10-K 1 caplease_10k-123112.htm FORM 10-K caplease_10k-123112.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-K
(Mark One)
 
 x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2012
 
OR
 
 o
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
8.375% Series B Cumulative Redeemable Preferred Stock, $0.01 par value
New York Stock Exchange
7.25% Series C 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 o  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 o  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 o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o
 
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   o                                           Accelerated filer     x                         Non-accelerated filer     o                                    Smaller reporting company   o
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No    x
As of June 30, 2012, 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 $263 million, based upon the closing price of $4.15 on the New York Stock Exchange on June 29, 2012.
 
As of February 15, 2013, there were 75,936,172 shares of Common Stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant's definitive proxy statement for the registrant's 2013 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.
 
2
Item 1.
Business.
2
Item 1A.
Risk Factors.
13
Item 1B.
Unresolved Staff Comments.
25
Item 2.
Properties.
25
Item 3.
Legal Proceedings.
25
Item 4.
Mine Safety Disclosures.
25
PART II.
 
26
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
26
Item 6.
Selected Financial Data.
28
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
30
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk.
47
Item 8.
Financial Statements and Supplementary Data.
52
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
100
Item 9A.
Controls and Procedures.
100
Item 9B.
Other Information.
100
PART III.
 
101
Item 10.
Directors, Executive Officers and Corporate Governance.
101
Item 11.
Executive Compensation.
101
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
101
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
101
Item 14.
Principal Accounting Fees and Services.
101
PART IV.
 
102
Item 15.
Exhibits and Financial Statement Schedules.
102
PART V.
 
105
SIGNATURES
  105

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 could 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 our 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 a diversified portfolio of single tenant commercial real estate properties subject to long-term leases to high credit quality tenants. Many of the properties we own 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.
 
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.
 
During 2012, we continued to grow our investment portfolio with approximately $190 million of real property acquisitions and new build-to-suit commitments, and we expect to continue our growth in 2013 and future years.
 
We have invested in certain owned properties that are leased primarily but not exclusively by one tenant.  We have also invested in certain owned properties which were previously leased by one tenant but as a result of lease non-renewals have now become multi-tenant properties. We expect these types of properties will continue to comprise a portion of our portfolio for the foreseeable future. References in this Annual Report on Form 10-K to our “Single Tenant Owned Property Portfolio” include those properties leased primarily but not exclusively by one tenant but do not include our two multi-tenant properties.
 
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. The remaining debt portfolio will continue to decrease over time as principal payments are received on the investments. 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 portfolio produces stable, high quality cash flows generated by long-term leases to primarily investment grade tenants. As of December 31, 2012, we had an approximately $1.9 billion investment portfolio, including the following assets by type:
 
   
Investment(1)
       
   
(in thousands)
   
Percentage
 
Owned properties
  $ 1,853,967       95.3 %
Debt investments
               
Loans
               
Long-term mortgage loans
    24,318       1.3 %
Corporate credit notes
    3,214       0.2 %
Commercial mortgage loan securitizations
    14,419       0.7 %
Certificated mortgage loan investments
    47,899       2.5 %
Other
    175       0.0 %
Total
  $ 1,943,991       100.0 %
(1)  Here and elsewhere in Item 1 of this Annual Report on 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.
 
 
2

 

Our main 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.
 
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 tenant is of high credit quality. As of December 31, 2012, approximately 84% of our Single Tenant Owned Property Portfolio was invested in properties leased to investment grade or implied investment grade tenants, and the weighted average tenant credit rating was A-. Further, our top ten tenants, which comprise approximately 47% 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, 2012, our portfolio had the following credit characteristics:
 
Credit Rating (1) (2)
 
Investment
(in thousands)
   
Percentage
 
Investment grade rating of A- or A3 and above
  $ 781,422       42.4 %
Investment grade rating of below A- or A3
    432,131       23.4 %
Implied investment grade rating
    319,305       17.3 %
Non-investment grade rating
    309,462       16.8 %
Unrated
    935       0.1 %
    $ 1,843,255       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 our two multi-tenant properties.  Table also does not include the Fort Wayne, IN property which became vacant as of January 1, 2013.
 
 
(2)
Seven of our owned real properties within the Single Tenant Owned Property Portfolio where our aggregate investment is $368,463 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 properties subject to long-term leases. As of December 31, 2012, the weighted average remaining lease term on our Single Tenant Owned Property Portfolio was approximately 6 years. We intend to hold our assets for the long-term, capturing the stable lease cash flows that will be produced from the 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 continue to grow our business without the need to significantly expand our general and administrative costs and headcount.
 
 
·
Finance with Attractive, Low Cost Debt. Our strategy is to finance most of our assets with attractive, low cost debt, in order to allow us to invest in a greater number of assets and enhance our asset returns. We seek to finance many of our assets with conservative levels of long-term, fixed rate, non-recourse debt.  The use of non-recourse debt enables us to isolate the default risk to solely the asset or assets financed. We also have been building an unencumbered pool of assets to improve financial flexibility and expect to continue to pledge most of these assets to a revolving line of credit in order to provide us with an immediate source of liquidity through borrowings under the line.
 
