10-K 1 v334696_10k.htm FORM 10-K

 

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

 

FORM 10-K

 

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

 

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

 

For the transition period from . to .

 

Commission File No. 1-32248 

GRAMERCY CAPITAL CORP.

(Exact name of registrant as specified in its charter)

 

Maryland   06-1722127
(State or other jurisdiction
incorporation or organization)
  (I.R.S. Employer of
Identification No.)

 

420 Lexington Avenue, New York, NY 10170

 

(Address of principal executive offices — zip code)

 

(212) 297-1000

 

(Registrant’s telephone number, including area code)

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

Title of Each Class   Name of Each Exchange on Which Registered
Common Stock, $0.001 Par Value   New York Stock Exchange
Series A Cumulative Redeemable    
Preferred Stock, $0.001 Par Value   New York Stock Exchange

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None

 

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

 

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

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes x No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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. ¨

 

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

 

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

 

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

 

As of March 18, 2013, there were 60,737,604 shares of the Registrant’s common stock outstanding. The aggregate market value of common stock held by non-affiliates of the registrant (49,069,376 shares) at June 30, 2012, was $122,673,440. The aggregate market value was calculated by using the closing price of the common stock as of that date on the New York Stock Exchange, which was $2.50 per share.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant's Definitive Proxy Statement for its 2013 Annual Meeting of Stockholders expected 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.

 

 
 

 

GRAMERCY CAPITAL CORP.
FORM 10-K
TABLE OF CONTENTS

 

10-K PART AND ITEM NO.

 

  Page
PART I
1. Business 3
1A. Risk Factors 13
1B. Unresolved Staff Comments 28
2. Properties 28
3. Legal Proceedings 30
4. Mine Safety Disclosures 30
5. Market for Registrant’s Common Equity, Related Stockholders Matters and Issuer Purchases of Equity Securities 31
6. Selected Financial Data 33
7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 35
7A. Quantitative and Qualitative Disclosures About Market Risk 59
8. Financial Statements and Supplementary Data 60
9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 122
9A. Controls and Procedures 122
9B. Other Information 122
PART III
10. Directors, Executive Officers and Corporate Governance of the Registrant 123
11. Executive Compensation 123
12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 123
13. Certain Relationships and Related Transactions and Director Independence 123
14. Principal Accounting Fees and Services 123
PART IV
15. Exhibits, Financial Statements and Schedules 124
Signatures 129

 

 
 

 

 

Part I

 

ITEM 1. BUSINESS

 

General

 

Gramercy Capital Corp., or the “Company” or “Gramercy”, is a self-managed, integrated commercial real estate investment and asset management company. In June 2012, following a strategic review process completed by a special committee of our board of directors, we announced that we will focus on deploying our capital into income-producing net leased real estate. Our new investment criteria focuses on net lease investments in markets across the United States. As of December 31, 2012, we own directly or in joint venture, a portfolio of 116 office and industrial buildings totaling approximately 4.9 million square feet, net leased on a long-term basis to tenants, including Bank of America, Nestlé Waters, Philips Electronics and others. We also have an asset and property management business which operates under the name Gramercy Asset Management (formerly Gramercy Realty) and currently manages for third-parties approximately $1.7 billion of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. Additionally, we have a commercial real estate finance business which operates under the name Gramercy Finance and manages approximately $1.7 billion of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity and commercial mortgage-backed securities, or CMBS, which are financed through three non-recourse Collateralized Debt Obligations, or Gramercy Real Estate CDO 2005-1, Ltd., a Cayman Island company, Gramercy Real Estate CDO 2006-1, Ltd., a Cayman Island company, and Gramercy Real Estate CDO 2007-1, Ltd., a Cayman Island company, or collectively, the CDOs. As described herein, in March 2013, we exited the commercial real estate finance business and sold the collateral management and sub-special servicing agreements for our CDOs which will result in the deconsolidation of Gramercy Finance from our Consolidated Balance Sheets. We have classified the assets and liabilities of Gramercy Finance as assets held-for-sale and have reported the results of operations of Gramercy Finance in discontinued operations. Neither Gramercy Finance nor Gramercy Asset Management is a separate legal entity but are divisions through which our commercial real estate finance and asset and property management businesses are conducted.

 

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and generally will not be subject to U.S. federal income taxes to the extent we distribute our taxable income, if any, to our stockholders. In the past we have established, and may in the future establish taxable REIT subsidiaries, or TRSs, to effect various taxable transactions. Those TRSs would incur U.S. federal, state and local taxes on the taxable income from their activities.

 

Recent Developments

 

In connection with our efforts to exit Gramercy Finance, on January 30, 2013, we entered into a purchase and sale agreement to transfer the collateral management and sub-special servicing agreements for our three CDOs, CDO 2005-1, CDO 2006-1 and CDO 2007-1, to CWCapital Investments LLC, or "CWCapital", for approximately $9.9 million, less certain adjustments and closing costs. We retained our subordinate bonds, preferred shares and ordinary shares in the CDOs, which may provide us with the potential to recoup additional proceeds over the remaining life of the CDOs based upon resolution of underlying assets within the CDOs, however, there is no guarantee that we will realize any proceeds from our equity position, or what the timing of these proceeds may be. The transaction closed in March 2013. In February 2013, we also sold a portfolio of repurchased notes previously issued by two of our three CDOs, generating cash proceeds of approximately $34.4 million. In addition, we expect to receive additional cash proceeds for past CDO servicing advances of approximately $14.0 million when specific assets within the CDOs are liquidated. We believe that the sale of the collateral management and sub-special servicing agreements and sale of repurchased notes of our CDOs achieves a number of important objectives, including, (i) maximizing the value of the servicing business through the sale to a large servicing operation (ii) simplifying our going-forward business and significantly reducing our ongoing management, general and administrative expenses through elimination of CDO related personnel costs and servicing advance requirements; (iii) generating in excess of $50.0 million in liquidity currently invested in the CDO business; and (iv) providing for potential future proceeds through the retention of the equity in the CDOs. Immediately subsequent to the transfer of the collateral management and sub-special serving agreements, the assets and liabilities of the corresponding CDOs will be deconsolidated from our financial statements.

 

Other Information

 

Our corporate offices are located in midtown Manhattan at 420 Lexington Avenue, New York, New York 10170. We also have regional offices in Jenkintown, Pennsylvania and St. Louis, Missouri. As of December 31, 2012, we had 93 employees. We can be contacted at (212) 297-1000. We maintain a website at www.gkk.com. Our reference to our website is intended to be an inactive textual reference only. On our website, you can obtain, free of charge, a copy of 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, or the Exchange Act, as soon as practicable after we file such material electronically with, or furnish it to, the Securities and Exchange Commission, or the SEC. We have also made available on our website our audit committee charter, compensation committee charter, nominating and corporate governance committee charter, code of business conduct and ethics and corporate governance principles. Information on, or accessible through, our website is not part of, and is not incorporated into, this report. You can also read and copy materials we file with the SEC at its Public Reference Room at 100 F Street, NE, Washington, DC 20549 (1-800-SEC-0330). The SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding the issuers that file electronically with the SEC.

 

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Corporate Structure

We were formed in April 2004 as a Maryland corporation and we completed our initial public offering in August 2004. We conduct substantially all of our operations through our operating partnership, GKK Capital LP, or our Operating Partnership. We are the sole general partner of our Operating Partnership. Our Operating Partnership conducts our finance business primarily through two private real estate investment trusts, or REITs, Gramercy Investment Trust and Gramercy Investment Trust II, our commercial real estate investment business through various wholly owned entities, and our realty asset management business through a wholly-owned TRS. The chart below summarizes the organizational structure of these entities as of December 31, 2012:

 

 

We have elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and generally will not be subject to U.S. federal income taxes to the extent we distribute our taxable income, if any, to our stockholders. We have in the past established, and may in the future establish, taxable REIT subsidiaries, or TRSs, to effect various taxable transactions. Those TRSs would incur U.S. federal, state and local taxes on the taxable income from their activities.

 

Unless the context requires otherwise, all references to “Gramercy,” “the Company,” “we,” “our,” and “us” in this Annual Report on Form 10-K mean Gramercy Capital Corp., a Maryland corporation, and one or more of its subsidiaries, including our Operating Partnership.

 

Business and Strategy

 

Our principal business strategy is to acquire real estate assets that generate stable, recurring cash flows with minimal ongoing capital expenditures. We will primarily acquire single tenant office and industrial properties leased to high quality tenants operating in a variety of industries. We also generate cash flows from management fees related to the management of commercial real estate for third-parties. For the near-term, these cash flows are used to fund our continuing operations and we intend to retain any excess cash flow to grow our investment portfolio. Once we achieve sufficient scale, we expect to resume cash distributions to our preferred and common stockholders.

 

We may use leverage to grow our investment portfolio more quickly than would otherwise be possible and in order to maximize potential returns to stockholders. We are not limited with respect to the amount of leverage that we may use for the acquisition of any specific property. We may pursue obtaining a corporate credit facility or line of credit for working capital purposes or to facilitate with the acquisition of property investments, however, we intend to primarily use non-recourse mortgage financing that will allow us to limit our loss exposure on any property to the amount of equity invested in such property.

 

Property Investment

 

Bank of America Portfolio - In August 2012, we formed a joint venture, or the Joint Venture, with an affiliate of Garrison Investment Group, or Garrison. Subsequently, in December 2012, we contributed approximately $59.1 million in cash plus the issuance of 6.0 million shares of our common stock, valued at $15.0 million, representing a 50% equity interest in the Joint Venture’s acquisition of an office portfolio of 113 properties, or the Bank of America Portfolio, from KBS Real Estate Investment Trust, or KBS. The acquisition was financed with a $200.0 million two year, floating rate, interest-only mortgage loan with a spread to 30 day LIBOR of 4.15%, collateralized by 67 properties of the portfolio. The mortgage contains three one-year extensions conditional upon the satisfaction of certain terms. The Bank of America Portfolio was previously part of the Gramercy Asset Management division, beneficial ownership of which was transferred to KBS pursuant to a collateral transfer and settlement agreement dated September 1, 2011. The Bank of America Portfolio totals approximately 4.2 million rentable square feet and is 84% leased to Bank of America, N.A., under a master lease expiring in 2023, with a total portfolio occupancy of approximately 89%. The Joint Venture’s asset strategy for this portfolio acquisition is to sell non-core multi-tenant assets and retain a core net-lease portfolio of high quality assets in primary and strong secondary markets, primarily leased to Bank of America. In addition to our pro rata share of the net income of the portfolio, pursuant to the joint venture agreement, we will receive an asset management fee as well as a performance based fee for the portfolio management.

 

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Indianapolis Industrial Portfolio - In November 2012, we also acquired two Class A industrial properties located in the Indianapolis, Indiana metropolitan statistical area, or the Indianapolis Industrial Portfolio, totaling approximately 540 thousand square feet for a purchase price of approximately $27.1 million. The Indianapolis Industrial Portfolio is 100% leased to three tenants for an average lease term of approximately 10.2 years.

 

Philips Building - We own a 25% interest in the equity owner of a fee interest in 200 Franklin Square Drive, a 200 thousand square foot building located in Somerset, New Jersey which is 100% net leased to Philips Holdings, USA Inc., a wholly-owned subsidiary of Royal Philips Electronics, through December 2021.

 

Investment Strategy

 

We expect that substantially all of our investments will be the ownership of income producing real property located within the United States. Investments are not restricted as to type or location, however, we expect to acquire and manage a portfolio of primarily office and industrial properties located in target markets where we believe the combination of strong demographic and economic growth, high quality infrastructure, competitive labor pools and business friendly local governments will present opportunities for long-term capital appreciation. We will also focus on specialty assets where high barriers to replacement or other factors may create intrinsic asset value.

     

As we grow, we expect to diversify our portfolio to avoid dependence on any one particular tenant, facility type, geographic location or tenant industry. By diversifying our portfolio, we intend to reduce the adverse effect of a single under-performing investment or a downturn in any particular industry or geographic region.

 

Our portfolio is expected to primarily be comprised of single-tenant and multi-tenant office and industrial real property; however, we will also consider acquisitions of retail and medical properties and ground leases. We expect to purchase properties from other real estate owners and developers or from users in sale leaseback transactions. We may also enter into joint ventures in order to acquire larger transactions or diversify risk. We seek to obtain long term leases or leases with high likelihood of renewal. We also intend to enter into “build-to-suit” transactions whereby we would pay for the construction of a facility based upon the tenants specifications, then lease the facility to the tenant on a long-term basis.

 

As part of a potential property acquisition, we also evaluate the creditworthiness of the tenant and the tenant’s ability to generate sufficient cash flow to make payments to us pursuant to the lease. We evaluate each potential tenant for its creditworthiness, considering factors such as the rating by a national credit rating agency, if any, management experience, industry position and fundamentals, operating history and capital structure. We may seek tenants who are small to middle-market businesses, many of which do not have publicly rated debt. By leasing properties to these tenants, we believe that we will generally be able to charge rent that is higher than the rent charged to tenants with recognized credit, thereby achieving a higher return from these properties as compared with properties leased to companies whose credit potential is well known. We may also lease properties to large, publicly traded companies in order to diversity the overall credit of our tenant base. The creditworthiness of a tenant is determined on a tenant by tenant and case by case basis. Therefore, general standards for creditworthiness cannot be applied.

 

We perform a due diligence review with respect to each potential property acquisition, such as evaluating the physical condition, evaluating compliance with zoning and site requirements, as well as completing an environmental site assessment in an attempt to determine potential environmental liabilities associated with a property prior to its acquisition, although there can be no assurance that hazardous substances or wastes (as defined by present or future federal or state laws or regulations) will not be discovered on the property after we acquire it.

 

We review the structural soundness of the improvements on the property and may engage a structural engineer to review all aspects of the structures in order to determine the longevity of each building on the property. This review normally also includes the components of each building, such as the roof, the electrical wiring, the heating and air-conditioning system, the plumbing, parking lot and various other aspects such as compliance with state and federal building codes.

 

We physically inspect the real estate and surrounding area as part of determining the value of the real estate. Our due diligence is aimed at arriving at the value of the property based on historical and projected operating results as well as the value of the real estate under the assumption that it was not rented to the current tenant. As part of this process, we may consider one or more of the following items:

 

The comparable value of similar real estate in the same general area of the prospective property.

 

The comparable real estate rental rates for similar properties in the same area of the prospective property.

 

Alternative property uses that may offer higher value.

 

The cost of replacing the property if it were to be sold.

 

We may supplement our valuation with a real estate appraisal in connection with each investment that we consider. When appropriate, we may also engage experts to undertake some or all of the due diligence efforts described above.

 

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We seek to acquire investment properties that are essential or important to the ongoing operations of the prospective tenant. We believe that these investment properties provide better opportunity to relet properties to the current tenant at the end of the lease term.

 

Investment policy

 

All real estate investments, dispositions and financings must be approved by a credit committee consisting of our most senior officers, including the affirmative vote of our chief executive officer. Real estate investments and dispositions at a loss (based on book value at the time of sale) having a transaction value greater than $20.0 million must also be approved by the investment committee of our board of directors. Our full board of directors must approve all such transactions having a value greater than $50.0 million. Additionally, the investment committee of our board of directors must approve non-recourse financings greater than $20.0 million and our full board of directors must approve all recourse financings, regardless of amount, and non-recourse financings greater than $50.0 million.

 

We generally intend to hold each investment property we acquire for an extended period. However, circumstances might arise which could result in the early sale of some properties. We also may acquire a portfolio of properties with the intention of holding only a core group of properties and disposing of the remainder of the portfolio in single or multiple sales. The determination of whether a particular property should be sold or otherwise disposed of will be made after consideration of all relevant factors, including prevailing economic conditions, with a view to achieving maximum capital appreciation. The selling price of a property will depend on many of the same factors identified above with respect to acquisitions of investments.

 

We may use a TRS to acquire or hold property, including equity interests that may not be deemed to be REIT-qualified assets. Taxes paid by such entity will reduce the cash available to us to fund our continuing operations and cash available for distributions to our preferred and common stockholders. Our finance business owns one property and an interest in another property in TRSs.

 

Some of our investments have been made and may continue to be made through joint ventures that permit us to own interests in larger properties or portfolios without restricting the diversity of our portfolio. We will not enter into a joint venture to make an investment that we would not otherwise purchase on our own under our existing investment policies.

 

Use of Leverage

 

We may choose to use mortgage borrowings in amounts that we believe will maximize the return to our stockholders. We expect that these mortgage borrowings will be structured as non-recourse to us, with limited exceptions that would trigger recourse to us only upon the occurrence of certain fraud, misconduct, environmental or bankruptcy events. The use of non-recourse financing allows us to limit our exposure to the amount of equity invested in the properties pledged as collateral for our borrowings. Non-recourse financing generally restricts a lender’s claim and as a result, the lender generally may look only to the property securing the debt for satisfaction of the debt. We believe that this financing strategy, to the extent available, protects our other assets. Our organization documents do not limit the amount or percentage of indebtedness that we may incur, however we do not expect our leverage to exceed 60% of our invested capital in the aggregate.

 

We currently do not have a corporate credit facility or line-of-credit, however, we will likely look to obtain such a facility in the future for working capital purposes or to facilitate acquisitions of investments. We would not expect to use a credit facility or similar borrowings to finance investments on a long term basis, and would instead utilize proceeds from such borrowing for acquisitions and we would seek to repay such borrowings when more permanent, non-recourse borrowings are obtained for specific investments. Credit facilities or similar borrowings are likely to be subject to full or partial recourse as well as more restrictive covenants such as requirements to keep a certain amount of un-invested cash on hand, the maintenance of a minimum tangible net worth, or the requirement for us to maintain a certain portion of our assets free from other liens. There is no guarantee as to whether or when we could obtain such a facility or any potential terms thereof.

 

We believe that, by operating on a leveraged basis, we will have more funds available and, therefore, will make more investments than would otherwise be possible if we operated on a non-leveraged basis. We believe that leverage creates the potential for a more diversified portfolio and maximizes potential returns to our stockholders. We can provide no assurance that financing will be available on terms acceptable to us, or at all.

 

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Our organizational documents do not limit the amount or percentage of indebtedness that we may incur. The amount of leverage we will deploy for particular investments will depend on an assessment of a variety of factors, which may include the availability and cost of financing the assets, the creditworthiness of our tenants, the health of the U.S. economy and commercial mortgage markets, our outlook for the level, slope and volatility of interest rates, and the overall quality of the properties that may be securing the indebtedness.

 

Asset and Property Management

 

Our asset and property management business, which operates under the name Gramercy Asset Management, currently manages for third-parties, approximately $1.7 billion of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. In 2011, the business of Gramercy Asset Management changed from being primarily an owner of commercial properties to being primarily a third-party manager of commercial properties. The amount of Gramercy Asset Management’s revenues declined as a substantial portion of rental revenues from properties owned by us, were replaced with fee revenues of a substantially smaller scale for managing properties for third-parties.

