the underlying tenant is of high credit quality. As of December 31, 2011, approximately 93% of our Single Tenant Portfolio was invested in properties leased to investment grade or implied investment grade tenants and the weighted average underlying tenant credit rating on our Single Tenant Portfolio was A-. Further, our top ten tenants, which comprise approximately 57% of our entire portfolio, were all rated investment grade or implied investment grade and had a weighted average credit rating of A+. As of December 31, 2011, our Single Tenant Portfolio had the following credit characteristics:

 

Credit Rating (1) (2)  Investment
(in thousands)
   Percentage 
Investment grade rating of A- or A3 and above  $847,870    50.5%
Investment grade rating of below A- or A3   481,091    28.6%
Implied investment grade rating   233,388    13.9%
Non-investment grade rating   117,382    7.0%
Unrated   828    0.0%
   $1,680,559    100.00%

 

(1)Reflects the tenant’s or lease guarantor’s actual or implied S&P rating or equivalent rating if rated only by Moody’s, or in the case of most of our CMBS securities, actual ratings of the securities. Table does not include the Multi-Tenant Properties.
(2)Four of our owned real properties within the Single Tenant Owned Property Portfolio where our aggregate investment is $272,724 are leased to more than one tenant and, for purposes of determining the underlying tenant’s credit rating on these properties, we have considered the credit rating of only our primary tenant.

 

·Long-Term Assets Held for Investment. We invest in commercial real estate assets subject to long-term leases. As of December 31, 2011, the weighted average underlying tenant remaining lease term on our Single Tenant Portfolio was approximately 7 years, including approximately 7 years in the Single Tenant Owned Property Portfolio. We intend to hold our assets for the long-term, capturing the stable cash flows that will be produced from the underlying high credit quality tenants.
·Net Lease Focus. We focus on properties that are subject to a net lease where the tenant is typically responsible for all or substantially all of the property’s operating expenses. We believe that this asset class offers more stable and predictable returns than non-net leased properties and will allow us to grow our business more rapidly than we need to expand our general and administrative costs and headcount.
·Match-Fund with Long-Term, Fixed Rate, Non-Recourse Debt. We seek to “match-fund” or substantially “match-fund” our assets with long-term, fixed rate, non-recourse financing. By “match-funded” debt, we mean the maturity of the debt matches as closely as possible the lease maturity of the asset financed. Our financing strategy allows us to invest in a greater number of assets and enhance our asset returns. The use of non-recourse debt enables us to isolate the default risk to solely the asset or assets financed. We also seek to employ amortizing debt on our assets, or debt that will diminish over time as we make scheduled principal payments.

 

3
 

 

Our Competitive Strengths

 

·Established Investment and Portfolio Management Capabilities. We have an experienced in-house team of investment professionals that source, structure, review and close our transactions. In addition, we have developed an extensive national network of property owners, developers, investment sale brokers, tenants, borrowers, mortgage brokers, lenders, institutional investors and other market participants that helps us to identify and evaluate a variety of single tenant investment opportunities. We have developed a highly skilled asset management function for our assets which among other things monitors lease expirations and property operations and manages the renewal or re-let process on our properties.

 

·Experienced Senior Management Team. Our senior management team is comprised of individuals with expertise in commercial real estate, credit capital markets, asset management and legal, and has worked together for many years through various business cycles. We have substantial experience investing at all levels of the capital structure of single tenant properties. Since 1996, we have originated and underwritten more than $4.5 billion in single tenant transactions, including debt, equity and mezzanine and involving more than 500 properties with more than 100 different tenants. Since our initial public offering in March 2004, we have purchased more than $1.7 billion of single tenant properties.

 

·Stringent Underwriting Process. Since the founding of our predecessor entity in 1994, we have built and maintain today a strong credit philosophy and underwriting discipline. We have a comprehensive underwriting and due diligence process that is overseen by our investment committee, which consists of our key employees, including the chief executive officer, president, chief financial officer and chief investment officer. Our investment committee formally reviews and approves each investment we make prior to funding and all portfolio divestitures. We also have an investment oversight committee of the Board of Directors that approves investments in excess of $50 million.

 

·Financing Expertise. We have substantial experience in financing single tenant assets. We have developed various financing structures that have enabled us to efficiently finance our assets, and we expect to continue to do so in the future as credit markets recover. The structures we have created have enabled us to enhance the returns on our portfolio without reducing credit quality in search of yield.

 

·Market Expertise. We have been in the net lease business since 1994 and have recognized expertise in the net lease marketplace. We are highly skilled in analyzing single tenant leases and have developed a market leading franchise in our sector. Prior to our initial public offering in 2004, we were primarily a lender focused on originating first mortgage loans on net lease properties and selling substantially all of the loans we originated, either through whole-loan or small pool sales or through gain-on-sale commercial mortgage-backed securitizations.

 

Our Portfolio

 

Owned Properties

 

Owned properties comprise approximately 95% of our current portfolio on an investment basis. All of our owned properties have been acquired since the closing of our initial public offering in 2004. We invest in most commercial property types (e.g., office, warehouse, GSA and retail), and our investment analysis includes a thorough review of the credit quality of the underlying tenant and the strength of the related lease. We also analyze the property’s real estate fundamentals, including location and type of the property, vacancy rates and trends in vacancy rates in the property’s market, rental rates within the property’s market, recent sales prices and demographics in the property’s market. We believe that over time, the value of our owned real estate will appreciate. For more detail on our due diligence process, please see “Transaction Review Process” below. We target properties that have one or more of the following characteristics:

 

·located in primary metropolitan markets such as Philadelphia, Washington D.C., Chicago and New York/New Jersey;

 

·fungible asset type that will facilitate a re-let of the property if the tenant does not renew;

 

·barriers to entry in the property’s market, such as zoning restrictions or limited land for future development; and

 

·core facility of the tenant.

 

4
 

 

As of December 31, 2011, we had an approximately $1.7 billion owned property portfolio. We believe the strength of this portfolio is exhibited by the following:

 

·approximately 11.6 million rentable square feet with 96.1% occupancy;

 

·64 properties in 26 states and leases with 34 different tenants across the Single Tenant Owned Property Portfolio;

 

·no tenant represents more than five percent of our entire portfolio, except Nestlé Holdings, Inc. at 11.2% (three properties), the United States Government at 11.0% (seven properties) and TJX Companies, Inc. at 5.2% (one property);

 

·95% investment grade or implied investment grade tenants in the Single Tenant Owned Property Portfolio;

 

·weighted average tenant credit rating of A in the Single Tenant Owned Property Portfolio;

 

·weighted average remaining lease term of approximately 7 years in the Single Tenant Owned Property Portfolio; and

 

·well diversified portfolio by property type, geography, tenant and tenant industry.

 

The occupancy rate (at each year-end) and average annual rent per square foot (for each of the years) for our owned property portfolio for each of the last three years were as follows:

 

   2011   2010   2009 
Occupancy rate   96.1%   95.9%   95.2%
Average annual rent per square foot  $11.42   $11.77   $12.84 

 

Property Type Diversification

The following pie chart summarizes the property types comprising our owned property portfolio as of December 31, 2011.

 

 

 

5
 

  

Tenant Industry Diversification

 

The following table sets forth certain information regarding the tenant industry concentrations in our owned property portfolio as of December 31, 2011.

 

Industry  Weighted Average
Credit Rating (1)
  

Investment (2)
(in thousands)

   Percent of
Total
 
Insurance   A   $261,915    16.1%
Food & Beverage   AA-    258,724    15.9%
Government   AA+    212,461    13.0%
Financial   BBB-    145,871    9.0%
Grocery   BBB    108,986    6.7%
Retail Department Stores   A    93,016    5.7%
Building Materials   A    83,244    5.1%
Retail Jewelry   A-    77,640    4.8%
Automotive   BB+    67,900    4.2%
Engineering   BBB-    57,433    3.5%
Healthcare   AA-    49,084    3.0%
Communications   BBB    47,499    2.9%
Hotel   BBB    47,343    2.9%
Energy   BBB    33,119    2.0%
Publishing   BBB+    20,837    1.3%
Retail Drug   BBB+    18,468    1.1%
Other   N/A    44,938    2.8%
Total   A   $1,628,479    100.0%

 

(1)Reflects actual or implied S&P rating (or equivalent rating if rated only by Moody’s) of tenant(s) or lease guarantor(s).

 

(2)Table does not include the Johnston, Rhode Island property which is currently vacant. Table also does not include a portion of our investment attributed to vacant space in the Landmark building in Omaha, Nebraska.

 

Geographic Diversification

 

The following table sets forth certain information regarding the top twenty states where our owned properties are located as of December 31, 2011.

 

State  Number of Properties   Investment
(in Thousands)
   Percent of Total 
PA  4   $205,937    12.2%
CA  7    202,197    12.0%
TX  6    135,604    8.1%
MD  4    130,766    7.8%
NJ  2    127,871    7.6%
IL  2    108,700    6.5%
IN  3    91,477    5.4%
VA  3    90,049    5.4%
CO  2    70,018    4.2%
KS  3    54,143    3.2%
NE  2    52,306    3.1%
RI  1    42,956    2.6%
KY  6    41,686    2.5%
AL  2    40,406    2.4%
WA  1    39,612    2.4%
GA  4    36,348    2.2%
TN  3    34,170    2.0%
LA  1    29,624    1.8%
WI  1    29,165    1.7%
FL  1    27,266    1.6%
NC  1    27,236    1.6%
NY  1    17,285    1.0%
Other  4    47,605    2.8%
Total  64   $1,682,424    100.0%
                

 

6
 

 

Lease Expirations

The following table sets forth certain information regarding scheduled lease expirations in our owned property portfolio as of December 31, 2011.

 

Year of Lease
Expiration
  Square Feet
Subject to
Expiring Lease
   Current
Annualized Base
Rent
(in thousands)
  

Percent
of Annual Rent

(1)

 
2012   2,757,308   $21,615    17.1%
2013   427,240    8,683    6.8%
2014   90,870    852    0.7%
2015   738,235    10,677    8.4%
2016   1,195,424    15,685    12.4%
2017   1,122,727    16,601    13.1%
2018   130,303    1,877    1.5%
2019   189,993    5,870    4.6%
2020   518,145    8,879    7.0%
2021   2,316,682    14,812    11.7%
Thereafter   1,643,439    21,204    16.7%

 

(1) Represents lease expiration dates as a percentage of current annualized rent on all properties other than the Johnston, Rhode Island property which is currently vacant.

 

The US Government (NIH) lease and the three Nestlé leases comprise virtually all of the square footage subject to expiring leases in 2012. We are in active discussions with the tenant and expect to extend or renew the leases at three of these four properties within the next few months. We do not expect to extend or renew the lease at the fourth property and are currently marketing that property for re-let at the conclusion of the existing lease term or sale. The four properties currently generate annual rental revenue in accordance with generally accepted accounting principles (GAAP) of $22.4 million. Assuming we enter into the lease renewals or extensions as expected, we estimate that the three properties will generate annual rental revenue in accordance with GAAP of $15.4 million (or $17.5 million assuming we also re-tenant the fourth property at our current estimate of market rent for that location). While the foregoing represents our best estimates, we cannot make any assurance regarding the expected outcomes of our leasing efforts at these properties, including as to when and on what terms we will be able to lease or sell any property which we may need to re-tenant.

 

7
 

   

The following is a tabular presentation of our owned property portfolio as of December 31, 2011: 

 

                               (in thousands)
Tenant or Guarantor   Location   Property Type   Square
Feet
 

Purchase Date

 

Lease

Maturity (1)

 

Form of

Ownership

   

2012 Estimated

Annual Rent (2)

  Purchase
Price
 

Investment

(3)

Abbott Laboratories   6480 Busch Blvd, Columbus, OH   Office   111,776   11/2004   11/2016   Fee   1,010   12,025   $    12,065
Abbott Laboratories   1850 Norman Drive North, Waukegan, IL   Office   131,341   8/2005   8/2017   Fee     1,770     20,325   20,362
Aetna Life Insurance Company   1333 - 1385 East Shaw Avenue, Fresno, CA   Office   122,605   10/2006   11/2016   Fee     1,887     24,255   25,688
Allstate Insurance Company   401 McCullough Drive, Charlotte, NC   Office   191,681   12/2005   12/2015   Fee     2,167     27,172   27,236
Allstate Insurance Company   1819 Electric Road (aka State Hwy. 419), Roanoke, VA   Office   165,808   12/2005   12/2015   Fee     2,307     28,928   28,935
AMEC plc   10777 Clay Road, Houston, TX   Office   227,486   6/2011   12/2020   Fee     2,058     25,000   25,437
Aon Corporation(4)   1000 Milwaukee Ave, Glenview, IL   Office   412,409   8/2004   4/2017   Fee     7,126     85,750   88,338
Baxter International, Inc.   555 North Daniels Way, Bloomington, IN   Warehouse   125,500   10/2004   9/2016   Fee     872     10,500   10,779
Bunge North America, Inc.   6700 Snowden Road, Fort Worth, TX   Industrial   107,520   4/2007   4/2026   Fee     685     10,100   10,268
Cadbury Holdings Limited    945 Route 10, Whippany, NJ   Office   149,475   1/2005   3/2021   Fee     3,740     48,000   50,231
Capital One Financial Corporation   3905 N. Dallas Parkway, Plano, TX   Office   159,000   6/2005   2/2015   Fee     2,353     27,900   31,175
Choice Hotels International, Inc.(5)   10720, 10750 & 10770 Columbia Pike, Silver Spring, MD   Office   223,912   11/2004   5/2013   Fee     5,747     43,500   47,343
Cimarex Energy Company (Development Property)(6)   206 S. Cheyenne, Tulsa, OK   Office   N/A   7/2011   N/A   Joint Venture/Fee         7,682   7,682
Cooper Tire & Rubber Company   500 Bartram Parkway, Franklin, IN   Warehouse   807,042   12/2010   5/2021   Fee     2,596     32,500   32,562
County of Yolo, California   25 North Cottonwood Street, Woodland, CA   Office   63,000   1/2007   6/2023   Fee     1,125     16,400   16,857
Crozer-Keystone Health System   8 Morton Avenue, Ridley, PA   Medical Office   22,708   8/2004   4/2019   Ground Lease     457     4,477   5,879
CVS Corporation   100 Mazzeo Drive, Randolph, MA   Retail   88,420   9/2004   1/2014   Fee     771     10,450   14,101
Farmers Group, Inc.   3039-3041 Cochran Street, Simi Valley, CA   Office   271,000   1/2007   1/2017   Fee     3,192     41,812   41,879
Farmers New World Life Insurance Company   3003 77th Avenue Southeast, Mercer Island, WA   Office   155,200   12/2005   12/2020   Fee     2,740     39,550   39,612
General Motors Financial Company, Inc.   4001 Embarcadero Drive, Arlington, TX   Office   246,060   12/2006   8/2017   Fee     3,273     43,000   43,374
Invesco Holding Co. Ltd.   4340, 4346 & 4350 South Monaco St., Denver, CO   Office   263,770   3/2006   10/2016   Fee     5,381     69,300   70,018
ITT Corporation   12975 Worldgate Drive, Herndon, VA   Office   167,285   5/2005   3/2019   Fee     5,520     46,081   56,747
Johnson Controls, Inc.   6750 Bryan Dairy Road, Pinellas Park, FL   Warehouse   307,275   12/2006   8/2016   Fee     2,159     27,000   27,266
Koninklijke Ahold, N.V.   4001 New Falls Road, Levittown, PA   Retail   70,020   6/2006   4/2026   Fee     1,439     18,575   21,104
Lowes Companies, Inc.(7)   26501 Aliso Creek Rd., Aliso Viejo, CA   Retail   181,160   5/2005   8/2024   Fee     3,467     52,860   53,621
Lowes Companies, Inc.   2401/2501 Elysian Fields Ave., New Orleans, LA   Office   133,841   11/2011   5/2030   Fee     2,314     28,474   29,624
Michelin North America, Inc.   5600 Cane Run Rd, Louisville, KY   Warehouse   150,000   9/2010   5/2021   Fee     804     8,071   8,071
Multi-tenant (currently vacant)   1301 Atwood Avenue, Johnston, RI   Office   345,842   4/2007   N/A   Ground Lease         55,443   42,956
Multi-tenant (Dodge building)   9394 West Dodge Road, Omaha, NE   Office   133,685   4/2007   Various   Ground Lease     2,316     10,785   18,617
Multi-tenant (Landmark building)   1299 Farnam Street, Omaha, NE   Office   292,714   4/2007   Various   Ground Lease     3,217     30,097   33,689
Nestle Holdings, Inc.   555 Nestle Way, Breinigsville, PA   Warehouse   1,045,153   4/2007   12/2012   Estate for Years     9,451     74,215   85,938
Nestle Holdings, Inc.(8)   2909 Pleasant Center Road, Fort Wayne, IN   Warehouse   764,177   4/2007   12/2012   Estate for Years     5,643     43,837   48,136
Nestle Holdings, Inc.(9)   2 Nestle Way, Lathrop, CA   Warehouse   751,021   4/2007   12/2012   Estate for Years     6,010     52,357   64,151
Omnicom Group, Inc.   1660 North Westridge Circle, Irving, TX   Office   101,120   6/2005   5/2013   Fee     1,409     18,100   18,333
Pearson Plc.   3833 Greenway and 2201 Noria Road, Lawrence, KS   Office   194,665   4/2006   4/2021   Fee     1,529     20,750   20,837
The Kroger Co.   Various locations in KY (five), GA (four), and TN (two)   Retail   685,135   4/2007   1/2022   Estate for Years     5,364     64,037   87,882
Tiffany & Co.   15 Sylvan Way, Parsippany, NJ   Office/Warehouse   367,740   9/2005   9/2025   Fee     4,982     75,000   77,640
Time Warner Entertainment Company, L.P.   1320 North  Dr. Martin Luther King Jr. Drive, Milwaukee, WI   Office   154,849   11/2006   12/2016   Fee     2,144     28,530   29,165
TJX Companies, Inc.   2760 Red Lion Road, Philadelphia, PA   Warehouse   1,015,500   3/2006   6/2021   Fee     6,215     90,125   93,016
T-Mobile USA, Inc.   695 Grassmere Park, Nashville, TN   Office   69,287   11/2006   1/2017   Fee     1,434     16,195   16,250
United States Government (FBI)   200 McCarty Avenue, Albany, NY   GSA (US Government)   98,184   10/2006   9/2018   Fee     1,312     16,350   17,285
United States Government (SSA)   1029 Camino La Costa, Austin, TX   GSA (US Government)   23,311   8/2005   2/2016   Fee     710     6,900   7,016
United States Government (DEA)   1003 17th Street North, Birmingham, AL   GSA (US Government)   35,616   8/2005   12/2020   Fee     1,297     13,369   13,770
United States Government (FBI)   1100 18th Street, North, Birmingham, AL   GSA (US Government)   96,278   8/2005   5/2020   Fee     2,797     21,850   26,636
United States Government (EPA)   300 Minnesota Avenue, Kansas City, KS   GSA (US Government)   71,979   8/2005   3/2023   Fee     2,652     29,250   33,306
United States Government (NIH)(10)   6116 Executive Bvd, Bethesda, MD   GSA (US Government)   207,055   9/2005   5/2012   Fee     3,486     81,500   83,423
United States Government (VA)   Lot 37, Santiago De los Caballeros Avenue, Ponce, PR   GSA (US Government)   56,500   11/2004   2/2015   Fee     1,300     13,218   13,758
Walgreen Co.   700 Frederick Blvd, Portsmouth, VA   Retail Drug   13,905   11/2004   7/2018   Fee     356     4,165   4,367
            11,579,010               $                 130,583   $     1,575,762   $    1,682,424

 

(1)Except in the case of our Multi-Tenant Properties, includes lease maturity for our primary tenant. Four of our owned properties within the Single Tenant Owned Property Portfolio are leased to more than one tenant (see footnotes (4), (5), (7) and (10) below).
(2)Reflects scheduled base rent due for 2012 under our lease with the tenant or tenants. Does not reflect straight-line rent adjustments required under GAAP. Also does not include expense recoveries or above or below market rent amortization adjustments required by GAAP.
(3)Includes carry value of any related intangible assets under GAAP.
(4)As of December 31, 2011, approximately 2% of the property was leased to one other tenant.
(5)As of December 31, 2011, approximately 22% of the property was leased to seven other tenants.
(6)We are currently funding construction of the property through a joint venture with the developer. We will acquire the developer’s interest in the joint venture upon completion of construction (estimated in first quarter 2013), at which time the lease with the tenant, which is for a twelve year term, will commence.
(7)As of December 31, 2011, approximately 18% of the property was leased to two other tenants.
(8)Property is 100% subleased to General Mills Operations, Inc. through and until the scheduled lease maturity.
(9)Property is 100% subleased to Del Monte Corporation through and until the scheduled lease maturity.
(10)As of December 31, 2011, approximately 6% of the property was leased to three other tenants.

 

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Estate for Years and Ground Leased Properties

 

With respect to certain of our owned properties, we own the improvements on the land and control the land through an estate for years with an option to enter into a ground lease at the expiration of the estate for years (Nestlé and Kroger properties). A third party who we refer to as a remainderman owns the remaining interest. For each of these properties, we also have an option to purchase the land at the expiration of the estate for years and on the last day of the primary term and each renewal term of the ground lease from the remainderman for fair market value. If we exercise the purchase option, the fair market value will be agreed to by us and the remainderman or if the parties cannot agree determined through an appraisal process. For certain of our other owned properties, we own the improvements on the land and control the land through a ground lease (Crozer-Keystone Health System, Omaha, Nebraska properties and Johnston, Rhode Island property). A third party owns and leases the land to us. We have the right to transfer our interest in all of these properties at any time and our interest in all of these properties will revert to the remainderman or land owner at the expiration of the ground lease estate unless we have purchased the land or extended the leasehold estate. The approximate duration of our interest in these properties assuming the full estate for years term, if any, and all ground lease options are exercised, is as follows: Nestlé properties, 61 years; Kroger properties, 70 years; Omaha, Nebraska properties, 64 years; Crozer-Keystone Health System property, 35 years; and Johnston, Rhode Island property, 48 years.