 
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 investments 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 $4.8 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 $1.9 billion of single tenant properties.
 
 
3

 
 
 
·
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 includes our 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.
 
 
·
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. We have substantial experience in financing single tenant assets. 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
 
We primarily own and manage a diversified portfolio of single tenant commercial real estate properties subject to long-term leases to high credit quality tenants. As of December 31, 2012, some of the highlights of our investment portfolio were as follows:
 
 
approximately $1.9 billion owned property portfolio;
 
 
own approximately 12.1 million square feet with 92.9% occupancy;
 
 
● 
71 properties in 25 states and leases with 43 different tenants across the Single Tenant Owned Property Portfolio;
 
 
● 
ten largest tenants all rated investment grade or implied investment grade with an average credit rating of A;
 
 
● 
84% of our Single Tenant Owned Property Portfolio invested in properties leased to investment grade or implied investment grade tenants;
 
 
● 
weighted average tenant credit rating of A- across the Single Tenant Owned Property Portfolio;
 
 
● 
weighted average remaining lease term of approximately 6 years across the Single Tenant Owned Property Portfolio; and
 
 
● 
  well diversified portfolio by property type, geography, tenant and tenant industry.
 
Owned Properties
 
Owned properties comprise approximately 95% of our current portfolio on a total investment basis. All of our owned properties have been acquired since the closing of our initial public offering in 2004. We invest in a variety of commercial property types (e.g., office, warehouse, United States Government and retail), and our investment analysis includes a thorough review of the credit quality of the underlying tenant or tenants and the strength of the related leases. We also thoroughly 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. 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 good markets with strong growth prospects;
 
 
·
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.
 
The following table sets forth the occupancy rate as of the end of the last three fiscal years and the average annual rent per square foot for each of the last three fiscal years for our owned property portfolio:
 
   
2012
   
2011
   
2010
 
Occupancy rate
    92.9 %     96.2 %     94.7 %
Average annual rent per square foot
  $ 12.17     $ 11.37     $ 11.72  
 
 
4

 

Property Type Diversification
 
The following table summarizes the property types comprising our owned property portfolio as of December 31, 2012.
 
Property Type
 
Investment
   
Percentage
 
Office
  $ 971,373       52 %
Warehouse
    382,252       21 %
Retail
    206,331       11 %
GSA (US Government)
    195,856       11 %
Office/Warehouse
    77,640       4 %
Other
    20,514       1 %
Total
  $ 1,853,967       100 %
 
Tenant Industry Diversification
 
The following table sets forth certain information regarding the tenant industry concentrations in our owned property portfolio as of December 31, 2012.
 
Industry
   
Weighted Average
Credit Rating (1)
   
Investment (2)
(in thousands)
   
Percent of
Total
 
Insurance
    A     $ 263,066       14.7 %
Government
   
AA+
      213,128       11.9 %
Food & Beverage
   
BBB+
      212,338       11.8 %
Financial
   
BBB-
      164,985       9.2 %
Energy
   
BBB
      143,190       8.0 %
Grocery
   
BBB
      108,986       6.1 %
Retail Department Stores
    A       93,016       5.2 %
Building Materials
    A-       83,244       4.6 %
Retail Jewelry
    A-       77,640       4.3 %
Automotive
   
BBB-
      67,900       3.8 %
Healthcare
    A       67,184       3.7 %
Telecommunications
   
BBB
      62,250       3.5 %
Engineering
   
BBB-
      57,439       3.2 %
Communications
   
BBB
      54,499       3.0 %
Hotel
   
BB+
      47,529       2.6 %
Retail Drug
   
BBB-
      29,051       1.6 %
Publishing
   
BBB+
      20,837       1.2 %
Other
    N/A       29,335       1.6 %
Total
    A-     $ 1,795,617       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 Fort Wayne, IN property which became vacant as of January 1, 2013.  Table also does not include a portion of our investment attributed to vacant space in the Landmark building in Omaha, NE.
 
 
5

 
 
Geographic Diversification
 
The following table sets forth certain information regarding the top states where our owned properties are located as of December 31, 2012.
 
State
 
Number of Properties
   
Investment 
(in thousands)
   
Percent of Total
 
TX
    11     $ 275,766       14.9%  
PA
    4       207,687       11.2%  
CA
    7       202,197       10.9%  
MD
    4       131,594       7.1%  
NJ
    2       127,871       6.9%  
IL
    2       109,449       5.9%  
VA
    4       100,631       5.4%  
CO
    4       96,120       5.2%  
IN
    3       91,477       4.9%  
KS
    3       54,143       2.9%  
NE
    2       52,600       2.8%  
OK
    1       41,691       2.2%  
KY
    6       41,686       2.2%  
AL
    2       40,406       2.2%  
WA
    1       39,612       2.1%  
GA
    4       36,347       2.0%  
TN
    3       34,171       1.8%  
LA
    1       29,624       1.6%  
WI
    1       29,165       1.6%  
FL
    1       27,266       1.5%  
NC
    1       27,236       1.5%  
Other
    4       57,229       3.1%  
Total
    71     $ 1,853,967       100.0  
 
Lease Expirations
 
The following table sets forth certain information regarding scheduled lease expirations in our owned property portfolio as of December 31, 2012.
 