 

During 2011, we sought to extend or restructure Gramercy Asset Management’s $240.5 million mortgage loan with Goldman Sachs Mortgage Company, or GSMC, Citicorp North America, Inc., or Citicorp, and SL Green Realty Corp. (NYSE: SLG), or SL Green, or the Goldman Mortgage Loan, and Gramercy Asset Management’s $549.7 million senior and junior mezzanine loans with KBS, GSMC, Citicorp and SL Green, or the Goldman Mezzanine Loans. The Goldman Mortgage Loan was collateralized by approximately 195 properties held by Gramercy Asset Management and the Goldman Mezzanine Loans were collateralized by the equity interest in substantially all of the entities comprising our Gramercy Asset Management division, including its cash and cash equivalents. Subsequent to the final maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans, we entered into a series of short term extensions to provide additional time to exchange and consider proposals for an extension, modification, restructuring or refinancing of the Goldman Mortgage Loan and the Goldman Mezzanine Loans and to explore an orderly transition of the collateral to the lenders if such discussions failed. On May 9, 2011, we announced that the scheduled maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans occurred without repayment and without an extension or restructuring of the loans by the lenders.

 

Notwithstanding the maturity and non-repayment of the loans, we maintained active communications with the lenders and In September 2011, we entered into a collateral transfer and settlement agreement, or the Settlement Agreement, for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, Gramercy Asset Management’s senior mezzanine lender, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among us and the mortgage and mezzanine lenders and, subject to certain termination provisions, our continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, we transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that we agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011.

 

In September 2011, we entered into an asset management arrangement upon the terms and conditions set forth in the Settlement Agreement, or the Interim Management Agreement, to provide for our continued management of the KBS portfolio through December 31, 2013 for a fixed fee of $10.0 million annually, plus the reimbursement of certain costs. The Settlement Agreement obligated the parties to negotiate in good faith to replace the Interim Management Agreement with a more complete and definitive management services agreement on or before March 31, 2012 and on March 30, 2012, we entered into an Asset Management Services Agreement, or the Management Agreement, with KBS Acquisition Sub, LLC, or KBSAS, a wholly-owned subsidiary of KBS Real Estate Investment Trust, Inc., or KBS REIT, pursuant to which we provide asset management services to KBSAS with respect to the transferred properties, or the KBS Portfolio. The Management Agreement provides for continued management of the KBS Portfolio by GKK Realty Advisors, LLC, or the Manager, through December 31, 2015 for (i) a base management fee of $12.0 million per year, payable monthly, plus the reimbursement of all property related expenses paid by Manager on behalf of KBSAS, subject to deferral of $167 thousand per month at KBSAS’s option until the accrued amount equals $2.5 million or June 30, 2013, whichever is earlier, and (ii) an incentive fee, or the Threshold Value Profits Participation, in an amount equal to the greater of: (a) $3.5 million or (b) 10% of the amount, if any, by which the portfolio equity value exceeds $375.0 million (as adjusted for future cash contributions into, and distributions out of, KBSAS by KBS REIT). In December 2012, concurrently with the purchase of the Bank of America Portfolio by our joint venture with Garrison the base management fee of the Management Agreement was reduced by $3.0 million per year to $9.0 million per year, which was partially offset by the asset management fee we now receive from Garrison. In any event, the Threshold Value Profits Participation is capped at a maximum of $12.0 million. The Threshold Value Profits Participation is payable 60 days after the earlier to occur of June 30, 2014 (or March 31, 2015 upon satisfaction of certain extension conditions, including the payment by KBSAS to Manager of a $750 thousand extension fee) and the date on which KBSAS, directly or indirectly, sells, conveys or otherwise transfers at least 90% of the KBS Portfolio (by value).

 

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We may terminate the Management Agreement (i) without any KBSAS default under the Management Agreement, on or after December 31, 2012, upon 90 days’ prior written notice or (ii) at any time by five business days’ prior written notice in the event of a KBSAS default under the Management Agreement. The Management Agreement may be terminated by KBSAS, (i) without cause (as defined in the Management Agreement), with an effective termination date of March 31 or September 30 of any year but at no time prior to September 30, 2013, upon 90 days’ prior written notice or (ii) at any time after April 1, 2013 for cause. In the event of a termination of the Management Agreement by KBSAS after April 1, 2013 but prior to December 31, 2015, we will be entitled to receive a declining balance termination fee, ranging from $5.0 million to $2.0 million, calculated as specified in the Management Agreement.

 

We have an integrated asset management platform within Gramercy Asset Management to consolidate responsibility for, and control over, leasing, lease administration, property management, operations, construction management, tenant relationship management and property accounting. To the extent that we provide asset management services for third-party property owners, we provide such services in consultation with and at the direction of such owners.

 

Commercial Real Estate Finance

 

Our commercial real estate finance business operates under the name Gramercy Finance. We have invested in and manage a diversified portfolio of $1.7 billion of real estate loans, including whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, CMBS and preferred equity involving commercial properties throughout the United States. Gramercy Finance also held interests in five real estate properties acquired through foreclosures. Substantially, all of the investments managed by Gramercy Finance were financed through three non-recourse CDOs. As further described below, in March 2013, we exited the commercial real estate finance business and sold the collateral management and sub-special servicing agreements for our CDOs which will result in the deconsolidation of Gramercy Finance from our Consolidated Balance Sheets. We have classified the assets and liabilities of the Gramercy Finance segment as assets held-for-sale and have reported the results of operations of Gramercy Finance in discontinued operations.

 

On January 30, 2013, we entered into a purchase and sale agreement to transfer the collateral management and sub-special servicing agreements for our CDOs, to CWCapital for approximately $9.9 million, less certain adjustments and closing costs. We retained our subordinate bonds, preferred shares and ordinary shares in the CDOs, which may provide us with the potential to recoup additional proceeds over the remaining life of the CDOs based upon resolution of underlying assets within the CDOs, however, there is no guarantee that we will realize any proceeds from our equity position, or what the timing of those proceeds might be. The transaction closed on March 15, 2013.

 

In connection with the sale, we recognized impairment charges of approximately $27.2 million within discontinued operations on loans and real estate investments to adjust the carrying value to the lower of cost or market. We also recognized other-than-temporary impairments of approximately $128.0 million within discontinued operations as we could no longer express the intent to hold CMBS that were in an unrealized loss position long enough to recover our amortized cost.

 

Our commercial real estate finance investments include the following:

 

Whole Loans — We had originated fixed-rate, permanent whole loans with terms of up to 15 years. At origination, our whole loans typically had last-dollar loan-to-value ratios between 65% and 75%. The initial stated maturity of our whole loan investments range from five years to 15 years.

 

Bridge Loans — We had offered floating rate bridge whole loans to borrowers who are seeking debt capital with a final term to maturity of not more than five years to be used in the acquisition, construction or redevelopment of a property. Bridge financing enables the borrower to employ short-term financing while improving the operating performance and physical aspects of the property and avoid burdening it with restrictive long-term debt. The bridge loans we originated were predominantly secured by first mortgage liens on the property. At origination, our bridge loans typically had last-dollar loan-to-value ratios between 70% and 80%. The initial stated maturity of our bridge loans range from two years to five years.

 

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Subordinate Interests in Whole Loans — We had purchased from third-parties, and may have retained from whole loans we originated, subordinate interests in whole loans. Subordinate interests are participation interests in mortgage notes or loans secured by a lien subordinated to a senior interest in the same loan. The subordination is generally evidenced by a co-lender or participation agreement between the holders of the related senior interest and the subordinate interest. In some instances, the subordinate interest lender may additionally require a security interest in the stock or partnership interests of the borrower as part of the transaction. At origination, our subordinate interests in whole loans typically had last-dollar loan-to-value ratios between 65% and 85%. Subordinate interest lenders have the same obligations, collateral and borrower as the senior interest lender, but typically are subordinated in recovery upon a default. Subordinate interests in whole loans share certain credit characteristics with second mortgages, in that both are subject to greater credit risk with respect to the underlying mortgage collateral than the corresponding senior interest. Subordinate interests generally will have terms matching those of the whole loan of which they are a part, typically two to 15 years.

 

Mezzanine Loans — We had acquired or originated mezzanine loans that are senior to the borrower’s equity in, and subordinate to a mortgage loan, on a property. These loans are secured by pledges of ownership interests, typically in whole but occasionally in part (but usually with effective sole control over all the ownership interests), in entities that directly or indirectly own the real property. In addition, we may have required other collateral to secure mezzanine loans, including letters of credit, personal guarantees, or collateral unrelated to the property. We typically structured our mezzanine loans to receive a stated coupon (benchmarked usually against LIBOR, or occasionally against a Treasury index or a swap index). We may have in certain select instances structured our mezzanine loans to receive a stated coupon plus a percentage of gross revenues and a percentage of the increase in the fair market value of the property securing the loan, payable upon maturity, refinancing or sale of the property. At origination, these investments typically have initial terms from two to ten years. At origination, our mezzanine loans usually had last-dollar loan-to-value ratios of between 65% and 90%, depending on their vintage.

 

Commercial Mortgage-Backed Securities (CMBS) — We had acquired CMBS that are created when commercial loans are pooled and securitized. CMBS are secured by or evidenced by ownership interests in a single commercial mortgage loan or a pool of mortgage loans secured by commercial properties. A majority of our CMBS are rated by at least one rating agency. CMBS are generally pass-through certificates that represent beneficial ownership interests in common law trusts whose assets consist of defined portfolios of one or more commercial mortgage loans. They are typically issued in multiple tranches whereby the more senior classes are entitled to priority distributions from the trust’s income to make specified interest and principal payments on such tranches. Losses and other shortfalls on the mortgage pool are borne by the most subordinate classes, which receive payments only after the more senior classes have received all principal and/or interest to which they are entitled. Expected maturities of our CMBS investments range from several months to up to 10 years.

 

Preferred Equity — We had originated preferred equity investments in entities that directly or indirectly own commercial real estate. Preferred equity is not secured, but holders have priority relative to common equity holders on cash flow distributions and proceeds from capital events. In addition, preferred holders can often enhance their position and protect their equity position with covenants that limit the entity’s activities and grant us the exclusive right to control the property after an event of default. With preferred equity investments, we may become a special limited partner or member in the ownership entity and may be entitled to take certain actions, or cause liquidation, upon a default. Preferred equity typically is more highly leveraged, with last-dollar loan-to-value ratios at origination of 85% to more than 90% and may have mandatory redemption dates (that is, maturity dates) that range from three years to five years.

 

Hedging Activities

 

We may use a variety of commonly used derivative instruments that are considered conventional, or “plain vanilla” derivatives, including interest rate swaps, caps, collars and floors, in our risk management strategy to limit the effects of changes in interest rates on our operations. Each of our CDOs maintains a minimum amount of allowable unhedged interest rate risk. The CDO that closed in 2005 permits a minimum amount of unhedged interest rate risk of 20% of the net outstanding principal balance and both the CDO that closed in 2006 and the CDO that closed in 2007 permit a minimum amount of unhedged interest rate risk of 5% of the net outstanding principal balance. The majority of our derivative instruments were owned by our CDOs and were transferred with the CDOs’ liabilities in connection with the disposal of Gramercy Finance. Our hedging strategy consists of entering into interest rate swap and interest rate cap contracts. The value of our derivatives may fluctuate over time in response to changing market conditions, and will tend to change inversely with the value of the risk in our liabilities that we intend to hedge. Hedges are sometimes ineffective because the correlation between changes in value of the underlying investment and the derivative instrument is less than was expected when the hedging transaction was undertaken. We continuously monitor the effectiveness of our hedging strategies and we have retained the services of an outside financial services firm with expertise in the use of derivative instruments to advise us on our overall hedging strategy, to effect hedging trades, and to provide the appropriate designation and accounting of all hedging activities from a GAAP and tax accounting and reporting perspective.

 

These instruments are used to hedge as much of the interest rate risk as we determine is in the best interest of our stockholders, given the cost of such hedges. To the extent that we enter into a hedging contract to reduce interest rate risk on indebtedness incurred to acquire or carry real estate assets, any income that we derive from the contract is not considered income for purposes of the REIT 95% gross income test and is either non-qualifying for the 75% gross income test (hedges entered into prior to August 1, 2008), or is not considered income for purposes of the 75% gross income test (hedges entered into after July 31, 2008). This change in character for the 75% gross income test was included in the Housing and Economic Recovery Act of 2008. We can elect to bear a level of interest rate risk that could otherwise be hedged when we believe, based on all relevant facts, that bearing such risk is advisable.

 

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Equity Capital Policies

 

Subject to applicable law and our charter, our board of directors has the authority, without further stockholder approval, to issue additional authorized common stock and preferred stock or otherwise raise capital, including through the issuance of senior securities, in any manner and on the terms and for the consideration it deems appropriate.

 

We may, under certain circumstances, repurchase our common or preferred stock in private transactions with our stockholders if those purchases are approved by our board of directors and are in accordance with our charter. Our board of directors has no present intention of causing us to repurchase any shares, and any action would only be taken in conformity with applicable federal and state laws and the applicable requirements for qualifying as a REIT, for so long as our board of directors concludes that we should remain a qualified REIT.

 

Other Policies

 

We operate in a manner that we believe will not subject us to regulation under the Investment Company Act. We may invest in the securities of other issuers for the purpose of exercising control over such issuers. We do not underwrite the securities of other issuers.

 

Future Revisions in Policies and Strategies

 

Our board of directors has the power to modify or waive our investment guidelines, policies and strategies. Among other factors, developments in the market that either affects the policies and strategies mentioned herein or that change our assessment of the market may cause our board of directors to revise our investment guidelines, policies and strategies.

 

Competition

 

We compete with other REITs, specialty finance companies, insurance companies, mutual funds, hedge funds, institutional investors, investment banking firms, private equity firms, and other entities, which may have greater financial resources and lower costs of capital available to them than we have. To the extent that a competitor is willing to risk larger amounts of capital in a particular transaction or to employ more liberal standards when evaluating potential investments than we are, our origination volume and profit margins for our investment portfolio could be adversely affected. Our competitors may also be willing to accept lower returns on their investments and may succeed in originating or acquiring assets that we have targeted for acquisition. We also compete with numerous commercial properties for tenants. Some of the properties we compete with may be newer or have more desirable locations or the competing properties’ owners may be willing to accept lower rents than are acceptable to us. In addition, the competitive environment for leasing is affected considerably by a number of factors including, among other things, changes in economic factors and supply and demand of space. These factors may make it difficult for us to lease existing vacant space and space associated with future lease expirations at rental rates that are sufficient to meet our capital needs. 

 

Although we believe that we are positioned to compete effectively in each facet of our business, there is considerable competition in our market sector and there can be no assurance that we will compete effectively or that we will not encounter increased competition in the future that could limit our ability to conduct our business effectively.

 

Compliance With The Americans With Disabilities Act of 1990

 

Properties that we acquire, and the properties underlying our investments, are required to meet federal requirements related to access and use by disabled persons as a result of the Americans with Disabilities Act of 1990, or the Americans with Disabilities Act. In addition, a number of additional federal, state and local laws may require modifications to any properties we purchase, or may restrict further renovations of our properties, with respect to access by disabled persons. Noncompliance with these laws or regulations could result in the imposition of fines or an award of damages to private litigants. Additional legislation could impose additional financial obligations or restrictions with respect to access by disabled persons. If required changes involve greater expenditures than we currently anticipate, or if the changes must be made on a more accelerated basis, our ability to make distributions could be adversely affected.

 

Industry Segments

 

We have three reportable operating segments: Realty/Corporate, Asset Management and Finance. The reportable segments were determined based on the management approach, which looks to our internal organizational structure. These three lines of business require different support infrastructures. In 2012, as a result of the KBS Settlement and Management Agreements, we changed the composition of our business segments to separate Asset Management from Realty.

 

The Realty/Corporate segment includes all of our activities related to investment and ownership of commercial properties with credit grade tenants throughout the United States. The Realty/Corporate segment generates revenues from rental revenues from properties that we own.

 

The Asset Management segment includes substantially all of our activities related to third-party asset and property management of commercial properties leased primarily to financial institutions and affiliated users throughout the United States. The Asset Management segment generates revenues from fee income related to the Management Agreement with KBS and from our Joint Venture with Garrison.

 

In March 2013, we announced that we disposed of the Finance segment, and as a result, the Finance segment has been classified as held-for-sale and included in discontinued operations. The Finance segment includes all of our activities related to origination, acquisition and portfolio management of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity, CMBS and other real estate related securities. The Finance segment primarily generates revenues from interest income on loans, other lending investments and CMBS owned in our CDOs.

 

Employees

 

As of December 31, 2012, we had 93 employees. Our employees are not represented by a collective bargaining agreement.

 

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Corporate Governance and Internet Address; Where Readers Can Find Additional Information

 

We emphasize the importance of professional business conduct and ethics through our corporate governance initiatives. Our board of directors consists of a majority of independent directors; the Audit, Nominating and Corporate Governance, and Compensation Committees of our board of directors are composed exclusively of independent directors. We have adopted corporate governance guidelines and a code of business conduct and ethics.

 

We file annual, quarterly and current reports, proxy statements and other information required by the Exchange Act with the SEC. Readers may read and copy any document that we file at the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, D.C. 20549, U.S.A. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. Our SEC filings are also available to the public from the SEC’s internet site at www.sec.gov . Copies of these reports, proxy statements and other information can also be inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street, New York, New York 10005.

 

Our internet site is www.gkk.com. Our reference to our website is intended to be an inactive textual reference only. We make available free of charge through our internet site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Also posted on our website in the “Investor Relations — Corporate Governance” section are charters for our Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee as well as our Corporate Governance Guidelines and our Code of Business Conduct and Ethics governing our directors, officers and employees. Information on, or accessible through, our website is not a part of, and is not incorporated into, this report.

 

Investment Company Act Exemption

 

We have conducted our operations and intend to continue to conduct our operations so as not to become regulated as an investment company under the Investment Company Act. We believe that there are a number of exclusions or exemptions under the Investment Company Act that may be applicable to us. We will either be excluded from the definition of an investment company under Section 3(a)(1)(C) of the Investment Company Act, by owning or proposing to acquire “investment securities” having a value not exceeding 40% of the value of our total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, or by qualifying for the exclusions from registration provided by Sections 3(a)(1)(A), 3(c)(5)(C) and/or 3(c)(6) of the Investment Company Act. We will monitor our portfolio periodically and prior to each acquisition to confirm that we continue to qualify for the relevant exclusion or exemption.

 

Qualifying for the Section 3(c)(5)(C) exemption requires that at least 55% of our portfolio be comprised of “qualifying assets,” and a total of at least 80% of our portfolio be comprised of “qualifying assets” and “real estate-related assets,” a category that includes qualifying assets. We generally expect real property investments, whole mortgage loans, and Tier 1 mezzanine loans to be qualifying assets, in each case meeting certain qualifications based on SEC staff no-action letters. The treatment of distressed debt securities as qualifying assets is based on the characteristics of the particular type of loan, including its foreclosure rights. Although SEC staff no-action letters have not specifically addressed the categorization of these types of assets, we believe junior (first loss) interests in CMBS pools may constitute qualifying assets under Section 3(c)(5)(C), provided that we have the unilateral right to foreclose, directly or indirectly, on the mortgages in the pool and that we may act as the controlling class or directing holder of the pool. Tier 1 mezzanine loans are loans granted to a mezzanine borrower that directly owns interests in the entity that owns the property being financed. Subordinate interests in whole loans may constitute qualifying assets under Section 3(c)(5)(C), provided that we have, among other things, approval rights in connection with any material decisions pertaining to the administration and servicing of the relevant mortgage loan and, in the event that the mortgage loan becomes non-performing, we have effective control over the remedies relating to the enforcement of the loan, including ultimate control of the foreclosure process. We generally do not treat preferred equity investments as qualifying assets. In relying on the exemption provided by Section 3(c)(5)(C), we also make investments so that at least 80% of our portfolio is comprised of qualifying assets and real estate-related assets. We expect that all of these classes of investments will be considered real estate assets under the Investment Company Act for the purposes of the 80% investment threshold.