 

Multi-Tenant Properties

We have classified three owned properties within our portfolio as Multi-Tenant Properties, one in Johnston, Rhode Island, and two in Omaha, Nebraska.

 

The property in Johnston, Rhode Island is currently vacant and has been so since the prior tenant vacated in October 2009. We are actively marketing the building to prospective tenants and expect to re-let the property over time on a multi-tenant basis, though we cannot make any assurance as to when and on what terms we will be able to do so.

 

The following table summarizes certain additional information about the two Omaha, Nebraska properties (the Dodge Building and the Landmark Building) as of December 31, 2011:

 

Location    Pct Leased     Number of
Tenants
  Major Tenants (Lease Maturity (1))
               
9394 West Dodge Road, Omaha, NE   99%   6   Hayneedle Inc. (Feb 2016), The Maids International, Inc. (Aug 2016), Union Pacific Railroad Company (Jun 2018), Dex Media, Inc. (Jun 2013)
1299 Farnam Street, Omaha, NE   68%   14   Pacific Life Insurance Company (Jun 2015), Adesta, LLC (Aug 2013), Stinson Morrison Hecker (Jun 2015), Booz Allen Hamilton (Jun 2013)

 

 

 

(1)Reflects the date of the tenant’s early termination option where applicable, which if exercised would require the tenant to pay an early termination fee.

 

We continue to actively market the remaining space in the Landmark Building to prospective tenants and expect to fill that space over time, though we cannot make any assurance as to when and on what terms will be able to do so.

 

Loan Investments

 

Loan investments comprise approximately 2% of our current portfolio, compared to 11% of our portfolio at December 31, 2010. During 2011, we significantly reduced the size of our loan investment portfolio, primarily through the sale of our CDO during September.

 

All of our existing loan investments were originated and underwritten by us and are secured by single tenant commercial real estate collateral. Our loan investments are comprised of:

 

·Long-term mortgage loans: nine fully or nearly fully amortizing first mortgage loans on properties subject to long-term net leases.
·Corporate credit notes: four fully amortizing notes, each of which represents one of two notes comprising a single first mortgage loan on a net lease property with loan cash flows allocated and priorities to the loan collateral established among the two notes. Each corporate credit note generally ranges from 10% to 20% of the original loan amount, and has a junior claim on the real estate mortgage, but a senior claim on the rents in the event of a tenant bankruptcy and lease rejection.

 We expect our new investment activity will continue to consist primarily of the ownership of real properties. However, we may make long-term mortgage loans, corporate credit notes and other loan and loan type investments, including mezzanine loans, bridge loans, development loans and preferred equity financings, from time to time in the future.

 

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As of December 31, 2011, we had an approximately $33.7 million loan portfolio. We believe the strength of our loan portfolio is exhibited by the following:

 

·weighted average remaining lease term on the underlying leases of approximately 14 years;
·77% investment grade or implied investment grade underlying tenants;
·loan investments on 13 properties in 12 states with 7 different underlying tenant obligors; and
·weighted average underlying tenant credit rating of BBB+.

The following is a tabular presentation of our loan portfolio as of December 31, 2011:

 

                              (in thousands)       
                              Original                  
Tenant or Guarantor   Location   Property Type  

Square Feet

  Coupon    

Lease

Expiration

 

Loan

Maturity

  Principal
Balance
   

Principal

Balance

    Carry Value  

Loan to Realty

Value (1)

 
Long-Term Mortgage Loans                                                  
Bank Of America, N.A.   Mt. Airy, MD   Bank Branch   4,500   6.42 %   12/2026   12/2026                  3,469                  3,185                    3,185   72 %
CVS Corporation   Evansville, IN   Retail Drug   12,900   6.22 %   1/2033   1/2033                    3,351                    3,081                      3,081   70 %
CVS Corporation   Greensboro, GA   Retail Drug   11,970   6.52 %   1/2030   1/2030                    1,395                    1,207                      1,207   71 %
CVS Corporation   Shelby Twp., MI   Retail Drug   11,970   5.98 %   1/2031   1/2031                    2,540                    2,353                      2,353   83 %
Koninklijke Ahold, N.V.   Bensalem, PA   Retail   67,000   7.24 %   5/2020   5/2020                    3,153                    2,405                      2,438   69 %
Lowes Companies, Inc. (2)   Framingham, MA   Retail   156,543   N/A   10/2031   9/2031                    5,545                    5,613                      1,673   81 %
Walgreen Co.   Dallas, TX   Retail Drug   14,550   6.46 %   12/2029   12/2029                    3,534                    3,041                      3,041   71 %
Walgreen Co.   Nacogdoches, TX   Retail Drug   14,820   6.80 %   9/2030   9/2030                    3,649                    3,267                      3,267   64 %
Walgreen Co.   Rosemead, CA   Retail Drug   12,004   6.26 %   12/2029   12/2029                    5,333                    4,665                      4,665   65 %
                                             31,969                  28,816                    24,909      
                                                   
Corporate Credit Notes                                                  
Federal Express Corporation   Bellingham, WA   Warehouse   30,313   5.78 %   10/2018   3/2015                       362                       161                         160   60 %
Hercules Incorporated   Wilmington, DE   Office   518,409   9.32 %   5/2013   5/2013                  20,000                    7,806                      7,806   65 %
Lowes Companies, Inc.   N. Windham, ME   Retail   138,134   5.28 %   1/2026   9/2015                    1,140                       520                         515   75 %
Walgreen Co.   Jefferson City, TN   Retail Drug   14,266   5.49 %   3/2030   5/2015                       786                       319                         319   76 %
                                             22,288                    8,806                      8,800      
                                                   
Total                             $           54,257   $           37,622   $              33,709      

 

(1)All percentages have been rounded to the nearest whole percentage. Loan to realty value is the ratio of the principal balance of the loan as of December 31, 2011 to the appraised value of the real estate that secures the loan at the time the loan was made. The current value of the real estate may be different. The loan to realty value for each corporate credit note includes the principal balance of the portion of the loan we have sold.
(2)The loan is a zero coupon note, with a balloon balance of $9,784 due in full at the maturity date of September 2031.

Commercial Mortgage-Backed and Other Real Estate Securities

As of December 31, 2011, real estate securities aggregated approximately $59.4 million, or approximately 3% of our portfolio. During 2011, we significantly reduced the size of our securities portfolio, primarily through the sale of our CDO during September.

 

Our securities investments are currently comprised primarily of pro rata investments in one or more first mortgage loans on properties net leased to a single tenant. While these investments are structurally similar to our long-term mortgage loan investments, we classify them as securities for financial reporting purposes because they have a CUSIP number. Our securities investments also include senior, subordinate and interest-only classes of primarily net lease loan securitizations.

 

The weighted average credit rating on our securities portfolio was BB+ as of December 31, 2011, with 55% of the portfolio rated investment grade or implied investment grade. These statistics reflect the actual ratings on our CMBS securities and underlying tenant ratings on our other real estate securities.

 

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Our securities investments as of December 31, 2011 are summarized in the following table: 

 

      (in thousands)        
Security Description  CUSIP No.  Face Amount (1)   Carry Value   Cost Basis  Coupon   Maturity Date 
Investments in Commercial Mortgage Loan Securitizations                           
BACM 2006-4, Class H (rated CCC)  05950 WAT5  $4,000   $800   $-   5.98%   Sep 2016 
BACMS 2002-2, Class V-1 (7-Eleven, Inc.) (rated AA-)  05947 UJE9   656    555    555   8.44%   Sep 2019 
BACMS 2002-2, Class V-2 (Sterling Jewelers) (not rated)  05947 UJF6   1,001    828    828   8.40%   Jan 2021 
CALFS 1997-CTL1, Class D (rated B-)  140281 AF3   3,000    1,200    3,000   6.16%   Dec 2016 
CapLease CDO 2005-1, Class A (rated BBB+)  140274 AA9   2,661    2,345    2,326   4.93%   Jan 2015 
CapLease CDO 2005-1, Class B (rated BBB-)  140274 AC5   2,000    1,410    1,400   5.04%   Jan 2015 
CMLBC 2001-CMLB-1, Class H (rated B-)  201736 AM7   11,907    2,639    7,139   6.25%   Mar 2024 
CMLBC 2001-CMLB-1, Class J (rated D)  201736 AN5   6,383    672    756   6.25%   Oct 2025 
NLFC 1999-LTL-1, Class X (IO) (rated AAA)  63859 CCG6   3,916    2,533    3,916   10.36%   Jan 2024 
        35,523    12,981    19,918          
                             
Investments in Certificated Mortgage Loan Transactions                            
Certificated Mortgage Loan (with Alcatel-Lucent USA Inc. as tenant in Highlands Ranch, CO) (rated B)  72817#AA6    24,527    20,648    24,818   6.70%   Sep 2020 
Certificated Mortgage Loan (with CVS Corporation as tenant / multi-property) (rated BBB+)  126650 BB5   16,867    17,410    16,867   5.88%   Jan 2028 
Certificated Mortgage Loan (with Koninklijke Ahold, N.V. as tenant / multi-property) (rated BBB)  008686 AA5   7,489    8,395    7,578   7.82%   Jan 2019 
        48,882    46,454    49,263          
                             
Total      $84,405   $59,435   $69,181          
                              

 

(1) Represents face amount or, in the case of the NLFC 1999-LTL-1, Class X (IO) bond, our amortized cost.

 

We have adopted the cost-recovery method, in which all receipts are applied to reduce our cost basis, on a limited number of our securities investments.

 

The weighted average life of our securities portfolio as of December 31, 2011 was 6.7 years.

 

Portfolio Financing

 

Our portfolio financing strategy is to finance our portfolio with long-term fixed rate debt, as soon as practicable after we invest, on a secured, non-recourse basis. We seek to finance the portfolio with “match-funded” or substantially “match-funded” debt, meaning that we obtain debt whose maturity matches as closely as possible the maturity of the asset financed. By doing so, we attempt to lock-in the positive spread on the assets (representing the difference between our yield and our cost of financing). We also employ amortizing debt on our assets, or debt that will diminish over time as we make scheduled principal payments. Through non-recourse debt, we seek to limit the overall company exposure in the event we default on the debt to the amount we have invested in the asset or assets financed.

 

As of December 31, 2011, our long-term asset financings were comprised of non-recourse first mortgage financings (on most of our owned real properties) and one non-recourse secured term loan (completed in December 2007). We sold another term financing structure, our March 2005 CDO, during September 2011. We also have financed certain of our assets on a floating rate revolving credit agreement with Wells Fargo Bank.

 

As of December 31, 2011, the following statistics summarize various aspects of our overall portfolio financing position:

 

·overall leverage of approximately 66%;
·$972.9 million of non-recourse first mortgage debt at a weighted average coupon of 5.55% and a weighted average effective financing rate of 5.6%;
·$88.1 million of non-recourse secured term debt at a coupon of 5.81% and an effective financing rate of 6.0%; and
·$70.7 million of recourse debt to Wells Fargo Bank under a floating rate LIBOR based revolving credit agreement at an effective financing rate of 3.6%.

Since 2008, we have been lowering our overall leverage level and we expect to continue to do so in the future. As part of efforts to continue to reduce leverage, we may increase the number of assets we own without financing. Since 2008, we have reduced debt obligations by $454 million and reduced overall leverage by 13 percentage points to 66%. We expect our leverage levels to decrease over time, primarily as a result of scheduled principal amortization on our debt and lower or no leverage on new asset acquisitions.

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Hedging Strategy

 

For assets that have not yet been financed with long-term fixed rate debt, we may employ a hedging strategy to manage our exposure to interest rate fluctuations prior to the time we obtain long-term fixed rate financing. We do so by entering into hedging transactions that we expect to offset the impact to us of changes in interest rates. As interest rates increase, the hedge transactions are intended to offset the increased interest cost on the expected future financing with gains on the hedge positions. Our hedging transactions have historically consisted primarily of forward starting interest rate swaps. Interest rate swaps are agreements between two parties to exchange, at particular intervals, payment streams calculated on a specified notional amount.

 

We do not hedge those assets that we have financed with long-term fixed rate debt, as our yields and spreads on those assets are fixed and, therefore, not impacted by fluctuations in interest rates.

 

We will continue to seek to manage our interest rate exposure taking into account market conditions, the cost of and risks associated with the hedging transactions and the limitations on hedging transactions imposed by the REIT tax rules. As of December 31, 2011, we had no open hedge transactions.

 

Revenue Concentrations in 2011

 

The United States Government accounted for approximately 12.8% of our total revenue during 2011. The United States Government and Nestlé Holdings, Inc. accounted for approximately 14.6% and 10.3%, respectively, of our total revenue from our owned properties segment during 2011. Other than the foregoing, we had no greater than 10% revenue concentrations based on total revenue or on a total revenue by segment basis during 2011. Approximately 12.1% and 11.3%, respectively, of our total revenue from our debt investments segment during 2011 was obtained from investments where CVS Corporation and Kohl’s Corporation is the tenant (or lease guarantor), but not our obligor.

 

Investment Network

 

Our level of new investment activity is influenced by market conditions. During 2011, we purchased two single tenant properties for a total purchase price of $53.5 million, completed the development of a build-to-suit project with a total investment of $8.1 million, and commenced another build-to-suit project with an expected total investment of $53 million. We expect to continue our portfolio growth momentum during 2012.

 

We maintain a comprehensive marketing, advertising and public relations program that supports our investment efforts. The objective of the program is to build our name recognition and reinforce our position as an industry leader in the single tenant market segment. We believe, based upon our experience and responses from customers, that we have been successful in achieving our objectives of market awareness and prominence.

 

We primarily source property acquisition opportunities through investment sale brokers and directly from a growing number of developers and owners or investors in real estate assets. We expect these same contacts will periodically identify loan business for us.

 

During 2010, we launched a development joint venture program designed to source build-to-suit investments at higher rates of return relative to completed projects. We believe that by entering into projects with established developer partners, we can provide the capital needed to get projects built, while at the same time, securing long-term investment assets for our company at yields significantly higher than those available for completed properties. The program is being met with significant interest from developers and tenants, and during 2011, we completed one project (for Michelin North America, Inc.) and commenced a second (for Cimarex Energy Co.) which is scheduled for completion during the first quarter of 2013.

 

Transaction Review Process

 

Once a prospective investment opportunity is identified, the potential transaction undergoes a comprehensive review and due diligence process that is overseen by our investment committee, which consists of our key employees, including the chief executive officer, president, chief financial officer and chief investment officer. The focus of our asset review falls into four primary areas:

 

·credit and financial analyses of the tenant as well as an assessment of the tenant’s business, the overall industry segment and the tenant’s market position within the industry;
·lease quality, including an analysis of the term, tenant termination and abatement rights, landlord obligations and other lease provisions;
·a real estate fundamentals review and analysis;
·an analysis of our ability to finance the asset; and
·an analysis of the risk adjusted returns on the investment.

 

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Prior to entering into any transaction, our investment professionals, assisted by our chief investment officer and chief financial officer as necessary, conducts a review of the tenant’s credit quality. This review may include reviews of publicly available information, including any public credit ratings, financial statements, debt and equity analyst reports, and reviews of corporate credit spreads, stock prices, market capitalization and other financial metrics.

 

While we have no defined minimum credit rating or balance sheet size for tenants, we anticipate that a majority of our tenants will have investment grade or implied investment grade credit ratings. For those tenants that either are below investment grade or are unrated, we may conduct additional due diligence, including additional financial reviews of the tenant and a more comprehensive review of the business segment and industry in which the tenant operates.

 

Assuming that the credit of the tenant under the lease is satisfactory, a thorough review is then conducted into the quality of the lease, focusing primarily on the landlord’s obligations under the lease and those provisions of the lease that would permit the tenant to terminate or abate rent prior to the conclusion of the primary lease term. We analyze the lease to ensure that all or substantially all of the property expenses are borne by the tenant or that any property expenses not borne by the tenant are sufficiently underwritten to assure that we can isolate a predictable cash flow from the asset. Each lease is also reviewed by outside counsel and a lease summary is provided to our investment professionals for use in evaluating the transaction.

 

We conduct a review with respect to the quality of the real estate subject to the lease. The property is reviewed from a traditional real estate perspective, including quality of construction and maintenance, location and value of the real estate and technical issues such as title, survey and environmental. Appraisals, environmental and engineering reports are obtained from third-parties and reviewed by our investment professionals and/or legal counsel. We thoroughly review the property’s real estate fundamentals, including location and type of the property, vacancy rates and trends in vacancy rates in the property’s market, rental rates within the property’s market, recent sales prices and demographics in the property’s market. As described in detail under “Our Portfolio—Owned Properties” above, we target properties with one or more of the following: located in a primary metropolitan market, fungible asset type, barriers to entry in the market, and a core facility of the tenant. In addition, we may evaluate, or engage a third-party provider to evaluate, alternative uses for the real estate and the costs associated with converting to such alternative uses, as well as examine the surrounding real estate market in greater detail.

 

In addition to our review of the quality of any individual transaction, our investment committee also:

 

·evaluates our current portfolio, including consideration of how the subject transaction affects asset diversity and credit concentrations in the tenant, industry or credit level;
·determines whether we can implement appropriate legal and financial structures, including our ability to control the asset in a variety of circumstances, such as an event of default by the tenant or the borrower, as applicable;
·evaluates the leveraged and unleveraged yield on the asset and how that yield compares to our target yields for that asset class and our analysis of the risk profile of the investment; and
·determines our plans for financing and hedging the asset.

We use integrated systems such as customized software and models to support our decisions on pricing and structuring investments. Before issuing any form of commitment to fund an investment transaction, the transaction must be approved by our investment committee. The committee meets frequently and on an as-needed basis to evaluate potential investments.

 

In addition, we have a three-member investment oversight committee of our Board of Directors, which approves all transactions in excess of $50 million. Our chief executive officer is the only member of this committee who is an employee of our company.

 

We believe that we can continue to grow our business more rapidly than we need to expand our general and administrative costs and headcount.

 

Asset Management

 

We manage a diverse portfolio of primarily single tenant commercial real estate assets. For our owned properties where we are responsible for day-to-day management of the property, we typically hire third party property managers who are overseen by employees of our company. Our owned property investments also require that we perform a variety of asset management functions, such as:

 

·meeting periodically with our tenants;
·monitoring lease expirations and tenant space requirements and renewing leases as they mature or re-letting space;

13
 

 

·monitoring the financial condition and credit ratings of our tenants;
·performing physical inspections of our properties;
·making periodic improvements to properties where required;
·monitoring portfolio concentrations (e.g., tenant, industry); and
·monitoring real estate market conditions where we own properties.

 Asset Surveillance System

 

We also have created an on-going asset surveillance system that:

 

·tracks the status of our investments and investment opportunities;
·links into a management program that includes the underlying asset acquisition documents;
·loads expected asset cash flows from our investment files into the system;
·imports data from the system into our financial accounting system;
·monitors actual cash flows on each asset through servicer reports;
·immediately identifies issues such as non-payment of rent and servicer advances of rent or debt service through servicer exception reports; and
·automatically generates system e-mail notifications when the credit ratings of underlying tenants change.

Through this single system we are able to track and document the entire lifecycle of our assets.

 

Closing Process

 

From the time we begin to consider an investment until the investment is closed, the prospective transaction undergoes a variety of defined steps and procedures. In connection with the closing process, we will typically need to rely on certain third parties not under our control, including tenants, sellers, lenders, brokers, outside counsel, title companies, environmental consultants, appraisers, engineering consultants and other product or service providers. Our personnel carefully manage the closing process and have developed a streamlined set of procedures, checklists and relationships with many of the third-party providers with whom we do business on an on-going basis.

 

As set forth under “Transaction Review Process” above, each transaction goes through a multi-stage review overseen by our investment committee. Transaction review and the documentary process surrounding it is supported by the use of standardized transaction documents, including closing checklists and form acquisition documents. All of our transactions are closed by our in-house closing staff. That staff seeks to close our property acquisitions four to eight weeks after a purchase and sale agreement is signed, while at the same time maintaining our transaction review standards.

 

Competition

 

We are subject to significant competition. Our competitors include other public and private REITs, private real estate companies, pension funds and individuals. We may face new competitors and, due to our focus on single tenant properties located throughout the United States, and because many of our competitors are locally and/or regionally focused, we will not encounter the same competitors in each region of the United States.

 

Many of our competitors have greater financial and other resources and may have other advantages over our company. Our competitors may be willing to accept lower returns on their investments and may succeed in buying the assets that we have targeted for acquisition. We may also incur costs on unsuccessful acquisitions that we will not be able to recover.

 

Environmental Matters

 

Under various federal, state and local environmental laws, a current owner of real estate may be required to investigate and clean up contaminated property. Under these laws, courts and government agencies have the authority to impose cleanup responsibility and liability even if the owner did not know of and was not responsible for the contamination. For example, liability can be imposed upon us based on the activities of our tenants or a prior owner. In addition to the cost of the cleanup, environmental contamination on a property may adversely affect the value of the property and our ability to sell, rent or finance the property, and may adversely impact our investment in that property. 

 

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Prior to acquisition of a property, we obtain Phase I environmental reports. These reports are prepared in accordance with an appropriate level of due diligence and generally include a physical site inspection, a review of relevant federal, state and local environmental and health agency database records, one or more interviews with appropriate site-related personnel, review of the property’s chain of title and review of historic aerial photographs and other information on past uses of the property and nearby or adjoining properties. We may also obtain a Phase II investigation which may include limited subsurface investigations and tests for substances of concern where the results of the Phase I environmental reports or other information indicates possible contamination or where our consultants recommend such procedures.

 

We believe that our portfolio is in compliance in all material respects with all federal, state and local laws and regulations regarding hazardous or toxic substances and other environmental matters.