Year of Lease Expiration
 
Square Feet
Subject to
Expiring Lease
   
Current Annualized Base Rent
(in thousands)
   
Percent
of Annual Rent (1)
 
2013
    602,407     $ 15,553       11.6 %
2014
    90,870       863       0.6 %
2015
    760,075       11,239       8.3 %
2016
    1,207,558       16,140       12.0 %
2017
    2,937,650       24,423       18.1 %
2018
    256,423       4,643       3.4 %
2019
    362,722       9,412       7.0 %
2020
    878,085       13,164       9.8 %
2021
    2,384,675       15,662       11.6 %
2022
    819,489       7,522       5.6 %
Thereafter
    958,304       15,996       11.9 %
                         
 
(1)  Represents lease expiration dates as a percentage of current annualized base rent on all properties other than the Fort Wayne, IN property which became vacant as of January 1, 2013.
 
The primary scheduled lease maturities in 2013 are: (i) 174,235 square feet leased to Choice Hotels International, Inc. in Silver Spring, MD scheduled to mature in May 2013, (ii) 101,120 square feet leased to Omnicom Group, Inc. in Irving, TX scheduled to mature in May 2013 and (iii) 191,278 square feet leased to the United States Government (NIH) in Bethesda, MD scheduled to mature in November 2013.  We do not expect the Choice Hotels or Omnicom leases to be renewed or extended and are actively marketing those properties for re-let upon conclusion of the tenant’s lease term.  We lease approximately 22% of the space at the Choice building to three other tenants.  We are not aware at this time of the United States Government (NIH)’s plans with respect to the Bethesda, MD property beyond the scheduled lease expiration in November 2013.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Upcoming Lease Maturities and Expected and Potential Tenant Rollovers” for annual rental revenue in accordance with generally accepted accounting principles  in the United States (GAAP) from these properties and our estimate of current market rents for these properties. We cannot make any assurance regarding the timing or expected outcomes of our leasing efforts at these properties, including as to when and on what terms we will be able to lease any property which we may need to re-tenant.
 
 
6

 
 
The following is a tabular presentation of our owned property portfolio as of December 31, 2012:
 
                            (in thousands)  
Tenant or Guarantor
Location
Property Type
 
Square
Feet
   
Purchase Date
   
Lease Maturity (1)
 
Form of Ownership
 
2013 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
    1,932       24,255       25,688  
Allstate Insurance Company
401 McCullough Drive, Charlotte, NC
Office
    191,681       12/2005       12/2015  
Fee
    2,222       27,172       27,236  
Allstate Insurance Company
1819 Electric Road (aka State Hwy. 419), Roanoke, VA
Office
    165,808       12/2005       12/2015  
Fee
    2,365       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
    7,328       85,750       89,087  
AT&T Services, Inc.
2270 Lakeside Blvd., Richardson, TX
Office
    203,239       5/2012       3/2020  
Fee
    2,286       29,324       29,324  
Baxter International, Inc.
555 North Daniels Way, Bloomington, IN
Warehouse
    125,500       10/2004       9/2016  
Fee
    872       10,500       10,779  
Becton, Dickinson and Company(5)
5859 Farinon Drive, San Antonio, TX
Office
    95,898       12/2012       3/2021  
Fee
    1,445       18,100       18,100  
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
    2,419       27,900       31,175  
Choice Hotels International, Inc.(6)
10720, 10750 & 10770 Columbia Pike, Silver Spring, MD
Office
    223,912       11/2004       5/2013  
Fee
    2,510       43,500       47,529  
Cimarex Energy Company (Development Property)(7)
206 S. Cheyenne, Tulsa, OK
Office
    N/A       7/2011       N/A  
Joint Venture/Fee
          41,691       41,691  
Comcast Corporation
7475 S Joliet St, Englewood, CO
Office
    61,436       12/2012       12/2020  
Fee
    553       7,000       7,000  
Cooper Tire & Rubber Company
500 Bartram Parkway, Franklin, IN
Warehouse
    807,042       12/2010       5/2021  
Fee
    2,674       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 and 10 Morton Avenue, Ridley Park, PA
Medical Office
    22,708       8/2004       4/2019  
Ground Lease
    469       4,477       5,879  
CVS Corporation
100 Mazzeo Drive, Randolph, MA
Retail
    88,420       9/2004       1/2014  
Fee
    771       10,450       14,101  
Del Monte Corporation
2 Nestle Way, Lathrop, CA
Warehouse
    751,021       4/2007       12/2017  
Estate for Years
    2,491       52,357       64,151  
Exelis, Inc. (formerly ITT Corporation)
12975 Worldgate Drive, Herndon, VA
Office
    167,285       5/2005       3/2019  
Fee
    5,657       46,081       56,747  
Farmers Group, Inc.
3039-3041 Cochran Street, Simi Valley, CA
Office
    271,000       1/2007       1/2017  
Fee
    3,288       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
    2,815       39,550       39,612  
General Motors Financial Company, Inc.
4001 Embarcadero Drive, Arlington, TX
Office
    246,060       12/2006       8/2017  
Fee
    3,339       43,000       43,374  
Invesco Holding Co. Ltd.
4340, 4346 & 4350 South Monaco St., Denver, CO
Office
    263,770       3/2006       10/2016  
Fee
    5,475       69,300       70,020  
Johnson Controls, Inc.
6750 Bryan Dairy Road, Pinellas Park, FL
Warehouse
    307,275       12/2006       8/2016  
Fee
    2,223       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.(8)
26501 Aliso Creek Rd., Aliso Viejo, CA
Retail
    181,160       5/2005       8/2024  
Fee
    3,470       52,860       53,621  
Lowes Companies, Inc.
2401/2501 Elysian Fields Ave., New Orleans, LA
Retail
    133,841       11/2011       5/2030  
Fee
    2,314       28,474       29,624  
MetroPCS Communications, Inc.
2250 Lakeside Blvd, Richardson, TX
Office
    115,583       5/2012       11/2018  
Fee
    2,592       16,676       16,676  
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 (Dodge building)
9394 West Dodge Road, Omaha, NE
Office
    133,685       4/2007    
Various
 