 

Qualification for the Section 3(a)(1)(C), Section 3(c)(5)(C) and/or Section 3(c)(6) exclusions or exemptions may limit our ability to make certain investments. No assurance can be given that the SEC staff will concur with our classification of our assets, or that the SEC staff will not, in the future, issue further guidance that may require us to reclassify those assets for purpose of qualifying for an exemption or exclusion from regulation under the Investment Company Act. To the extent that the staff of the SEC provides more specific guidance regarding any of the matters bearing upon the definition of investment company and the exceptions to that definition, we may be required to adjust our investment strategy accordingly. Any additional guidance from the staff of the SEC could provide additional flexibility to us, or it could further inhibit our ability to pursue the investment strategy we have chosen.

 

Registration as an Investment Adviser

 

   GKK Manager LLC, a Delaware limited liability company (“GKKM”) is the collateral manager for our CDOs and is registered as an investment adviser with the SEC under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  GKKM is wholly owned by Gramercy Investment Trust and Gramercy Investment Trust II and is indirectly owned by Gramercy.  As a registered investment adviser with the SEC, GKKM is subject to the anti-fraud provisions of the Advisers Act and to fiduciary duties derived from those provisions which apply to its relationships with its clients, including our CDOs.  These provisions and duties impose restrictions and obligations on GKKM with respect to its dealings with clients, including for example restrictions on agency cross and principal transactions.  GKKM is subject to periodic SEC examinations and other requirements under the Advisers Act primarily intended to benefit and protect advisory clients.  These additional requirements relate, among other things, to maintaining an effective and comprehensive compliance program, recordkeeping and reporting requirements and disclosure requirements.  The Advisers Act generally grants the SEC broad administrative powers, including the power to limit or restrict an investment adviser from conducting advisory activities in the event it fails to comply with federal securities laws.  Additional sanctions that may be imposed for failure to comply with applicable requirements include the prohibition of individuals from associating with an investment adviser, the revocation of registration under the Advisers Act and other censures and fines.  Ongoing compliance with the Advisers Act and the rules promulgated thereunder may require GKKM (and indirectly Gramercy) to incur additional costs, and these costs may be material.  As a result of the sale of the CDO Agreements, we are in the process of de-registering as an investment adviser under the Advisers Act.

  

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Environmental Matters

 

Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner of real estate may become liable for the costs of removal or remediation of certain hazardous or toxic substances at, on, under or in its property. Those laws typically impose cleanup responsibility and liability without regard to whether the owner or control party knew of or was responsible for the release or presence of such hazardous or toxic substances. The costs of investigation, remediation or removal of those substances may be substantial. The owner or control party of a site may be subject to common law claims by third-parties based on damages and costs resulting from environmental contamination emanating from a site. Certain environmental laws also impose liability in connection with the handling of or exposure to asbestos-containing materials, pursuant to which third-parties may seek recovery from owners of real properties for personal injuries associated with asbestos-containing materials. We are not currently aware of any environmental issues which could materially affect us or our operations.

  

Federal regulations require building owners and those exercising control over a building’s management to identify and warn, via signs and labels, of potential hazards posed by workplace exposure to installed asbestos-containing materials and potentially asbestos-containing materials in the building. The regulations also set forth employee training, record keeping and due diligence requirements pertaining to asbestos- containing materials and potential asbestos-containing materials. Significant fines can be assessed for violation of these regulations. Building owners and those exercising control over a building’s management may be subject to an increased risk of personal injury lawsuits by workers and others exposed to asbestos-containing materials and potentially asbestos-containing materials as a result of these regulations. The regulations may affect the value of a building containing asbestos-containing materials and potential asbestos-containing materials in which we have invested. Federal, state and local laws and regulations also govern the removal, encapsulation, disturbance, handling and/or disposal of asbestos-containing materials and potential asbestos-containing materials when such materials are in poor condition or in the event of construction, remodeling, renovation or demolition of a building. Such laws may impose liability for improper handling or a release into the environment of asbestos-containing materials and potential asbestos-containing materials and may provide for fines to, and for third-parties to seek recovery from, owners or operators of real properties for personal injury or improper work exposure associated with asbestos-containing materials and potentially asbestos-containing materials.

 

Prior to closing any property acquisition, we obtain environmental assessments in a manner we believe prudent in order to attempt to identify potential environmental concerns at such properties. These assessments are carried out 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. We may also conduct limited subsurface investigations and test for substances of concern where the result of the first phase of the environmental assessments or other information indicates possible contamination or where our consultants recommend such procedures.

 

While we purchase many of our properties on an “as is” basis, our purchase contracts for such properties contain an environmental contingency clause, which permits us to reject a property because of any environmental hazard at such property. However, we do acquire properties which may have asbestos abatement requirements, for which we set aside appropriate reserves.

 

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

 

Insurance

 

We carry commercial liability and all risk property insurance, including flood, where required, earthquake, wind and terrorism coverage, on substantially all of the properties that we own. For certain net leased properties, however, we rely on our tenant’s insurance and do not maintain separate coverage. We continue to monitor the state of the insurance market and the scope and costs of specialty coverage, including flood, earthquake, wind and terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in future policy years.

 

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ITEM 1A. RISK FACTORS

 

Risks Related to Our Business

 

Our future growth will depend on our ability to raise additional debt and equity capital. We are subject to risks associated with debt and capital stock issuances and such issuances may have consequences to holders of our common and preferred stock.

 

Our future growth will depend, in large part, upon our ability to raise additional capital. If we were to raise additional capital through the issuance of equity securities, we could dilute the interests of holders of our common stock. Our Board of Directors may authorize the issuance of additional classes of preferred stock which may have rights that could dilute, or otherwise adversely affect, the interest of holders of our common stock.

 

We intend to incur additional indebtedness in the future, which may include a corporate credit facility. Such indebtedness could also have other important consequences to holders of our common and preferred stock, including, subjecting us to covenants restricting our operating flexibility, increasing our vulnerability to general adverse economic and industry conditions, limiting our ability to obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements, requiring the use of a portion of our cash flow from operations for the payment of principal and interest on our indebtedness, thereby reducing our ability to use our cash flow to fund working capital, acquisitions, capital expenditures and general corporate requirements, and limiting our flexibility in planning for, or reacting to, changes in our business and our industry.

 

A negative book equity balance may impair our ability to raise new debt or equity capital.

 

Beginning in the second quarter of 2007, the sub-prime residential lending and single family housing markets in the U.S. began to experience significant default rates, declining real estate values and increasing backlog of housing supply, and other lending markets experienced higher volatility and decreased liquidity resulting from the poor credit performance in the residential lending markets. Concerns in the residential sector of the capital markets quickly spread more broadly into the asset-backed, commercial real estate, corporate and other credit and equity markets. During 2008, 2009 and 2010, the global capital markets experienced volatility and a wide-ranging lack of liquidity. The impact of the global credit crisis on commercial mortgage finance was acute. Transaction volume declined significantly, credit spreads for forms of mortgage debt investments reached all-time highs, and other forms of financing from the debt markets were dramatically curtailed. The dislocation in the debt capital markets, coupled with a recession in the United States, reduced property valuations and adversely impacted commercial real estate fundamentals. These developments impacted the performance of our portfolio of financial and real property assets. Among other things, such conditions resulted in our recognizing significant amounts of loan loss reserves and impairments, and depressed the price of our common stock, effectively removing our ability to raise public capital during this period. As a result of recording these impairments, our book equity balance is negative, although we expect a significant reversal of the negative book equity once the sale of the collateral management and sub-servicing agreements is completed. Nevertheless, the capital markets may have a negative perception of our long-term and short-term financial prospects due to our current negative book equity balance and accordingly, our ability to raise new debt or equity capital could be impaired.

 

Termination of our Asset Management Agreement could harm our business.

 

We have agreed to manage the KBS portfolio on behalf KBS pursuant to the Management Agreement through December 31, 2015 for a fixed fee of $9.0 million annually, the reimbursement of certain costs and the potential to earn certain incentive fees as therein provided. The Management Agreement may be terminated by KBS without cause, with an effective termination date of March 31 or September 30 of any year but at no time prior to September 30, 2013, upon 90 days’ prior written notice. There can be no assurance a termination will occur notwithstanding our efforts. Upon any termination of the Management Agreement, our management fees, after payment of any termination payments required, would cease, thereby reducing our expected revenues, which could harm our business.

 

Lack of diversification in number of investments increases our dependence on individual investments.

 

If we acquire larger property interests, our portfolio will be concentrated in a smaller number of assets or with a less diverse tenant base, increasing the risk of loss to stockholders if a default or other problem arises. Alternatively, property sales may reduce the aggregate amount of our property investment portfolio, and number of investments in either or each, our portfolio may become concentrated in larger assets, thereby reducing the benefits of diversification by geography, property type, tenancy or other measures.

 

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If we fail to achieve adequate operating cash flow, our ability to make distributions will be adversely affected.

 

As a REIT, we must distribute annually at least 90% of our REIT taxable income, if any, to our stockholders, determined without regard to the deduction for dividends paid and excluding net capital gain. Our ability to make and sustain cash distributions is based on many factors, including the return on our investments, operating expense levels, and certain restrictions imposed by Maryland law. Some of the factors are beyond our control and a change in any such factor could affect our ability to pay future dividends. No assurance can be given as to our ability to pay distributions to our stockholders.

 

Our CDOs could generate “phantom” income.

 

Subsequent to the sale of the collateral manager agreements, we will continue to own the subordinate notes and preferred and ordinary shares of our CDOs. These retained interests in the CDOs could continue to generate taxable income for us despite the fact that, we will not receive cash distributions on our equity and subordinated note holdings from these CDOs until overcollateralization tests are met, if at all. Additionally, once the collateral manager agreements are sold, we will not control or have influence over the factors that most directly affect the overcollateralization and interest coverage tests of the respective CDOs. Should these CDOs continue to generate taxable income with no corresponding receipt of cash flow, our taxable income would continue to be recognized on each underlying investment in the relevant CDO. We would continue to be required to distribute 90% of our REIT taxable income (determined without regard to the dividends paid deduction and excluding net capital gain) from these transactions to continue to qualify as a REIT, despite the fact that we may not receive cash distributions on our equity and subordinated note holdings from these CDOs.

 

We may experience reductions in portfolio income which would reduce our ability to make distributions over time.

 

Due to our status as a REIT, we are required to distribute at least 90% of our REIT taxable income, if any, to stockholders. We may experience declines in the size of the investment portfolio over time. A reduction in the size of our portfolio would also result in reduced income available for distribution and thereby lessen our ability to make distributions to our stockholders.

 

We are dependent on key personnel whose continued service is not guaranteed.

 

We rely on a small number of persons who comprise our existing senior management team and our board of directors to implement our business and investment strategies. While we have entered into employment and/or retention agreements with certain members of our senior management team, they may nevertheless cease to provide services to us at any time.

 

The loss of services of any of our key management personnel or directors or significant numbers of other employees, or our inability to recruit and retain qualified personnel or directors in the future, could have an adverse effect on our business.

 

Quarterly results may fluctuate and may not be indicative of future quarterly performance.

 

Our quarterly operating results could fluctuate; therefore, you should not rely on past quarterly results to be indicative of our performance in future quarters. Factors that could cause quarterly operating results to fluctuate include, among others, variations in our investment origination volume, impairments, the degree to which we encounter competition in our markets and general economic conditions.

 

The competitive pressures we face as a result of operating in a highly competitive market could have a material adverse effect on our business, financial condition, liquidity and results of operations.

 

We have significant competition with respect to our acquisition and origination of assets with many other companies, including other REITs, insurance companies, private investment funds, hedge funds, specialty finance companies and other investors. Some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us. Furthermore, there is significant competition on a national, regional and local level with respect to property management services and in commercial real estate services generally and we are subject to competition from large national and multi-national firms as well as local or regional firms that offer similar services to ours. Some of our competitors may have greater financial and operational resources, larger customer bases, and more established relationships with their customers and suppliers than we do. The competitive pressures we face, if not effectively managed, may have a material adverse effect on our business, financial condition, liquidity and results of operations.

 

Also, as a result of this competition, we may not be able to take advantage of attractive origination and investment opportunities and therefore may not be able to identify and pursue opportunities that are consistent with our objectives. Competition may limit the number of suitable investment opportunities offered to us. It may also result in higher prices, lower yields and a narrower spread of yields over our borrowing costs, making it more difficult for us to acquire new investments on attractive terms. In addition, competition for desirable investments could delay the investment in desirable assets, which may in turn reduce our earnings per share and negatively affect our ability to declare distributions to our stockholders.

 

We are exposed to litigation risks in our role as property manager and special servicer.

 

GKK Realty Advisors' role as manager for the assets transferred to KBS and the Manager's role as collateral manager for our CDOs, as well as GKK Loan Servicing LLC's role as a special servicer expose us to litigation risks. In these roles, we make investment, asset management, loan work-out, and other decisions which could result in adverse financial impacts to third-parties. These parties may pursue legal action against us as a result of these decisions, the outcomes of which cannot be certain.

 

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The role of the Manager as collateral manager for our CDOs and GKK Realty Advisors’ role as property manager for the assets transferred to KBS may expose us to liabilities to CDO debt holders or KBS.

 

We were subject to potential liabilities to investors as a result of the Manager's role as collateral manager for our CDOs and our asset and property management business generally. In serving in such roles, we could be subject to claims by CDO debt holders and KBS that we did not act in accordance with our duties under our CDO and property management documentation or that we were negligent in taking or refraining from taking actions with respect to the underlying collateral in our CDOs or in managing the assets transferred to KBS. In particular, the discretion that we exercised in managing the collateral for our CDOs and managing the assets transferred to KBS could result in a liability due to inherent uncertainties surrounding the course of action that will result in the best long term results with respect to such collateral and investments. This risk could be increased due to the affiliated nature of our roles. If we were found liable for our actions as collateral manager or property manager and we were required to pay significant damages to our CDOs or KBS, our financial condition could be materially adversely effected.

 

Claims may arise under an indemnification provided by us to the trustee of our 2005 CDO and 2006 CDO in connection with note cancellations.

 

Our subsidiary, Gramercy Manager LLC, the current collateral manager, had provided separate limited indemnities to the trustee of our 2005 CDO and 2006 CDO in connection with CDO note cancellations we undertook in 2011 in accordance with the operative documents of each CDO. These cancellations were undertaken to reduce the total debt owed by our 2005 CDO and our 2006 CDO and improve their compliance with certain overcollateralization tests. Payments made by us, if any, under these indemnities would reduce our liquidity available for general corporate purposes and investments.

 

We may be subject to lender liability claims.

 

In recent years, a number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed “lender liability.” Generally, lender liability is founded on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty owed to the borrower or its other creditors or stockholders. There can be no assurance that such claims will not arise or that we will not be subject to significant liability if a claim of this type did arise.

 

We do not know what impact the Dodd-Frank Act will have on our business.

 

On July 21, 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act. The Dodd-Frank Act affects almost every aspect of the U.S. financial services industry, including certain aspects of the markets in which we operate. The Dodd-Frank Act imposes new regulations on us and how we conduct our business. For example, the Dodd-Frank Act will impose additional disclosure requirements for public companies and generally require issuers or originators of asset-backed securities to retain at least five percent of the credit risk associated with the securitized assets. In addition, the Dodd-Frank Act required us to register as an investment advisor with the SEC, which will increase our regulatory compliance costs and subject us to new restrictions as well as penalties for any future non-compliance with these regulations. Importantly, many key aspects of the changes imposed by the Dodd-Frank Act will be established by various regulatory bodies and other groups over the next several years. As a result, we do not know how significantly the Dodd-Frank Act will affect us. It is possible that the Dodd-Frank Act could, among other things, increase our costs of operating as a public company, impose restrictions on our ability to securitize assets and reduce our investment returns on securitized assets.

 

We are required to make a number of judgments in applying accounting policies and different estimates and assumptions in the application of these policies could result in changes to our reporting of financial condition and results of operations.

 

Various estimates are used in the preparation of our financial statements, including estimates related to asset and liability valuations (or potential impairments), and various receivables. Often these estimates require the use of market data values which may be difficult to assess, as well as estimates of future performance or receivables collectability which may be difficult to accurately predict. While we have identified those accounting policies that are considered critical and have procedures in place to facilitate the associated judgments, different assumptions in the application of these policies could result in material changes to our reports of financial condition and results of operations.

 

Maintenance of our Investment Company Act exclusions and exemptions imposes limits on our operations.

 

We believe that there are a number of exclusions and exemptions under the Investment Company Act that may be applicable to us and we have conducted and intend to continue to conduct our operations so as not to become regulated as an investment company under the Investment Company Act. We will either be excluded from the definition of investment company under Section 3(a)(1)(C) of the Investment Company Act, by owning or proposing to acquire “investment securities” having a value not exceeding 40% of the value of our total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, or exempted by qualifying for the exemptions from registration provided by Sections 3(a)(1)(A), 3(c)(5)(C) and/or 3(c)(6) of the Investment Company Act. Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer which is or holds itself out as being engaged primarily, or proposed to engage primarily in the business of investing, reinvesting or trading in securities. We believe we will not be considered an investment company under Section 3(a)(1)(A) of the Investment Company Act because we will not engage primarily or hold ourselves out as being engaged primarily in the business of investing, reinvesting or trading in securities. Section 3(c)(5)(C) exempts from the definition of “investment company” any person who is “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Additionally, Section 3(c)(6) exempts from the definition of “investment company” any company primarily engaged, directly or through majority-owned subsidiaries, in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The assets that we have acquired and may acquire in the future, therefore, are limited by the provisions of the Investment Company Act and the exclusions and exemptions on which we rely. In addition, we could, among other things, be required either (a) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (b) to register as an investment company, either of which could have an adverse effect on our business and our ability to pay dividends.