 

At December 31, 2011, we were not aware of any environmental concerns that would have a material adverse effect on our financial position or results of operations.

 

Employees

As of December 31, 2011, we had 19 full-time employees. We have an experienced staff, many of the members of which have been previously employed by the real estate departments from major financial institutions, law firms and rating agencies. We believe that our relations with our employees are good. None of our employees are unionized.

 

Available Information

 

We are required to file annual, quarterly and current reports, proxy statements and other information with the SEC. Investors may read and copy any document that we file, including this Annual Report on Form 10-K, at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Investors may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, from which investors can electronically access our SEC filings.

 

We also make available free of charge on or through our Web site (www.caplease.com), our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Investors can access our filings with the SEC by visiting the “Investors” section of our web site at www.caplease.com.

 

The information on our web site is not, and shall not be deemed to be, a part of this report or incorporated into any other filings we make with the SEC.

Item 1A. Risk Factors.

Set forth below and elsewhere in this annual report on Form 10-K and in other documents we file or furnish with the SEC are risks and uncertainties that could adversely affect our business and operations and cause actual results to differ materially from the results contemplated by any forward-looking statements made by us or on our behalf.

Risks Related to Operations

Current market conditions expose us to a variety of risks.

Current economic and commercial real estate conditions continue to show signs of weakness and uncertainty and could negatively impact our ability to execute on our business plan. For example, these conditions could adversely impact our ability to:

 

·add new assets to the portfolio, which could cause our common stock price to decline;
·retain tenants or promptly re-let vacant space on favorable terms as leases mature, which could result in a reduction of our funds from operations and cash available for distribution;
·sell assets or refinance debt on favorable terms or at all, which could result in a reduction of our results of operations and weaken our liquidity and financial condition; and
·raise additional equity capital to support our business on favorable terms or at all, which could cause our common stock price to decline.

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If we lower or eliminate our dividend, the market value of our common stock may decline.

 

The level of our common stock dividend is established by our Board of Directors from time to time based on a variety of factors, including market conditions, our cash available for distribution, our funds from operations and our maintenance of REIT status. Various factors could cause our Board of Directors to decrease or eliminate our common stock dividend level, including our desire due to market conditions or otherwise to maintain higher levels of liquidity, tenant defaults resulting in a material reduction in our cash flows or a material loss resulting from an adverse change in one or more of the tenants underlying our investments. We have not established a minimum dividend payment level and we cannot assure you that we will be able to pay dividends in the future. If we lower or eliminate our common stock dividend, the market value of common stock in our company could be adversely affected.

 

We conduct a significant part of our business with Wells Fargo Bank, N.A. and its affiliates, and their continued business with us is not guaranteed.

 

We rely on Wells Fargo Bank, N.A. and its affiliates in various aspects of our business. For example:

 

·Wells Fargo Bank and its affiliates provide us with asset financing through a revolving credit agreement.
·We have obtained mortgage financing on our owned properties from Wells Fargo Bank (as successor to Wachovia Bank, N.A.) in the past, and we expect to continue to do so in the future.
·Affiliates of Wells Fargo Bank have performed investment banking services for us, including in connection with our initial public offering, our CDO transaction and each of our follow-on public equity offerings.

These parties are not obligated to do business with us, and any adverse developments in their business or in our relationship with them could result in these parties choosing not to do business with us or a significant reduction in our business with them. Termination of our business or a significant reduction in our business with these parties could have a material adverse effect on our business, operating results, financial condition and liquidity.

 

The market price of our stock may be adversely impacted by our pace of investment activity.

The markets in which we compete for investments are competitive and our pace of investment activity continues to be impacted by competitive and market conditions. If our pace of investment activity does not match market expectations the market price of our stock could be adversely affected.

 

Risks Related to Portfolio Assets

Single tenant leases involve significant risks of tenant default.

We primarily own and manage commercial real estate properties that are leased to a single tenant. Therefore, the financial failure of, or other default in payment by, a single tenant under its lease is likely to cause a complete reduction in the operating cash flows from that property and a significant reduction in the value of that property, and could cause a significant reduction in our revenues, cash flows and hence our liquidity, and a significant impairment loss recorded directly to our Statement of Operations.

 

Credit ratings may prove to be inaccurate.

We consider credit ratings assigned by S&P and/or Moody’s to our tenants, their guarantors or parent companies and to our structured CMBS securities when making investment and leasing decisions. A credit rating is not a guarantee of continued financial performance and only reflects the rating agency's opinion of an entity's ability to meet its financial commitments, such as its senior unsecured obligations, in accordance with their stated terms. A rating may ultimately prove not to accurately reflect the credit risk associated with a particular tenant. In addition, ratings may be changed, qualified, suspended, placed on watch or withdrawn over time. If a tenant’s rating is downgraded, qualified, suspended, placed on watch or withdrawn, such tenant may be more likely to default in its obligations to us, and investors may view our cash flows as less stable.

 

An adverse change in the financial condition of one or more tenants could have a material adverse impact on us.

We rely on rent payments from our tenants for our cash flows and make property investments based on the financial strength of such tenant and our expectations of their continued payment of rent under the lease. Therefore, adverse changes in the financial condition of the tenants or the certainty of their ability to pay rents could have a material adverse impact on us. For example:

 

·The bankruptcy or insolvency of any of our tenants could result in that tenant ceasing to make rental payments, resulting in a reduction of our cash flows and losses to our company. In addition to the rent loss, due to our focus on net leased properties, our expenses will likely increase as the tenant will no longer pay or reimburse us for the operating costs at the property.

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·The credit quality of the tenant or tenants is frequently a significant factor in determining the value of our properties, and an adverse change in the subject tenant’s financial condition or a decline in the credit rating of such tenant may result in a decline in the value of our properties and a resulting impairment charge directly to our Statement of Operations.
·An adverse change in the financial condition of one or more of our tenants or a decline in the credit rating of one or more of our tenants could result in a margin call if the related asset is being financed on our Wells Fargo Bank credit agreement, and could make it more difficult for us to arrange long-term financing for that asset, including by increasing our cost of financing.

 Our assets may be subject to impairment charges, which could materially adversely affect our financial condition and results of operations.

 

We periodically evaluate our investments for impairment indicators. If we determine that an impairment has occurred (and solely in the case of our securities investments, the impairment is due to credit factors), we would be required to reduce the carrying value of the investment, and record a loss directly to the Statement of Operations in the applicable period. The judgment regarding the existence of impairment indicators is based on a variety of factors such as market conditions, the status of significant leases, the financial condition of major tenants, our expectations regarding future cash flows and the estimated fair value of our investment and/or related collateral. We incurred substantial impairment charges in each of the last three years, including $7.7 million of other-than-temporary impairment losses on one of our securities investments during 2010, and $11.9 million of impairment losses on an owned property in 2009. We may continue to take similar impairment charges in the future. These impairments could have a material adverse effect on our financial condition and results of operations.

 

Bankruptcy laws will limit our remedies if a tenant becomes bankrupt and rejects the lease.

 

We rely on rent payments from the tenant to service our financing of the asset and generate the return we expect to earn. If the tenant becomes insolvent or bankrupt, they have the right under the United States Bankruptcy Code to reject the lease and rent payments could cease. In such a case, our remedies will be limited under the Bankruptcy Code. The premises may not be recoverable promptly from the tenant and our claim for damages, which will be unsecured and is limited to rent under the lease for the greater of one year or 15 percent (but not more than three years) of the remaining term, plus rent already due but unpaid, may not be sufficient to cover our debt service and any other expenses with respect to the property.

 

We are subject to tenant credit concentrations that make us more susceptible to adverse events with respect to certain tenants.

We are subject to tenant credit concentrations, the most significant of which are the following as of December 31, 2011:

 

·approximately $198.2 million, or 11.2%, of our assets represent investments in three properties leased to, or leases guaranteed by, Nestlé Holdings, Inc.;
·approximately $195.2 million, or 11.0%, of our assets represent investments in seven properties leased to the United States Government; and
·approximately $93.0 million, or 5.2%, of our assets represent investments in one property leased to, or lease guaranteed by, TJX Companies, Inc.

Any bankruptcy, insolvency or failure to make rental payments by, or any adverse change in the financial condition of, one or more of these tenants, or any other tenant to whom we may have a significant credit concentration now or in the future, could result in a material reduction of our cash flows and hence our liquidity or material losses to our company.

 

We are subject to tenant industry concentrations that make us more susceptible to adverse events with respect to certain industries.

We are subject to industry concentrations, the most significant of which are the following as of December 31, 2011:

 

·approximately $261.9 million, or 16.2%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the insurance industry (e.g., Aon Corporation, Allstate Insurance Company, Farmers New World Life Insurance Company and Aetna Life Insurance Company);
·approximately $258.7 million, or 16.0%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the food and beverage industry (e.g., Nestlé Holdings, Inc. and Cadbury Holdings Limited);

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·approximately $212.5 million, or 13.1%, of our assets represent investments in properties leased to, or leases guaranteed by, federal or state governmental entities or branches or units thereof (e.g., United States Government and County of Yolo, California);

 

·approximately $145.9 million, or 9.0%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the financial industry (e.g., Capital One Financial Corporation, General Motors Financial Company, Inc. and Invesco Holding Co. Ltd.);

 

·approximately $109.0 million, or 6.7%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the retail grocery industry (e.g., The Kroger Co. and Koninklijke Ahold, N.V.);

 

·approximately $93.0 million, or 5.2%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the retail department stores industry (TJX Companies, Inc.); and

 

·approximately $83.2 million, or 5.1%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the building materials industry (Lowe’s Companies, Inc.).

 

Any downturn in one or more of these industries, or in any other industry in which we may have a significant credit concentration now or in the future, could result in a material reduction of our cash flows and hence our liquidity or material losses to our company.

 

We are subject to geographic concentrations that make us more susceptible to adverse events in these areas.

 

We are subject to geographic concentrations, the most significant of which are the following as of December 31, 2011:

  

·approximately $208.4 million, or 11.8%, of our assets represent investments in properties located in the Philadelphia, Pennsylvania metropolitan area;

 

·approximately $187.5 million, or 10.6%, of our assets represent investments in properties located in the Washington, D.C. metropolitan area;

  

·approximately $127.9 million, or 7.2%, of our assets represent investments in properties located in the New York City and Northern New Jersey area;

  

·approximately $108.7 million, or 6.1%, of our assets represent investments in properties located in the Chicago, Illinois metropolitan area;

  

·approximately $106.2 million, or 6.0%, of our assets represent investments in properties located in the Dallas/Fort Worth, Texas metropolitan area; and

  

·approximately $100.2 million, or 5.7%, of our assets represent investments in properties located in the Southern California area.

  

An economic downturn or other adverse events or conditions such as terrorist attacks or natural disasters in one or more of these areas, or any other area where we may have a significant credit concentration now or in the future, could result in a material reduction of our cash flows and hence our liquidity or material losses to our company.

 

Our investments in assets backed by below investment grade credits have a greater risk of default.

 

We invest in assets where the underlying tenant’s credit rating is below investment grade (approximately $117.4 million, or 7.0%, of our portfolio as of December 31, 2011). Investments backed by below investment grade tenants comprised a larger percentage of our new investment activity during 2010 and 2011 and may continue to do so in the future. These investments will have a greater risk of default and bankruptcy than investments in properties leased exclusively to investment grade tenants.

 

Our investments in assets where the underlying tenant does not have a publicly available credit rating expose us to certain risks.

 

We have historically been successful at obtaining attractively priced long-term financing for our assets due in part to the high credit quality of the underlying tenant. When we invest in a property where the underlying tenant does not have a publicly available credit rating, we rely on our own estimates of the tenant’s credit rating. If our lender disagrees with our ratings estimates, we may not be able to obtain our desired level of leverage and/or our financing costs may exceed those that we projected. This outcome could have an adverse impact on our returns on that asset and hence our operating results.

 

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Real estate investments are relatively illiquid and their values may decline.

Real estate investments are relatively illiquid. Our ability to vary our portfolio by selling and buying investments in response to changes in economic and other conditions is limited. We may encounter difficulty in disposing of properties when tenants vacate either at the expiration of the applicable lease or otherwise. If we decide to sell any of our investments, our ability to do so and the prices we receive upon sale may be affected by many factors, including debt structures in place on the investment, any limits of our form of property ownership such as an estate for years or ground lease, the number of potential buyers, the number of competing properties on the market and other market conditions, as well as whether the property is leased and if it is leased, the terms of the lease. As a result, we may be unable to sell our investments for an extended period of time or without incurring a loss, which would adversely affect our results of operations, liquidity and financial condition.

 

Our real estate investments are subject to risks particular to real property.

We are subject to general risks of investing in real estate. These risks may include those listed below:

 

·non-performance of lease obligations by tenants;
·civil unrest, acts of God, including earthquakes, floods and other natural disasters, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred on September 11, 2001;
·adverse changes in national and local economic and market conditions;
·the costs of complying or fines or damages as a result of non-compliance with the Americans with Disabilities Act;
·changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;
·the ongoing need for capital improvements, particularly in older structures; and
·other circumstances beyond our control.

Should any of these events occur, our financial condition, liquidity and operating results could be adversely affected.

 

Risks Related to Ownership of Real Estate

We may not be able to renew our leases or re-lease our properties.

Upon the maturity of leases at our properties, we may not be able to renew the leases or re-let all or a portion of that property, or the terms of renewal or re-letting (including the cost of concessions to tenants) may be less favorable to us than the current lease terms. We focus on single tenant properties and non-renewal of the lease by the tenant is likely to result in some downtime before the property is re-leased and a complete reduction in the cash flows from the property until the property is re-let. In addition, we will be responsible for all of the operating costs following a vacancy at a single tenant building. If we are unable to renew existing leases or re-let promptly all or a substantial portion of the space located in our properties, or if the rental rates upon renewal or re-letting are significantly lower than the current rates, our funds from operations and cash available for distribution to stockholders will be adversely affected due to the resulting reduction in rental receipts and increase in property operating costs.

 

Current economic weakness could adversely impact our ability or the terms under which we are able to renew leases as they mature or re-let vacant space.

 

Operating expenses of our properties could reduce our cash flow and funds available for future dividends.

For certain of our owned properties, we are responsible for operating costs of the property. In these instances, our lease requires the tenant to reimburse us for all or a portion of these costs, either in the form of an expense reimbursement or increased rent. Our reimbursement may be limited to a fixed amount or a specified percentage annually. To the extent operating costs exceed our reimbursement, our returns and net cash flows from the property and hence our overall operating results and cash flows could be materially adversely affected.

 

We have greater exposure to operating costs when we invest in owned properties leased to the United States Government.

Our leases with the United States Government are typical Government Services Administration, or GSA, type leases. These leases do not provide that the United States Government is wholly responsible for operating costs of the property, but include an operating cost component within the rent we receive that increases annually by an agreed upon percentage based upon the Consumer Price Index, or CPI. Thus, we have greater exposure to operating costs on our properties leased to the United States Government because if the operating costs of the property increase faster than the CPI, we will bear those excess costs.

 

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We are subject to risks associated with the development of properties.

 

We have begun and expect to continue to make new investments through our construction to acquisition program, where we fund all or substantially all of the construction costs for a build-to-suit project through a joint venture with a developer partner. As of December 31, 2011, we had one project in process (scheduled for completion in the first quarter of 2013) where we have funded $8.2 million toward a total expected investment including amounts borrowed of approximately $53 million. We are subject to certain risks associated with the development of this or any other property we intend to develop, including the following:

 

·Completion of the project in a timely and workmanlike manner will be dependent upon the efforts of various parties outside of our control, such as our developer partner and the general contractor and any subcontractors. Construction could be delayed if these parties fail to perform their obligations or for a variety of other reasons outside of our control, which could subject us to losses for failure to timely deliver the completed project to the tenant or result in a termination of the underlying lease.
·Unanticipated environmental conditions at the property could also delay completion of the project or force us to abandon the project if we determine that remediation of the conditions would be too expensive.
·Construction costs may exceed original estimates, which could adversely impact our expected return from the investment.

 

Our investments in properties subject to an estate for years or ground lease are subject to various unique risks.

Our ownership interest in certain properties includes an estate for years in or a ground lease of the land, along with fee title to the improvements on the land. An estate for years and a ground lease are more limited forms of ownership than a fee interest, as they generally mean that another unrelated party has a present or future interest in the land. Our estate for years and ground lease investments are subject to a variety of risks which could materially adversely impact the value of our investment, such as:

·the existence of the estate for years or ground lease and the interest of a third party in the property could reduce the value of our investment or make it more difficult or more expensive to sell or obtain financing for our investment; and
·unless we have purchased the land, we will lose any remaining investment in these properties when the estate for years and/or ground lease expires.

An uninsured loss or a loss that exceeds the insurance policy limits on our owned properties could subject us to lost capital or revenue on those properties.

Our comprehensive loss insurance policies may include substantial deductibles and certain exclusions. For example, our earthquake insurance coverage for properties we own in California will typically include a customary deductible of five percent of our insurable value. If we are subject to an uninsured loss or a loss that is subject to a substantial deductible, we could lose part of our capital invested in, and anticipated revenue from, the property, which could harm our operating results and financial condition and our ability to pay dividends.

 

Noncompliance with environmental laws could adversely affect our financial condition and operating results.

The real properties we own are subject to various federal, state and local environmental laws. Under these laws, courts and government agencies have the authority to require the current owner of a contaminated property to clean up the property, even if the owner did not know of and was not responsible for the contamination. For example, liability can be imposed upon us based on activities of one of our tenants or a prior owner.

 

Prior to acquisition of a property, we obtain Phase I environmental reports and, in some cases, a Phase II environmental report. However, these reports may not reveal all environmental conditions at a property and we may incur material environmental liabilities of which we are unaware. The costs incurred to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could adversely affect our financial condition, liquidity and operating results.

 

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New rules relating to the accounting for leases could adversely affect our business.

The Financial Accounting Standards Board and International Accounting Standards Board have proposed accounting rules that may be adopted in 2012 or 2013 and would require tenants (but not landlords) to capitalize all leases on their balance sheets by recognizing their rights and obligations. Because landlords are exempted from the rules in their current form, our financial statements are not expected to be materially impacted. However, there can be no assurance that landlords will continue to be exempted from any final rules that may be adopted. If any final rules do not exempt landlords, our financial statements could be materially impacted such as by capitalizing our leases and changing the timing of recognition of lease income. If the proposal is adopted in its current form, it could adversely affect us by causing tenants to approach their leasing decisions differently. Tenants may favor owning as opposed to leasing properties, because this accounting change would remove many of the differences in the way tenants account for owned property versus leased property. Tenants may also prefer shorter lease terms, in an effort to reduce the lease liability required to be recorded on the balance sheet. The proposal could also make lease renewal options less attractive, as, under certain circumstances, the rules would require a tenant to assume that a renewal right would be exercised and accrue a liability relating to the longer lease term.

 

Risks Related to Debt Assets

We invest in CMBS securities, including subordinate securities, which entail significant risks.

We invest in commercial mortgage-backed securities, or CMBS. CMBS securities entitle the holder to receive payments that depend primarily on the cash flow from a specified pool of commercial mortgage loans. Our CMBS investments primarily include classes of securities backed by pools of first mortgage loans on net lease properties (with most of the underlying loan collateral originated by us in the mid to late 1990s). Generally, we have invested in subordinate classes of the securitization pool, or securities that are in a near “first loss” position in the event of losses on the assets within the pool. Consequently, in the event of a loss on one or more commercial real estate loans contained in a securitization, we could lose all or a substantial portion of our investment in the related security.

 

We have limited recourse in the event of a default on any of our mortgage loans.

Our mortgage loan investments are non-recourse obligations of the property owner, and, in the event of default, we are generally dependent entirely on the loan collateral to recover our investment. Our loan collateral consists primarily of a mortgage on the underlying property and an assignment of the tenant’s lease. In the event of a default, we may not be able to recover the premises promptly and the proceeds we receive upon sale of the property may be adversely affected by risks generally incident to interests in real property, including changes in general or local economic conditions and/or specific industry segments, declines in real estate values, increases in interest rates, real estate tax rates and other operating expenses including energy costs, changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, and other factors which are beyond our or our borrower’s control. As discussed above, bankruptcy laws will limit our remedies with respect to the tenant’s lease. There can be no assurance that our remedies with respect to the loan collateral will provide us with a recovery adequate to recover our investment.

 

We may experience losses on our mortgage loans.

Our portfolio includes mortgage loans on properties subject to a net lease. The typical net lease requires the borrower or tenant to maintain casualty insurance on the underlying property. These insurance policies may include substantial deductibles and certain exclusions. If the underlying property is subject to a casualty loss that is uninsured or subject to a substantial deductible, rent payments on the related lease may cease, our loan may default and we could lose some or all of our investment.

 

Our collateral rights under our corporate credit notes are limited.

Our collateral rights on our corporate credit notes are more limited than the collateral rights we have under our long-term mortgage loans. Our corporate credit notes represent one of two notes comprising a single first mortgage loan on a net lease property. Both notes are secured by the same first mortgage and assignment of the tenant’s lease and rents, and the note holders have agreed amongst themselves that the corporate credit note holder will have a junior claim on the real estate mortgage and a senior claim on the rents in the event of a tenant bankruptcy and lease rejection. So our collateral rights with respect to the real estate mortgage will be junior to the holder of the related real estate note. Further, while we will have a senior claim on the lease assignment in a tenant bankruptcy, as discussed above, our claim for damages will be unsecured and limited to an amount defined under the Bankruptcy Code (the greater of one year’s rent or 15% (but not more than three years) of rent over the remaining lease term, plus rent already due but unpaid). Therefore, there can be no assurance that our remedies with respect to the loan collateral will provide us with a recovery adequate to recover our investment.

 

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We may make mezzanine investments and they will likely have a greater risk of loss than mortgage loans.