Ground Lease
    2,338       10,785       18,617  
Multi-tenant (Landmark building)
1299 Farnam Street, Omaha, NE
Office
    292,714       4/2007    
Various
 
Ground Lease
    2,896       30,097       33,983  
Nestle Holdings, Inc.
555 Nestle Way, Breinigsville, PA
Warehouse
    1,045,153       4/2007       12/2017  
Estate for Years
    4,599       74,215       87,688  
Omnicom Group, Inc.
1660 North Westridge Circle, Irving, TX
Office
    101,120       6/2005       5/2013  
Fee
    560       18,100       18,333  
Pearson Plc.
3833 Greenway Drive and 2201 Noria Road, Lawrence, KS
Office
    194,665       4/2006       4/2021  
Fee
    1,567       20,750       20,837  
Praxair, Inc.(9)
1585 Sawdust Rd., The Woodlands, TX
Office
    175,035       6/2012       5/2022  
Fee
    3,028       40,450       40,562  
Pulte Mortgage LLC
7390 S. Iola St, Englewood, CO
Office
    95,265       12/2012       3/2020  
Fee
    1,604       19,100       19,100  
The Kroger Co.
136 W. Belmont Drive, Calhoun, GA
Retail
    65,849       4/2007       1/2022  
Estate for Years
    465       5,334       7,320  
The Kroger Co.
302 Brighton Park Blvd, Frankfort, KY
Retail
    53,886       4/2007       1/2022  
Estate for Years
    422       4,495       6,169  
The Kroger Co.
2020 Mallory Lane, Franklin, TN
Retail
    62,348       4/2007       1/2022  
Estate for Years
    564       6,461       8,867  
The Kroger Co.
1002 S. Broadway, Georgetown, KY
Retail
    62,363       4/2007       1/2022  
Estate for Years
    491       6,192       8,498  
The Kroger Co.
9501 Northshore Drive, Knoxville, TN
Retail
    62,348       4/2007       1/2022  
Estate for Years
    554       6,596       9,053  
The Kroger Co.
6678 Covington Hwy., Lithonia, GA
Retail
    57,032       4/2007       1/2022  
Estate for Years
    535       5,834       8,006  
The Kroger Co.
540 Island Fort Road, Madisonville, KY
Retail
    61,503       4/2007       1/2022  
Estate for Years
    419       4,265       5,853  
The Kroger Co.
808 N. 12th Street, Murray, KY
Retail
    56,162       4/2007       1/2022  
Estate for Years
    449       4,406       6,046  
The Kroger Co.
1670 Starlite Drive, Owensboro, KY
Retail
    62,360       4/2007       1/2022  
Estate for Years
    444       5,136       7,048  
The Kroger Co.
3651 Peachtree Parkway, Suwanee, GA
Retail
    65,726       4/2007       1/2022  
Estate for Years
    563       7,255       9,957  
The Kroger Co.
400 Peachtree Industrial Blvd, Suwanee, GA
Retail
    75,558       4/2007       1/2022  
Estate for Years
    621       8,062       11,064  
Tiffany & Co.
15 Sylvan Way, Parsippany, NJ
Office/Warehouse
    367,740       9/2005       9/2025  
Fee
    4,982       75,000       77,640  
Time Warner Cable Enterprises LLC
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
    1,462       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       17,306  
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 (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 (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 (EPA)
300 Minnesota Avenue, Kansas City, KS
GSA (US Government)
    71,979       8/2005       3/2023  
Fee
    2,877       29,250       33,306  
United States Government (NIH) (10)
6116 Executive Bvd, Bethesda, MD
GSA (US Government)
    207,055       9/2005       11/2013  
Fee
    6,662       81,500       84,064  
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  
Vacant (11)
2909 Pleasant Center Road, Fort Wayne, IN
Warehouse
    764,177       4/2007       N/A  
Estate for Years
    -       43,837       48,136  
Vitamin Shoppe Industries Inc. (Development Property) (12)
14038 North Washington Hwy, Ashland, VA
Warehouse
    N/A       8/2012       N/A  
Fee
    -       10,583       10,583  
Walgreen Co.
700 Frederick Blvd, Portsmouth, VA
Retail Drug
    13,905       11/2004       7/2018  
Fee
    356       4,165       4,367  
WorleyParsons Limited (13)
15721 Park Row Boulevard, Houston, TX
Office
    143,797       12/2012       12/2019  
Fee
    2,820       35,500       35,500  
Total
        12,123,421                       $ 131,191     $ 1,731,061     $ 1,853,967  
 