 

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To maintain our qualification for an exclusion from registration under the Investment Company Act pursuant to Sections 3(c)(5)(C) and 3(c)(6) at least 55% of our portfolio, or the assets of our majority-owned subsidiaries, must be comprised of qualifying assets under Section 3(c)(5)(C) of the Investment Company Act, and 80% of our portfolio, or the assets of our majority-owned subsidiaries, must be comprised of qualifying assets and real estate-related assets under Section 3(c)(5)(C) of the Investment Company Act. In addition, we may not issue “redeemable securities.” To comply with the Section 3(c)(5)(C) exemption, we may from time to time buy RMBS and other qualifying assets. We generally expect that mortgage loans, junior (first loss) interests in whole pool CMBS, real property investments, certain distressed debt securities and Tier 1 mezzanine loans to be qualifying assets under the Section 3(c)(5)(C) exemption from the Investment Company Act. Tier 1 mezzanine loans are loans granted to a mezzanine borrower that directly owns interests in the entity that owns the property being financed. The treatment of distressed debt securities as qualifying assets is, and will be, based on the characteristics of the particular type of loan, including its foreclosure rights. Although SEC staff no-action letters have not specifically addressed the categorization of these types of assets, we believe junior (first loss) interests in CMBS pools may constitute qualifying assets under Section 3(c)(5)(C) provided that we have the unilateral right to foreclose, directly or indirectly, on the mortgages in the pool and that we may act as the controlling class or directing holder of the pool. Similarly, subordinate interests in whole loans may constitute qualifying assets under Section 3(c)(5)(C) provided that, among other things, approval rights in connection with any material decisions pertaining to the administration and servicing of the relevant mortgage loan and, in the event that the mortgage loan becomes non-performing, we have effective control over the remedies relating to the enforcement of the loan, including ultimate control of the foreclosure process. We generally do not treat non-Tier 1 mezzanine loans and preferred equity investments as qualifying assets. Although we monitor our portfolio periodically and prior to each origination or acquisition of a new asset or disposition of an existing asset, there can be no assurance that we will be able to maintain an exclusion or exemption from registration under the Investment Company Act. Further, we may not be able to invest in sufficient qualifying and/or real estate-related assets and future revision or interpretations of the Investment Company Act may cause us to lose our exclusion or exemption or force us to re-evaluate our portfolio and our business strategy. Such changes may prevent us from operating our business successfully. No assurance can be given that the SEC staff will concur with our classification of our assets, or that the SEC staff will not, in the future, issue further guidance that may require us to reclassify those assets for purpose of qualifying for an exemption or exclusion from regulation under the Investment Company Act. To the extent that the staff of the SEC provides more specific guidance regarding any of the matters bearing upon the definition of investment company and the exceptions to that definition, we may be required to adjust our investment strategy accordingly. Any additional guidance from the staff of the SEC could provide additional flexibility to us, or it could further inhibit our ability to pursue the investment strategy we have chosen.

 

In consultation with legal and tax advisors, we periodically evaluate our assets, and also evaluate prior to an acquisition or origination the structure of each prospective investment or asset, to determine whether we avoid coming within the definition of investment company in Section 3(a)(1)(C) and/or whether we believe the investment will be a qualifying asset for purposes of maintaining the exemptions found in Sections 3(c)(5)(C) and/or 3(c)(6) from registration under the Investment Company Act. We consult with counsel to assist us with such determination as appropriate. If we are obligated to register as an investment company, we would have to comply with a variety of substantive requirements under the Investment Company Act, including limitations on capital structure, restrictions on specified investments, prohibitions on transactions with affiliates, changes in the composition of our board of directors and compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.

 

The Advisers Act imposes numerous obligations on registered investment advisers such as GKKM.

 

The Advisers Act imposes numerous obligations on registered investment advisers such as GKKM, including record-keeping, operational and marketing requirements, disclosure obligations and prohibitions on fraudulent activities. The Investment Company Act imposes stringent governance, compliance, operational, disclosure and related obligations on registered investment companies and their investment advisers and distributors, such as GKKM. The SEC is authorized to institute proceedings and impose sanctions for violations of the Advisers Act and the Investment Company Act, ranging from fines and censure to termination of an investment adviser’s registration. Investment advisers also are subject to certain state securities laws and regulations. Non-compliance with the Advisers Act, the Investment Company Act or other federal and state securities laws and regulations could result in investigations, sanctions, disgorgement, fines and reputational damage.

 

We may incur losses as a result of ineffective risk management processes and strategies.

 

We seek to monitor and control our risk exposure through a risk and control framework encompassing a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems, internal controls, management review processes and other mechanisms. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Thus, we may, in the course of our activities, incur losses. Recent market conditions have involved unprecedented dislocations and highlight the limitations inherent in using historical data to manage risk.

 

The models that we use to assess and control our risk exposures reflect assumptions about the degrees of correlation or lack thereof among prices of various asset classes or other market indicators. In times of market stress or other unforeseen circumstances, previously uncorrelated indicators may become correlated, or conversely previously correlated indicators may move in different directions. These types of market movements have at times limited the effectiveness of our hedging strategies and have caused us to incur significant losses, and they may do so in the future. These changes in correlation can be exacerbated where other market participants are using risk models with assumptions or algorithms that are similar to ours. In these and other cases, it may be difficult to reduce our risk positions due to the activity of other market participants or widespread market dislocations, including circumstances where asset values are declining significantly or no market exists for certain assets. To the extent that we make investments that do not have an established liquid trading market or are otherwise subject to restrictions on sale or hedging, we may not be able to reduce our positions and therefore reduce our risk associated with such positions. 

 

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We may change our investment and operational policies without stockholder consent.

 

We may change our investment and operational policies, including our policies with respect to investments, acquisitions, growth, operations, indebtedness, capitalization and distributions, at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, the types of investments described in this filing. A change in our investment strategy may increase our exposure to interest rate risk, default risk and real estate market fluctuations, all of which could adversely affect our ability to make distributions.

 

Terrorist attacks and other acts of violence or war may affect the market for our common stock, the industry in which we conduct our operations and our profitability.

 

Terrorist attacks may harm our results of operations and the stockholders’ investment. We cannot assure the stockholders that there will not be further terrorist attacks against the U.S. or U.S. businesses. These attacks or armed conflicts may directly impact the property underlying our asset-based securities or the securities markets in general. Losses resulting from these types of events are uninsurable.

 

More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the U.S. and worldwide financial markets and economy. Adverse economic conditions could harm the value of our properties, or the securities markets in general which could harm our operating results and revenues and may result in increased volatility of the value of our securities.

 

We are highly dependent on information systems and third-parties, and systems failures could significantly disrupt our business, which may, in turn, negatively affect the market price of our common stock and our ability to make distributions to our stockholders.

 

Our business is highly dependent on communications and information systems, some of which are provided by third-parties. Any failure or interruption of our systems could cause delays or other problems, which could have a material adverse effect on our operating results and negatively affect the market price of our common stock and our ability to make distributions to our stockholders.

 

Risks Related to Our Investments

 

Investing in real estate is a competitive business and we will rely on acquisitions in order to grow.

 

In order to grow we need to continue to acquire and finance investment properties and sell non-core properties. The acquisition and sale of investment properties is subject to competitive pressures from many market participants and we expect strong competition from other REITs, businesses, individuals, fiduciary accounts and plans, as well as other entities engaged in real estate investment and financing. Many of these competitors are larger than we are and have access to greater financial resources. Such competition may limit our ability to acquire properties and grow or may result in a higher cost to us for properties we wish to purchase.

 

We structure many of our real property acquisitions using complex structures often based on forecasted results for the acquisitions, and if the acquired properties underperforms forecasted results, our financial condition and operating results may be harmed.

 

We may acquire some of our properties under complex structures that we tailor to meet the specific needs of the tenants and/or sellers. For instance, we may enter into transactions under which a portion of the properties are vacant or will be vacant following the completion of the acquisition. If we fail to accurately forecast the leasing of such properties following our acquisition, our operating results and financial condition, as well as our ability to pay dividends to stockholders, may be adversely impacted.

 

Cash flow from operations depends in part on the ability to lease space to tenants on economically favorable terms. We could be adversely affected by various facts and events over which we have limited or no control.

 

We could be adversely affected by various facts and events over which we have limited or no control, such as (i) lack of demand in areas where our properties are located; (ii) inability to retain existing tenants and attract new tenants; (iii) oversupply of space and changes in market rental rates; (iv) declines in our tenants' creditworthiness and ability to pay rent, which may be affected by their operations, the current economic situation and competition within their industries from other operators; (v) defaults by and bankruptcies of tenants, (vi) failure of tenants to pay rent on a timely basis, or failure of tenants to comply with their contractual obligations; (vii) economic or physical decline of the areas where the properties are located; and (viii) deterioration of physical condition of our properties. Negative market conditions or adverse events affecting our existing or potential tenants, or the industries in which they operate, could have an adverse impact on our ability to attract new tenants, re-lease space, collect rent or renew leases, which could adversely affect our financial condition.

 

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At any time, any tenant may experience a downturn in its business that may weaken its operating results or overall financial condition. As a result, a tenant may delay lease commencement, fail to make rental payments when due, decline to extend a lease upon its expiration, become insolvent or declare bankruptcy. Any tenant bankruptcy or insolvency, leasing delay or failure to make rental payments when due could result in the termination of the tenant's lease and material losses to us.

 

If tenants do not renew their leases as they expire, we may not be able to rent or sell the properties. Furthermore, leases that are renewed, and some new leases for properties that are re-leased, may have terms that are less economically favorable than expiring lease terms, or may require us to incur significant costs, such as renovations, tenant improvements or lease transaction costs. Negative market conditions may cause us to sell vacant properties for less than their carrying value, which could result in impairments. Any of these events could adversely affect our financial condition. A significant portion of the costs of owning property, such as real estate taxes, insurance and maintenance, are not necessarily reduced when circumstances cause a decrease in rental revenue from the properties. In a weakened financial condition, tenants may not be able to pay these costs of ownership and we may be unable to recover these operating expenses from them.

 

We expect to lease a significant portion of our real estate to middle market businesses which may be more susceptible to adverse market conditions.

 

We expect that a substantial number of our properties will be leased to middle market businesses that generally have less financial and other resources than larger businesses. Middle-market companies are more likely to be adversely affected by a downturn in their respective businesses or in the regional, national or international economy. As such negative market conditions affecting existing or potential middle-market tenants, or the industries in which they operate, could adversely affect our financial condition.

 

We may be adversely affected by unfavorable economic changes in geographic areas where our properties are concentrated.

 

Adverse conditions in the areas where our properties are located (including business layoffs or downsizing, industry slowdowns, changing demographics and other factors) and local real estate conditions (such as oversupply of, or reduced demand for, office, industrial or retail properties) may have an adverse effect on the value of our properties. A material decline in the demand or the ability of tenants to pay rent for office, industrial or retail space in these geographic areas may result in a material decline in our cash available for distribution.

 

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

 

Real estate investments are subject to risks particular to real property, including:

 

acts of God, including earthquakes floods and other natural disasters, which may result in uninsured losses;

 

acts of war or terrorism, including the consequences of terrorist attacks;

 

adverse changes in national and local economic and market conditions, including the credit and securitization markets;

 

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;

 

real estate conditions, such as an oversupply of or a reduction in demand for real estate space in the area;

 

the perceptions of tenants and prospective tenants of the convenience, attractiveness and safety of our properties;

 

competition from comparable properties;

 

the occupancy rate of our properties;

 

the ability to collect on a timely basis all rent from tenants;

 

the effects of any bankruptcies or insolvencies of major tenants;

 

the expense of re-leasing space;

 

changes in interest rates and in the availability, cost and terms of mortgage funding;

 

the impact of present or future environmental legislation and compliance with environmental laws; and

 

cost of compliance with the Americans with Disabilities Act;

 

If any of these or similar events occur, it may reduce our return from an affected property or investment and reduce or eliminate our ability to make distributions to stockholders.

  

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Joint investments could be adversely affected by our lack of sole decision-making authority and reliance upon a co-venturer’s financial condition.

 

We co-invest with third-parties through partnerships, joint ventures, co-tenancies or other entities, acquiring non-controlling interests in, or sharing responsibility for managing the affairs of, a property, partnership, joint venture, co-tenancy or other entity. Therefore, we will not be in a position to exercise sole decision-making authority regarding that property, partnership, joint venture or other entity. Investments in partnerships, joint ventures, or other entities may involve risks not present were a third-party not involved, including the possibility that our partners, co-tenants or co-venturers might become bankrupt or otherwise fail to fund their share of required capital contributions. Additionally, our partners or co-venturers might at any time have economic or other business interests or goals which are inconsistent with our business interests or goals. These investments may also have the potential risk of impasses on decisions such as a sale, because neither we nor the partner, co-tenant or co-venturer would have full control over the partnership or joint venture. Consequently, actions by such partner, co-tenant or co-venturer might result in subjecting properties owned by the partnership or joint venture to additional risk. In addition, we may in specific circumstances be liable for the actions of our third-party partners, co-tenants or co-venturers.

 

We may in the future enter, into joint venture agreements that contain terms in favor of our partners that may have an adverse effect on the value of our investments in the joint ventures. For example, we may be entitled under a particular joint venture agreement to an economic share in the profits of the joint venture that is smaller than our ownership percentage in the joint venture, our partner may be entitled to a specified portion of the profits of the joint venture before we are entitled to any portion of such profits and our partner may have rights to buy our interest in the joint venture, to force us to buy the partner’s interest in the joint venture or to compel the sale of the property owned by such joint venture. These rights may permit our partner in a particular joint venture to obtain a greater benefit from the value or profits of the joint venture than us, which may have an adverse effect on the value of our investment in the joint venture and on our financial condition and results of operations.

 

The bankruptcy or insolvency of our tenants under their leases or delays by our tenants in making rental payments could seriously harm our operating results and financial condition.

 

Any bankruptcy filings by or relating to one of our tenants could bar us from collecting pre-bankruptcy debts from that tenant or its property, unless we receive an order permitting us to do so from the bankruptcy court. A tenant bankruptcy could delay our efforts to collect past due balances under the relevant leases, and could ultimately preclude full collection of these sums. If a lease is rejected by a tenant in bankruptcy, we would have only a general unsecured claim for damages. Any unsecured claim we hold against a bankrupt entity may be paid only to the extent that funds are available and only in the same percentage as is paid to all other holders of unsecured claims. We may recover substantially less than the full value of any unsecured claims, which would harm our financial condition.

 

Many of our tenants within our joint venture with Garrison, are banks that are not eligible to be debtors under the federal bankruptcy code, but would be subject to the liquidation and insolvency provisions of applicable banking laws and regulations. If the FDIC were appointed as receiver of a banking tenant because of a tenant’s insolvency, we would become an unsecured creditor of the tenant and be entitled to share with the other unsecured non-depositor creditors in the tenant’s assets on an equal basis after payment to the depositors of their claims. The FDIC has broad powers to reject any contract (including a lease) of a failed depository institution that the FDIC deems burdensome if the FDIC determines that such rejection is necessary to promise the orderly administration of the institution’s affairs. By federal statute, a landlord under a lease rejected by the FDIC is not entitled to claim any damages with respect to the disaffirmation, other than rent through the effective date of the disaffirmation. The amount paid on claims in respect of the lease would depend on, among other factors, the amount of assets of the insolvent tenant available for unsecured claims. We may recover substantially less than the full value of any unsecured claims, which could have a material adverse effect on our operating results and financial condition, as well as our ability to pay dividends to stockholders at historical levels or at all.

 

We may experience losses if the creditworthiness of our tenants deteriorates and they are unable to meet their obligations under our leases.

 

We own the properties leased to the tenants of our real estate investments and we receive rents from the tenants during the terms of our leases. A tenant’s ability to pay rent is determined by the creditworthiness of the tenant. If a tenant’s credit deteriorates, the tenant may default on its obligations under our lease and the tenant may also become bankrupt. The bankruptcy or insolvency of our tenants or other failure to pay is likely to adversely affect the income produced by our real estate investments. If a tenant defaults, we may experience delays and incur substantial costs in enforcing our rights as landlord. If a tenant files for bankruptcy, we may not be able to evict the tenant solely because of such bankruptcy or failure to pay. A court, however, may authorize a tenant to reject and terminate its lease with us. In such a case, our claim against the tenant for unpaid, future rent would be subject to a statutory cap that might be substantially less than the remaining rent owed under the lease. In addition, certain amounts paid to us within 90 days prior to the tenant’s bankruptcy filing could be required to be returned to the tenant’s bankruptcy estate. In any event, it is highly unlikely that a bankrupt or insolvent tenant would pay in full amounts it owes us under a lease. In other circumstances, where a tenant’s financial condition has become impaired, we may agree to partially or wholly terminate the lease in advance of the termination date in consideration for a lease termination fee that is likely less than the agreed rental amount. Without regard to the manner in which the lease termination occurs, we are likely to incur additional costs in the form of tenant improvements and leasing commissions in our efforts to lease the space to a new tenant. In any of the foregoing circumstances, our financial performance, the market prices of our securities and our ability to pay dividends could be materially adversely affected.

  

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Lease defaults or terminations or landlord-tenant disputes may adversely reduce our income from our leased property portfolio.

 

Lease defaults or terminations by one or more of our significant tenants may reduce our revenues unless a default is cured or a suitable replacement tenant is found promptly. In addition, disputes may arise between the landlord and tenant that result in the tenant withholding rent payments, possibly for an extended period. These disputes may lead to litigation or other legal procedures to secure payment of the rent withheld or to evict the tenant. Any of these situations may result in extended periods during which there is a significant decline in revenues or no revenues generated by the property. If this were to occur, it could adversely affect our results of operations.

 

Our real estate investments may be illiquid, which could restrict our ability to respond rapidly to changes in economic conditions.

 

The real estate and real estate-related assets in which we invest are generally illiquid. In addition, the instruments that we purchase in connection with privately negotiated transactions are not registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. As a result, our ability to sell under-performing assets in our portfolio or respond to changes in economic and other conditions may be relatively limited.

 

We may not be able to relet or renew leases at the properties held by us on terms favorable to us.

 

We are subject to risks that upon expiration or earlier termination of the leases for space located at our properties the space may not be relet or, if relet, the terms of the renewal or reletting (including the costs of required renovations or concessions to tenants) may be less favorable that current lease terms. Any of these situations may result in extended periods where there is a significant decline in revenues or no revenues generated by a property. If we are unable to relet or renew leases for all or substantially all of the spaces at these properties, if the rental rates upon such renewal or reletting are significantly lower than expected, or if our reserves for these purposes prove inadequate, we will experience a reduction in net income and may be required to reduce or eliminate distributions to our stockholders.

 

A significant portion of our properties owned by our Joint Venture are leased to financial institutions, making us more economically vulnerable in the event of a downturn in the banking industry.

 

The real estate owned by our joint venture with Garrison is leased primarily to financial institutions. Individual banks, as well as the banking industry in general, may be adversely affected by negative economic and market conditions throughout the United States or in the local economies in which regional or community banks operate, including negative conditions caused by the recent disruptions in the financial markets. In addition, changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System, may have an adverse impact on banks’ loan portfolios and allowances for loan losses. As a result, we may experience higher rates of lease default or terminations in the event of a downturn in the banking industry than we would if our tenant base was more diversified.

 

Liability relating to environmental matters may impact the value of the properties that we may acquire or underlying our investments.

 

Under various U.S. federal, state and local laws, an owner or operator of real property may become liable for the costs of removal of certain hazardous substances released on its property. These laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. If we fail to disclose environmental issues, we could also be liable to a buyer or lessee of a property.

 

There may be environmental problems associated with our properties which we were unaware of at the time of acquisition. The presence of hazardous substances may adversely affect our ability to sell real estate or borrow using real estate as collateral. The presence of hazardous substances, if any, on our properties may adversely affect our ability to sell an affected property and we may incur substantial remediation costs, thus harming our financial condition. In addition, although our leases, will generally require our tenants to operate in compliance with all applicable laws and to indemnify us against any environmental liabilities arising from a tenant’s activities on the property, we nonetheless would be subject to strict liability by virtue of our ownership interest for environmental liabilities created by such tenants, and we cannot ensure the stockholders that any tenants we might have would satisfy their indemnification obligations under the applicable sales agreement or lease. The discovery of material environmental liabilities attached to such properties could have a material adverse effect on our results of operations and financial condition and our ability to make distributions to our stockholders.