We have made and may continue to make in the future mezzanine and other generally subordinate investments. These investments generally involve a higher degree of risk than our first mortgage loans. We may not be able to recover some or all of any future mezzanine investments.

 

We may be required to repurchase assets that we have sold or to indemnify holders of the debt issued in our term financings.

If any of the assets we have pledged to obtain long-term financing do not comply with representations and warranties that we make about certain characteristics of the assets, the borrowers and the underlying properties, we may be required to repurchase those assets, repay the related borrowings or replace the assets with substitute assets. In addition, in the case of assets that we have sold such as those in our CDO, we may be required to indemnify persons for losses or expenses incurred as a result of a breach of a representation or warranty. Repurchased assets may require a significant allocation of working capital to carry on our books, and our ability to borrow against such assets may be limited. Any significant repurchases, repayments or indemnification payments could materially and adversely affect our financial condition, liquidity and operating results.

 

Risks Related to Borrowings

Our use of debt financing could have a material adverse effect on our financial condition.

We are subject to the risks normally associated with debt financing, including the risk that our cash flows will be insufficient to meet required principal and interest payments on the debt, and the risk that we will be unable to refinance our existing indebtedness, or that the terms of such refinancing will not be as favorable as the terms of our existing indebtedness. As of December 31, 2011, the scheduled principal payments on our long-term debt over the next five years and thereafter were as follows:

 

   Expected Maturity Dates 
   2012   2013   2014   2015   2016   Thereafter 
   (in thousands, notional amounts) 
Mortgages on real estate investments  $136,077   $74,371   $79,534   $270,668   $281,147   $127,207 
Credit agreement   3,271    67,397                 
Secured term loan   15,380    13,602    12,349    13,405    12,528    20,878 
Convertible senior notes   35,009                     
Other long-term debt                   30,930     

  

Included in the above amounts are balloon payments on our debt instruments, including $117 million of non-recourse mortgage debt due in August 2012 on our three Nestlé properties and $35 million of convertible senior notes that may be put to us by the holders in October 2012. Most of our debt provides for balloon payments that are payable at maturity. Our ability to make these balloon payments will depend upon our ability to refinance the related debt, raise additional equity capital and/or sell assets or any related collateral. Our ability to accomplish these goals will be affected by various factors existing at the relevant time, such as capital and credit market conditions, the state of the national and regional economies, local real estate conditions, available interest rate levels, the lease terms for and equity in and value of any related collateral, our financial condition and the operating history of the collateral, if any. We cannot provide any assurance that we will be able to repay our debt or refinance it on terms as favorable as the existing indebtedness or at all. If we are unable to obtain sufficient financing to fund the scheduled balloon payments or to sell the related collateral at a price that generates sufficient proceeds to make the scheduled balloon payments, we could lose all or a substantial portion of our investment in the asset financed.

 

Our convertible senior notes and other long-term debt referenced in the table above are unsecured and, therefore, it may be more difficult to generate sufficient proceeds to repay these obligations in the future. These obligations are also recourse, meaning that our lender will have general recourse against our assets if we fail to make required payments on the debt.

 

Our debt obligations could adversely affect our ability to execute on our growth strategy as we may need to utilize the liquidity we could otherwise use to add new assets to repay our debt obligations.

 

If our debt cannot be repaid, refinanced or extended, we may not be able to make distributions to stockholders at expected levels or at all. Further, if prevailing interest rates or other factors at the time of a refinancing result in higher interest rates or other restrictive financial covenants upon the refinancing, then such refinancing would adversely affect our cash flows and funds available for operation and distribution.

 

22
 

 

Our credit agreement with Wells Fargo Bank is a secured, recourse obligation and exposes us to interest rate and margin call risks.

 

We have financed certain of our investments pursuant to a credit agreement we have entered into with Wells Fargo Bank. This borrowing agreement exposes us to a variety of risks, including the following:

 

·It is priced at floating rates based on one-month LIBOR, or the London Interbank Offered Rate. Therefore, increases in the one-month LIBOR rate will cause our borrowing costs to increase and our net income to decrease.
·The agreement is recourse to all of our other assets. In the event we are unable to satisfy our payment obligations under the agreement from the assets securing our borrowings, we will remain obligated to satisfy these obligations out of other assets of our company.
·We are subject to margin call risk under the credit agreement documents. Wells Fargo Bank has the right in its sole discretion to revalue our collateral, provided that Wells Fargo Bank may not reduce the value of any of our collateral other than CMBS securities due to general credit spread or interest rate fluctuations. In the event Wells Fargo Bank determines that the value of our collateral has decreased, it has the right to make a margin call. A margin call would require us to make up any collateral shortfall with cash or additional portfolio assets. We may not have sufficient cash or portfolio assets to do so. A failure to meet a margin call could cause us to default under the agreement and otherwise have a material adverse effect on our financial condition and operating results.
·We have borrowed the full amount permitted under the loan documents based on the lender’s current valuation of our collateral. In order to borrow any additional amounts under the credit agreement, we will be required to post additional collateral. Further, Wells Fargo Bank has the right to reject any asset that we seek to finance pursuant to the credit agreement.

Leveraging our portfolio is an important component of our strategy and subjects us to increased risk of loss.

A key component of our strategy is to borrow against, or leverage, our assets to allow us to invest in a greater number of assets and enhance our asset returns. However, leverage also subjects us to increased risk of loss. We are more highly leveraged compared to certain of our competitors. The use of leverage may result in increased losses to us in the following ways:

 

·We rely on the cash flows from the assets financed to fund our debt service requirements. Therefore, in the event of a tenant default on its rent payments, our losses are expected to increase as we will need to fund our debt service requirements from other sources.
·To the extent we have financed our assets under our variable rate credit agreement with Wells Fargo Bank, our debt service requirements will increase as short-term interest rates rise. In addition, if short-term interest rates rise in excess of the yields on our assets financed, we will be subject to losses.
·Our lenders will have a first priority claim on the collateral we pledge and the right to foreclose on the collateral. Therefore, if we default on our debt service obligations, we would be at risk of losing the related collateral.
·Our credit agreement with Wells Fargo Bank is a fully recourse lending arrangement. Therefore, if we default on this agreement, our lenders will have general recourse to our company’s assets, rather than limited recourse to just the assets financed.

We may not be able to implement our long-term financing strategy.

Part of our business strategy is to secure long-term financing of our assets to enable us to invest in a greater number of assets and enhance our asset returns. Our ability to implement our long-term financing strategy is subject to the following risks:

 

·We may not be able to achieve our desired leverage level due to market conditions, decreases in the market value of our assets, increases in interest rates and other factors.
·We are subject to conditions in the mortgage and other long-term financing markets which are beyond our control, including the liquidity of these markets and maintenance of attractive credit spreads.
·In the event of an adverse change in the financial condition of our underlying tenant, it may not be possible or it may be uneconomical for us to obtain long-term financing for the subject asset.

Our inability to implement our long-term financing strategy may cause us to experience lower leveraged returns on our assets than would otherwise be the case, and could have a material adverse effect on our operating results.

 

23
 

 

Certain of our assets are cross-collateralized, and certain of our indebtedness is cross-defaulted.

 

As of December 31, 2011, our three Nestlé properties all serve as collateral for a single mortgage note on the three properties. In addition, (1) our secured term loan is secured by interests in 28 of our investments and (2) our credit agreement with Wells Fargo Bank is secured by interests in 19 of our investments. To the extent that any of our investments are cross-collateralized, the lender will have recourse to any and all of the assets that secure the debt in the event that we default under the loan documents. Therefore, cross-collateralizing our investments generally exposes us to increased risk of loss under the related financing arrangement.

 

In addition, our credit agreement with Wells Fargo Bank and our convertible senior notes contain cross-default provisions, meaning that a default under one obligation could result in the other lender accelerating the maturity of our obligations to them.

 

We may not be able to finance our investments on a long-term basis on attractive terms, which may require us to seek more costly financing for our investments or to liquidate assets.

As part of our investment strategy, we may acquire new assets and finance them on a floating rate, recourse borrowing agreement with the expectation that we will obtain long-term, fixed rate, non-recourse financing in the future. During the period we finance these assets on a recourse facility, we bear the risk of being unable to finance the assets on a non-recourse basis at attractive prices or in a timely matter, or at all. If it is not possible or economical for us to finance such assets on a non-recourse basis, we may be unable to pay down our recourse borrowings, or be required to liquidate the assets at a loss in order to do so. If we sell an asset at less than what the lender has advanced to us against that asset, we will remain liable to the lender for the shortfall because of the recourse nature of the facility.

 

Hedging transactions may not effectively protect us against anticipated risks and may subject us to certain other risks and costs.

We may enter into hedging transactions to manage our exposure to interest rate fluctuations prior to the time we obtain long-term fixed rate financing for our assets. Our hedging strategy exposes us to certain risks, among them the following:

 

·If we do not complete the long-term financing or obtain it in the time frame we designate at the time of the hedge transaction, our hedging strategy may not have the desired beneficial impact on our results of operations or financial condition.
·Our hedging strategy may serve to reduce the returns which we could possibly achieve if we did not utilize the hedge.
·Our hedging transactions may not perform as expected, including during periods of market dislocation.
·No hedging activity can completely insulate us from the risks associated with changes in interest rates and, therefore, our hedging strategy may not have the desired beneficial impact on our results of operations or financial condition.
·Hedging transactions are entered into at the discretion of our management team and they may conclude that it is not in our company’s best interest to hedge the interest rate risks with respect to certain expected long-term financings, particularly during periods of market dislocation. We are not currently carrying an open interest rate hedge to manage our exposure to interest rate fluctuations for assets for which we may obtain long-term financing for in the future. Our decision to do so leaves us exposed to increases in long-term interest rates for those assets and, therefore, may make it more difficult or more costly to obtain long-term financing.
·Hedging costs increase as the period covered by the hedge increases and during periods of rising and volatile interest rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising.

We may fail to qualify for hedge accounting treatment.

We record derivative and hedge transactions in accordance with United States generally accepted accounting principles. Under these standards, we may fail to qualify for hedge accounting treatment for a number of reasons, including if we use instruments that do not meet the applicable accounting definition of a derivative (such as short sales), we fail to satisfy applicable accounting hedge documentation requirements or we fail initial or subsequent quarterly hedge effectiveness assessment requirements. If we fail to qualify for hedge accounting treatment, our operating results may suffer because any losses on the derivatives we enter into would be charged to our Statement of Operations without any offset from the change in fair value of the related hedged transaction.

24
 

Risks Related to Business Strategy and Policies

 

We face significant competition that could harm our business.

 

We are subject to significant competition. Our competitors include other public and private REITs, private real estate companies, pension funds and individuals. We may face new competitors and, due to our focus on single tenant properties located throughout the United States, and because many of our competitors are locally and/or regionally focused, we will not encounter the same competitors in each region of the United States. Many of our competitors have greater financial and other resources and may have other advantages over our company. Our competitors may be willing to accept lower returns on their investments, may have access to lower cost capital and may succeed in buying the assets that we target for acquisition. We may incur costs on unsuccessful acquisitions that we will not be able to recover. Our failure to compete successfully could have a material adverse effect on our financial condition, liquidity and operating results.

 

Our network of investment sale brokers and independent mortgage brokers may sell investment opportunities to our competitors.

 

An important source of our investments is our network of investment sale brokers and independent mortgage brokers. These brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with many of these brokers and actively compete with us in our efforts to obtain investments from these brokers. As a result, we may lose potential transactions to our competitors, causing our investment pace to fail to meet market expectations, which could have a material adverse effect on the market price of our stock.

 

Joint venture investments will expose us to certain risks.

 

We may from time to time enter into joint venture transactions for portions of our exiting or future portfolio assets, which may include certain of our real properties and/or some or all of our loan and securities investments. Investing in this manner subjects us to certain risks, among them the following:

 

·We will not exercise sole decision-making authority regarding the joint venture’s business and assets and, thus, we may not be able to take actions that we believe are in our company’s best interests.
·We may be required to accept liability for obligations of the joint venture (such as recourse carve-outs on mortgage debt obligations) beyond our economic interest.
·Our returns on joint venture assets may be adversely affected if the assets are not held for the long-term, or a period of about ten years.

Our ability to grow our business will be limited by our ability to attract debt or equity financing, and we may have difficulty accessing capital on attractive terms.

 

We expect to fund future investments primarily from debt or equity capital. Therefore, our ability to grow is dependent upon the availability of debt or equity capital from public or institutional investors. Further, additional debt and/or equity capital may not be available to us at an acceptable cost. The capital markets also have been, and in the future may be, adversely affected by various other events or conditions beyond our control, such as the United States’ military involvement in the Middle East and elsewhere, the terrorist attacks on September 11, 2001, the ongoing War on Terrorism by the United States and the bankruptcy of major companies, such as Lehman Brothers Holdings Inc. and Enron Corp. Events such as an escalation in the War on Terrorism, new terrorist attacks, or additional bankruptcies in the future, as well as other events beyond our control, could adversely affect the availability and cost of capital for our business. As a REIT, we will also be dependent upon the availability and cost of capital in the REIT markets specifically, which can be impacted by various factors such as interest rate levels, the strength of real estate markets and investors’ appetite for REIT investments. We cannot assure you that we will be successful in attracting sufficient debt or equity financing to fund future investments, or at an acceptable cost.

 

Future offerings of debt and equity may not be available to us or may adversely affect the market price of our common stock.

 

We expect to continue to increase our capital resources by making additional offerings of equity and debt securities in the future, which would include classes of preferred stock, common stock and senior or subordinated notes. All debt securities and other borrowings, as well as all classes of preferred stock, will be senior to our common stock in a liquidation of our company. Additional equity offerings could dilute our stockholders’ equity, reduce the market price of shares of our common stock, or be of preferred stock having a distribution preference that may limit our ability to make distributions on our common stock. Market conditions could cause us to seek sources of potentially less attractive capital. Our ability to estimate the amount, timing or nature of additional offerings is limited as these factors will depend upon market conditions and other factors.

 

 

25
 

  

The concentration of our company’s common stock could have an adverse impact on the value of your investment.

As of December 31, 2011, approximately 48.1% of our common stock was owned by eight different institutional investors (based on SEC filings made by these investors). This concentration of ownership could have an adverse impact on the value of your investment, including as a result of the following:

 

·Trading volume in our stock may be limited, which will reduce the liquidity of your investment.
·The sale of a significant number of our shares in the open market by a significant stockholder or otherwise could cause our stock price to decline.
·Although none of these investors on its own controls a majority of our common stock, these owners could determine to act together and given their significant concentration may be able to take actions that are not in your best interest.

REIT distribution requirements could adversely affect our ability to execute our business plan and may require us to incur debt or sell assets to make such distributions.

To maintain our status as a REIT, we must distribute annually at least 90% of our taxable income. To the extent we satisfy this requirement but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax and may be subject to a 4% nondeductible excise tax on our undistributed taxable income. We generally intend to distribute each year all or substantially all of our taxable income so as to comply with the REIT requirements and to avoid federal income tax and nondeductible excise tax.

From time to time, we may generate less cash flow than taxable income, for example, if we are required to use cash income we receive from our assets to make principal payments on our indebtedness or due to timing differences in when we record income for tax purposes.

As a result of the foregoing, we may be required to take one or more of the following steps in order to comply with the REIT distribution requirements and to avoid corporate income tax and the 4% nondeductible excise tax:

·sell assets in adverse market conditions;
·borrow on unfavorable terms;
·distribute amounts that would otherwise be invested in future investments, capital expenditures or repayment of debt;
·distribute shares of our common stock rather than cash; or
·utilize cash on hand to fund distributions.

Thus, compliance with the REIT distribution requirements may hinder our ability to grow, which could adversely affect the value of our common stock.

 

The federal income tax laws governing REITs are complex, and our failure to qualify as a REIT under the federal tax laws will result in adverse tax consequences.

We intend to continue to operate in a manner that will allow us to qualify as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Accordingly, we cannot be certain that we will be successful in qualifying as a REIT. At any time, new laws, interpretations, or court decisions may change the federal tax laws or the federal income tax consequences of our qualification as a REIT.

 

If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income. Our taxable income would be determined without deducting any distributions to our stockholders. We might need to borrow money or sell assets in order to pay any such tax. If we cease to qualify as a REIT, we no longer would be required to distribute most of our taxable income to our stockholders. Unless the federal income tax laws excused our failure to qualify as a REIT, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT.

 

Our ownership limitations may restrict or prevent you from engaging in certain transfers of our stock.

In order to maintain our REIT qualification, no more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal income tax laws to include various kinds of entities) during the last half of any taxable year. “Individuals” for this purpose include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts. In order to preserve our REIT qualification, our charter generally prohibits any person from directly or indirectly owning more than 9.9% in value or in number of shares, whichever is more restrictive, of any class or series of the outstanding shares of our capital stock.

 

 

26
 

  

If anyone transfers shares in a way that would violate our ownership limits, or prevent us from continuing to qualify as a REIT under the federal income tax laws, we will consider the transfer to be null and void from the outset and the intended transferee of those shares will be deemed never to have owned the shares or those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate our ownership limits. Anyone who acquires shares in violation of our ownership limits or the other restrictions on transfer in our charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of our stock falls between the date of purchase and the date of redemption or sale.

 

Provisions of our charter and Maryland law may limit the ability of a third-party to acquire control of our company.

Our charter contains restrictions on stock ownership and transfer.

As described above, our charter contains stock ownership limits. These limits may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for stock of our company or otherwise be in the best interest of our stockholders.

 

Our Board of Directors may issue additional stock without stockholder approval.

Our charter authorizes our Board of Directors to amend the charter to increase or decrease the aggregate number of shares of stock we have authority to issue, without any action by the stockholders. Issuances of additional shares of stock may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for stock of our company or otherwise be in the best interest of our stockholders.

 

Other provisions of our charter and bylaws may delay or prevent a transaction or change of control.

Our charter and bylaws also contain other provisions that may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders. For example, our charter and bylaws provide that: a two-thirds vote of stockholders is required to remove a director, vacancies on our Board of Directors may only be filled by the remaining directors (or, if no directors remain, by the stockholders), the number of directors may be fixed only by the directors, our bylaws may only be amended by our directors and a majority of shares is required to call a special stockholders meeting.

 

Increased market interest rates may reduce the value of our stock.

We believe that investors consider the dividend distribution rate on shares of REIT stock, expressed as a percentage of the market price of the shares, relative to market interest rates as an important factor in deciding whether to buy or sell shares of REIT stock. If market interest rates go up, prospective purchasers of REIT stock may expect a higher dividend distribution rate. Higher interest rates would also likely increase our borrowing costs and might decrease cash available for distribution. Thus, higher market interest rates could cause the market price of stock in our company to decline.

 

The market price of our stock may vary substantially.

Various factors can affect the market price of our stock including the following:

 

·actual or anticipated variations in our quarterly results of operations;
·the extent of investor interest in our company, real estate generally or commercial real estate specifically;
·the reputation of REITs generally and the attractiveness of their equity securities in comparison to other equity securities, including securities issued by other real estate companies, and fixed income securities;
·changes in expectations of future financial performance or changes in estimates of securities analysts;
·fluctuations in stock market prices and volumes; and
·announcements by us or our competitors of acquisitions, investments or strategic alliances.

We depend on our key personnel.

We depend on the efforts and expertise of our senior management team. There is no guarantee that any member of our senior management team will remain employed with our company. If any member of our senior management team were to die, become disabled or otherwise leave our employ, we may not be able to replace him with a person of equal skill, ability and industry expertise.

 

27
 

Item 1B. Unresolved Staff Comments.

None.

Item 2. Properties.

Our corporate offices are located at 1065 Avenue of the Americas, New York, New York 10018. Our lease at this property expires in September 2013.

 

Our owned real properties are described above under “Business—Our Portfolio—Owned Properties.”

Item 3. Legal Proceedings.

From time to time, we are involved in legal proceedings in the ordinary course of business. We do not believe that any matter we are currently involved in will have a material adverse effect on our business, results of operations or financial condition. However, periodic settlements and/or professional or other fees and expenses related to any matter could have an adverse impact on our results of operations in the quarterly or annual period in which they are recognized.

Item 4. Mine Safety Disclosures.

Not applicable.

  

28
 

 

PART II. 

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Information and Holders of Record

 

Our common stock has been listed for trading on the New York Stock Exchange (“NYSE”) under the symbol “LSE” since our initial public offering on March 19, 2004. On February 15, 2012, the reported closing sale price per share of common stock on the NYSE was $4.17 and there were 646 holders of record of our common stock. The table below sets forth the quarterly high and low sales prices of our common stock on the NYSE for the periods indicated.

 

Fiscal Year  Low   High 
2010          
First Quarter  $3.99   $5.72 
Second Quarter   4.44    6.30 
Third Quarter   4.42    5.81 
Fourth Quarter   5.45    6.32 
           
2011          
First Quarter  $5.18   $6.01 
Second Quarter   4.73    5.60 
Third Quarter   3.47    5.01 
Fourth Quarter   3.06    4.33 

 

Dividends

The table below sets forth the cash dividends paid on our common stock for the periods indicated:

 

Quarter Ended  Dividend Payment Date   Dividend per Share 
2010          
March 31, 2010  April 15, 2010   $0.06 
June 30, 2010  July 15, 2010    0.06 
September 30, 2010  October 15, 2010    0.06 
December 31, 2010  January 18, 2011    0.065 
          
2011         
March 31, 2011  April 15, 2011   $0.065 
June 30, 2011  July 15, 2011    0.065 
September 30, 2011  October 17, 2011    0.065 
December 31, 2011  January 17, 2012    0.065 

 

We generally intend to distribute each year all or substantially all of our REIT taxable income (which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles) to our stockholders so as to comply with the REIT provisions of the Internal Revenue Code and to avoid federal income tax and the nondeductible excise tax. Our dividend policy is determined from time to time by our Board of Directors in their sole discretion, and will depend on factors such as our cash available for distribution, our funds from operations, our maintenance of REIT status, market conditions and such other factors as our Board of Directors deems relevant.