(1)
Except in the case of our Multi-Tenant Properties, includes lease maturity for our primary tenant. Seven of our owned properties within the Single Tenant Owned Property Portfolio are leased to more than one tenant (see footnotes (4), (5), (6), (8), (9), (10) and (13) below).
(2)
Reflects scheduled base rent due for 2013 under our lease with the tenant or tenants except for development properties. Does not reflect straight-line rent adjustments required under GAAP. Also does not include tenant reimbursements of property expenses 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, 2012, approximately 2% of the property was leased to one other tenant.
(5)
As of December 31, 2012, approximately 48% of the property was leased to two other tenants.  Beginning in April 2013, Becton, Dickinson will begin leasing the space of a vacating tenant at which point one other tenant will occupy 29% of the property.
(6)
As of December 31, 2012, approximately 22% of the property was leased to three other tenants.
(7)
We are currently funding construction of the property on a build-to-suit basis for the tenant. Upon completion of construction (estimated in second quarter 2013), the tenant’s 12 year lease term will commence.
(8)
As of December 31, 2012, approximately 18% of the property was leased to two other tenants.
(9)
As of December 31, 2012, approximately 39% of the property was leased to four other tenants.
(10)
As of December 31, 2012, approximately 4% of the property was leased to two other tenants.
(11)
Until December 31, 2012, the property was leased to Nestlé Holdings, Inc. and subleased by General Mills Operations, Inc. The property became vacant as of January 1, 2013, and is currently being marketed for re-let.
(12)
We are currently funding construction of the property on a build-to-suit basis for the tenant. Upon completion of construction (estimated in second quarter 2013), the tenant’s 15 year lease term will commence.
(13)
As of December 31, 2012, approximately 9% of the property was leased to two other tenants.
 
 
7

 
 
Ground Leased and Estate for Years Properties
 
With respect to certain of our owned properties, we own the improvements on the land and control the land through a ground lease or an estate for years with an option to enter into a ground lease at the expiration of the estate for years. A third party owns the land or a future interest in the land. For most of these properties, we also have an option to purchase the land at fair market value at various scheduled dates in the future. If we exercise the purchase option, the fair market value will be agreed to by us and the land owner or if the parties cannot agree determined through an appraisal process.
 
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 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: Breinigsville, PA, Lathrop, CA and Fort Wayne, IN warehouse properties, 60 years; Kroger properties, 69 years; Omaha, NE properties, 63 years; and Crozer-Keystone Health System property, 34 years.
 
Multi-Tenant Properties
 
We have classified two owned properties within our portfolio as multi-tenant properties, as each is no longer leased primarily by a single tenant.  Both properties are located in Omaha, NE.  We have not classified properties leased primarily but not exclusively by one tenant as multi-tenant properties.
 
The following table summarizes certain additional information about the two multi-tenant properties as of December 31, 2012:
 
 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. (Aug 2015)
1299 Farnam Street, Omaha, NE
    70 %     16  
Pacific Life Insurance Company (Jun 2015), G4S Technology LLC (Aug 2013), Stinson Morrison Hecker, LLP (Jun 2015), Booz Allen Hamilton Inc. (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 at the 1299 Farnam Street property 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
 
As of December 31, 2012, loan investments aggregated approximately $27.5 million, or approximately 2% of our portfolio. All of our loan investments were originated and underwritten by us and are secured by single tenant commercial real estate collateral. Our loan investments are comprised principally of:
 
 
·
Long-term mortgage loans: fully or nearly fully amortizing first mortgage loans on properties subject to long-term net leases.
 
 
·
Corporate credit notes: fully amortizing notes with each representing 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.
 
 
8

 
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 on an opportunistic basis in the future.
 
The following is a tabular presentation of our loan portfolio as of December 31, 2012:
 
                                   
(in thousands)
       
Tenant or Guarantor
 
Location
 
Property Type
 
Square Feet
   
Coupon
   
Lease Expiration
   
Loan Maturity
   
Original
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     $ 3,082     $ 3,082       69 %
CVS Corporation
 
Evansville, IN
 
Retail Drug
    12,900       6.22 %     1/2033       1/2033       3,351       3,009       3,009       68 %
CVS Corporation
 
Greensboro, GA
 
Retail Drug
    11,970       6.52 %     1/2030       1/2030       1,395       1,172       1,172       69 %
CVS Corporation
 
Shelby Twp., MI
 
Retail Drug
    11,970       5.98 %     1/2031       1/2031       2,540       2,297       2,297       81 %
Koninklijke Ahold, N.V.
 
Bensalem, PA
 
Retail
    67,000       7.24 %     5/2020       5/2020       3,153       2,250       2,277       65 %
Lowes Companies, Inc.(2)
 
Framingham, MA
 
Retail
    156,543       N/A       10/2031       9/2031       5,545       5,651       1,830       80 %
Walgreen Co.
 