 

Rising operating expenses relating to our properties could reduce our cash flow and funds available for future distributions.

 

Our properties are subject to operating risks common to real estate in general, any or all of which may negatively affect us. If the properties do not generate revenue sufficient to meet expenses, including debt service, tenant improvements, leasing commissions and other capital expenditures, our cash flow will be negatively impacted and we may have to utilize our existing liquidity to cover these expenses or risk forfeiture of the assets if we default on any associated debt obligations.

 

 

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

 

Under the terms and conditions of the leases currently in force on our properties, tenants generally are required to indemnify and hold us harmless from liabilities resulting from injury to persons, air, water, land or property, on or off the premises, due to activities conducted on the properties, except for claims arising from the negligence or intentional misconduct of us or our agents. Additionally, tenants are generally required, at the tenants’ expense, to obtain and keep in full force during the term of the lease, liability and property damage insurance policies issued by companies holding general policyholder ratings of at least “A” as set forth in the most current issue of Best’s Insurance Guide. Insurance policies for property damage are generally in amounts not less than the full replacement cost of the improvements less slab, foundations, supports and other customarily excluded improvements and insure against all perils of fire, extended coverage, vandalism, malicious mischief and special extended perils (“all risk,” as that term is used in the insurance industry). Insurance policies are generally obtained by the tenant providing general liability coverage varying between $1.0 million and $10.0 million depending on the facts and circumstances surrounding the tenant and the industry in which it operates. These policies include liability coverage for bodily injury and property damage arising out of the ownership, use, occupancy or maintenance of the properties and all of their appurtenant areas.

 

Our properties may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.

 

When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property. In addition, the presence of significant mold could expose us to liability from our tenants, employees of our tenants and others if property damage or health concerns arise.

 

Our properties may contain asbestos which could lead to liability for adverse health effects and costs of remediating asbestos.

 

Certain laws and regulations govern the removal, encapsulation or disturbance of asbestos-containing materials, or ACMs, when those materials are in poor condition or in the event of building renovation or demolition, impose certain worker protection and notification requirements, and govern emissions of and exposure to asbestos fibers in the air. These laws may also impose liability for a release of ACMs and may enable third-parties to seek recovery against us for personal injury associated with ACMs. There are or may be ACMs at certain of our properties. We have either developed and implemented or are in the process of developing and implementing operations and maintenance programs that establish operating procedures with respect to ACMs.

 

In March 2005, GAAP clarified that the term conditional asset retirement obligation as a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation is recognized when incurred — generally upon acquisition, construction, or development and (or) through the normal operation of the asset.

 

To comply with GAAP we assessed the cost associated with our legal obligation to remediate asbestos in our properties known to contain asbestos. We believe that the majority of the costs associated with our remediation of asbestos have been identified and recorded in compliance with GAAP, however other obligations associated with asbestos in our properties may exist. Other obligations associated with asbestos in our properties will be recorded in our consolidated statement of operations in the future when/if the cost is incurred.

 

Compliance with the Americans with Disabilities Act and fire, safety and other regulations may require us to make unintended expenditures that adversely impact our ability to pay dividends to stockholders at historical levels or at all.

 

All of our properties are required to comply with the Americans with Disabilities Act. The Americans with Disabilities Act has separate compliance requirements for “public accommodations” and “commercial facilities,” but generally requires that buildings be made accessible to people with disabilities. Compliance with the Americans with Disabilities Act requirements could require removal of access barriers and non-compliance could result in imposition of fines by the U.S. government or an award of damages to private litigants or both. While the tenants to whom we lease properties are obligated by law to comply with the Americans with Disabilities Act provisions with respect to their operations, we could be required to expend our own funds to achieve such compliance should our tenants fail to do so. In addition, we (and not our tenants) are generally required to comply with Americans with Disabilities Act provisions within the parking lots, access ways and other common areas of the properties we own and to operate our properties in compliance with fire and safety regulations, building codes and other land use regulations, as they may be adopted by governmental agencies and bodies and become applicable to our properties. We may be required to make substantial capital expenditures to comply with those requirements and these expenditures could have a material adverse effect on our ability to pay dividends to stockholders at historical levels or at all.

 

 

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In addition to the indemnities and required insurance policies identified above, many of our properties are also covered by flood and earthquake insurance policies obtained by and paid for by the tenants as part of their risk management programs. Additionally, we have obtained blanket liability and property damage insurance policies to protect us and our properties against loss should the indemnities and insurance policies provided by the tenants fail to restore the properties to their condition prior to a loss. All of these policies may involve substantial deductibles and certain exclusions. In certain areas, we may have to obtain earthquake and flood insurance on specific properties as required by our lenders or by law. We have also obtained terrorism insurance on some of our larger office buildings, but this insurance is subject to exclusions for loss or damage caused by nuclear substances, pollutants, contaminants and biological and chemical weapons. Should a loss occur that is uninsured or in an amount exceeding the combined aggregate limits for the policies noted above, or in the event of a loss that is subject to a substantial deductible under an insurance policy, we could lose all or part of our capital invested in, and anticipated revenue from, one or more of the properties, which could have a material adverse effect on our operating results and financial condition, as well as our ability to pay dividends to stockholders at historical levels or at all.

 

We are subject to risks and uncertainties associated with operating our asset and property management business.

 

We will encounter risks and difficulties as we operate our asset and property management business. In order to achieve our goals as a property manager, we must:

 

actively manage the assets in such portfolios in order to realize targeted performance; and

 

create incentives for our management and professional staff to develop and operate the asset and property management business.

 

If we do not successfully operate our asset and property management business to achieve the investment returns that we or the market anticipates, our operations may be adversely impacted.

 

Some of our portfolio investments may be recorded at fair value, as a result, there will be uncertainty as to the value of these investments.

 

Changes in the market values of our investments in securities available for sale will be directly charged or credited to stockholders’ equity. As a result, a decline in values may reduce the book value of our assets. Moreover, if the decline in value of a security is other-than-temporary, such decline will reduce earnings. Any such charges may result in volatility in our reported earnings and may adversely affect the market price of our common stock. Some of our portfolio investments may be in the form of securities, including CMBS, that are not publicly traded. The fair value of securities and other investments that are not publicly traded may not be readily determinable. We value these investments quarterly. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments were materially higher than the values that we ultimately realize upon their disposal.

 

Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks and costs.

 

The cost of using hedging instruments increases as the period covered by the instrument 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 and hedging costs have increased.

 

In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot be assured that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.

 

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We may enter into derivative contracts that could expose us to contingent liabilities in the future.

 

Part of our investment strategy may involve entering into derivative contracts that could require us to fund cash payments in the future under certain circumstances, e.g., the early termination of the derivative agreement caused by an event of default or other early termination event, or the decision by a counterparty to request margin securities it is contractually owed under the terms of the derivative contract. The amount due would be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges. These economic losses would be reflected in our financial results of operations, and our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time, and the need to fund these obligations could adversely impact our financial condition.

 

Risk Relating to Our Capital Structure and Access to Liquidity

 

If we issue senior securities we will be exposed to additional restrictive covenants and limitations on our operating flexibility, which could adversely affect our ability to pay dividends.

 

If we decide to issue senior securities in the future, it is likely that they will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Holders of senior securities may be granted specific rights, including but not limited to: the right to hold a perfected security interest in certain of our assets, the right to accelerate payments due under the indenture, rights to restrict dividend payments and rights to require approval to sell assets. Additionally, any convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common stock. We, and indirectly our stockholders, will bear the cost of issuing and servicing such securities.

 

In a period of rising interest rates, our interest expense could increase while the interest we earn on our fixed-rate investments would not change, which would adversely affect our profitability.

 

Our operating results depend in large part on differences between the income from our investments, net of financing costs. In most cases, for any period during which our investments are not match-funded, the income from such investments will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and market value of our investments. Interest rate fluctuations resulting in our interest expense exceeding our interest income would result in operating losses for us and may limit or eliminate our ability to make distributions to our stockholders. For more information on interest rate risk, see Item 7A, “Quantitative and Qualitative Disclosure About Market Risk” in this Annual Report on Form 10-K.

 

If credit spreads widen before we obtain long-term financing for our assets, the value of our assets may suffer.

 

We price our assets based on our assumptions about future credit spreads for financing of those assets. We have obtained, and may obtain in the future, longer term financing for our assets using structured financing techniques. Such issuances entail interest rates set at a spread over a certain benchmark, such as the yield on United States Treasury obligations, swaps or LIBOR. If the spread that investors are paying on our current structured finance vehicles and will pay on future structured finance vehicles we may engage in over the benchmark widens and the rates we are charging or will charge on our assets are not increased accordingly, our income may be reduced or we could suffer losses, which could affect our ability to make distributions to our stockholders.

 

Risks Related to Our Organization and Structure

 

Maryland takeover statutes may prevent a change of control of our company, which could depress our stock price.

 

Under Maryland law, certain “business combinations” between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange, or asset transfers or issuance or reclassification of equity securities. An interested stockholder is defined as:

 

any person who beneficially owns 10% or more of the voting power of the corporation’s shares; or

 

an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of the then outstanding voting stock of the corporation.

 

A person is not an interested stockholder under the statute if our board of directors approves in advance the transaction by which he otherwise would have become an interested stockholder.

 

After the five-year prohibition, any business combination between the Maryland corporation and an interested stockholder generally must be recommended by our board of directors of the corporation and approved by the affirmative vote of at least:

 

80% of the votes entitled to be cast by holders of outstanding shares of voting stock of the corporation; and

 

two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or by the interested stockholder’s affiliates or associates, voting together as a single group.

 

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The business combination statute may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer, including potential acquisitions that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders. 

 

We have opted out of these provisions of the Maryland General Corporation Law, or the MGCL, with respect to its business combination provisions and its control share provisions by resolution of our board of directors and a provision in our bylaws, respectively. However, in the future our board of directors may reverse its decision by resolution and elect to opt in to the MGCL’s business combination provisions, or amend our bylaws and elect to opt in to the MGCL’s control share provisions.

 

Additionally, Title 8, Subtitle 3 of the MGCL permits our board of directors, without stockholder approval and regardless of what is provided in our charter or bylaws, to implement takeover defenses, some of which we do not have. These provisions may have the effect of inhibiting a third-party from making us an acquisition proposal or of delaying, deferring or preventing a change in our control under circumstances that otherwise could provide the stockholders with an opportunity to realize a premium over the then-current market price.

 

Our authorized but unissued preferred stock may prevent a change in our control which could be in the stockholders’ best interests.

 

Our charter authorizes us to issue additional authorized but unissued shares of our common stock or preferred stock. Any such issuance could dilute our existing stockholders’ interests. In addition, our board of directors may classify or reclassify any unissued shares of preferred stock and may set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board of directors may establish a series of preferred stock that could delay or prevent a transaction or a change in control that might be in the best interest of our stockholders.

 

Changes in market conditions could adversely affect the market price of our common stock.

 

As with other publicly traded equity securities, the value of our common stock depends on various market conditions which may change from time to time. Among the market conditions that may affect the value of our common stock are the following:

 

the general reputation of REITs and the attractiveness of our equity securities in comparison to other equity securities, including securities issued by other real estate-based companies;

 

our financial performance; and

 

general stock and bond market conditions.

 

The market value of our common stock is based primarily upon the market’s perception of our growth potential and our current and potential future earnings and cash distributions. Consequently, our common stock may trade at prices that are higher or lower than our net asset value per share of common stock. If our future earnings or cash dividends are less than expected, it is likely that the market price of our common stock will decline. 

 

Risks Related to Our Taxation as a REIT

 

Our failure to qualify as a REIT would result in higher taxes and reduced cash available for stockholders.

 

We intend to continue to operate in a manner so as to qualify as a REIT for U.S. federal income tax purposes. Our continued qualification as a REIT depends on our satisfaction of certain asset, income, organizational, distribution and stockholder ownership requirements on a continuing basis. Our ability to satisfy some of the asset tests depends upon the fair market values of our assets, some of which are not able to be precisely determined and for which we will not obtain independent appraisals. If we were to fail to qualify as a REIT in any taxable year, and certain statutory relief provisions were not available, we would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and distributions to stockholders would not be deductible by us in computing our taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution. Unless entitled to relief under certain Internal Revenue Code provisions, we also would be disqualified from taxation as a REIT for the four taxable years following the year during which we ceased to qualify as a REIT.

 

REIT distribution requirements could adversely affect our liquidity.

 

In order to qualify as a REIT, each year we must distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, and not including any net capital gain. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our net taxable income, we will be subject to U.S. federal corporate income tax on our undistributed net taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under U.S. federal tax laws.

  

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When necessary, we intend to continue to make distributions to our stockholders to comply with the REIT distribution requirements and avoid corporate income tax and/or excise tax. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets or borrow funds on a short-term or long-term basis to meet the 90% distribution requirement or avoid corporate income or excise tax. We may own assets that generate mismatches between taxable income and available cash. These assets may include (a) securities that have been financed through financing structures which require some or all of available cash flows to be used to service borrowings, (b) loans or CMBS we hold that have been issued at a discount and require the accrual of taxable economic interest in advance of receipt in cash (c) distressed debt on which we may be required to accrue taxable interest income even though the borrower is unable to make current debt service payments in cash and (d) debt investments that generate taxable income but are held by one or more of our CDOS which is not currently making cash distributions to us as the owner of the non-investment liabilities and equity of the CDO. As a result, the requirement to distribute a substantial portion of our net taxable income could cause us to: (a) sell assets in adverse market conditions, (b) borrow on unfavorable terms or (c) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt to comply with REIT requirements.

 

Further, amounts distributed will not be available to fund investment activities. We expect to fund our investments by raising equity capital and through borrowings from financial institutions and the debt capital markets. If we fail to obtain debt or equity capital in the future, it could limit our ability to grow, which could have a material adverse effect on the value of our common stock.

 

In January 2011, an “ownership change” for purposes of Section 382 of the Internal Revenue Code, of 1986, as amended, occurred which limits our ability to utilize our net operating losses and net capital losses against future taxable income, increasing our dividend distribution requirement which could adversely affect our liquidity.

 

We have substantial net operating and net capital loss carry forwards which we have used to offset our tax and/or distribution requirements. In January 2011, an “ownership change” for purposes of Section 382 of the Internal Revenue Code occurred, which will limit our ability to use these losses in the future. In general, an “ownership change” occurs if there is a change in ownership of more than 50% of our common stock during any cumulative three year period. For this purpose, determinations of ownership changes are generally limited to shareholders deemed to own 5% or more of our common stock. Such a change in ownership may be triggered by regular trading activity in our common stock, which is generally beyond our control. The provisions of Section 382, will impose an annual limit to the amount of net operating loss carryforward that can be used by us to offset future ordinary taxable income, beginning with our 2011 taxable year. Such limitations may increase our dividend distribution requirement in the future which could adversely affect our liquidity.

 

Complying with REIT requirements may limit our ability to hedge effectively.

 

The existing REIT provisions of the Internal Revenue Code may limit our ability to hedge our operations. Except to the extent provided by Treasury regulations, (i) for transactions entered into on or prior to July 30, 2008, any income from a hedging transaction we enter into in the normal course of our business primarily to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets, including gain from the sale or disposition of such a transaction, will not constitute gross income for purposes of the 95% gross income test (and will generally constitute non-qualifying income for purposes of the 75% gross income test) and (ii) for transactions entered into after July 30, 2008, any income from a hedging transaction where the instrument hedges interest rate risk on liabilities used to carry or acquire real estate or hedges risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the 75% or 95% gross income tests will be excluded from gross income for purposes of the 75% and 95% gross income tests. To qualify under either (i) or (ii) of the preceding sentence, the hedging transaction must be clearly identified as specified in Treasury regulations before the close of the day on which it was acquired, originated or entered into. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both of the gross income tests. In addition, we must limit our aggregate income from non-qualified hedging transactions, from our provision of services and from other non-qualifying sources, to less than 5% of our annual gross income (determined without regard to gross income from qualified hedging transactions). As a result, we may have to limit our use of certain hedging techniques or implement those hedges through TRSs. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur or could increase the cost of our hedging activities. If we fail to satisfy the 75% or 95% limitations, we could lose our REIT qualification for U.S. federal income tax purposes, unless our failure was due to reasonable cause and not due to willful neglect, and we meet certain other technical requirements. Even if our failure was due to reasonable cause, we might incur a penalty tax.

 

We may in the future choose to pay dividends in our own stock, in which case you may be required to pay income taxes in excess of the cash dividends you receive.

 

We may in the future distribute taxable dividends that are payable in cash and shares of our common stock at the election of each stockholder. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as ordinary income to the extent of our current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. stockholder may be required to pay income taxes with respect to such dividends in excess of the cash dividends received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our common stock.

 

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The stock ownership limit imposed by the Internal Revenue Code for REITs and our charter may inhibit market activity in our stock and may restrict our business combination opportunities.

 

In order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year. Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. Unless exempted by our board of directors, no person may own more than 9.8% of the aggregate value of the outstanding shares of our stock. Our board of directors may not grant such an exemption to any proposed transferee whose ownership of in excess of 9.8% of the value of our outstanding shares would result in the termination of our status as a REIT. These ownership limits could delay or prevent a transaction or a change in our control that might be in the best interest of our stockholders.

 

The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing loans and selling our loans and real estate properties, that may be treated as sales for U.S. federal income tax purposes.

 

A REIT’s gain from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans and real estate, held primarily for sale to customers in the ordinary course of business.

 

We might be subject to this tax if we were to sell or securitize loans or dispose of loans or real estate in a manner that was treated as a sale of the loans or real estate for U.S. federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans or real estate and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial to us. It may be possible to reduce the impact of the prohibited transaction tax by engaging in securitization transactions treated as sales and loan and real estate dispositions through one or more of our TRSs, subject to certain limitations. Generally, to the extent that we engage in securitizations treated as sales or dispose of loans or real estate through one or more TRSs, the income associated with such activities would be subject to full corporate income tax at standard rates. 

 

The “taxable mortgage pool” rules may limit the manner in which we effect future securitizations and may subject us to U.S. federal income tax and increase the tax liability of our stockholders.

 

Certain of our current and future securitizations, such as our CDOs, could be considered to result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a REIT, so long as we or another private subsidiary REIT own 100% of the equity interests in a taxable mortgage pool, our qualification as a REIT would not be adversely affected by the characterization of the securitization as a taxable mortgage pool. We would generally be precluded, however, from holding equity interests in such securitizations through our operating partnership (unless held through a private subsidiary REIT), selling to outside investors equity interests in such securitizations or from selling any debt securities issued in connection with such securitizations that might be considered to be equity interests for tax purposes. These limitations will preclude us from using certain techniques to maximize our returns from securitization transactions.

 

Furthermore, we are taxable at the highest corporate income tax rate on a portion of the income arising from a taxable mortgage pool that is allocable to the percentage of our shares held by “disqualified organizations,” which are generally certain cooperatives, governmental entities and tax-exempt organizations that are exempt from unrelated business taxable income. We expect that disqualified organizations will own our shares from time to time.