 

Tax Characteristics of 2011 Dividends

 

The following table summarizes the taxable nature of our common dividends during 2011:

 

Total common dividend per share (tax basis)  $0.26 
Capital gain   0.00%
Ordinary income   0.00%
Return of capital   100.00%
    100.00%

 

29
 

 

Stock Price Performance Graph

 

The graph below compares the cumulative total stockholder return of our common stock with that of the Standard & Poor’s 500 Composite Stock Price Index and the Standard & Poor’s 500 REIT Index from December 31, 2006 through December 31, 2011. The graph assumes that you invested $100 at the close of market on December 31, 2006 in our common stock and each of the indexes, with dividends reinvested. The comparisons in this graph are provided in accordance with Securities and Exchange Commission disclosure requirements and are not intended to forecast or be indicative of the future performance of our common stock.

 

   Base                     
   Period                     
Company / Index  12/31/06   12/31/07   12/31/08   12/31/09   12/31/10   12/31/11 
CapLease, Inc.   100    78.61    17.44    47.30    65.78    48.42 
S&P 500 Index   100    105.49    66.46    84.05    96.71    98.76 
S&P 500 REIT Index   100    82.90    48.75    60.95    80.29    90.38 

 

 

Common Stock Repurchases

 

During August 2011, our Board of Directors approved a share repurchase program authorizing us to repurchase in the aggregate up to $20 million of our outstanding common stock. The program has no expiration date and permits us to purchase shares through a variety of methods, including in the open market or through privately negotiated transactions, in accordance with applicable securities laws. It does not obligate us to make any repurchases at any specific time or situation. The timing and extent to which we repurchase our shares will depend upon a variety of factors, including market conditions, our liquidity, and regulatory requirements.

 

30
 

 

The following is a summary of our common stock repurchases during the three months ended December 31, 2011, all of which were conducted under the share repurchase program described above.

 

           Total Number of   Maximum Dollar Value 
           Shares Purchased as   of Shares That May 
   Total Number of   Average Price Paid   Part of Publicly   Yet be Repurchased 
Month  Shares Repurchased   Per Share   Announced Program   Under the Program 
                 
October 1-31, 2011   163,021   $3.64    1,746,348   $13,348,734 
                     
November 1-30, 2011   22,902   $3.66    1,769,250   $13,264,460 
                     
December 1-31, 2011      $    1,769,250   $13,264,460 

 

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Item 6. Selected Financial Data.

 

The following selected historical financial information for the five years ended December 31, 2011 is derived from our audited consolidated financial statements. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included in this Form 10-K.

 

   Year ended December 31, 
   2011   2010   2009   2008   2007 
   (in thousands, except per share amounts) 
Statement of Operations data                         
Revenues:                         
Rental revenue  $127,995   $121,661   $130,495   $131,025   $119,698 
Interest income from loans and securities   19,655    27,621    30,668    35,040    35,368 
Tenant reimbursements   13,900    12,159    11,473    11,457    11,215 
Other revenue   793    974    1,532    764    583 
Total revenues   162,343    162,415    174,168    178,286    166,864 
Expenses:                         
Interest expense   76,594    83,024    88,195    95,967    94,655 
Property expenses   27,216    24,690    20,410    19,497    18,543 
General and administrative expenses   10,628    10,660    10,881    11,608    10,661 
General and administrative expenses - stock based compensation   2,785    2,541    2,118    1,978    1,621 
Depreciation and amortization expense on real
property
   47,632    45,956    48,957    50,679    45,123 
Other expenses   199    267    308    314    306 
Total expenses   165,054    167,138    170,869    180,043    170,909 
Other gains (losses):                         
Gain (loss) on investments, net   648    (7,949)   (10,886)   (3,309)   (372)
Provision for loss on property investment           (11,923)        
(Loss) gain on derivatives               (19,496)   203 
Gain (loss) on extinguishment of debt   (3,698)   (293)   9,829    1,713    1,363 
Total other gains (losses)   (3,050)   (8,242)   (12,980)   (21,092)   1,194 
Provision for income taxes           (201)        
Loss from continuing operations   (5,761)   (12,965)   (9,885)   (22,849)   (2,851)
Discontinued operations:                         
Income (loss) from discontinued operations   42    (227)   (60)   (85)   368 
Gain (loss) on investments, net   1,426                (55)
Provision for loss on property investment   (16,423)       (4,076)   (354)    
Gain on extinguishment of debt   18,861                 
Total discontinued operations   3,906    (227)   (4,136)   (439)   313 
Net loss before non-controlling interest in consolidated subsidiaries   (1,855)   (13,192)   (14,018)   (23,288)   (2,538)
Non-controlling interest in consolidated subsidiaries   20    52    51    124    33 
Net loss   (1,835)   (13,140)   (13,967)   (23,164)   (2,505)
Dividends allocable to preferred shares   (6,510)   (5,618)   (2,844)   (2,844)   (2,844)
Net loss allocable to common stockholders  $(8,345)  $(18,758)  $(16,811)  $(26,008)  $(5,349)
                          
Earnings per share:                         
Income (loss) per common share, basic and diluted:                         
Loss from continuing operations  $(0.19)  $(0.33)  $(0.26)  $(0.56)  $(0.14)
Income (loss) from discontinued operations   0.06        (0.08)   (0.01)   0.01 
Net loss per common share, basic and diluted  $(0.13)  $(0.33)  $(0.34)  $(0.57)  $(0.13)
Weighted average number of common shares outstanding, basic and diluted   64,758    56,189    49,297    45,526    40,739 
Dividends declared per common share  $0.26   $0.25   $0.21   $0.60   $0.80 
Dividends declared per preferred share  $2.03   $2.03   $2.03   $2.03   $2.03 

 

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   Year ended December 31, 
   2011   2010   2009   2008   2007 
   (in thousands) 
Other data                         
Cash flows from operating activities  $48,917   $47,689   $57,364   $64,359   $30,945 
Cash flows from investing activities   118,456    (25,051)   70,342    9,547    (309,062)
Cash flows from financing activities   (128,955)   (28,442)   (97,599)   (99,514)   307,739 

 

   As of December 31, 
   2011   2010   2009   2008   2007 
   (in thousands) 
Balance sheet data                         
Real estate investments, net  $1,401,526   $1,398,399   $1,408,819   $1,510,413   $1,563,570 
Loans held for investment, net   33,139    210,040    221,211    285,779    269,293 
Commercial mortgage-backed securities   59,435    145,965    153,056    161,842    198,187 
Cash and cash equivalents   71,160    32,742    38,546    8,439    34,047 
Total assets   1,641,623    1,870,271    1,904,415    2,045,525    2,158,067 
Mortgages on real estate investments   972,924    928,429    943,811    972,324    983,770 
Collateralized debt obligations       254,210    263,310    268,265    268,227 
Repurchase agreement obligations                   232,869 
Credit agreement   70,668    105,345    126,262    189,262     
Secured term loan   88,142    101,880    114,070    123,719    129,521 
Convertible senior notes   34,522    33,926    49,452    66,239    68,017 
Other long-term debt   30,930    30,930    30,930    30,930    30,930 
Total stockholders’ equity   384,795    350,472    313,210    323,578    356,440 

 

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Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read in conjunction with the consolidated financial statements and the notes to those financial statements, included elsewhere in this filing. Except where otherwise indicated or where the context is clear, the portfolio statistics in Item 7 of this Form 10-K represent or are calculated from our carry value for financial reporting purposes before depreciation and amortization. With respect to our loan portfolio, we have adjusted our carry value to exclude a $0.5 million general loss reserve.

 

When we use the term “we,” “us,” “our” or “the Company” we mean CapLease, Inc. and its majority-owned subsidiaries. All interests in our properties are held through special purpose entities which are separate and distinct legal entities.

 

Overview

 

We are a REIT that primarily owns and manages single tenant commercial real estate properties subject to long-term leases to high credit quality tenants. We focus on properties that are subject to a net lease, or a lease that requires the tenant to pay all or substantially all property operating expenses, such as utilities, real estate taxes, insurance and routine maintenance. We also have made and expect to continue to make investments in single tenant properties where the owner has exposure to property operating expenses when we determine we can sufficiently underwrite that exposure and isolate a predictable cash flow.

 

In addition to our portfolio of owned properties, we have a modest portfolio of first mortgage loans and other debt investments on single tenant properties. That debt portfolio was reduced significantly during 2011 as a result of our sale of the assets and associated liabilities comprising our CDO, as well as the individual sale of certain other loans and securities. While the focus of our investment activity is expected to remain the ownership of real properties, we may continue to make debt investments from time to time on an opportunistic basis in the future.

 

As a result of lease non-renewals, we have classified three properties as “multi-tenant properties,” as each is no longer leased primarily by a single tenant. As of December 31, 2011, we had an approximately $1.8 billion investment portfolio, including $1.7 billion of owned properties and $0.1 billion of loans and other debt investments.

 

Our primary business objective is to generate stable, long-term and attractive returns based on the spread between the yields generated by our assets and the cost of financing our portfolio. We believe that our focus on assets leased to high credit quality tenants subject to long-term leases will provide us with a stable and predictable stream of cash flows that will support our business and the payment of dividends to our stockholders for the foreseeable future.

 

The principal sources of our revenues are rental income on our owned real properties and interest income from our debt investments (loans and securities). In order to grow our revenues, we will be primarily dependent on our ability to add new assets to our portfolio. We are also intensely focused on growing revenues by re-letting vacant space within our portfolio. As of December 31, 2011, the occupancy rate in our owned property portfolio was 96.1% with virtually all of the vacant space being in our office property in Johnston, Rhode Island and one of the two office buildings in Omaha, Nebraska. We cannot provide any assurance as to when and on what terms we will be able to re-let properties that are or may become vacant in our portfolio.

 

The principal sources of our expenses are interest expense on our assets financed, depreciation expense on our real properties, general and administrative expenses and property expenses (net of expense recoveries). With the exception of our credit agreement with Wells Fargo Bank, all of our outstanding debt is currently fixed rate and, therefore, the interest expense we pay is not subject to fluctuation based on changes in market interest rates. Our credit agreement with Wells Fargo Bank is floating rate debt and, therefore, the interest expense we pay is expected to increase if interest rates, in particular the one-month LIBOR rate, increase.

 

The average remaining lease term on our owned properties is approximately 7 years, although we have some leases that are scheduled to mature over the next few years. We are subject to the risk that our tenants do not renew their leases at maturity and that we are unable to promptly re-let the property, or that the terms of renewal or re-letting may be less favorable to us than the current lease terms, any of which could result in a reduction in our revenues and an increase in our property operating costs.

 

We rely on leverage to allow us to invest in a greater number of assets and enhance our asset returns. Our overall portfolio leverage, expressed as a percentage of our total debt to our total assets before depreciation and amortization on owned properties and with other minor adjustments, was approximately 66% as of December 31, 2011. Our leverage ratios by segment as of December 31, 2011 were approximately 63% for the owned properties segment and 72% for the debt investments segment. See “Liquidity and Capital Resources—Leverage” below for information about our use of leverage ratios and how we compute them.

 

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We expect our leverage level to continue to decrease over time, primarily as a result of scheduled principal amortization on our debt and lower or no leverage on new asset acquisitions. During 2011, the focus of our portfolio activity was on continuing the portfolio growth momentum we started in 2010 and continuing to reduce our leverage. During 2011, we purchased two single tenant properties for a total purchase price of $53.5 million, completed the development of a build-to-suit project with a total investment of $8.1 million, and commenced another build-to-suit project with an expected total investment of $53 million. We also reduced our debt obligations by $258 million, and brought down our leverage level by 600 basis points to 66%.

 

Our portfolio financing strategy is to finance our assets with long-term fixed rate debt as soon as practicable after we invest, generally on a secured, non-recourse basis. Through non-recourse debt, we seek to limit the overall company exposure in the event we default on the debt to the amount we have invested in the asset or assets financed. We also had $136.1 million of recourse debt obligations outstanding as of December 31, 2011, including $70.7 million outstanding under our credit agreement with Wells Fargo Bank which is scheduled to mature in July 2013. We also hold certain assets unencumbered by debt and expect to continue to do so in the future.

 

We will be required to repay or refinance our debt obligations at maturity, which we expect, although cannot provide any assurance, that we will be able to do. To the extent we are unable to refinance debt obligations, we may rely on a combination of cash on hand, cash from asset sales, and cash from future debt or equity capital raises to fund the liquidity needed to repay the obligations. Our ability to refinance debt, sell assets and/or raise capital on favorable terms will be highly dependent upon prevailing market conditions. We have two debt obligations scheduled to mature or potentially come due during 2012, comprised of $117 million of non-recourse mortgage notes on our three Nestlé properties maturing in August and $35 million of convertible senior notes that may be put to us by the holders in October.

 

Business Environment

 

The performance of our existing portfolio and our ability to add new assets will continue to be impacted by market conditions. Commercial real estate market conditions are improving, although various signs of weakness still persist reflecting the weak U.S. economy. For example, delinquency rates on commercial real estate loans remains at historic highs, which has impacted the amount and terms of credit available for new transactions. Further, overall transaction volumes remain lower compared to historic norms and interest rates remain at historic lows, which have driven significant competition for new investment opportunities. We cannot provide any assurance as to when and at what yields and other terms we will be able to continue to add new assets to our portfolio.

 

In addition, while rents and property values have been recovering in some markets, weakness and uncertainty persists, particularly in those markets hardest hit by the recent downturn. We have a series of leases maturing over the next several years and commercial real estate conditions in the relevant markets at lease maturity will have a significant impact on our ability to retain tenants or re-let vacant properties promptly and on favorable terms as leases mature.

 

We also have a series of non-recourse mortgages on our owned properties maturing over the next several years and lending for commercial real estate transactions remains uneven and muted, which could impact our ability to sell properties and refinance maturing debt on favorable terms or at all.

 

Our ability to execute on our business plan, including to add new assets to our portfolio and support additional investments in our existing assets, will continue to be impacted by capital market conditions. The stock market in general and the market price of our common stock in particular continue to be volatile. We cannot make any assurance that capital markets will be favorable to us at any time.

 

Application of Critical Accounting Policies

 

Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of financial statements in conformity with GAAP requires the use of judgments, estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from these estimates. The following is a summary of our accounting policies that are most affected by judgments, estimates and assumptions. The summary should be read in conjunction with the more complete discussion of our accounting policies included in Note 2 to the consolidated financial statements in this Annual Report on Form 10-K.

 

Impairment on Owned Real Properties.

 

We are required under GAAP to review our owned properties for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The evaluation includes estimating and reviewing anticipated future undiscounted cash flows to be derived from the asset. If such cash flows are less than the asset’s carrying value, an impairment charge is recognized to earnings to the extent by which the asset’s carrying value exceeds the estimated fair value. Estimating future cash flows is highly subjective and includes an evaluation of factors such as the anticipated cash flows from the property, which may include rent from current leases in place and projected future leases, estimated capital expenditures, and an estimate of proceeds to be realized upon sale of the property. Our estimates could differ materially from actual results. We recorded impairment losses on our owned properties of $16.4 million in 2011 (and a gain on debt extinguishment of $18.9 million related to the transfer of the same property to the lender) and $16.0 million in 2009 (including $11.9 million on the write-down to estimated fair value of the vacant property in Johnston, Rhode Island and $4.1 million on the sale of one property during 2009 and a second property sold during 2010). We did not record any impairment losses on our owned properties during 2010.

 

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Impairment of Loan Investments.

 

We are required under GAAP to periodically evaluate each of our loan investments for possible impairment. In accordance with applicable accounting guidance, our impairment analysis includes both a general reserve component (on performing loans) and an asset-specific component (on loans where we have deemed it probable that we will not be able to collect all amounts due according to the contractual terms). Significant judgment is required in the analysis of each component, including (under the general reserve component) making estimates of the likelihood of default and lease rejection given the credit characteristics of the tenant, and estimates of stressed collateral values and potential bankruptcy claim recoveries, and (under the asset-specific component) evaluating factors such as the status of the loans (i.e., current or expected payment or other defaults), the credit quality of the underlying tenants, the present value of expected future cash flows on the loans, the fair market value of our collateral, and the amount and status of any senior debt. These estimates are highly subjective and could differ materially from actual results. As of December 31, 2011, we had a general loan loss reserve of $0.5 million (established in 2008) and no asset-specific loan loss reserves.

 

Purchase Accounting for Acquisition of Real Estate.

 

We are required under GAAP to allocate the purchase price of rental real estate acquired to the following based on fair values:

 

·acquired tangible assets, consisting of land, building and improvements; and

 

·identified intangible assets and liabilities, consisting of above-market and below-market leases, in-place leases and tenant relationships.

 

In estimating the fair value of the tangible and intangible assets acquired, we consider information obtained about each property as a result of our due diligence activities and other market data, and utilize various valuation methods, such as estimated cash flow projections utilizing appropriate discount and capitalization rates, estimates of replacement costs, and available market information. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant (the “dark value”).

 

Above-market and below-market lease values for acquired properties are recorded based on the present value of the difference between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease. Fair market lease rates are measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market rate renewal options for below-market leases. In computing present value, we consider the costs which would need to be invested to achieve the fair market lease rates. We use a discount rate which reflects the risks associated with the leases acquired. The capitalized above-market lease values are amortized as a reduction of base rental revenue over the remaining term of the respective leases, and the capitalized below-market lease values are amortized as an increase to base rental revenue over the remaining initial terms plus the terms of any below-market renewal options of the respective leases.

 

Other intangible assets acquired include in-place leases and tenant relationships which are valued based on management’s evaluation of the specific characteristics of each tenant’s lease and our overall relationship with the respective tenant. Factors considered by management in its analysis of in-place lease values include an estimate of the dark value of the property, carrying costs during the hypothetical expected time it would take management to find a tenant to lease the space for the existing lease term (a “lease-up period”) considering current market conditions, and costs to execute similar leases. Management estimates carrying costs, including such factors as real estate taxes, insurance and other operating expenses during the expected lease-up period, considering current market conditions and costs to execute similar leases. In estimating costs to execute similar leases, management considers leasing commissions and other related expenses. Characteristics considered by management in valuing tenant relationships include the nature and extent of our existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals. The value of in-place leases is amortized to expense over the remaining initial terms of the respective leases. The value of tenant relationship intangibles is amortized to expense over the anticipated life of the relationships. Through December 31, 2011, we have assigned no value to tenant relationships on any of our acquisitions.

 

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Commercial Mortgage-Backed Securities.

 

We are required under GAAP to estimate the fair value of our securities investments quarterly. Management evaluates a variety of inputs and then estimates fair value based on those inputs. The primary inputs evaluated by management are broker quotations, collateral values, subordination levels and liquidity of the security. Our estimates of fair value are subject to significant variability based on market conditions, including interest rates and credit spreads. Once we estimate fair value, we are then required under GAAP to assess whether any unrealized losses on securities below our carry value reflect a decline in value which is other-than-temporary. If an other-than-temporarily impaired security is intended to be sold or required to be sold prior to the recovery of its carrying amount, the full amount of the impairment loss is charged to earnings. Otherwise, losses on the security must be separated into two categories, the portion which is considered credit loss, which is charged to earnings, and the portion due to other factors, which is charged to other comprehensive income (loss), a component of balance sheet equity. Significant judgment is required in this analysis. In determining whether a decline in value is other-than-temporary, we consider whether the decline is due to factors such as changes in interest rates or credit spreads (indicator of temporary decline) or credit rating downgrades on the securities or credit defaults on the underlying collateral assets (indicator of an other-than-temporary decline). In estimating other-than-temporary impairment losses, management considers a variety of factors including (1) the financial condition and near-term prospects of the credit, including credit rating of the security and the underlying tenant and an estimate of the likelihood and expected timing of any default, (2) whether we expect to hold the investment for a period of time sufficient to allow for anticipated recovery in fair value, (3) the length of time and the extent to which the fair value has been below cost, (4) current market conditions, (5) expected cash flows from the underlying collateral and an estimate of underlying collateral values, and (6) subordination levels within the securitization pool. These estimates are highly subjective and could differ materially from actual results. We recorded other-than-temporary impairment losses on our CMBS securities of $48,000 in 2011, $7.9 million in 2010, and $0.1 million in 2009.

 

Stock Based Compensation.

 

Pursuant to our 2004 stock incentive plan, we have made and expect to continue to make awards of common stock to our employees with vesting subject to attainment of performance criteria. Under applicable accounting guidance, we are required to estimate the probability of vesting of these shares quarterly and recognize expense (generally equal to the fair market value of the shares awarded on the grant date) for any shares deemed probable to vest over the period the employee is required to perform services to receive the shares. We base our estimates of probability on an assessment of our actual results against the relevant performance criteria. These estimates may change over time as our actual results against the criteria are re-assessed. Changes in these estimates could have a material impact on the expense we recognize.

 

2011 Transaction Summary

 

The following summarizes our significant transactions during the year ended December 31, 2011.

 

Investments

 

·During the second quarter, we completed construction through our development joint venture program of a warehouse/distribution building for Michelin North America, Inc. in Louisville, Kentucky and purchased our developer partner’s interest at completion. The tenant commenced paying rent in May. Our total investment in the property is $8.1 million. The lease with Michelin North America is for a 10-year term.

 

·During the second quarter, we acquired an office building located in Houston, Texas and leased to a subsidiary of AMEC plc until December 2020, for a purchase price of $25 million.

 

·During the third quarter, we commenced construction through our development joint venture program of a 17 story office building primarily for Cimarex Energy Co. in Tulsa, Oklahoma with a project budget of $51.8 million and an estimated total investment of $55 million. We expect to fund about half of the project costs from cash on hand and the other half pursuant to a loan agreement we entered into with Bank of Oklahoma. The project is expected to be completed in the first quarter of 2013. The lease with Cimarex Energy Co. is in force and rent will commence as building floors are completed and delivered to the tenant and the 12 year lease term will commence upon completion and delivery of all building floors to the tenant. As of December 31, 2011, we have funded $8.2 million of our expected commitment to the project. See Note 3 of the consolidated financial statements included in this Form 10-K.