Dallas, TX
 
Retail Drug
    14,550       6.46 %     12/2029       12/2029       3,534       2,949       2,949       69 %
Walgreen Co.
 
Nacogdoches, TX
 
Retail Drug
    14,820       6.80 %     9/2030       9/2030       3,649       3,179       3,179       62 %
Walgreen Co.
 
Rosemead, CA
 
Retail Drug
    12,004       6.26 %     12/2029       12/2029       5,333       4,522       4,522       63 %
                                              31,969       28,111       24,318          
                                                                         
Corporate Credit Notes
                                                                       
Federal Express Corporation
 
Bellingham, WA
 
Warehouse
    30,313       5.78 %     10/2018       3/2015       362       124       123       57 %
Hercules Incorporated
 
Wilmington, DE
 
Office
    518,409       9.32 %     5/2013       5/2013       20,000       2,470       2,470       59 %
Lowes Companies, Inc.
 
N. Windham, ME
 
Retail
    138,134       5.28 %     1/2026       9/2015       1,140       392       389       72 %
Walgreen Co.
 
Jefferson City, TN
 
Retail Drug
    14,266       5.49 %     3/2030       5/2015       786       232       232       73 %
                                              22,288       3,218       3,214          
                                                                         
Total
                                          $ 54,257     $ 31,329     $ 27,532          
 
 
 
(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, 2012 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, 2012, real estate securities aggregated approximately $62.3 million, or approximately 3% of our portfolio. 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.
 
Our securities investments as of December 31, 2012 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 D)
 
05950WAT5
  $ 4,000     $ 60     $       6.01 %
Sep 2016
BACMS 2002-2, Class V-1 (7-Eleven, Inc.) (rated AA-)
 
05947UJE9
    714       625       625       8.44 %
Sep 2019
BACMS 2002-2, Class V-2 (Sterling Jewelers) (not rated)
 
05947UJF6
    1,090       935       933       8.40 %
Jan 2021
CALFS 1997-CTL1, Class D (rated B-)
 
140281AF3
    2,550       2,423       2,550       6.16 %
Nov 2017
CMLBC 2001-CMLB-1, Class H (rated B-)
 
201736AM7
    11,907       5,954       7,321       6.25 %
Mar 2024
CMLBC 2001-CMLB-1, Class J (rated D)
 
201736AN5
    6,383       1,213       362       6.25 %
Oct 2025
NLFC 1999-LTL-1, Class X (IO) (rated AAA)
 
63859CCG6
    3,474       3,210       3,474       10.36 %
Jan 2024
          30,119       14,419       15,265            
                                       
Investments in Certificated Mortgage Loan Transactions
                                     
Certificated Mortgage Loan (with Alcatel-Lucent USA Inc. as tenant in Highlands Ranch, CO) (rated B)
 
72817#AA6
    23,487       21,675       23,741       6.70 %
Sep 2020
Certificated Mortgage Loan (with CVS Corporation as tenant / multi-property) (rated BBB+)
 
126650BB5
    16,216       18,689       16,216       5.88 %
Jan 2028
Certificated Mortgage Loan (with Koninklijke Ahold, N.V. as tenant / multi-property) (rated BBB)
 
008686AA5
    6,546       7,534       6,616       7.82 %
Jan 2020
          46,249       47,899       46,573            
                                       
Total
      $ 76,368     $ 62,318     $ 61,838            
 
(1) Represents face amount or, in the case of the NLFC 1999-LTL-1, Class X (IO) bond, our amortized cost.
 
The weighted average life of our securities portfolio as of December 31, 2012 was 6.5 years.
 
 
9

 
 
Portfolio Financing
 
A key component of our portfolio financing strategy is to finance most of our assets with attractive, low cost debt.  Doing so allows us to invest in a greater number of assets and enhance our asset returns. We seek to finance many of our assets with conservative levels of long-term, fixed rate, non-recourse debt.  The use of non-recourse debt enables us 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 in most case employ amortizing debt on our assets, or debt that will diminish over time as we make scheduled principal payments.
 
We also have been building an unencumbered pool of assets to improve financial flexibility and expect to continue to pledge most of these assets to a revolving line of credit in order to provide us with an immediate source of liquidity through borrowings under the line.  We have also pledged certain of our remaining loan assets to a floating rate, recourse, term loan, where the borrowings are expected to fully amortize over the loan term as principal payments are received on the loans.
 
As of December 31, 2012, the following statistics summarize various aspects of our overall portfolio financing position:
 
 
·
overall leverage of approximately 61%;
 
 
·
$1.0 billion of non-recourse first mortgage debt at a weighted average coupon of 5.39% and a weighted average effective financing rate of 5.6%;
 
 
·
$72.4 million of non-recourse secured term debt at a coupon of 5.81% and an effective financing rate of 6.0%; and
 
 
·
$67.7 million of recourse debt to the lenders under two floating rate LIBOR based credit agreements at an effective financing rate of 4.1%.
 
We expect our leverage levels 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.
 