 

In addition, if we realize excess inclusion income and allocate it to stockholders, this income cannot be offset by net operating losses of our stockholders. If the stockholder is a tax-exempt entity and not a disqualified organization, then this income would be fully taxable as unrelated business taxable income under Section 512 of the Internal Revenue Code. If the stockholder is a foreign person, it would be subject to U.S. federal income tax withholding on this. Nominees or other broker/dealers who hold our stock on behalf of disqualified organizations are subject to tax at the highest corporate income tax rate on a portion of our excess inclusion income allocable to the stock held on behalf of disqualified organizations. If the stockholder is a REIT, a regulated investment company, or RIC, common trust fund, or other pass-through entity, its allocable share of our excess inclusion income could be considered excess inclusion income of such entity and such entity will be subject to tax at the highest corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. Accordingly, such investors should be aware that a portion of our income may be considered excess inclusion income. Finally, if we fail to qualify as a REIT, our taxable mortgage pool securitizations will be treated as separate taxable corporations for U.S. federal income tax purposes.

 

We may be unable to generate sufficient revenue from operations to pay our operating expenses and to pay distributions to our stockholders.

 

As a REIT, we are generally required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and not including net capital gains, each year to our stockholders. To qualify for the tax benefits accorded to REITs, we have and intend to continue to make distributions to our stockholders in amounts such that we distribute all or substantially all our net taxable income each year, subject to certain adjustments. However, our ability to make distributions may be adversely affected by the risk factors described in this Annual Report on Form 10-K. In the event of a downturn in our operating results and financial performance or unanticipated declines in the value of our asset portfolio, we may be unable to declare or pay quarterly distributions or make distributions to our stockholders. The timing and amount of distributions are in the sole discretion of our board of directors, which considers, among other factors, our earnings, financial condition, debt service obligations and applicable debt covenants, REIT qualification requirements and other tax considerations and capital expenditure requirements as our board may deem relevant from time to time.

 

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Although our use of TRSs may be able to partially mitigate the impact of meeting the requirements necessary to maintain our qualification as a REIT, our ownership of and relationship with our TRSs will be limited and a failure to comply with the limits would jeopardize our REIT qualification and may result in the application of a 100% excise tax.

 

A REIT may own up to 100% of the stock of one or more TRSs. A TRS generally may hold assets and earn income that would not be qualifying assets or income if held or earned directly by a REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 25% (20% for tax years commencing before January 1, 2009) of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis.

 

Our TRSs, including GKK Management Co., LLC, GKK Trading Corp., GIT Trading Corp., Whiteface Holdings, LLC and GWF II SPE, LLC will pay U.S. federal, state and local income tax on their taxable income, and their after-tax net income will be available for distribution to us but will not be required to be distributed to us. We anticipate that the aggregate value of TRS securities owned by us will be less than 25% of the value of our total assets (including such TRS securities). Furthermore, we will monitor the value of our respective investments in our TRSs for the purpose of ensuring compliance with the rule that no more than 25% of the value of a REIT’s assets may consist of TRS securities (which is applied at the end of each calendar quarter). In addition, we will scrutinize all of our transactions with our TRSs for the purpose of ensuring that they are entered into on arm’s-length terms in order to avoid incurring the 100% excise tax described above. The value of the securities that we hold in our TRSs may not be subject to precise valuation. Accordingly, there can be no complete assurance that we will be able to comply with the 25%, limitation discussed above or avoid application of the 100% excise tax discussed above.

 

Cautionary Note Regarding Forward-Looking Information

 

This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. You can identify forward-looking statements by the use of forward-looking expressions such as “may,” “will,” “should,” “expect,” “believe,” “anticipate,” “estimate,” “intend,” “plan,” “project,” “continue,” or any negative or other variations on such expressions. Forward-looking statements include information concerning possible or assumed future results of our operations, including any forecasts, projections, plans and objectives for future operations. Although we believe that our plans, intentions and expectations as reflected in or suggested by those forward-looking statements are reasonable, we can give no assurance that the plans, intentions or expectations will be achieved. We have listed below some important risks, uncertainties and contingencies which could cause our actual results, performance or achievements to be materially different from the forward-looking statements we make in this report. These risks, uncertainties and contingencies include, but are not limited to, the following:

 

the success or failure of our efforts to implement our current business strategy;

 

our ability to identify and complete additional property acquisitions and risks of real estate acquisitions;

 

availability of investment opportunities on real estate assets and real estate-related and other securities;

 

the performance and financial condition of tenants and corporate customers;

 

the adequacy of our cash reserves, working capital and other forms of liquidity;

 

the availability, terms and deployment of short-term and long-term capital;

 

demand for office and industrial space;

 

the actions of our competitors and our ability to respond to those actions;

 

the timing of cash flows from our investments;

 

the cost and availability of our financings, which depends in part on our asset quality, the nature of our relationships with our lenders and other capital providers, our business prospects and outlook and general market conditions;

 

the continuity of the management agreement for the KBS portfolio;

 

economic conditions generally and in the commercial finance and real estate markets and the banking industry specifically;

 

unanticipated increases in financing and other costs, including a rise in interest rates;

 

our ability to maintain our current relationships with financial institutions and to establish new relationships with additional financial institutions;

 

reduction in cash flows received from our investments, in particular our CDOs;

 

our ability to profitably dispose of non-core assets;

 

availability of, and ability to retain, qualified personnel and directors;

 

changes to our management and board of directors;

 

changes in governmental regulations, tax rates and similar matters;

 

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legislative and regulatory changes (including changes to laws governing the taxation of REITs or the exemptions from registration as an investment company);

 

environmental and/or safety requirements;

 

our ability to satisfy complex rules in order for us to qualify as a REIT, for federal income tax purposes and qualify for our exemption under the Investment Company Act, our operating partnership’s ability to satisfy the rules in order for it to qualify as a partnership for federal income tax purposes, and the ability of certain of our subsidiaries to qualify as REITs and certain of our subsidiaries to qualify as TRSs for federal income tax purposes, and our ability and the ability of our subsidiaries to operate effectively within the limitations imposed by these rules;

 

the continuing threat of terrorist attacks on the national, regional and local economies; and

 

other factors discussed under Item 1A, “Risk Factors” of this Annual Report on Form 10-K for the year ended December 31, 2012 and those factors that may be contained in any filing we make with the SEC, including Part II, Item 1A of our Quarterly Reports on Form 10-Q.

 

We assume no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. In evaluating forward-looking statements, you should consider these risks and uncertainties, together with the other risks described from time-to-time in our reports and documents which are filed with the SEC, and you should not place undue reliance on those statements.

 

The risks included here are not exhaustive. Other sections of this report may include additional factors that could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors, nor can it assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. 

 

SPECIAL NOTE REGARDING EXHIBITS

 

In reviewing the agreements included as exhibits to this Annual Report on Form 10-K, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about our company or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and:

 

should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk tone of the parties if those statements provide to be inaccurate;

 

have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement;

 

may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and

 

were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments.

 

Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. Additional information about our company may be found elsewhere in this Annual Report on Form 10-K and our other public filings, which are available without charge through the SEC’s website at http://www.sec.gov. See Item 1, “Business — Corporate Governance and Internet Address: Where Readers Can Find Additional Information.”

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

As of the date of this filing, we do not have any unresolved comments with the staff of the SEC.

 

ITEM 2. PROPERTIES (Amounts in thousands)

 

Our corporate headquarters are located in midtown Manhattan at 420 Lexington Avenue, New York, New York 10170. We also have regional offices located in Jenkintown, Pennsylvania and St. Louis, Missouri. We can be contacted at (212) 297-1000. We maintain a website at www.gkk.com. Our reference to our website is intended to be an inactive textual reference only. Information contained in our website is not, and should not be interpreted to be, part of this Annual Report on Form 10-K.

 

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As of December 31, 2012, our consolidated property investment portfolio consisted of 43 properties, including 28 bank branches, 2 industrial properties and 13 office buildings aggregating approximately 1.1 million rentable square feet. As of December 31, 2012, the occupancy of our consolidated properties was 70%. The weighted average remaining term of the leases in our consolidated portfolio was 8.2 years.

 

The following table presents our consolidated portfolio as of December 31, 2012 and 2011:

 

   Number of Properties   Rentable Square Feet   Occupancy 
Properties (1)  December 31,
2012
   December 31,
2011
   December 31,
2012
   December 31,
2011
   December 31,
2012
   December 31,
2011
 
Industrial Properties   2    -    539,429    -    100.0%   0%
Branches   28    41    192,537    261,732    34.9%   28.9%
Office Buildings   13    15    362,492    491,084    45.3%   44.7%
Land   -    -    -    -    0%   0%
Total   43    56    1,094,458    752,816    70.4%   39.2%

 

Set forth below is information regarding lease expirations for our consolidated properties as of December 31, 2012 (dollars in thousands):

 

Year of Lease
Expiration (1)
  Number of
Expiring
Leases
   Total Sq. Ft.
under
Expiring
Leases
   Percentage of
Total Rentable
Sq. Ft.
   2012 Contractual
Rent under
Expiring Leases
   Percentage of
2012 Contractual
Rent
 
Monthly   15    22,024    2.9%  $13    0.4%
2013   5    17,351    2.2%   128    3.4%
2014   3    8,524    1.1%   63    1.7%
2015   2    6,148    0.8%   80    2.1%
2016   4    18,664    2.4%   149    4.0%
2017   2    7,325    0.9%   135    3.6%
2018   4    86,881    11.3%   704    18.8%
2019   2    10,576    1.4%   73    1.9%
2020   8    67,479    8.8%   416    11.1%
2021   -   -   0%   -    0%
2022   2    169,666    22.0%   573    15.3%
2023 and thereafter   12    356,184    46.2%   1,414    37.7%
Total   59    770,822    100.0%  $3,748    100.0%

 

(1)Excludes leases for parking, signs and antennae.

 

As of December 31, 2012, Gramercy Finance held five interests in real estate acquired through foreclosures, all of which are classified as held-for-sale in connection with the classification of Gramercy Finance as held for sale.

 

Leased Properties

 

Our corporate offices at 420 Lexington Avenue, New York, New York are subject to an operating lease agreement with SLG Graybar Sublease LLC, an affiliate of SL Green, effective May 1, 2005. The lease is for approximately 7,300 square feet and carries a term of 10 years with rents of approximately $249 per annum for year one rising to $315 per annum in year ten. In May and June 2009, we amended our lease with SLG Graybar Sublease LLC to increase the leased premises by approximately 2,260 square feet. The additional premises is leased on a co-terminus basis with the remainder of our leased premises and carries rents of approximately $103 per annum during the initial year and $123 per annum during the final lease year. On June 25, 2012, the lease was amended to reduce the leased premises by approximately 600 square feet and to reduce rents by approximately $29 per annum during the initial year and $38 per annum during the final lease year. All other terms of the lease remain unchanged, except we now have the right to cancel the lease with 90 days notice.

 

Our regional management office located at 610 Old York Road, Jenkintown, Pennsylvania, is subject to an operating lease with an affiliate of KBS.  The lease is for approximately 17,000 square feet, and expires on August 31, 2013, with rents of approximately $322 per annum.  Our regional management office located at 800 Market Street, St. Louis, Missouri is subject to an operating lease with St. Louis BOA Plaza, LLC.  The lease is for approximately 2,000 square feet, expires on September 30, 2013, and is cancelable with 90 days’ notice.  The lease is subject to rents of $32 per annum.

 

29
 

 

Development Plans

 

As of December 31, 2012, we have no plans for the renovation, improvement or development of our properties other than in connection with its on-going repair and maintenance and tenant leasing programs.

 

ITEM 3. LEGAL PROCEEDINGS

 

Two of the Company’s subsidiaries were named as defendants in a case filed in August 2011 captioned Colfin JIH Funding LLC and CDCF JIH Funding, LLC v. Gramercy Warehouse Funding I LLC and Gramercy Loan Services LLC in New York State Supreme Court, New York County. The dispute arose from the financing of the Jameson Inns and Signature Inns. Plaintiffs asserted a breach of contract claim under an intercreditor agreement against the subsidiaries.

 

The same two of the Company’s subsidiaries were named as defendants in a case filed in December 2011 captioned U.S. Bank National Association, as Trustee et al v. Gramercy Warehouse Funding I LLC and Gramercy Loan Services LLC in New York State Supreme Court, New York County. The dispute arose from the same financing of the Jameson Inns and Signature Inns. U.S. Bank National Association, or U.S. Bank, by and through its attorney in fact, Wells Fargo Bank, N.A., asserted a breach of contract claim against the subsidiaries.

 

In January 2013, the Company settled the claims for $5.3 million, which was fully accrued for as of December 31, 2012.

 

In addition, the Company and/or one or more of its subsidiaries is party to various litigation matters that are considered routine litigation incidental to its business, none of which are considered material.

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not applicable. 

 

30
 

 

Part II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our common stock began trading on the New York Stock Exchange, or the NYSE, on August 2, 2004 under the symbol “GKK.” On March 15, 2013, the reported closing sale price per share of common stock on the NYSE was $4.35 and there were approximately 209 holders of record of our common stock. This number does not include stockholders’ shares held in nominee or street name. The table below sets forth the quarterly high and low closing sales prices of our common stock on the NYSE for the years ended December 31, 2012 and 2011 and the distributions paid by us with respect to the periods indicated.

 

   2012   2011 
Quarter Ended  High   Low   Dividends   High   Low   Dividends 
March 31  $3.07   $2.34   $-   $5.31   $2.77   $- 
June 30  $2.68   $2.45   $-   $4.26   $2.02   $- 
September 30  $3.09   $2.31   $-   $3.72   $2.35   $- 
December 31  $3.05   $2.56   $-   $3.22   $2.50   $- 

 

If dividends are declared in a quarter, those dividends will be paid during the subsequent quarter. Beginning with the third quarter of 2008, our board of directors elected to not pay a dividend on our common stock. Additionally our board of directors elected not to pay the Series A preferred stock dividend of $0.50781 per share beginning with the fourth quarter of 2008. The unpaid Series A preferred stock dividend has been accrued for seventeen quarters as of December 31, 2012. Based on current estimates of our taxable loss, we expect that we will have no distribution requirements in order to maintain our REIT status for the 2012 tax year and we expect that we will continue to elect to retain capital for liquidity purposes; however, as our new business strategy is implemented and sustainable cash flows grow, we will re-evaluate our dividend policy with the intention of resuming dividends. In accordance with the provisions of our charter, we may not pay any dividends on our common stock until all accrued dividends and the dividend for the then current quarter on the Series A preferred stock are paid in full. We expect to continue our policy of generally distributing 100% of our taxable income through dividends, although there is no assurance as to future dividends because they depend on future earnings, capital requirements and financial condition. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Dividends” for additional information regarding our dividends.

 

In connection with Mr. Gordon F. DuGan’s agreement to serve as our Chief Executive Officer, on June 7, 2012, Mr. DuGan also agreed to purchase 1,000,000 shares of our common stock from us on June 29, 2012 for an aggregate purchase price of $2.5 million or $2.52 per share. The per share purchase price was equal to the closing price of our common stock on the New York Stock Exchange on the day prior to the date Mr. DuGan entered into the subscription agreement with us to purchase such shares of common stock. The issuance of such shares of common stock was a private placement exempt from the registration requirements of the Securities Act. We intend to use the net proceed from this issuance for general corporate purposes, which may include, but not limited to, acquisitions of single tenant lease investments.

 

We issued to KBS Acquisition Sub-Owner 2, LLC (i) 2,000,000 shares of our common stock; (ii) 2,000,000 shares of our Class B-1 non-voting common stock; and (iii) 2,000,000 shares of our Class B-2 non-voting common stock, on December 6, 2012. The shares were issued as consideration for the our contribution to the joint venture which purchased the Bank of America Portfolio on the same date and were valued at $2.75 which was the closing price of our common stock on the New York Stock Exchange as of the date of the executed purchase and sale agreement. Each share of the Class B-1 common stock and Class B-2 common stock will be convertible into one share of our common stock at the option of the holder at any time on or after September 5, 2013 and December 6, 2013, respectively. Each share of Class B-1 common stock and Class B-2 common stock that has not previously been converted and remains outstanding on March 5, 2014 shall, automatically and without any action on the part of the holder thereof, convert into one share of common stock on such date. While outstanding, each share of Class B-1 common stock and Class B-2 common stock will have identical rights to dividends and other distributions as our common stock. The issuance of such shares of common stock was a private placement exempt from the registration requirements of the Securities Act. 

 

31
 

 

Stock Performance Graph

 

This graph compares the performance of our shares with the Standard & Poor’s 500 Composite Index and the NAREIT All REIT Index. This graph assumes $100 invested on January 1, 2008 and assumes the reinvestment of dividends.

 

 

Equity Compensation Plan Information

 

The following table summarizes information, as of December 31, 2012, relating to our equity compensation plans pursuant to which shares of our common stock or other equity securities may be granted from time to time.

 

Plan Category  (a)
Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
   (b)
Weighted-average
exercise price of
outstanding
options, warrants
and rights
   (c) 
Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding securities
reflected in column (a))
 
Equity compensation plans approved by security holders (1)   360,251   $16.14    1,932,511 
Equity compensation plans not approved by security holders (2)   -    -    - 
Total   360,251   $16.14    2,432,511 

 

(1)Includes information related to our 2004 Equity Incentive Plan.
(2)Includes information related to our 2012 Inducement Equity Incentive Plan.

 

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ITEM 6. SELECTED FINANCIAL DATA

 

The following tables set forth our selected financial data and should be read in conjunction with our Financial Statements and notes thereto included in Item 8, “Financial Statements and Supplementary Data” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K. Certain prior year balances have been reclassified to conform with the current year presentation for assets classified as discontinued operations.