 

·During the fourth quarter, we acquired a retail property located in New Orleans, Louisiana and leased to a subsidiary of Lowe’s Companies, Inc. until May 2030, for a purchase price of $28.5 million. See Note 3 of the consolidated financial statements included in this Form 10-K.

 

Sales

 

·During the first quarter, we sold two CMBS bonds each secured by portions of the mortgage financing on the office building located at 180 Maiden Lane, New York, New York (WBCMT 2004-C15, Class 180ML-D and Class 180ML-E).  The total of $23 million face amount of securities were sold at a 98 dollar price. See Note 6 of the consolidated financial statements included in this Form 10-K.

 

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·During the second quarter, we sold a generic CMBS bond with an $11 million face amount backed by a variety of 2005-2006 vintage commercial mortgage loans for a 79.50 dollar price. See Note 6 of the consolidated financial statements included in this Form 10-K.

 

·During the second quarter, we sold two long-term mortgage loans each on separate retail properties leased to Home Depot USA, Inc. for total sales proceeds of $16.9 million, and a net gain of $0.7 million. See Note 6 of the consolidated financial statements included in this Form 10-K.

 

·During the third quarter, we sold two small retail properties for aggregate net cash proceeds of $5.8 million and net gain of $1.4 million. See Note 6 of the consolidated financial statements included in this Form 10-K.

 

·During the third quarter, we completed the sale of our March 2005 collateralized debt obligation transaction, or CDO. For legal and accounting purposes, the sale resulted in the transfer by us of the various assets in the CDO trust along with the transfer of the obligation to pay debt service on the various CDO note classes. The CDO sale generated cash proceeds net of debt repaid and excluding accrued interest of approximately $30.2 million, and a net gain of $3.9 million, before the charge-off of various deferred CDO costs totaling $3.7 million, including deferred realized losses on cash flow hedges of $2.3 million and deferred issuance costs of $1.2 million. See Notes 4, 5, 6 and 9 of the consolidated financial statements included in this Form 10-K.

 

Financings

 

·During the second quarter, we obtained or assumed $34.1 million of nonrecourse mortgage financing on two recent property purchases at a weighted average coupon of 5.68%, including $17.9 million of mortgage debt on the property leased to Cooper Tire & Rubber Company purchased in December 2010, and $16.3 million of mortgage debt on the property leased to a subsidiary of AMEC plc purchased in June 2011.

 

·During the third quarter, we entered into a loan agreement with Bank of Oklahoma to provide construction financing of approximately one-half of the project costs related to the Tulsa, Oklahoma development joint venture project. Pursuant to the agreement, Bank of Oklahoma has agreed to fund up to $24 million of project costs beginning after we have funded an aggregate of $24 million to the project. Upon completion of the project, the construction loan will automatically convert to a term loan of up to $31 million. As of December 31, 2011, we had not drawn any amounts under such loan agreement. See Note 9 of the consolidated financial statements included in this Form 10-K.

 

·During the fourth quarter, we assumed $16.8 million of nonrecourse mortgage financing on the property we purchased in New Orleans, Louisiana, comprised of three fully amortizing notes maturing in August 2030 and bearing interest at a weighted average coupon of 5.46%.

 

Capital Raising

 

·During the second quarter, we raised net proceeds of approximately $54 million from a marketed common stock offering. We issued 10,150,000 shares at a price to the public of $5.60 per share. See Note 13 of the consolidated financial statements included in this Form 10-K.

 

Share Buyback

 

·As part of the $20 million share repurchase authorized by our Board of Directors in August, we repurchased an aggregate of 1,769,250 shares of common stock at an average price of $3.79 per share during 2011, utilizing an aggregate of $6.7 million of cash on hand. See Note 13 of the consolidated financial statements included in this Form 10-K.

 

Property Acquisitions

 

During the quarter ended December 31, 2011, we completed the following real estate acquisition.

 

                      Net  
Month  Tenant/      Purchase   Capitalization   Lease   Rentable  
Acquired  Guarantor   Location   Price   Rate   Expires   Square Feet 
November   Lowe’s    2401/2501 Elysian   $28.5 million    8.1%   May 2030    133,841 
    Companies, Inc.    Fields Avenue,                     
        New Orleans, LA                      

  

We compute capitalization rate by dividing the estimated net operating income of the property by the purchase price for such property. We define net operating income as property specific revenues (rental revenue, property expense recoveries and other revenue) less property specific expenses (real estate taxes, insurance, repairs and maintenance and other property expenses). In estimating net operating income, we compute rental revenue in accordance with generally accepted accounting principles in the United States, including the impact of straight-line rent and market lease amortization adjustments.

 

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Business Segments

 

We conduct our business through two operating segments:

 

·operating real estate (including our investments in owned real properties); and

 

·debt investments (including our loan investments as well as our investments in securities).

 

Segment data for the year ended December 31, 2011 are as follows (amounts in thousands):

 

   Corporate /   Operating   Debt     
   Unallocated   Real Estate   Investments   Total 
Total revenues  $769   $142,680   $18,894   $162,343 
Total expenses   19,388    133,390    12,276    165,054 
Other gain (loss)   -    (1,234)   (1,816)   (3,050)
Income (loss) from continuing operations   (18,619)   8,055    4,803    (5,761)
Total assets   78,690    1,468,962    93,971    1,641,623 

 

Segment data for the year ended December 31, 2010 are as follows (amounts in thousands):

 

   Corporate /   Operating   Debt     
   Unallocated   Real Estate   Investments   Total 
Total revenues  $856   $134,437   $27,122   $162,415 
Total expenses   19,799    129,343    17,996    167,138 
Other gain (loss)   (293)   -    (7,949)   (8,242)
Income (loss) from continuing operations   (19,236)   5,095    1,176    (12,965)
Total assets   48,213    1,463,362    358,696    1,870,271 

 

Segment data for the year ended December 31, 2009 are as follows (amounts in thousands):

 

   Corporate /   Operating   Debt     
   Unallocated   Real Estate   Investments   Total 
Total revenues  $492   $143,407   $30,269   $174,168 
Total expenses   21,196    129,957    19,716    170,869 
Other gain (loss)   9,829    (11,923)   (10,886)   (12,980)
Provision for income tax   -    -    201    201 
Income (loss) from continuing operations   (10,875)   1,526    (533)   (9,882)
Total assets   54,618    1,471,987    377,810    1,904,415 

 

Comparison of Year Ended December 31, 2011 to the Year Ended December 31, 2010

 

The following discussion compares our operating results for the year ended December 31, 2011 to the comparable period in 2010.

 

Revenue.

 

Total revenue was basically unchanged at $162.3 million in 2011, from $162.4 in 2010, as an increase in rental revenue and tenant reimbursements was offset by a decrease in interest income.

 

Rental revenue and tenant reimbursements, in the aggregate, increased $8.1 million, or 6%, to $141.9 million, primarily reflecting the addition of the property leased to Cooper Tire & Rubber Company in December 2010, the property leased to Michelin North America, Inc. in May 2011, the property leased to a subsidiary of AMEC plc in June 2011, and the property leased to a subsidiary of Lowe’s Companies, Inc. in November 2011.

 

Interest income decreased $8.0 million, or 29%, to $19.7 million during 2010, primarily as a result of lower balances on debt investments and the sale of the CDO on September 1, 2011.

 

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Expenses.

 

Total expenses decreased $2.1 million, or 1%, to $165.1 million, as a decrease in interest expense was largely offset by an increase in property expenses and depreciation expense.

 

Interest expense decreased $6.4 million, or 8%, to $76.6 million, from $83.0 million. The decrease in the 2011 period resulted primarily from $5.4 million of lower interest expense on the CDO due to lower debt outstanding and the sale of the CDO on September 1, 2011, $0.9 million of lower interest expense on floating rate borrowings (resulting from lower borrowings and lower effective borrowing rate in the 2011 period), $0.8 million of lower interest expense on the secured term loan due to lower borrowings outstanding, and $0.6 million of lower interest expense on convertible debt due to repurchases of the convertible debt. Interest expense on property mortgages was $1.2 million higher as interest expense on the new mortgages on the Cooper Tire & Rubber Company, AMEC plc and Lowe’s Companies, Inc. properties was partially offset by principal paydowns on other property mortgage debt obligations. The Company’s average balance outstanding and effective financing rate under floating rate borrowings was approximately $85 million at 3.49% during the 2011 period (average one-month LIBOR of 0.23%), compared with approximately $107 million at 3.66% during the 2010 period (average one-month LIBOR of 0.27%). Market interest rates remained low during 2011 but we cannot predict the level of market interest rates in the future.

 

Property expense increased $2.5 million, or 10%, to $27.2 million, primarily reflecting increased property operating costs such as repairs and utilities, more than half of which was recovered from tenants. The net amount of property expenses we incurred in 2011 (net of tenant reimbursements) was $13.3 million, compared to $12.5 million in 2010.

 

General and administrative expense of $10.6 million in 2011, was basically unchanged from $10.7 million in 2010.

 

General and administrative expense-stock based compensation increased $0.2 million, or 10%, to $2.8 million. The increase was primarily a result of higher share prices year over year, which primarily impacted the value of prior year performance share grants that do not price until the eligible vesting year. As of December 31, 2011, $3.1 million of unvested shares (fair value at the grant dates) is expected to be charged to our Consolidated Statement of Operations ratably over the remaining vesting period (through March 2015) assuming vesting criteria are satisfied. As of December 31, 2011, we have not yet commenced expense accrual related to the following number of share awards because the applicable performance criteria have not yet been determined: 39,345 restricted shares made in 2008, 209,430 restricted shares made in 2009, 144,675 restricted shares made in 2010 and 130,950 restricted shares made in 2011.

 

Depreciation and amortization expense on real property increased $1.7 million, or 4%, to $47.6 million, primarily reflecting the addition of the property leased to Cooper Tire & Rubber Company in December 2010, the property leased to Michelin North America, Inc. in May 2011, the property leased to a subsidiary of AMEC plc in June 2011, and the property leased to a subsidiary of Lowe’s Companies, Inc. in November 2011.

 

Other gains (losses).

 

We had gain on investments, net, of $0.6 million in the 2011 period, compared to $7.9 million of net losses on investments during the 2010 period. The amount in the 2011 period primarily includes gains of $3.9 million on sale of the CDO (before related loss on extinguishment of debt discussed below) during the third quarter, and $0.7 million on the sale of two loans during the second quarter, partially offset by losses of $2.9 million on the sale of CMBS securities during the first and second quarter and $1.0 million on the write-off of a loan investment during the second quarter (see Note 4 of the consolidated financial statements included in this Form 10-K). The gains and losses on sale are discussed at Note 6 of the consolidated financial statements included in this Form 10-K.

 

We had $3.7 million of losses on extinguishment of debt during the 2011 period, from the charge-off of various deferred CDO costs in connection with the sale of our CDO during September 2011 (see Note 6 of the consolidated financial statements included in this Form 10-K).

 

Discontinued operations.

 

We had $3.9 million of net gains from discontinued operations in the 2011 period, comprised of $1.4 million of gains on two property sales during the third quarter (see Note 6 of the consolidated financial statements included in this Form 10-K), and $18.9 million of gain on debt extinguishment and $16.4 million of impairment losses on the transfer of the Hartford, Connecticut property to the lender (see Note 3 of the consolidated financial statements included in this Form 10-K). We had $0.2 million of loss from properties classified as discontinued operations during the 2010 period.

 

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Net (loss).

 

Net (loss) decreased $11.3 million, to $(1.8) million in 2011, from $(13.1) million in 2010, primarily reflecting the change in other gains (losses) including those from discontinued operations from 2010 to 2011 ($9.1 million) and lower total expenses in 2011 ($2.1 million). Net (loss) allocable to common stockholders was $(8.3) million in 2011, reflecting dividends to preferred stockholders of $6.5 million.

 

Comparison of Year Ended December 31, 2010 to the Year Ended December 31, 2009

 

The following discussion compares our operating results for the year ended December 31, 2010 to the comparable period in 2009.

 

Revenue.

 

Total revenue decreased $11.8 million, or 7%, to $162.4 million. The decrease was primarily attributable to decreases in rental revenue and interest income.

 

Rental revenue and tenant reimbursements, in the aggregate, decreased $8.1 million, or 6%, to $133.8 million, primarily reflecting the vacancy of our property in Johnston, Rhode Island during the fourth quarter of 2009.

 

Interest income decreased $3.0 million, or 10%, to $27.6 million during 2010, primarily as a result of lower loan balances and lower interest rates on cash balances.

 

Other revenue decreased $0.6 million, or 36%, to $1.0 million, from $1.5 million, primarily reflecting the lease termination payment we received on the Omaha, Nebraska properties during 2009.

 

Expenses.

 

Total expenses decreased $3.7 million, or 2%, to $167.1 million. The decrease in expenses was primarily attributable to lower interest expense and depreciation expense in the 2010 period, offset in part by higher property expenses in the 2010 period.

 

Interest expense decreased $5.2 million, or 6%, to $83.0 million, from $88.2 million. The decrease in the 2010 period resulted primarily from $2.1 million of lower interest expense on floating rate borrowings (resulting from lower borrowings in the 2010 period), $1.5 million of lower interest expense on convertible debt due to repurchases of the convertible debt, $0.7 million of lower interest expense on the secured term loan, $0.5 million of lower interest expense on property mortgages, and $0.4 million of lower interest expense on collateralized debt obligations due to repurchases in 2009. The Company’s average balance outstanding and effective financing rate under its floating rate borrowings was approximately $107 million at 3.66% during the 2010 period (average one-month LIBOR of 0.27%), compared with approximately $157 million at 3.71% during the 2009 period (average one-month LIBOR of 0.35%).

 

Property expense increased $4.3 million, or 21%, to $24.7 million, primarily reflecting carrying costs associated with the Johnston, Rhode Island property of approximately $1.7 million and expenses on the Omaha, Nebraska properties where the leases are now gross and were previously net during 2009 when the property was leased to a single tenant. The net amount of property expenses we incurred in 2010 (net of expense recoveries from our tenants) was $12.5 million, compared to $8.9 million in 2009.

 

General and administrative expense in 2010 was largely unchanged from 2009, as it decreased $0.2 million, or 2%, to $10.7 million from $10.9 million.

 

General and administrative expense-stock based compensation increased $0.4 million, or 20%, to $2.5 million. The increase was primarily a result of higher share prices year over year, which primarily impacted the value of prior year performance share grants that do not price until the eligible vesting year.

 

Depreciation and amortization expense on real property decreased $3.0 million, or 6%, to $46.0 million, primarily due to the value of our in place lease on the property in Johnston, Rhode Island being fully amortized at the scheduled lease maturity in July 2009.

 

Other gains (losses).

 

We had loss on investments, net, of $7.9 million during 2010, compared to $10.9 million of losses in 2009. The 2010 losses reflect other-than-temporary impairment losses primarily on one security investment (see Note 5). The 2009 amount reflects $10.3 million of losses on three assets that were sold during 2009 (two loans and one security/pass through certificate) (see Note 6), $0.4 million of impairment losses on a mezzanine loan investment (see Note 4), and $0.1 million of impairment losses on a security investment (see Note 5).

 

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We had no provision for loss on property investment in the 2010 period, compared to $11.9 million of loss during the 2009 period. The amount in the 2009 period comprises impairment losses on the Johnston, Rhode Island property (see Note 3).

 

We had $0.3 million of losses on extinguishment of debt in 2010, compared to $9.8 million of gains in the 2009 period. These amounts related primarily to repurchases of our convertible senior notes (see Note 9).

 

Discontinued operations.

 

We had $0.2 million of loss from properties classified as discontinued operations during the 2010 period. During 2009, we had $4.1 million of net losses from discontinued operations, comprised of losses on two properties that were sold (OSHA and Cott) (see Note 6).

 

Net (loss).

 

Net (loss) decreased $0.8 million, to $(13.1) million in 2010, from $(14.0) million in 2009, as lower investments losses, interest expense and depreciation and amortization expense on real property during 2010 was substantially offset by lower revenues and gain on debt extinguishment and higher property expenses during 2010. Net (loss) allocable to common stockholders was $(18.8) million in 2010, reflecting dividends to preferred stockholders of $5.6 million.

 

Funds from Operations

 

Funds from operations, or FFO, is a non-GAAP financial measure. We believe FFO is a useful additional measure of our performance because it facilitates an understanding of our operating performance after adjustment for real estate depreciation, a non-cash expense which assumes that the value of real estate assets diminishes predictably over time. In addition, we believe that FFO provides useful information to the investment community about our financial performance as compared to other REITs, since FFO is generally recognized as an industry standard for measuring the operating performance of an equity REIT. FFO does not represent cash generated from operating activities in accordance with GAAP and is not indicative of cash available to fund cash needs. FFO should not be considered as an alternative to net income or earnings per share determined in accordance with GAAP as an indicator of our operating performance or as an alternative to cash flow as a measure of liquidity. Since all companies and analysts do not calculate FFO in a similar fashion, our calculation of FFO may not be comparable to similarly titled measures reported by other companies.

 

We calculate FFO in accordance with standards established by the National Association of Real Estate Investment Trusts (“NAREIT”) which defines FFO as net income (loss) (computed in accordance with GAAP) excluding gains (or losses) from sales of property and impairment losses on depreciable real estate, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.

 

The following table reconciles our net income (loss) allocable to common stockholders to FFO for the years ended December 31, 2011, December 31, 2010 and December 31, 2009.

 

   Year ended December 31, 
(in thousands, except per share amounts)  2011   2010   2009 
Net loss allocable to common stockholders  $(8,345)  $(18,758)  $(16,811)
Add (deduct)               
Non-controlling interest in consolidated subsidiaries   (20)   (52)   (51)
Depreciation and amortization expense on real property   47,632    45,956    48,957 
Depreciation and amortization expense on discontinued operations   1,996    2,453    2,735 
(Gain) loss on property sales   (1,426)        
Provision for loss on property investment           11,923 
Provision for loss on property investment on discontinued operations   16,423        4,076 
Funds from operations  $56,260   $29,599   $50,829 
                
Weighted average number of common shares outstanding, diluted   64,758    56,189    49,297 
Weighted average number of OP units outstanding   156    156    156 
Weighted average number of common shares and OP units outstanding, diluted   64,914    56,345    49,453 
                
Net loss per common share, basic and diluted  $(0.13)  $(0.33)  $(0.34)
Funds from operations per share  $0.87   $0.53   $1.03 

 

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Liquidity and Capital Resources

 

Short-Term Liquidity.

 

We define our short-term liquidity as our ability to generate adequate amounts of cash to meet day-to-day operating expenses and material cash commitments over the next twelve months. Our primary sources of short-term liquidity are available cash and cash equivalents, cash provided by operations, and a portion of the cash proceeds from issuances of debt and equity capital. We may also use revolving loan borrowings under our credit agreement with Wells Fargo Bank to finance, likely on a short-term basis, a portion of our new investment activity. As of December 31, 2011, we had $71.2 million in available cash and cash equivalents. As of February 23, 2012, we had $57.8 million in available cash and cash equivalents. We believe that our sources of short-term liquidity will be sufficient to enable us to satisfy our short-term liquidity requirements, including the payment of our dividend.

 

As a REIT, we are required to distribute at least 90% of our taxable income to our stockholders on an annual basis, and we intend to distribute all or substantially all of our REIT taxable income in order to comply with the distribution requirements of the Code and to avoid federal income tax and the nondeductible excise tax. We declared total cash dividends of $0.26 per share of common stock during the year ended December 31, 2011, including $0.065 per share in each of the first, second, third and fourth quarters. We declared a cash dividend of $0.5078125 per share of 8.125% Series A cumulative redeemable preferred stock in each of the first, second, third and fourth quarters of 2011. Our dividend policy is subject to revision at the discretion of our Board of Directors. All distributions will be made at the discretion of our Board of Directors and will depend on our cash available for distribution, our funds from operations, our maintenance of REIT status, market conditions and such other factors as our Board of Directors deems relevant.

 

While we believe we will be able to satisfy our short-term liquidity requirements, the following are the primary factors that we believe could have a material adverse effect on our plans:

 

·payment defaults on our assets which we expect could be triggered primarily in the event of the bankruptcy of the underlying tenant or tenants;

 

·unexpected capital expenditures on our owned properties;

 

·margin calls on our Wells Fargo Bank credit agreement; or

 

·margin calls on any future risk management transactions.

 

Long-Term Liquidity.

 

We define our long-term liquidity as our ability to generate adequate amounts of cash to meet cash demands and commitments beyond the next 12 months, including balloon payments on our debt obligations and capital expenditures on our owned properties. Our primary sources of long-term liquidity are our cash and cash equivalents, cash provided by operations, cash from long-term financings on our asset investments and issuances of debt and equity capital. We may continue to selectively sell assets to allow us to generate additional long-term liquidity. We believe that our various sources of long-term liquidity will be sufficient to enable us to satisfy our long-term liquidity requirements.

 

Our primary long-term liquidity requirement is repayment of our debt obligations. We intend generally to manage our debt maturities by refinancing or repaying the related debt at maturity. We expect to utilize a combination of (i) cash on hand, (ii) cash from sales of assets which may include the collateral for the debt, and (iii) cash from future debt or equity capital raises, to fund any liquidity needed to satisfy these obligations. These actions, however, may not enable us to generate sufficient liquidity to satisfy our borrowings and, therefore, we cannot provide any assurance we will be able to refinance or repay our debt obligations as they come due. Our ability to refinance debt, sell assets and/or raise capital on favorable terms will be highly dependent upon prevailing market conditions. See “Item 1A—Risk Factors—Risks Relating to Borrowings—Our use of debt financing could have a material adverse effect on our financial condition.” in this Annual Report on Form 10-K.