Revenue Concentrations in 2012
 
The United States Government accounted for approximately 13.1% of our total revenue during 2012. The United States Government accounted for approximately 13.8% of our total revenue from our owned properties segment during 2012. 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 2012. Approximately 20.2% and 17.9%, respectively, of our total revenue from our debt investments segment during 2012 was obtained from investments where Alcatel-Lucent USA Inc. or CVS Corporation is the tenant (or lease guarantor), but not our obligor.
 
Build-to-Suit Program
 
In recent years we have expanded our new investment activity beyond the traditional investment in completed properties with tenants in occupancy and paying rents, to include build-to-suit projects.  Through our build-to-suit program, we seek to source 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. We have sourced a series of investments through this program since it was launched in 2010, and expect this program to continue to be a component of our new investment activity in the future.
 
We have also been exploring investment in speculative development projects and may look to make limited investments in such projects in the future.
 
Transaction Review Process
 
Once a prospective investment opportunity is identified, the transaction undergoes a comprehensive review and due diligence process that is overseen by our investment committee, which includes our chief executive officer, president, chief financial officer and chief investment officer. The focus of our asset review falls into the following 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.
 
 
10

 
 
Prior to entering into any transaction, our investment professionals, assisted by our chief investment officer and chief financial officer as necessary, conduct 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 any property expenses not borne by the tenant are sufficiently underwritten. 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 good markets with strong growth prospects, 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 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 without the need to significantly 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;
 
 
·
monitoring the financial condition and credit ratings of our tenants;
 
 
11

 
 
 
·
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.
 
Competition
 
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 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.
 
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, 2012, we were not aware of any environmental concerns that would have a material adverse effect on our financial position or results of operations.
 
 
12

 
 
Employees
 
As of December 31, 2012, we had 17 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 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 or at all 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.
 
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.
 
 
13

 
 
 
·
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 and various of our other 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 common stock could be adversely affected.
 
Risks Related to Portfolio Assets
 
Single tenant leases involve significant risks of tenant default.
 
Most of the properties we own are leased to a single tenant. Therefore, a 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 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, among other factors. 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.
 
 
·
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 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 losses and losses of disposition, 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 have incurred substantial impairment losses and losses on disposition in the past, and may continue to do so in the future. These losses could have a material adverse effect on our financial condition and results of operations.
 
 
14

 
 
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, 2012:
 
 
·
approximately $195.9 million, or 10.1%, of our assets represent investments in seven properties leased to the United States Government;
 
 
·
approximately $93.0 million, or 4.8%, of our assets represent investments in one property leased to TJX Companies, Inc.; and
 
 
·
approximately $89.1 million, or 4.6%, of our assets represent investments in one property leased to, or lease guaranteed by, Aon Corporation.
 
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, 2012:
 
 
·
approximately $263.1 million, or 13.5%, 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 $212.3 million, or 10.9%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the food and beverage industry (e.g., Del Monte Corporation, Nestlé Holdings, Inc., Cadbury Holdings Limited and Bunge North America, Inc.);
 
 
·
approximately $209.7 million, or 10.8%, 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 $165.0 million, or 8.5%, 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., Invesco Holding Co. Ltd. and Pulte Mortgage LLC);
 
 
·
approximately $143.2 million, or 7.4%, of our assets represent investments in properties leased to, or leases guaranteed by, companies in the energy industry (e.g., AMEC plc, Cimarex Energy Company, Praxair, Inc. and WorleyParsons Limited); and
 
 
·
approximately $118.8 million, or 6.1%, 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.).
 
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, 2012:
 
 
·
approximately $210.0 million, or 10.8%, of our assets represent investments in properties located in the Philadelphia, PA metropolitan area;
 
 
15

 
 
 
·
approximately $188.3 million, or 9.7%, of our assets represent investments in properties located in the Washington, D.C. metropolitan area;
 
 
·
approximately $152.1 million, or 7.8%, of our assets represent investments in properties located in the Dallas/Fort Worth, TX metropolitan area;
 
 
·
approximately $127.9 million, or 6.6%, of our assets represent investments in properties located in the Northern New Jersey area;
 
 
·
approximately $109.4 million, or 5.6%, of our assets represent investments in properties located in the Chicago, IL metropolitan area;
 
 
·
approximately $101.5 million, or 5.2%, of our assets represent investments in properties located in the Houston, TX metropolitan area; and
 
 
·
approximately $100.0 million, or 5.2%, 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 $309.5 million, or 16.8%, of our portfolio as of December 31, 2012). Investments backed by below investment grade tenants have comprised a larger percentage of our new investment activity in recent years 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.
 
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, whether the property is leased and if it is leased, the duration and other terms of the lease, as well as 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 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.
 
 
16

 
 
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. In addition to our Fort Wayne, IN property where the lease expired on December 31, 2012, we have certain other leases which are scheduled to mature during 2013.  See Item 1 of this Form 10-K under “Business—Our Portfolio—Owned Properties—Lease Expirations.”
 
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 conditions 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.
 
We are subject to risks associated with the development of properties.
 
We have begun and expect to continue to make new investments through our build-to-suit program, where we engage experienced developers as partners and agree to fund and construct commercial real estate projects on a build-to-suit basis for large corporate tenants.  As of December 31, 2012, we had two such projects in process, one for Cimarex Energy Co. in Tulsa, OK and another for Vitamin Shoppe, Inc. in Ashland, VA.  We are subject to certain risks associated with the development of these or any other properties 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.
 