 

Operating Data (In thousands, except share and per share data) 

 

   For the year ended December 31, 
   2012   2011   2010   2009   2008 
Total revenues  $36,821   $7,772   $1,197   $72   $57 
Property operating expenses   23,226    5,947    4,033    4,963    4,344 
Interest expense   -    -    280    2    - 
Management fees   -    -    -    -    30,299 
Incentive fee   -    -    -    -    2,350 
Depreciation and amortization   256    136    174    251    121 
Management, general and administrative   25,446    22,150    22,369    37,365    7,190 
Total expenses   48,928    28,233    26,856    42,581    44,304 
Loss from continuing operations before equity in income (loss) from joint ventures and provision for taxes   (12,107)   (20,461)   (25,659)   (42,509)   (44,247)
Equity in net income (loss) of joint ventures   (2,904)   121    (303)   113    119 
Loss from continuing operations before provision for taxes, gain on extinguishment of debt, and discontinued operations   (15,011)   (20,340)   (25,962)   (42,396)   (44,128)
Gain on extinguishment of debt   -    -    -    106,177    - 
Provision for taxes   (3,330)   (563)   (966)   (2,534)   - 
Net income (loss) from continuing operations   (18,341)   (20,903)   (26,928)   61,247    (44,128)
Net income (loss) from discontinued operations   (153,207)   358,380    (946,615)   (581,646)   103,816 
Net income (loss)   (171,548)   337,477    (973,543)   (520,399)   59,688 
Net (income) loss attributable to non-controlling interest   -    -    (145)   770    (385)
Net income (loss) attributable to Gramercy Capital Corp.   (171,548)   337,477    (973,688)   (519,629)   59,303 
Accrued preferred stock dividends   (7,162)   (7,162)   (8,798)   (9,414)   (9,344)
Excess of carrying amount of tendered preferred stock over consideration paid   -    -    13,713    -    - 
Net income (loss) avaliable to common stockholders  $(178,710)  $330,315   $(968,773)  $(529,043)  $49,959 
Net income (loss) per common share- Basic  $(3.44)  $6.58   $(19.40)  $(10.61)  $1.06 
Net income (loss) per common share- Diluted  $(3.44)  $6.58   $(19.40)  $(10.52)  $1.06 
Basic weighted average common shares outstanding   51,976,462    50,229,102    49,923,930    49,854,174    47,205,078 
Diluted weighted average common shares and common share equivalents outstanding   51,976,462    50,229,102    49,923,930    50,306,816    47,205,078 

 

33
 

 

Balance Sheet Data (In thousands)

 

   Year ended December 31, 
   2012   2011   2010   2009   2008 
Total real estate investments, net  $23,109   $7,631   $2,226,212   $3,148,790   $3,248,461 
Loans and other lending investments, net   73    828    1,512    -    - 
Commercial mortgage-backed securities   -    -    -    -    - 
Assets held for sale, net   1,952,264    2,078,146    2,441,827    2,633,225    3,551,767 
Investment in unconsolidated joint ventures   72,742    496    3,650    84,865    93,919 
Total assets   2,168,836    2,258,330    5,491,993    6,765,437    7,818,098 
Mortgage note payable   -    -    1,640,671    1,702,155    1,833,005 
Mezzanine loans payable   -    -    549,713    553,522    580,462 
Unsecured credit facility   -    -    -    -    172,301 
Term loan, credit facility and repurchase
    facility
   -    -    -    -    48,842 
Collateralized debt obligations   -    -    -    -    - 
Junior subordinated notes   -    -    -    52,500    - 
Deferred interest debentures held by trusts
   that issued trust preferred securities
   -    -    -    -    150,000 
Total liablilites   2,420,664    2,698,760    5,984,986    6,197,919    6,785,665 
Stockholders' equity   (251,828)   (440,430)   (492,993)   567,518    1,032,433 

 

Other Data (In thousands)

 

   For the year ended December 31, 
   2012   2011   2010   2009   2008 
Funds from operations (1)  $(157,767)  $395,288   $53,283   $(417,610)  $123,495 
Cash flows provided by operating activities  $283   $87,105   $116,831   $86,960   $171,755 
Cash flows provided by (used by) investing activities  $248,288   $51,133   $154,707   $131,121   $(490,572)
Cash flows provided by (used by) financing activities  $(306,894)  $(195,358)  $(189,038)  $(216,564)  $162,519 

 

(1)We present FFO because we consider it an important supplemental measure of our operating performance and believe that it is frequently used by securities analysts, investors and other interested parties in the evaluation of REITS. We also use FFO as one of several criteria to determine performance-based incentive compensation for members of our senior management, which may be payable in cash or equity awards. The revised White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts, or NAREIT, defines FFO as net income (loss) (determined in accordance with GAAP), excluding impairment write-downs of investments in depreciable real estate and investments in in-substance real estate investments, gains or losses from debt restructurings and sales of depreciable operating properties, plus real estate-related depreciation and amortization (excluding amortization of deferred financing costs), less distributions to non-controlling interests and gains/losses from discontinued operations and after adjustments for unconsolidated partnerships and joint ventures. FFO does not represent cash generated from operating activities in accordance with GAAP and should not be considered as an alternative to net income (determined in accordance with GAAP), as an indication of our financial performance, or to cash flow from operating activities (determined in accordance with GAAP) as a measure of our liquidity, nor is it entirely indicative of funds available to fund our cash needs, including our ability to make cash distributions. Our calculation of FFO may be different from the calculation used by other companies and, therefore, comparability may be limited.

 

A reconciliation of FFO to net income computed in accordance with GAAP is provided under the heading of “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Funds from Operations.”

 

34
 

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Amounts in thousands, except for share and per share data)

 

Overview

 

Gramercy Capital Corp. is a self-managed, integrated commercial real estate investment and asset management company. In June 2012, following a strategic review process completed by a special committee of our board of directors, we announced that we will focus on deploying our capital into income-producing net leased real estate. Our new investment criteria focuses on net lease investments in markets across the United States. As of December 31, 2012, we own directly or in joint venture, a portfolio of 116 office and industrial buildings totaling approximately 4.9 million square feet, net leased on a long-term basis to tenants, including Bank of America, Nestlé Waters, Philips Electronics and others. We also have an asset and property management business which operates under the name Gramercy Asset Management (formerly Gramercy Realty) and currently manages for third-parties approximately $1.7 billion of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. Additionally, we have a commercial real estate finance business which operates under the name Gramercy Finance and manages approximately $1.7 billion of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity and commercial mortgage-backed securities, or CMBS, which are financed through three non-recourse CDOs. As described herein, in March 2013, we exited the commercial real estate finance business and sold the collateral management and sub-special servicing agreements for our CDOs which will result in the deconsolidation of Gramercy Finance from our Consolidated Balance Sheets. We have classified the assets and liabilities of the Gramercy Finance segment as assets held-for-sale and have reported the results of operations of Gramercy Finance in discontinued operations. Neither Gramercy Finance nor Gramercy Asset Management is a separate legal entity but are divisions through which our commercial real estate finance and asset and property management businesses are conducted.

 

In connection with our efforts to exit Gramercy Finance, on January 30, 2013, we entered into a purchase and sale agreement to transfer the collateral management and sub-special servicing agreements for our three CDOs to CWCapital for approximately $9.9 million, less certain adjustments and closing costs. We retained our subordinate bonds, preferred shares and ordinary shares in the CDOs, which may provide us with the potential to recoup additional proceeds over the remaining life of the CDOs based upon resolution of underlying assets within the CDOs, however, there is no guarantee that we will realize any proceeds from our equity position, or what the timing of these proceeds may be. The transaction closed in March 2013. In February 2013, we also sold a portfolio of repurchased notes previously issued by two of our three CDOs, generating cash proceeds of approximately $34.4 million. In addition, we expect to receive additional cash proceeds for past CDO servicing advances of approximately $14.0 million when specific assets within the CDOs are liquidated. We believe that the sale of the collateral management and sub-special servicing agreements and sale of repurchased notes of our CDOs achieves a number of important objectives, including, (i) maximizing the value of the servicing business through the sale to a large servicing operation (ii) simplifying our going-forward business and significantly reducing our ongoing management, general and administrative expenses through elimination of CDO related personnel costs and servicing advance requirements; (iii) generating in excess of $50.0 million in liquidity currently invested in the CDO business; and (iv) providing for potential future proceeds through the retention of the equity in the CDOs. Immediately subsequent to the transfer of the collateral management and sub-special serving agreements, the assets and liabilities of the corresponding CDOs will be deconsolidated from our financial statements.

 

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and generally will not be subject to U.S. federal income taxes to the extent we distribute our taxable income, if any, to our stockholders. We have in the past established, and may in the future establish taxable REIT subsidiaries, or TRSs, to effect various taxable transactions. Those TRSs would incur U.S. federal, state and local taxes on the taxable income from their activities.

 

We conduct substantially all of our operations through our operating partnership, GKK Capital LP, or our Operating Partnership. We are the sole general partner of our Operating Partnership. Our Operating Partnership conducts our finance business primarily through two private REITs, Gramercy Investment Trust and Gramercy Investment Trust II; our commercial real estate investment business through various wholly-owned entities; and our realty management business through a wholly-owned TRS.

 

Unless the context requires otherwise, all references to “Gramercy,” “our Company,” “we,” “our” and “us” mean Gramercy Capital Corp., a Maryland corporation, and one or more of its subsidiaries, including our Operating Partnership.

 

Our principal business strategy is to acquire real estate assets that generate stable, recurring cash flows with minimal outgoing capital expenditures. We also general cash flows from management fees related to the management of commercial real estate for third-parties. For the near-term, these cash flows are used to fund our continuing operations and we intend to retain any excess cash flow to grow our investment portfolio. Once we achieve sufficient scale, we expect to resume cash distributions to our preferred and common stockholders.

 

35
 

 

Property Investment

 

In August 2012, we formed a joint venture with an affiliate of Garrison. Subsequently, in December 2012, we contributed approximately $59,061 in cash plus the issuance of 6,000,000 shares of our common stock, valued at $15,000 as of the date of the execution of the purchase agreement to acquire a 50% equity interest in the joint venture’s acquisition of an office portfolio of 113 properties, or the Bank of America Portfolio, from KBS. The acquisition was financed with a $200,000 two-year, floating rate, interest-only mortgage loan with a spread to 30-day LIBOR of 4.15%, collateralized by 67 properties of the portfolio. The mortgage contains three one-year extensions conditional upon the satisfaction of certain terms. The Bank of America Portfolio was previously part of the Gramercy Asset Management division, beneficial ownership of which was transferred to KBS pursuant to a collateral transfer and settlement agreement dated September 1, 2011. The Bank of America Portfolio totals approximately 4.2 million rentable square feet and is 84% leased to Bank of America, N.A., under a master lease expiring in 2023, with a total portfolio occupancy of approximately 89%. The joint venture’s asset strategy for this portfolio acquisition is to sell non-core multi-tenant assets and retain a core net-lease portfolio of high quality assets in primary and strong secondary markets, primarily leased to Bank of America. In addition to our pro rata share of the net income of the portfolio, pursuant to the joint venture agreement, we will receive an asset management fee as well as a performance based fee for the portfolio management.

 

In November 2012, we also acquired two Class A industrial properties located near Indianapolis, Indiana, or the Indianapolis Industrial Portfolio, totaling approximately 540,000 square feet for a purchase price of $27,125. The Indianapolis Industrial Portfolio is 100% leased to three tenants for an average lease term of approximately 10.2 years.

 

We own a 25% interest in the equity owner of a fee interest in 200 Franklin Square Drive, a 200,000 square foot building located in Somerset, New Jersey which is 100% net leased to Philips Holdings, USA Inc., a wholly-owned subsidiary of Royal Philips Electronics through December 2021.

 

Asset and Property Management

 

Our asset and property management business, which operates under the name Gramercy Asset Management, currently manages for third-parties, approximately $1,700,000 of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. In 2011, the business of Gramercy Asset Management changed from being primarily an owner of commercial properties to being primarily a third-party manager of commercial properties. The scale of Gramercy Asset Management’s revenues declined as a substantial portion of rental revenues from properties owned by us, were replaced with fee revenues of a substantially smaller scale for managing properties for third-parties.

 

During 2011, we sought to extend or restructure Gramercy Asset Management’s $240,523 Goldman Mortgage Loan, and Gramercy Asset Management’s $549,713 Goldman Mezzanine Loans. The Goldman Mortgage Loan was collateralized by approximately 195 properties held by Gramercy Asset Management and the Goldman Mezzanine Loans were collateralized by the equity interest in substantially all of the entities comprising our Gramercy Asset Management division, including its cash and cash equivalents. Subsequent to the final maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans, we entered into a series of short term extensions to provide additional time to exchange and consider proposals for an extension, modification, restructuring or refinancing of the Goldman Mortgage Loan and the Goldman Mezzanine Loans and to explore an orderly transition of the collateral to the lenders if such discussions failed. On May 9, 2011, we announced that the scheduled maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans occurred without repayment and without an extension or restructuring of the loans by the lenders.

 

Notwithstanding the maturity and non-repayment of the loans, we maintained active communications with the lenders and in September 2011, we entered into the Settlement Agreement, for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, Gramercy Asset Management’s senior mezzanine lender, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among us and the mortgage and mezzanine lenders and, subject to certain termination provisions, our continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, we transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that we agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011.

 

In September 2011, we entered into an asset management arrangement upon the terms and conditions set forth in the Settlement Agreement, or the Interim Management Agreement, to provide for our continued management of the KBS portfolio through December 31, 2013 for a fixed fee of $10,000 annually, plus the reimbursement of certain costs. The Settlement Agreement obligated the parties to negotiate in good faith to replace the Interim Management Agreement with a more complete and definitive management services agreement on or before March 31, 2012 and on March 30, 2012, we entered into an Asset Management Services Agreement, or the Management Agreement, with KBS Acquisition Sub, LLC, or KBSAS, a wholly-owned subsidiary of KBS Real Estate Investment Trust, Inc., or KBS REIT, pursuant to which the Company provides asset management services to KBSAS with respect to the transferred properties, or the KBS Portfolio. The Management Agreement provides for continued management of the KBS Portfolio by GKK Realty Advisors, LLC, or the Manager, through December 31, 2015 for (i) a base management fee of $12,000 per year, payable monthly, plus the reimbursement of all property related expenses paid by Manager on behalf of KBSAS, subject to deferral of $167 per month at KBSAS’s option until the accrued amount equals $2,500 or June 30, 2013, whichever is earlier, and (ii) an incentive fee, or the Threshold Value Profits Participation, in an amount equal to the greater of: (a) $3,500 or (b) 10% of the amount, if any, by which the portfolio equity value exceeds $375,000 (as adjusted for future cash contributions into, and distributions out of, KBSAS by KBS REIT). In December 2012, concurrently with the purchase of the Bank of America Portfolio by our joint venture with Garrison, the base management fee of the Management Agreement was reduced by $3,000 per year to $9,000 per year, which was partially offset by the asset management fee we receive from Garrison. In any event, the Threshold Value Profits Participation is capped at a maximum of $12,000. The Threshold Value Profits Participation is payable 60 days after the earlier to occur of June 30, 2014 (or March 31, 2015 upon satisfaction of certain extension conditions, including the payment by KBSAS to Manager of a $750 extension fee) and the date on which KBSAS, directly or indirectly, sells, conveys or otherwise transfers at least 90% of the KBS Portfolio (by value).

 

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We may terminate the Management Agreement (i) without any KBSAS default under the Management Agreement, on or after December 31, 2012, upon 90 days’ prior written notice or (ii) at any time by five business days’ prior written notice in the event of a KBSAS default under the Management Agreement. The Management Agreement may be terminated by KBSAS, (i) without cause (as defined in the Management Agreement), with an effective termination date of March 31 or September 30 of any year but at no time prior to September 30, 2013, upon 90 days’ prior written notice or (ii) at any time after April 1, 2013 for cause. In the event of a termination of the Management Agreement by KBSAS after April 1, 2013 but prior to December 31, 2015, we will be entitled to receive a declining balance termination fee, ranging from $5,000 to $2,000, calculated as specified in the Management Agreement.

 

Commercial Real Estate Finance

 

Our commercial real estate finance business operates under the name Gramercy Finance. We have invested in and manage a diversified portfolio of $1,700,000 of real estate loans, including whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, CMBS and preferred equity involving commercial properties throughout the United States. As of December 31, 2012, Gramercy Finance also held interests in five real estate properties acquired through foreclosures. Substantially, all of the investments managed by Gramercy Finance were financed through three non-recourse CDOs. As further described below, in March 2013, we exited the commercial real estate finance business and sold the collateral management and sub-special servicing agreements for our CDOs which will result in the deconsolidation of Gramercy Finance from our Consolidated Balance Sheets. We have classified the assets and liabilities of the Gramercy Finance segment as assets held-for-sale and have reported the results of operations of Gramercy Finance in discontinued operations.

 

On January 30, 2013, we entered into a purchase and sale agreement to transfer the collateral management and sub-special servicing agreements for our CDOs, to CWCapital for approximately $9,900, less certain adjustments and closing costs. We retained our subordinate bonds, preferred shares and ordinary shares in the CDOs, which may provide us with the potential to recoup additional proceeds over the remaining life of the CDOs based upon resolution of underlying assets within the CDOs, however, there is no guarantee that we will realize any proceeds from our equity position, or what the timing of those proceeds might be. The transaction closed on March 15, 2013.

 

In connection with the sale, we recognized impairment charges of $27,180 within discontinued operations on loans and real estate investments to adjust the carrying value to the lower of cost or market. We also recognized other-than-temporary impairments of $128,087 within discontinued operations as we could no longer could express the intent to hold CMBS that were in an unrealized loss position long enough to recover amortized cost.

 

Critical Accounting Policies

 

The following discussion related to our Consolidated Financial Statements should be read in conjunction with the financial statements appearing in Item 8 of this Annual Report on Form 10-K.

 

Our discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, known as GAAP. These accounting principles require us to make some complex and subjective decisions and assessments. Our most critical accounting policies involve decisions and assessments, which could significantly affect our reported assets, liabilities and contingencies, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time and made based upon information available to us at that time. We evaluate these decisions and assessments on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. We have identified our most critical accounting policies to be the following:

  

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Variable Interest Entities

 

Consolidated VIEs

 

As of December 31, 2012, the consolidated balance sheet includes $1,913,353 of assets and $2,374,516 of liabilities related to three consolidated VIEs, which are classified as held-for-sale. Due to the non-recourse nature of these VIEs, and other factors discussed below, our net exposure to loss from investments in these entities is limited to our beneficial interests in these VIEs.

 

Collateralized Debt Obligations

 

We consolidate three collateralized debt obligations, or CDOs, which are VIEs and which are included in Gramercy Finance and are classified as held-for-sale. Since we are the collateral manager of the three CDOs and can make decisions related to the collateral that would most significantly impact the economic outcome of the CDOs, we have concluded that we are the primary beneficiary of the CDOs as of December 31, 2012. These CDOs invest in commercial real estate debt instruments, the majority of which we originated within the CDOs, and are financed by the debt and equity issued. We are the collateral manager of all three CDOs. As a result of consolidation, our subordinate debt and equity ownership interests in these CDOs have been eliminated, and the Consolidated Balance Sheets reflects both the assets held and debt issued by these CDOs to third-parties. Similarly, the operating results and cash flows include the gross amounts related to the assets and liabilities of the CDOs, as opposed to our net economic interests in these CDOs. Refer to Note 6 for further discussion of fees earned related to the management of the CDOs.

 

Our interest in the assets held by these CDOs is restricted by the structural provisions of these entities, and the recovery of these assets will be limited by the CDOs’ distribution provisions, which are subject to change due to non-compliance with covenants, which are described further in Note 6. The liabilities of the CDO trusts are non-recourse, and can generally only be satisfied from the respective asset pool of each CDO.

 

We are not obligated to provide any financial support to these CDOs. As of December 31, 2012, we have no exposure to loss as a result of the investment in these CDOs.

 

Unconsolidated VIEs

 

Investment in Commercial Mortgage-Backed Securities

 

We have investments in CMBS, which are considered to be VIEs. The majority of our securities portfolio, with an aggregate face amount of $1,179,802, is financed by our CDOs, and are included in Gramercy Finance and are classified as held-for-sale. We have not consolidated the aforementioned CMBS investments due to the determination that based on the structural provisions and nature of each investment, we do not directly control the activities that most significantly impact the VIEs’ economic performance. Our exposure to loss is limited to our interests in the consolidated CDOs described above.