 

We have two recourse debt obligations that are scheduled to mature or potentially come due over the next two years. Our convertible senior notes can be put to us at the option of the note holders for a repurchase price of 100% of the principal amount of the notes in October 2012 and our credit agreement with Wells Fargo Bank is scheduled to mature in July 2013. See Note 9 of the consolidated financial statements included in this Form 10-K. The convertible senior notes are unsecured obligations and the credit agreement with Wells Fargo Bank is a secured borrowing agreement. With respect to the convertible notes, we have through various repurchase transactions reduced the principal amount of notes outstanding to $35.0 million as of December 31, 2011 (from $75 million at original issuance in October 2007). To the extent the notes are put to us in October, we intend to repay or refinance that obligation. With respect to the Wells Fargo Bank credit agreement, the principal amount of the debt is scheduled to decline modestly over time until maturity as we receive principal payments on the assets financed and apply a portion of that principal to the outstanding debt. We then intend to repay or refinance (which may include extending) the remaining obligation at or prior to the maturity date in July 2013.

 

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While we believe we will be successful in either refinancing or repaying these obligations at or prior to maturity, we cannot provide any assurance we will be able to do so. If we are unsuccessful in refinancing these obligations, we may not have sufficient liquidity to repay the debt in full at maturity. Our failure to do so is a default under the debt and could materially adversely affect our financial condition and operating results in a variety of ways. For example, if we default under the Wells Fargo Bank credit agreement, the bank could foreclose on the related collateral causing us to lose some of our assets. Wells Fargo Bank and the convertible note holders also would have general recourse against our company if we default in our obligations to them. In addition, each of these obligations is cross-defaulted with the other, meaning that a default under one obligation could result in the other lender accelerating the maturity of our obligations to them.

 

We have various non-recourse mortgage debt obligations that are scheduled to mature in the future, including $117.0 million of mortgage debt on the Nestlé properties scheduled to mature in August 2012. See the schedule of mortgage note maturities included at Note 9 in our consolidated financial statements included in this Form 10-K. In connection with the maturity of our mortgage debt obligations, we intend to evaluate a variety of alternatives with respect to our investment in the subject property, including refinancing the debt, utilizing cash on hand and other sources of liquidity to repay the mortgage debt, and selling the property. If we are unsuccessful with one or more of these alternatives, we could convey the property to the lender to satisfy in full our obligations under the non-recourse debt.

 

Related to the mortgage debt on the Nestlé properties, in addition to evaluating a potential refinance or repayment of the debt, we are evaluating alternatives for restructuring the debt with the lender, including extending the loan or making a variety of loan modifications such as permanently or temporarily reducing debt service payments. The restructuring alternatives we consider will be influenced by whether we renew the terms of the leases or subleases at the properties or re-let the properties to new tenants and the economic terms of any such leases. The existing leases are scheduled to expire in December 2012, and we currently expect to renew the leases at two of the three properties within the next few months. We do not expect to renew the lease at the third property and are currently marketing that property for re-let or sale.

 

Our mortgage debt obligations are non-recourse and not cross-defaulted with our other debt obligations, and therefore, we do not believe default of any of our mortgage debt obligations will threaten the viability of our company, although it could result in us losing all or some of our remaining investment in the property.

 

As an owner of commercial real estate, we are required to make capital expenditures to maintain and upgrade our properties. We expect the majority of these expenditures will be made as the leases mature and we renew existing leases or find new tenants to occupy the property. Any estimates we make of expected capital expenditures are highly subjective and actual amounts we spend may differ materially and will be impacted by a variety of factors, including market conditions which are beyond our control. We may be required to incur additional debt, sell assets and/or raise capital to generate the liquidity needed to pay for capital expenditures on our properties, and our ability to do so on favorable terms will be highly dependent upon prevailing market conditions. Our ability to satisfy our long-term liquidity requirements could be materially adversely affected by capital expenditures we make on our owned properties.

 

Share Repurchase Program

 

During August 2011, our Board of Directors approved a share repurchase program authorizing us to repurchase in the aggregate up to $20 million of our outstanding common stock. The program permits us to purchase shares through a variety of methods, including in the open market or through privately negotiated transactions, in accordance with applicable securities laws. It does not obligate us to make any repurchases at any specific time or situation. The timing and extent to which we repurchase our shares will depend upon a variety of factors, including market conditions, our liquidity, and regulatory requirements.

 

During the quarter ended December 31, 2011, we repurchased an aggregate of 185,923 shares of common stock through the above program at an average price of $3.64 per share, utilizing an aggregate of $0.7 million of cash on hand. During the year ended December 31, 2011, we repurchased an aggregate of 1,769,250 shares of common stock through the above program at an average price of $3.79 per share, utilizing an aggregate of $6.7 million of cash on hand.

 

Sources of Capital

 

General. We intend to continue to raise additional capital from time to time to enable us to continue to implement our growth strategy. Our ability to raise capital is influenced by market conditions, and we cannot assure you that conditions for raising capital will be favorable for us at any time.

 

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Shelf Registration Statement. We have a shelf registration statement on Form S-3 (File No. 333-171408) on file and effective with the Securities and Exchange Commission which we expect to utilize to issue public equity or debt capital from time to time in the future. Pursuant to the shelf registration statement, we may issue and sell publicly preferred stock, common stock, and debt securities, or any combination of such securities, from time to time in one or more offerings, up to an aggregate amount of $500 million. We utilized our shelf registration statement to issue common equity capital during the second quarter of 2011. Specifically, on April 5, 2011, we issued 10,000,000 shares of common stock in a public offering at a price to the public of $5.60 per share. Then, on May 4, 2011, we issued an additional 150,000 shares of common stock as part of such public offering, as a result of the underwriters partially exercising the over-allotment option. Inclusive of the over-allotment option, we raised net proceeds of $54.0 million, after the underwriting discount and estimated offering expenses. Through December 31, 2011, we have used a total of $48.8 million of the proceeds from the offering, with $33.5 million used to fund purchases of or improvements to owned properties, $8.5 million used to reduce outstanding indebtedness and $6.7 million used to repurchase our common stock.

 

As of December 31, 2011, we had remaining availability of $443 million under our shelf registration statement, and we may offer and sell any combination of common stock, preferred stock and/or senior or subordinated debt securities up to such amount from time to time. The availability under our shelf registration statement includes an aggregate of 2,693,900 shares of common stock and 995,100 shares of Series A preferred stock reserved for sale under the Brinson Patrick sales agreement described below, and an aggregate of 8,982,700 shares of common stock reserved for sale under the Merrill Lynch sales agreement described below.

 

ATM Offering. We have implemented an “at the market offering” program (as defined in Rule 415 of the Securities Act of 1933, as amended), which may be utilized by us from time to time to sell shares of our common stock and Series A preferred stock and increase liquidity. We have two separate sales agents for our “at the market offering” program, Brinson Patrick Securities Corporation and Merrill Lynch, Pierce Fenner & Smith Incorporated.

 

We are not currently selling shares through the “at the market offering” program, although we reserve the right to elect to do so in our sole discretion at any time in the future.

 

Our sales agreement with Brinson Patrick Securities Corporation permits us to issue and sell through Brinson Patrick, from time to time, shares of our common stock and Series A preferred stock, and Brinson Patrick has agreed to use its best efforts to sell such shares during the term of the agreement and on the terms set forth therein. Our Board of Directors initially authorized the sale of up to 5,000,000 shares of common stock and 1,000,000 shares of Series A preferred stock pursuant to the sales agreement with Brinson Patrick from time to time. Through December 31, 2011, we have sold 2,306,100 shares of common stock and 4,900 shares of Series A preferred stock pursuant to the agreement with Brinson Patrick. We are not obligated to sell any shares pursuant to the agreement and we may start and stop selling shares pursuant to the program at any time in our sole discretion. We must pay Brinson Patrick a commission of 1.5% of the gross sales price per share sold.

 

Our sales agreement with Merrill Lynch, Pierce Fenner & Smith Incorporated authorizes us to issue and sell, from time to time, up to 9,000,000 shares of common stock through or to Merrill Lynch, and Merrill Lynch has agreed to use its commercially reasonable efforts to sell such shares during the term of the agreement and on the terms set forth therein. We may sell our common stock to Merrill Lynch as principal for its own account at prices agreed upon at the time of sale. Through December 31, 2011, we have sold a total of 17,300 shares of common stock pursuant to our sales agreement with Merrill Lynch. We are not obligated to sell any shares pursuant to the agreement and we may start and stop selling shares pursuant to the program at any time in our sole discretion. We must pay Merrill Lynch a commission of 2.0% of the gross sales price per share sold.

 

We did not sell any shares of common stock or Series A preferred stock pursuant to the sales agreements with Brinson Patrick and Merrill Lynch during the quarter ended December 31, 2011. We did not sell any shares of common stock or Series A preferred stock pursuant to the sales agreements with Brinson Patrick during the year ended December 31, 2011. The following table summarizes our sales of common stock pursuant to the sales agreement with Merrill Lynch during the year ended December 31, 2011. All shares were sold during January.

 

   During the year ended December 31, 2011 
           Compensation     
   Number of Shares   Average Price   to Agent   Net Proceeds (1) 
Merrill Lynch – common stock   14,200   $6.00   $1,708   $83,605 

 

(1)Net proceeds above do not include incidental third-party expenses associated with the at-the-market program.

 

Dividend Reinvestment and Stock Purchase Plan. In March 2007, we implemented a dividend reinvestment and direct stock purchase plan, which may be utilized by us from time to time to sell shares of our common stock and increase liquidity. We are not currently issuing new shares through the plan, although we reserve the right to elect to do so in our sole discretion at any time in the future.

 

The plan allows interested stockholders to reinvest all or a portion of their cash dividends in shares of our common stock and to make monthly purchases of our common stock generally up to a maximum of $10,000 (unless a higher amount is approved by us in our sole discretion). Shares purchased through the plan may be either (i) newly issued by us (which may be sold at a discount of up to 5% off of the average of the high and low sales prices on the applicable investment date) or (ii) purchased by the plan administrator in the open market, at our discretion. During the year ended December 31, 2011, we issued 27,697 shares of common stock through the plan at a price of $5.72 per share. During the year ended December 31, 2010, we issued 103 shares of common stock through the plan at a price of $5.85 per share. As of December 31, 2011, we have reserved an aggregate of 6,830,043 shares of common stock for future issuance pursuant to the dividend reinvestment and direct stock purchase plan.

 

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Leverage

 

We rely on leverage to allow us to invest in a greater number of assets and enhance our asset returns. Leverage also exposes us to a variety of risks which are discussed in more detail in this Annual Report on Form 10-K under the heading “Risk Factors.” In reviewing and analyzing our debt, we look at a variety of financial metrics such as our leverage ratios, weighted average and individual interest rates on the debt, weighted average and individual maturity dates and scheduled principal amortization and balloon balances due at maturity. We also evaluate a variety of subjective factors such as present and expected future market conditions.

 

Leverage ratios are a widely used financial measure by the real estate investment community, especially for REITs. We measure our leverage ratios by dividing total debt by total assets, as adjusted. We measure total assets, as adjusted, at historical cost before depreciation and amortization on owned properties. Therefore, our leverage ratios do not account for any fluctuations in value, up or down, that may have occurred since we acquired our owned properties. Other companies including other REITs may compute leverage ratios in a different manner and, therefore, our leverage ratios may not be comparable to similarly titled measures reported by other companies.

 

The following table sets forth the computation of our overall portfolio leverage ratio as of December 31, 2011 and December 31, 2010 (dollars in thousands).

 

   Dec 31, 2011   Dec 31, 2010 
Debt          
Mortgages on real estate investments  $972,924   $928,429 
Collateralized debt obligations       254,210 
Principal held by CDO trustee pending distribution       (1,607)
Credit agreement   70,668    105,345 
Secured term loan   88,142    101,880 
Convertible senior notes   34,522    33,926 
Other long-term debt   30,930    30,930 
Total Debt  $1,197,186   $1,453,113 
Assets          
Total assets  $1,641,623   $1,870,271 
Accumulated depreciation and amortization on owned properties   268,209    239,990 
Intangible liabilities on real estate investments   (35,219)   (37,405)
Principal held by CDO trustee pending distribution       (1,607)
Prepaid expenses and deposits   (1,381)   (2,197)
Accrued rental income   (41,387)   (39,506)
Deferred rental income   2     
Debt issuance costs, net   (3,889)   (5,999)
Other   (712)   (1,046)
Total Assets, as adjusted  $1,827,247   $2,022,501 
Leverage (Total Debt/Total Assets, as adjusted)   66%   72%

 

The following table sets forth the computation of our leverage ratios by segment as of December 31, 2011 (dollars in thousands).

 

   Mortgage   Secured Term   Credit Agreement             
(in thousands)  Debt   Loan Debt   Debt   Total Debt   Investment (1)   Leverage 
Owned Properties  $972,924   $24,436   $66,887   $1,064,247   $1,682,424    63%
Debt Investments       63,706    3,782   67,488    93,144    72%

 

(1)Represents our carry value for financial reporting purposes before depreciation and amortization on owned properties. The carry value of our debt investments has been adjusted to exclude a $500 general loss reserve.

 

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We expect our leverage level to continue to decrease over time, primarily as a result of scheduled principal amortization on our debt and lower or no leverage on new asset acquisitions.

 

Our portfolio financing strategy is to finance our assets with long-term fixed rate debt as soon as practicable after we invest, generally on a secured, non-recourse basis. Through non-recourse debt, we seek to limit the overall company exposure in the event we default on the debt to the amount we have invested in the asset or assets financed. We seek to finance our assets with “match-funded” or substantially “match-funded” debt, meaning that we seek to obtain debt whose maturity matches as closely as possible the maturity of the asset financed. Through December 31, 2011, our long-term fixed rate asset financings have been in the form of traditional third party non-recourse first mortgage financings (on most of our owned real properties) and one non-recourse secured term loan (completed in December 2007). As of December 31, 2011, we have financed on a long-term basis an aggregate of approximately $1.56 billion of portfolio assets with third party first mortgage debt of $972.9 million and a secured term loan of $88.1 million.

 

Long-Term Mortgage Financings

 

We have financed most of our owned properties through traditional first mortgage financings provided primarily through the commercial mortgage-backed securitization market. We also have utilized the term financings described below including the CDO transaction we sold during September 2011, to add incremental leverage on many of our owned properties.

 

During the quarter ended December 31, 2011, we assumed in-place mortgage financing on the property we acquired in New Orleans, Louisiana. The principal economic terms of the three fully amortizing notes we assumed are summarized in the following table:

 

   Assumed Face Amount         
   of Mortgage Note         
Property  (in thousands)   Coupon   Maturity Date 
Lowe’s Companies, Inc., New Orleans, LA  $7,722    5.32%   August 2030 
Lowe’s Companies, Inc., New Orleans, LA  8,621    5.57%   August 2030 
Lowe’s Companies, Inc., New Orleans, LA  434    5.93%   August 2030 

 

As of December 31, 2011, we had $972.9 million of non-recourse first mortgage debt at a weighted average coupon of 5.55% and a weighted average effective financing rate of 5.6%.

 

Our mortgage financings are all fixed rate financings. The notes typically mature over a long-term period of approximately ten years, and debt service is payable monthly. The notes are non-recourse to us subject to limited recourse exceptions and are secured by a mortgage on the property and an assignment of the underlying lease and rents on the property. The notes are frequently interest only for all or a portion of the note term, and in most cases require a balloon payment at maturity. As described above, we cannot provide any assurance we will be able to refinance or repay these obligations at maturity and our ability to do so on favorable terms will be highly dependent upon prevailing market conditions. See “Business Environment” above and “Item 1A—Risk Factors” in this Annual Report on Form 10-K.

 

Term Financings

 

We have financed most of our loan and securities investments as well as a select number of our owned properties through the term financings described below. As noted above, we have also utilized term financings to add incremental leverage on our owned properties financed with mortgage debt.

 

Secured Term Loan. In December 2007, we completed a secured term loan with a European bank. We transferred a pool of assets into a wholly-owned special purpose entity, called CapLease 2007-STL LLC, and issued debt to the lender secured by the assets in the pool. We retained all of the equity in the special purpose entity, or SPE, and, therefore, are entitled to all residual cash after the payment of scheduled principal and interest on the debt. The lender’s debt is structured to be senior to our equity. For example, all principal payments on the assets transferred to the SPE will be paid to the lender until the secured term loan in repaid in full. We are in a first loss position in the event of a payment default or loss on any of the SPE assets.

 

As of December 31, 2011, we had $88.1 million of debt outstanding under the secured term loan, secured by assets with a carry value of $113.4 million. The interest coupon on the loan is fixed at 5.81% annually until the loan matures in January 2018. Our effective financing rate on the loan is 6.0% annually (inclusive of hedge and closing costs). The loan is non-recourse to us, subject to limited non-recourse exceptions.

 

CDO Financing. During September 2011, we completed the sale of our March 2005 CDO. For legal and accounting purposes, the sale resulted in the transfer by us of the various assets in the CDO trust along with the transfer of the obligation to pay debt service on the various CDO note classes. The CDO sale generated cash proceeds net of debt repaid and excluding accrued interest of approximately $30.2 million, and a net gain of $3.9 million, before the charge-off of primarily deferred issuance costs and deferred realized gains on cash flow hedges totaling $3.7 million.

 

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Credit Agreement. We have entered into a credit agreement with Wells Fargo Bank, N.A. (as successor to Wachovia Bank, N.A.) and financed certain of our portfolio assets pursuant to the credit agreement. We also may utilize the undrawn amount of the lender’s revolving credit commitment to finance assets approved by the lender in its sole discretion at an advance rate of 60% of the asset’s value (as determined by the lender).

 

The credit agreement with Wells Fargo Bank includes the following terms:

 

·Size: maximum revolving credit commitment of $140 million;

 

·Maturity: maturity date of July 16, 2013; and

 

·Interest Rate: floating rate LIBOR-based facility with interest rate on our borrowings set at one-month LIBOR plus 275 basis points.

 

As of December 31, 2011, our outstanding borrowings under the agreement were $70.7 million and our effective financing rate was 3.6%.

 

The agreement is a floating rate LIBOR based facility. Our borrowings under the agreement are secured by a combination of first mortgage loan investments, intercompany mortgage loans on our owned property investments, commercial mortgage-backed securities and a first lien on our ownership interest in the real property located in Johnston, Rhode Island. Our obligations under the credit agreement are also fully recourse to all of our other assets and, pursuant to the margin call provisions in the agreement, we may be obligated to prepay a portion of the debt if Wells Fargo Bank determines the value of our collateral has declined, including as a result of an underlying tenant credit rating downgrade or other adverse tenant-credit event. In the event Wells Fargo Bank determines in its sole discretion that the value of our collateral has declined, Wells Fargo Bank may require us to prepay a portion of our borrowings, provided that Wells Fargo Bank may not reduce the value of any of our collateral other than CMBS securities due to general credit spread or interest rate fluctuations. As of December 31, 2011, we had $2.2 million borrowed against collateral classified as CMBS securities by Wells Fargo Bank.

 

We are required to comply with the following financial covenants under the credit agreement:

 

·minimum liquidity (basically cash and cash equivalents) of at least $12 million;

 

·minimum consolidated tangible net worth (basically stockholders’ equity before accumulated depreciation and amortization) of at least $360 million plus 75% of the aggregate net proceeds from equity offerings or capital contributions after July 16, 2010;

 

·maximum corporate leverage (basically total liabilities divided by total assets before accumulated depreciation and amortization) of 80%; and

 

·minimum interest coverage (basically EBITDA, or net income before income taxes, interest expense, and depreciation and amortization, divided by interest expense) of 105%.

 

As of December 31, 2011, we were in compliance with the above financial covenants, and we do not currently anticipate any difficulty in maintaining compliance with these covenants in future periods.

 

As of December 31, 2011, our $70.7 million of borrowings under our Wells Fargo Bank credit agreement were secured by loan investments with an aggregate carry value of $4.1 million, intercompany mortgage loans with an aggregate carry value of $100.5 million, CMBS investments with a carry value of $2.5 million and a single owned property with a carry value of $25.5 million.

 

We may pursue a variety of strategies for the assets financed on the credit agreement, which may include obtaining long-term fixed rate financing when market conditions permit, pursuing selected asset sales, and retiring the debt on selected assets and holding the assets unlevered. We expect credit market conditions to impact our ability to achieve these objectives and, therefore, we cannot provide any assurance as to the timing or our ability to do so.

 

Statement of Cash Flows

 

Operating activities provided $47.8 million of cash during the year ended December 31, 2011, primarily driven by net (loss) as adjusted by various non-cash gains, losses, income and charges of $50.7 million, partially offset by decreases in accounts payable and other liabilities of $3.7 million. Operating activities provided $47.7 million of cash during the year ended December 31, 2010, primarily driven by net (loss) as adjusted by various non-cash gains, losses, income and charges of $45.7 million. Operating activities provided $57.4 million of cash during the year ended December 31, 2009, primarily driven by net (loss) as adjusted by various non-cash gains, losses, income and charges of $60.2 million, partially offset by increases in other assets of $2.7 million.

 

48
 

 

We recognize rental income on our owned properties on a straight line basis in accordance with generally accepted accounting principles. As of December 31, 2011, this has resulted in us accruing $41.4 million of rental income in excess of actual rents due under the various leases. During the year ended December 31, 2011, rents on a straight-line basis exceeded actual rents due under the leases by $1.9 million. We expect the impact of straight-lining of rents to fluctuate over time as contractual rents step up and actual rents due increase under the various leases and we purchase additional properties. Certain of our owned properties are also subject to rents which pay semi-annually, rather than monthly, and this also impacts the quarter-to-quarter changes due to straight-lining of rents.