We also may enter into development projects on a speculative or other than build-to-suit basis in the future.  In addition to the risks set forth above, these projects would expose us to a variety of additional risks, including the following:
 
 
·
We may not be able to lease the available space in our recently completed projects at rents or occupancy levels that are sufficient to be profitable.
 
 
17

 
 
 
·
Delays in construction and leasing could subject us to increased expenses and construction costs, and reduce the profitability of the project.
 
 
·
Some developments may fail to achieve expectations, possibly making them unprofitable.
 
 
·
We may abandon development opportunities after we begin to explore them and as a result, we may fail to recover costs already incurred.
 
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.
 
New rules relating to the accounting for leases could adversely affect our business.
 
The Financial Accounting Standards Board and International Accounting Standards Board continue to propose and re-propose significant modifications to lease accounting rules, including a requirement that landlords and tenants capitalize lease rights and obligations on their balance sheets. The effective dates of these possible accounting changes, if any, are unknown at this time. The new rules if adopted could materially impact our financial statements by requiring us to capitalize our leases and change the timing of recognition of lease income. The rules 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 may 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. Tenants may also disfavor lease renewal options, as the new rules may 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.
 
 
18

 
 
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.
 
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.
 
 
19

 
 
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, 2012, the scheduled principal payments on our long-term debt over the next five years and thereafter were as follows:
 
   
Expected Maturity Dates
 
   
2013
   
2014
   
2015
   
2016
   
2017
   
Thereafter
 
   
(in thousands, notional amounts)
 
Mortgages on real estate investments
  $ 73,573     $ 183,975     $ 269,583     $ 278,214     $ 86,263     $ 119,146  
Credit agreements
    2,267       3,260       62,128                    
Secured term loan
    14,242       12,851       11,862       12,516       7,680       13,267  
Convertible senior notes
                            19,210        
Other long-term debt
                                  30,930  
 
Included in the above amounts are balloon payments on our debt instruments, including $55 million aggregate of non-recourse mortgage debt due in May 2013 on our Choice Hotels, Capital One and Omnicom properties. Most of our debt provides for balloon payments that are payable at maturity. Our ability to make these balloon payments will depend upon our cash balances and borrowing capacity under our revolving credit agreement and our ability to refinance the related debt, raise additional capital and/or sell assets or any related collateral. Our ability to refinance debt, raise capital and/or sell assets will in turn 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 credit agreements, convertible senior notes and other long-term debt referenced in the table above are recourse obligations, 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.
 
Our credit agreements are secured, recourse obligations and expose us to interest rate and unexpected prepayment risks.
 
We have financed certain of our investments pursuant to credit agreements we have entered into with Wells Fargo Bank and KeyBank. These borrowing agreements expose us to a variety of risks, including the following:
 
 
·
They are priced at floating rates based on LIBOR, or the London Interbank Offered Rate. Therefore, increases in LIBOR rates will cause our borrowing costs to increase and our net income to decrease.
 
 
·
Our obligations are secured by the assets we have pledged to the lender and recourse to all of our other assets. If we fail to make the required debt service payments, the lender can foreclose on the pledged assets and we could lose all or a substantial portion of our investment in such assets.  Further, in the event we are unable to satisfy our payment obligations under the agreements from the assets securing the borrowings, we will remain obligated to satisfy these obligations out of other assets of our company.
 
 
·
We have pledged certain assets which we refer to as the borrowing base to the lender to secure our obligations, and the value of the borrowing base determines the amount we may borrow.  The value of the borrowing base is subject to periodic redetermination which could require us to repay a portion of our then-outstanding borrowing, referred to as an overadvance.  The primary factors that could cause the value of the borrowing base to decline are a decline in net operating income from the property or a reduced valuation based on an updated appraisal which may be obtained by the lender at any time.  A failure to repay such an overadvance would be a default under the agreements and could have a material adverse effect on our financial and liquidity position.
 
 
·
Our credit agreement with Wells Fargo Bank is an uncommitted revolver, meaning the lender must agree to each asset financed, and we cannot assure you that we will be able to finance assets on this facility at any given time.
 
 
20

 
 
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 agreements with Wells Fargo Bank and KeyBank, 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 agreements with Wells Fargo Bank and KeyBank are fully recourse lending arrangements. Therefore, if we default on either of these agreements, the lender 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.
 
Certain of our assets are cross-collateralized, and certain of our indebtedness is cross-defaulted.
 
As of December 31, 2012, the three warehouse properties we own in Breinigsville, PA, Lathrop, CA and Fort Wayne, IN all serve as collateral for a single mortgage note. In addition, (1) our secured term loan is secured by interests in 28 of our investments, (2) our credit agreement with Wells Fargo Bank is secured by interests in 16 of our owned properties and (3) our credit agreement with KeyBank is secured by interests in 11 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 agreements with Wells Fargo Bank and KeyBank 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.
 
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.
 
 
·
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.
 
 
21

 
 
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 may sell investment opportunities to our competitors.