 

Investing activities provided $119.6 million of cash during the year ended December 31, 2011, which primarily resulted from proceeds from sale or prepayments of loan investments of $86.9 million, proceeds from sale of securities of $31.3 million, proceeds from sale of the CDO of $22.3 million, proceeds from sale of real estate of $5.2 million, and principal received from loans and securities of $15.0 million, partially offset by real estate purchases and improvements and construction in progress of $41.0 million. Investing activities used $25.1 million of cash during the year ended December 31, 2010, which primarily resulted from purchases of real estate of $33.5 million, real estate improvements and construction in progress of $8.1 million and leasing commission costs of $1.2 million, partially offset by net proceeds from the sale of owned properties of $3.4 million and principal received on loans of $11.2 million and securities of $3.3 million. Investing activities provided $70.3 million of cash during the year ended December 31, 2009, which primarily resulted from net proceeds from the sale of loans and securities of $48.7 million, net proceeds from the sale of owned properties of $6.5 million and net principal received on loans of $15.5 million and securities of $3.1 million.

 

Cash used in financing activities during the year ended December 31, 2011 was $129.0 million, which primarily resulted from net repayments and repurchases of debt of $156.5 million (including repayment and repurchases of CDO debt of $106.9 million, repayments on the Wells Fargo Bank credit agreement of $34.7 million, and repayments on the secured term loan of $13.7 million), dividends and distribution paid of $22.8 million and common stock repurchased of $6.7 million, partially offset by common stock issued of $54.3 million. Cash used in financing activities during the year ended December 31, 2010 was $28.4 million, which primarily resulted from net repayments of principal on debt of $56.6 million ($20.9 million, net on the Wells Fargo Bank credit agreement, $14.4 million, net, on property mortgages, $12.2 million on the secured term loan, and $9.1 million on the collateralized debt obligations), $17.3 million used to repurchase our convertible senior notes, and dividends and distributions paid of $19.0 million, partially offset by net proceeds from preferred stock issuances of $40.2 million and net proceeds from common stock issuances of $25.1 million. Cash used in financing activities during the year ended December 31, 2009 was $97.6 million, which primarily resulted from net repayments of principal on debt of $84.7 million ($63.0 million on the Wells Fargo Bank credit agreement, $12.1 million, net, on property mortgages, and $9.6 million on the secured term loan), $12.5 million used to repurchase our convertible senior notes and collateralized debt obligations, and dividends and distributions paid of $10.3 million, partially offset by net proceeds from common stock issuances of $11.0 million.

 

See our consolidated statements of cash flows in the historical consolidated financial statements included elsewhere in this filing for a reconciliation of our cash position for the periods described above.

 

Contractual Obligations

 

The following table outlines the timing of payment requirements related to our contractual obligations as of December 31, 2011 (in thousands, notional amounts):

 

       Less than 1             
   Total   year   2-3 years   4-5 years   After 5 years 
Mortgages on real estate investments  $969,004   $136,077   $153,905   $551,815   $127,207 
Credit agreement   70,668    3,271    67,397         
Secured term loan   88,142    15,380    25,951    25,933    20,878 
Convertible senior notes   35,009    35,009             
Other long-term debt   30,930            30,930     
Operating leases   1,364    766    591    7     
                          
Total  $1,195,117   $190,503   $247,844   $608,685   $148,085 

 

Notional amounts may differ from the carrying amounts reported on the Company’s Consolidated Balance Sheet.

 

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

 

Market risk refers to the risk of loss from adverse changes in the level of one or more market prices, rate indices or other market factors. We are exposed to market risk primarily from changes in interest rates, credit spreads, tenant credit ratings and equity prices. We may attempt to mitigate certain of these risks by entering into hedge and other risk management transactions during the short-term and fixed-rate financings for the long-term. We seek to obtain long-term fixed rate financing as soon as practicable after we make an asset investment. There can be no assurance, however, that such mitigation strategies will be completely or even partially successful. The level of our exposure to market risk is subject to factors beyond our control, including political risk (including terrorism), monetary and tax policy, general economic conditions and a variety of other associated risks.

 

Interest Rate Exposure

 

We are exposed to interest rate risk in various aspects of our business. The most significant ways we can be impacted by interest rates are as follows: increases in the level of interest rates may impact our ability to add new assets, as spreads on assets we are targeting may compress (unless there is a corresponding increase in asset returns). Declines in interest rates could result in greater demand for higher yielding assets and therefore increased competition for our asset class.

 

Also, to the extent we finance assets in our portfolio on our floating rate borrowing facilities, our net income from these fixed rate assets will decrease as interest rates rise (particularly LIBOR rates) and our borrowing cost increases. Our Wells Fargo Bank credit agreement and loan agreement with Bank of Oklahoma (no borrowings outstanding) are currently our only floating rate borrowing facilities. Low market interest rates kept our borrowing cost on the Wells Fargo Bank credit agreement low during 2010 and 2011 although we cannot predict the level of market interest rates in the future. In addition, as interest rates rise, our anticipated cost to finance assets on a long-term fixed rate basis may rise, causing our expected spread on assets to be reduced. We may attempt to mitigate these risks by entering into risk management transactions that react in a manner that offsets our increased interest costs and by locking our long-term financing cost as soon as practicable after we commit to an asset. As a result of market conditions, we are not currently carrying an open interest rate hedge to manage our exposure to interest rate fluctuations for assets for which we may obtain long-term financing for in the future. Our decision to do so leaves us exposed to increases in long-term interest rates for those assets and, therefore, may make it more difficult or more costly to obtain long-term financing. As noted above, there can be no assurance that our mitigation strategies will be successful.

 

Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also affect the yield required on our loans and real estate securities. Changes in the required yield would result in a higher or lower value for these assets. If the required market yields increase as a result of these interest rate changes, the value of our loans and real estate securities would decline relative to U.S. Treasuries. Conversely, if the required market yields decrease as a result of interest rate changes, the value of our loans and real estate securities would increase relative to U.S. Treasuries. These changes in the market value may affect the equity on our balance sheet or, if the value is less than our cost basis and we determine the losses to be other-than-temporary, our Statement of Operations through impairment losses on our loans or securities. These value changes may also affect our ability to borrow and access capital.

 

Credit Spread Curve Exposure

 

We are subject to credit spread risk in various aspects of our business. Credit spreads represent the portion of the required yield on an income investment attributable to credit quality. Credit spreads fluctuate over time as investor appetite for credit risk changes.

 

Changes in credit spreads can have many of the same impacts on us as a change in interest rates, or principally:

 

·increases in credit spreads can result in spread compression on investments we target and, thus, a slowing of our new investment pace;

 

·increases in credit spreads can increase our anticipated cost to finance assets not yet financed with long-term fixed rate debt, causing our expected spread on these assets to be reduced; and

 

·increases in credit spreads can lower the value of our loans and securities as required yields on these assets increase.

 

Tenant Credit Rating Exposure

 

Substantially all of our portfolio assets are subject to risks due to credit rating changes of the underlying tenant or tenants. Deterioration in the underlying tenant’s credit rating can result in a lower value for the related asset, which could result in a reduction in the equity on our balance sheet or, if the value is less than our cost basis and we determine the loss to be other-than-temporary, an impairment loss on our Statement of Operations. In addition, declines in the credit rating of a particular tenant prior to our obtaining long-term fixed rate financing could result in a margin call by the related lender, and precipitous declines may significantly impede or eliminate our ability to finance the asset. We manage these risks by maintaining diversity among our credits and assessing our aggregate exposure to ratings classes, in particular lower rated classes. We also seek to lock or procure long-term financing on our assets as promptly as practicable after we commit to invest.

 

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Equity Price Risk Exposure

 

We may seek to raise capital by sale of our common stock. Our ability to do so is dependent upon the market price of our common stock and general market conditions. Any common stock sales we make may be dilutive to existing stockholders.

 

Fair Value

 

For certain of our financial instruments, fair values are not readily available since there are no active trading markets as characterized by current exchanges between willing parties. Accordingly, we derive or estimate fair values using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved. However, the determination of estimated cash flows may be subjective and imprecise. Changes in assumptions or estimation methodologies can have a material affect on these estimated fair values. The fair values indicated below are indicative of the interest rate and credit spread environment as of December 31, 2011, and December 31, 2010, as the case may be, and may not take into consideration the effects of subsequent interest rate or credit spread fluctuations, or changes in the ratings of the underlying tenants.

 

The following summarizes certain data regarding our interest rate sensitive instruments as of December 31, 2011, and December 31, 2010 (dollars in thousands):

 

           Weighted Average         
           Effective Interest /        
   Carrying Amount   Notional Amount   Financing Rate   Maturity Date   Fair Value 
   12/31/2011   12/31/2010   12/31/2011   12/31/2010   12/31/2011   12/31/2011   12/31/2011   12/31/2010 
                                 
Assets:                                        
Loans held for investment (1)  $33,209   $210,441   $37,622   $214,049    7.3%   Various   $35,120   $223,099 
Commercial mortgage-backed securities (2)   59,435    145,965    84,405    189,187    8.4%   2015-2028    59,435    127,164 
                                         
Liabilities                                        
Mortgages on real estate investments (4)  $972,924   $928,429   $969,004   $925,264    5.6%   2012-2030   $1,002,247   $979,570 
Collateralized debt obligations (4)       254,210        254,361    N/A    N/A        220,907 
Credit agreement (3)   70,668    105,345    70,668    105,345    3.6%   2013    70,668    105,345 
Secured term loan (4)   88,142    101,880    88,142    101,880    6.0%   2018    78,302    95,145 
Convertible senior notes (5)   34,522    33,926    35,009    35,009    10.2%   2012    34,997    35,004 
Other long-term debt (6)   30,930    30,930    30,930    30,930    8.3%   2016    29,421    28,095 

 

 

(1)This portfolio of loans bears interest at fixed rates. We have estimated the fair value of this portfolio of loans with a discounted cash flow analysis, utilizing scheduled cash flows and discount rates estimated by management to approximate those that a willing buyer and seller might use. The maturity dates for the loans range from 2013 through 2033.

 

(2)Commercial mortgage-backed securities represent subordinate interests in securitizations, as well as pass-through certificates representing our pro rata investments in a pool of mortgage loans (collectively, CMBS). The notional values for the CMBS are shown at their respective face amounts. The fair values of CMBS reflect management’s best estimate and require a considerable amount of judgment and assumptions. Management evaluates a variety of inputs and then estimates fair value based on those inputs. The primary inputs evaluated by management are broker quotations, collateral values, subordination levels, and liquidity of the security. For the CMBS, we expect to receive monthly interest coupon payments, and contractual principal payments as scheduled.

 

(3)Our credit agreement bears interest at floating rates, and we believe that for similar financial instruments with comparable credit risks, the effective rates approximate market value. Accordingly, the carrying amounts outstanding are believed to approximate fair value.

 

(4)We estimate the fair value of mortgage notes on real estate investments, collateralized debt obligations and the secured term loan using a discounted cash flow analysis, based on our estimates of market interest rates. For mortgages where we have an early payment right, we also consider the prepayment amount to evaluate the fair value.

 

(5)The carry value and effective financing rate on the convertible senior notes reflect the impact of the accounting guidance applicable to the notes as of January 1, 2009. See Note 9 in our consolidated financial statements included in this Form 10-K. We estimate the fair value of our convertible senior notes using a discounted cash flow analysis, based upon management’s estimates of market interest rates, and indications of market yields, where available. The maturity date of our convertible senior notes reflects our expected maturity date in October 2012 when the note investors have the right to require us to repurchase their notes for cash and is used to compute the related fair value and weighted average effective interest rate.

 

(6)We estimate the fair value of our other long-term debt using a discounted cash flow analysis, based upon management’s estimates of market interest rates. The maturity date of our other long-term debt reflects our expected maturity date in January 2016 and is used to compute the related fair value and weighted average effective interest rate.

 

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Scheduled maturities of interest rate sensitive instruments as of December 31, 2011 are as follows:

 

   Expected Maturity Dates 
   2012   2013   2014   2015   2016   Thereafter 
   (in thousands, notional amounts) 
Loans held for investment  $6,293   $3,498   $1,108   $1,029   $918   $24,776 
Commercial mortgage-backed securities   3,329    3,882    4,509    8,866    8,939    54,880 
Mortgages on real estate investments   136,077    74,371    79,534    270,668    281,147    127,207 
Credit agreement   3,271    67,397                 
Secured term loan   15,380    13,602    12,349    13,405    12,528    20,878 
Convertible senior notes   35,009                     
Other long-term debt                   30,930     

 

The above table includes regularly scheduled principal amortization and balloon payments due to maturity on our debt obligations. See Note 9 in our consolidated financial statements included in this Form 10-K. The expected maturity dates shown for loans held for investment and commercial mortgage-backed securities are based on the contractual terms of the assets. The material assumptions used to determine fair value are included in footnotes 1 through 6 in the immediately preceding table.

 

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MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of CapLease, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States and includes those policies and procedures that:

 

·pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company;

 

·provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

 

·provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2011. In making the assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework.

 

Based on this assessment, management concluded that, as of December 31, 2011, the Company’s internal control over financial reporting is designed and operating effectively.

 

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Item 8.Financial Statements and Supplementary Data.

 

Index To Financial Statements

and Financial Statement Schedules

 

    Page
    Reference
       
Report of Independent Registered Public Accounting Firm   55  
       
Consolidated Balance Sheets as of December 31, 2011 and 2010   56  
       
Consolidated Statements of Operations for the years ended December 31, 2011, 2010 and 2009   57  
       
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2011, 2010 and 2009   58  
       
Consolidated Statements of Changes in Equity for the years ended December 31, 2011, 2010 and 2009   59  
       
Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009   60  
       
Notes to Consolidated Financial Statements   62  
       
Schedule III – Schedule of Real Estate and Accumulated Depreciation at December 31, 2011   94  
       
Schedule IV – Schedule of Loans Held for Investment at December 31, 2011   95  

 

54
 

  

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Stockholders

CapLease, Inc.

 

We have audited the accompanying consolidated balance sheets of CapLease, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income (loss), changes in equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedules of CapLease, Inc. listed in Item 15(a). We also have audited CapLease, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. CapLease, Inc.'s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company's internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CapLease, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Also in our opinion, CapLease, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

/s/ McGladrey & Pullen, LLP

New York, New York

February 23, 2012

 

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CapLease, Inc. and Subsidiaries

Consolidated Balance Sheets

 

   December 31, 
(Amounts in thousands, except share and per share amounts)  2011   2010 
Assets          
           
Real estate investments, net  $1,401,526   $1,398,399 
Loans held for investment, net   33,139    210,040 
Commercial mortgage-backed securities   59,435    145,965 
Cash and cash equivalents   71,160    32,742 
Other assets   76,363    83,125 
Total Assets  $1,641,623   $1,870,271 
           
Liabilities and Stockholders' Equity          
           
Mortgages on real estate investments  $972,924   $928,429 
Collateralized debt obligations       254,210 
Credit agreement   70,668    105,345 
Secured term loan   88,142    101,880 
Convertible senior notes   34,522    33,926 
Other long-term debt   30,930    30,930 
Total debt obligations   1,197,186    1,454,720 
Intangible liabilities on real estate investments   35,219    37,405 
Accounts payable and other liabilities   17,371    21,134 
Dividends and distributions payable   5,946    5,373 
Total Liabilities   1,255,722    1,518,632 
Commitments and contingencies          
Stockholders' equity:          
Preferred stock, $0.01 par value, 100,000,000 shares authorized, Series A cumulative redeemable preferred, liquidation preference $25.00 per share, 3,204,900 shares issued and outstanding   73,880    73,880 
Common stock, $0.01 par value, 500,000,000 shares authorized, 66,275,535 and 57,471,268 shares issued and outstanding, respectively   664    576 
Additional paid in capital   321,302    296,232 
Accumulated other comprehensive loss   (11,051)   (20,216)
Total Stockholders' Equity   384,795    350,472 
Non-controlling interest in consolidated subsidiaries   1,106    1,167 
Total Equity   385,901    351,639 
Total Liabilities and Equity  $1,641,623   $1,870,271 

 

See notes to consolidated financial statements.

 

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Consolidated Statements of Operations

 

   Year ended December 31, 
(Amounts in thousands, except per share amounts)  2011   2010   2009 
Revenues:               
Rental revenue  $127,995   $121,661   $130,495 
Interest income from loans and securities   19,655    27,621    30,668 
Tenant reimbursements   13,900    12,159    11,473 
Other revenue   793    974    1,532 
Total revenues   162,343    162,415    174,168 
Expenses:               
Interest expense   76,594    83,024    88,195 
Property expenses   27,216    24,690    20,410 
General and administrative expenses   10,628    10,660    10,881 
General and administrative expenses-stock based compensation   2,785    2,541    2,118 
Depreciation and amortization expense on real property   47,632    45,956    48,957 
Other expenses   199    267    308 
Total expenses   165,054    167,138    170,869 
Other gains (losses):               
Gain (loss) on investments, net   648    (7,949)   (10,886)
Provision for loss on property investment           (11,923)
Gain (loss) on extinguishment of debt   (3,698)   (293)   9,829 
Total other gains (losses)   (3,050)   (8,242)   (12,980)
Provision for income taxes           (201)
Loss from continuing operations   (5,761)   (12,965)   (9,882)
Discontinued operations:               
Income (loss) from discontinued operations   42    (227)   (60)
Gain on investments, net   1,426         
Provision for loss on property investment   (16,423)       (4,076)
Gain on extinguishment of debt   18,861         
Total discontinued operations   3,906    (227)   (4,136)
Net loss before non-controlling interest in consolidated subsidiaries   (1,855)   (13,192)   (14,018)
Non-controlling interest in consolidated subsidiaries   20    52    51 
Net loss   (1,835)   (13,140)   (13,967)
Dividends allocable to preferred shares   (6,510)   (5,618)   (2,844)
Net loss allocable to common stockholders  $(8,345)  $(18,758)  $(16,811)
                
Income (loss) per common share, basic and diluted:               
Loss from continuing operations  $(0.19)  $(0.33)  $(0.26)
Income (loss) from discontinued operations  $0.06   $(0.00)  $(0.08)
Net loss per common share, basic and diluted  $(0.13)  $(0.33)  $(0.34)
Weighted average number of common shares outstanding, basic and diluted   64,758    56,189    49,297 
Dividends declared per common share  $0.26   $0.25   $0.21 
Dividends declared per preferred share  $2.03   $2.03   $2.03 

 

See notes to consolidated financial statements.

 

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Consolidated Statements of Comprehensive Income (Loss)

 

   Year ended December 31, 
(Amounts in thousands)  2011   2010   2009 
             
Net loss before non-controlling interest in consolidated subsidiaries  $(1,855)  $(13,192)  $(14,018)
                
Other comprehensive income:               
Amortization of unrealized loss on securities previously classified as available for sale   150    1,765    562 
Increase (decrease) in fair value of securities available for sale   5,529    1,759    2,463 
Reclassification of derivative items into earnings   3,486    592    761 
Other comprehensive income   9,165    4,116    3,786 
                
Comprehensive income (loss)   7,310    (9,076)   (10,232)
                
Comprehensive (income) loss attributable to non-controlling interests   (18)   25    31 
                
Comprehensive income (loss) attributable to CapLease, Inc.  $7,292   $(9,051)  $(10,201)

 

See notes to consolidated financial statements

 

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CapLease, Inc. and Subsidiaries

Consolidated Statements of Changes in Equity

 

   Stockholders' Equity         
               Accumulated         
               Other         
       Common   Additional   Comprehensive        
   Preferred   Stock   Paid-In   Income   Non-controlling   Total 
(Amounts in thousands)  Stock   at Par   Capital   (Loss)    Interest   Equity 
Balance at December 31, 2008  $33,657   $474   $317,565   $(28,118)  $1,341   $324,919 
Incentive stock plan compensation expense           2,118            2,118 
Incentive stock plan grants issued and forfeited       11    (11)            
Net loss           (13,967)           (13,967)
Non-controlling interest in consolidated subsidiaries                   (51)   (51)
Issuance of common stock       32    11,014            11,046 
Dividends declared - preferred           (2,844)           (2,844)
Dividends declared - common           (10,508)           (10,508)
Distributions declared-operating partnership units                   (33)   (33)
Amortization of losses on securities previously classified as available for sale               562         562 
Increase in fair value of securities available for sale               2,463        2,463 
Reclassification of derivative items into earnings               761        761 
Balance at December 31, 2009   33,657    517    303,368    (24,332)   1,257    314,467 
Incentive stock plan compensation expense           2,541            2,541 
Incentive stock plan grants issued and forfeited       5    (5)            
Net loss           (13,140)           (13,140)
Non-controlling interest in consolidated subsidiaries                   (52)   (52)
Issuance of common stock       54    25,048            25,102 
Issuance of preferred stock   40,223                    40,223 
Repurchase of convertible senior notes-equity component           (1,050)           (1,050)
Dividends declared-preferred           (6,501)           (6,501)
Dividends declared-common           (14,029)           (14,029)
Distributions declared-operating partnership units                   (38)   (38)
Amortization of losses on securities previously classified as available for sale               1,765        1,765 
Increase in fair value of securities available for sale               1,759        1,759 
Reclassification of derivative items into earnings               592        592 
Balance at December 31, 2010   73,880    576    296,232    (20,216)   1,167    351,639 
Incentive stock plan compensation expense           2,785            2,785 
Incentive stock plan grants issued and forfeited       4    (4)            
Net loss           (1,835)           (1,835)
Non-controlling interest in consolidated subsidiaries                   (20)   (20)
Issuance of common stock       102    54,167            54,269 
Repurchase of common stock       (18)   (6,718)           (6,736)
Dividends declared-preferred           (6,510)           (6,510)
Dividends declared-common           (16,815)           (16,815)
Distributions declared-operating partnership units                   (41)   (41)
Amortization of losses on securities previously classified as available for sale               150        150 
Increase in fair value of securities available for sale               5,529        5,529 
Reclassification of derivative items into earnings               3,486        3,486 
Balance at December 31, 2011  $73,880   $664   $321,302   $(11,051)  $1,106   $385,901 

 

See notes to consolidated financial statements.

 

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CapLease, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

 

   Year ended December 31, 
(Amounts in thousands)