 

Real Estate Investments

 

We record acquired real estate investments at cost. Costs directly related to the acquisition of such investments are expensed as incurred. We allocate the purchase price of real estate to land, building and intangibles, such as the value of above-, below- and at-market leases and origination costs associated with the in-place leases at the acquisition date. The values of the above- and below-market leases are amortized and recorded as either an increase in the case of below-market leases or a decrease in the case of above-market leases to rental income over the remaining term of the associated lease. The values associated with in-place leases are amortized over the expected term of the associated lease. We assess the fair value of the leases at acquisition based upon estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known trends, and market/economic conditions that may affect the property. To the extent acquired leases contain fixed rate renewal options that are below-market and determined to be material, we amortize such below-market lease value into rental income over the renewal period.

 

Certain improvements are capitalized when they are determined to increase the useful life of the building. Depreciation is computed using the straight-line method over the shorter of the estimated useful life of the capitalized item or 40 years for buildings, five to ten years for building equipment and fixtures, and the lesser of the useful life or the remaining lease term for tenant improvements and leasehold interests. Maintenance and repair expenditures are charged to expense as incurred.

 

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In leasing office space, we may provide funding to the lessee through a tenant allowance. In accounting for tenant allowances, we determine whether the allowance represents funding for the construction of leasehold improvements and evaluate the ownership of such improvements. If we are considered the owner of the leasehold improvements, we capitalize the amount of the tenant allowance and depreciate it over the shorter of the useful life of the leasehold improvements or the lease term. If the tenant allowance represents a payment for a purpose other than funding leasehold improvements, or in the event we are not considered the owner of the improvements for accounting purposes, the allowance is considered to be a lease incentive and is recognized over the lease term as a reduction of rental revenue. Factors considered during this evaluation usually include (i) who holds legal title to the improvements, (ii) evidentiary requirements concerning the spending of the tenant allowance, and (iii) other controlling rights provided by the lease agreement (e.g. unilateral control of the tenant space during the build-out process). Determination of the accounting for a tenant allowance is made on a case-by-case basis, considering the facts and circumstances of the individual tenant lease.

 

We also review the recoverability of the property’s carrying value when circumstances indicate a possible impairment of the value of a property. The review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as changes in strategy resulting in an increased or decreased holding period, expected future operating income, market and other applicable trends and residual value, as well as the effects of leasing demand, competition and other factors. If management determines impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property for properties to be held and used and for assets held for sale, an impairment loss is recorded to the extent that the carrying value exceeds the fair value less estimated cost to dispose for assets held for sale. These assessments are recorded as an impairment loss in our Consolidated Statements of Comprehensive Income (loss) in the period the determination is made. The estimated fair value of the asset becomes its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated or amortized over the remaining useful life of that asset.

 

During 2012, we recorded impairment charges of $35,043 related to real estate, of which $26,298 was related to real estate classified as held-for-sale in connection with the disposal of Gramercy Finance. During 2011, we recorded impairment charges of $1,237 related to our investments in real estate. These properties were reclassified as discontinued operations as part of the Settlement Agreement with KBS.

 

During 2010, we recorded impairment charges of $933,884 related to our investments in real estate, including $85,294 of impairments on intangible assets. Impairment charges for properties classified as held for investment were $913,648 and $20,236 has been recorded on properties reclassified as discontinued operations. We recorded impairment charges totaling $912,147 in continuing operations during 2010 to reduce the carrying value of 692 properties to estimated fair value. All of the impaired properties served as collateral for the Goldman Mezzanine Loans and are part of the Gramercy Asset Management portfolio. We also recorded impairment charges on three leasehold properties totaling $1,501 based on the difference between estimated cash flow shortfalls over the sub-tenants’ lease term. No other real estate assets in the portfolio were determined to be impaired as of December 31, 2010 as a result of the analysis. The estimated fair values for the properties serving as collateral for the Goldman Mezzanine loans were calculated using discounted cash flows based on internally developed models and residual values calculated with capitalization rates utilizing a study completed by a third-party property management provider for similar types of buildings. We used a range of possible future outcomes or a probability-weighted approach to determine the proper timing of the impairment. We determined that, as of December 31, 2010, based on a likelihood of the range of possible outcomes and the probability-weighted cash flows, our investments in real estate were impaired.

 

Investments in Joint Ventures

 

We account for our investments in joint ventures under the equity method of accounting since we exercise significant influence, but do not unilaterally control the entities, and we are not considered to be the primary beneficiary. In the joint ventures, the rights of the other investors are protective and participating. Unless we are determined to be the primary beneficiary, these rights preclude us from consolidating the investments. The investments are recorded initially at cost as an investment in joint ventures, and subsequently are adjusted for equity in net income (loss) and cash contributions and distributions. Any difference between the carrying amount of the investments on our balance sheet and the underlying equity in net assets is evaluated for impairment at each reporting period. None of the joint venture debt is recourse to us. As of December 31, 2012 and 2011, we had investments of $131,986 and $496 in joint ventures, respectively of which $59,244 were classified as held-for-sale in connection with the disposal of Gramercy Finance at December 31, 2012.

 

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Assets Held-for-Sale

 

In connection with our efforts to exit Gramercy Finance and the commercial real estate finance business, we classified the assets and liabilities of Gramercy Finance as held-for-sale. As of December 31, 2012, we had assets classified as held-for-sale of $1,952,264 related to the disposal of Gramercy Finance. We recorded impairment charges of $27,180 within discontinued operations on loans and real estate investments to adjust the carrying value to the lower of cost or fair value and other-than-temporary impairments of $128,087 within discontinued operations as we no longer could express the intent to hold CMBS investments until the recovery of amortized cost for all CMBS in an unrealized loss position. For a further discussion regarding the measurement of financial instruments and real estate assets of the Gramercy Finance segment see Note 11, “Fair Value of Financial Instruments” and Note 3 “Dispositions and Assets Held-for-Sale”.

  

Real estate investments to be disposed of are reported at the lower of carrying amount or estimated fair value, less costs to sell. Once an asset is classified as held-for-sale, depreciation expense is no longer recorded and current and prior periods are reclassified as “discontinued operations.” As of December 31, 2012 and 2011, we had real estate investments held-for-sale of $88,806 and $42,965, respectively. We recorded impairment charges of $35,043, $1,237 and $20,236 during the years ended December 31, 2012, 2011 and 2010, respectively, related to real estate investments classified as held-for-sale.

 

Settlement of Debt

 

A gain on settlement of debt is recorded when the carrying amount of the liability settled exceeds the fair value of the assets transferred to the lender or special servicer. In 2012, we did not recognize any gain on settlement of debt.

 

Pursuant to the execution of the Settlement Agreement, the transfer of 867 Gramercy Asset Management properties, with an aggregate carrying value of $2,631,902 and associated mortgage, mezzanine and other liabilities of $2,843,345, occurred in September and December 2011 and we recognized a gain on settlement of debt of $285,634 in connection with such transfer as part of discontinued operations. The gain on settlement of debt includes $54,083 of gain on disposal of assets. During the year ended December 31, 2011, we recorded $2,489 of legal and professional fees related to the restructuring of the Goldman Mortgage Loan and the Goldman Mezzanine Loans.

 

In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. We recognized gain on settlement of debt of $74,191 year ended December 31, 2011 as part of discontinued operations. We realized a $15,892 gain on the disposal the assets, which is included in the gain on settlement of debt.

 

Tenant and Other Receivables

 

Tenant and other receivables are primarily derived from the rental income that each tenant pays in accordance with the terms of its lease, which is recorded on a straight-line basis over the initial term of the lease. Since many leases provide for rental increases at specified intervals, straight-line basis accounting requires us to record a receivable, and include in revenues, unbilled rent receivables that will only be received if the tenant makes all rent payments required through the expiration of the initial term of the lease. Tenant and other receivables also include receivables related to tenant reimbursements for common area maintenance expenses and certain other recoverable expenses that are recognized as revenue in the period in which the related expenses are incurred.

 

Tenant and other receivables are recorded net of the allowances for doubtful accounts, which as of December 31, 2012 and December 31, 2011 were $211 and $280, respectively. We continually review receivables related to rent, tenant reimbursements and unbilled rent receivables and determine collectability by taking into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectability of a receivable is in doubt, we increase the allowance for doubtful accounts or record a direct write-off of the receivable.

 

Intangible Assets

 

We follow the purchase method of accounting for business combinations. We allocate the purchase price of acquired properties to tangible and identifiable intangible assets acquired based on their respective fair values. Tangible assets include land, buildings and improvements on an as-if-vacant basis. We utilize various estimates, processes and information to determine the as-if-vacant property value. Estimates of value are made using customary methods, including data from appraisals, comparable sales, discounted cash flow analysis and other methods. Identifiable intangible assets include amounts allocated to acquired leases for above- and below-market lease rates and the value of in-place leases.

 

Above-market and below-market lease values for properties acquired are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between the contractual amount to be paid pursuant to each in-place lease and management’s estimate of the fair market lease rate for each such in-place lease, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. The capitalized below-market lease values are amortized as an increase to rental income over the initial term of the respective leases. If a tenant vacates its space prior to the contractual termination of the lease and no rental payments are being made on the lease, any unamortized balance of the related intangible will be written off.

 

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The aggregate value of intangible assets related to in-place leases is primarily the difference between the property valued with existing in-place leases adjusted to market rental rates and the property valued as-if-vacant. Factors considered by management in its analysis of the in-place lease intangibles include an estimate of carrying costs during the expected lease-up period for each property taking into account current market conditions and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the anticipated lease-up period, which is expected to average six months. We also estimate costs to execute similar leases including leasing commissions, legal and other related expenses. The value of in-place leases is amortized to expense over the initial term of the respective leases, which range primarily from one to 20 years. In no event does the amortization period for intangible assets exceed the remaining depreciable life of the building. If a tenant terminates its lease, the unamortized portion of the in-place lease value is charged to expense.

 

In making estimates of fair values for purposes of allocating purchase price, we utilize a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property and other market data. We also consider information obtained about each property as a result of its pre-acquisition due diligence, as well as subsequent marketing and leasing activities, in estimating the fair value of the tangible and intangible assets acquired and intangible liabilities assumed.

 

Valuation of Financial Instruments

 

ASC 820-10, “Fair Value Measurements and Disclosures,” among other things, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, fair values are not necessarily indicative of the amounts that we could realize on disposition of the financial instruments. Financial instruments with readily available actively quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and will require a lesser degree of judgment to be utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have less, or no, pricing observability and will require a higher degree of judgment to be utilized in measuring fair value. Pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair value amounts.

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. The level of pricing observability generally correlates to the degree of judgment utilized in measuring the fair value of financial instruments. The less judgment utilized in measuring fair value financial instruments such as with readily available actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability. Conversely, financial instruments rarely traded or not quoted have less observability and are measured at fair value using valuation models that require more judgment. Impacted by a number of factors, pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.

 

The three broad levels defined are as follows:

 

Level I — This level is comprised of financial instruments that have quoted prices that are available in active markets for identical assets or liabilities. The types of financial instruments included in this category are highly liquid instruments with actively quoted prices.

 

Level II — This level is comprised of financial instruments that have pricing inputs other than quoted prices in active markets that are either directly or indirectly observable. The nature of these financial instruments includes instruments for which quoted prices are available but traded less frequently and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.

 

Level III — This level is comprised of financial instruments that have little to no pricing observability as of the reported date. These financial instruments do not have active markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment and assumptions. Instruments that are generally included in this category are derivatives, whole loans, subordinate interests in whole loans and mezzanine loans.

 

CMBS securities and derivative instruments are carried at fair value, and are considered Level III. For more details, refer to Note 11 in the accompanying financials statements.

 

At December 31, 2011, we measured CMBS securities and derivative instruments at fair value on a recurring basis. We calculated the fair value using Level III inputs that required management to make significant judgments and assumptions.

 

CMBS available for sale:  The fair values of our available for sale CMBS securities are generally valued by a combination of (i) obtaining assessments from third-party dealers; and, (ii) pricing services who use combination of market-based inputs along with unobservable inputs that require significant judgment, such as assumptions on the underlying loans regarding net property operating income, capitalization rates, debt service coverage ratios and loan-to-value default thresholds, timing of workouts and recoveries, and loan loss severities. Third-party dealer marks, which are used to value the majority of our CMBS securities, are indications received from dealers in the respective security, from which we could transact at on the valuation date. We use all data points obtained, including comparable trades completed by us or available in the market place in determining our fair value of CMBS. Pricing service models are designed to replicate a market view of the underlying collateral, however, the models are most sensitive to the unobservable inputs such as timing of loan defaults and severity of loan losses and significant increases (decreases) in any of those inputs in isolation as well as any change in the expected timing of those inputs, would result in a significantly lower (higher) fair value measurement.

 

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Derivative instruments:  Fair values of our derivative instruments are valued using advice from a third-party derivative specialist, based on a combination of observable market-based inputs, such as interest rate curves, and unobservable inputs such as credit valuation adjustments due to the risk of non-performance.

 

At December 31, 2012, we measured real estate investments and loans subject to impairment or reserves for loan loss at fair value on a nonrecurring basis.

 

Real Estate investments:  The real estate investments identified for impairment have been classified as assets held-for-sale. The impairment on properties classified as held-for-sale is calculated by comparing unsolicited purchase offers to the carrying value of the respective property. The marketing valuations are based on internally developed discounted cash flow models which include assumptions that require significant management judgment regarding capitalization rates, lease-up periods, future occupancy rates, market rental rates, holding periods, capital improvements and other factors deemed necessary by management. The impairment is calculated by comparing our internally developed discounted cash flow methodology to the carrying value of the respective property.

 

Loans subject to impairments or reserves for loan loss:  The loans identified for impairment or reserves for loan loss are collateral dependent loans. Impairment or reserves for loan loss are measured by comparing management’s estimation of fair value of the underlying collateral to the carrying value of the respective loan. These valuations require significant judgments, which include assumptions regarding capitalization rates, leasing, creditworthiness of major tenants, occupancy rates, availability of financing, exit plan, loan sponsorship, actions of other lenders and other factors deemed necessary by management.

 

The valuations of financial instruments derived from pricing models may include adjustments to the financial instruments. These adjustments may be made when, in management’s judgment, either the size of the position in the financial instrument or other features of the financial instrument such as its complexity, or the market in which the financial instrument is traded (such as counterparty, credit, concentration or liquidity) require that an adjustment be made to the value derived from the pricing models. Additionally, an adjustment from the price derived from a model typically reflects management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider such an adjustment in pricing that same financial instrument.

 

Assets and liabilities presented at fair value and categorized as Level III are generally those that are marked to model using relevant empirical data to extrapolate an estimated fair value. The models’ inputs reflect assumptions that market participants would use in pricing the instrument in a current period transaction and outcomes from the models represent an exit price and expected future cash flows. The parameters and inputs are adjusted for assumptions about risk and current market conditions. Changes to inputs in valuation models are not changes to valuation methodologies; rather, the inputs are modified to reflect direct or indirect impacts on asset classes from changes in market conditions. Accordingly, results from valuation models in one period may not be indicative of future period measurements.

 

Revenue Recognition

 

Real Estate Investments

 

Rental income from leases is recognized on a straight-line basis regardless of when payments are contractually due. Certain lease agreements also contain provisions that require tenants to reimburse us for real estate taxes, common area maintenance costs and the amortized cost of capital expenditures with interest. Such amounts are included in both revenues and operating expenses when we are the primary obligor for these expenses and assume the risks and rewards of a principal under these arrangements. Under leases where the tenant pays these expenses directly, such amounts are not included in revenues or expenses.

 

Deferred revenue represents rental revenue and management fees received prior to the date earned. Deferred revenue also includes rental payments received in excess of rental revenues recognized as a result of straight-line basis accounting.

 

Other income includes fees paid by tenants to terminate their leases, which are recognized when fees due are determinable, no further actions or services are required to be performed by us, and collectability is reasonably assured. In the event of early termination, the unrecoverable net book values of the assets or liabilities related to the terminated lease are recognized as depreciation and amortization expense in the period of termination.

 

We recognize sales of real estate properties only upon closing. Payments received from purchasers prior to closing are recorded as deposits. Profit on real estate sold is recognized using the full accrual method upon closing when the collectability of the sale price is reasonably assured and we are not obligated to perform significant activities after the sale. Profit may be deferred in whole or part until the sale meets the requirements of profit recognition on sale of real estate.

 

Finance Investments

 

At December 31, 2012, our loans, other lending investments and CMBS are classified as held-for-sale in connection with the disposal of Gramercy Finance.

 

Interest income on debt investments is recognized over the life of the investments using the effective interest method and recognized on the accrual basis. Fees received in connection with loan commitments are deferred until the loan is funded and are then recognized over the term of the loan using the effective interest method. Anticipated exit fees, whose collection is expected, are also recognized over the term of the loan as an adjustment to yield. Fees on commitments that expire unused are recognized at expiration. Fees received in exchange for the credit enhancement of another lender, either subordinate or senior to us, in the form of a guarantee are recognized over the term of that guarantee using the straight-line method. 

 

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Income recognition is generally suspended for debt investments at the earlier of the date at which payments become 90 days past due or when, in our opinion, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed.

 

Reserve for Loan Losses

 

Specific valuation allowances are established for loan losses on loans in instances where it is deemed probable that we may be unable to collect all amounts of principal and interest due according to the contractual terms of the loan. The reserve is increased through the provision for loan losses on our Consolidated Statements of Operations and Comprehensive Income (Loss) and is decreased by charge-offs when losses are realized through sale, foreclosure, or when significant collection efforts have ceased. The determination of when significant collection efforts have ceased is based upon management’s assumption and judgments regarding the probability of a successful remediation and is based upon factors such as the nature of the underlying collateral or existence of additional collateral, borrower experience, financial strength, investment track record, and borrower credit.

 

We consider the present value of payments expected to be received, observable market prices, or the estimated fair value of the collateral (for loans that are dependent on the collateral for repayment), and compare it to the carrying value of the loan. The determination of the estimated fair value is based on the key characteristics of the collateral type, collateral location, quality and prospects of the sponsor, the amount and status of any senior debt, and other factors. We also include the evaluation of operating cash flow from the property during the projected holding period, and the estimated sales value of the collateral computed by applying an expected capitalization rate to the stabilized net operating income of the specific property, less selling costs, all of which are discounted at market discount rates. We also consider if the loan’s terms have been modified in a troubled debt restructuring. Because the determination of estimated value is based upon projections of future economic events, which are inherently subjective, amounts ultimately realized from loans and investments may differ materially from the carrying value at the balance sheet date.

 

Commercial Mortgage-Backed Securities

 

In connection with the disposal of Gramercy Finance, as of December 31, 2012 we could no longer express the intent to hold our CMBS securities in an unrealized loss position until the amortized cost basis is recovered, and as such we recognized an other-than-temporary impairment for all CMBS securities in an unrealized loss position equal to the entire difference between the amortized cost basis and the fair value.

 

On the date of acquisition of the CMBS securities, we determine the appropriate accounting model for impairment and revenue recognition based on our assessment of the risk of loss. We have designated our entire CMBS securities portfolio as available-for-sale. Securities that are considered to have a remote risk of loss are those securities that we have determined are of high credit quality and are sufficiently collateralized to protect the acquired class from losses.

 

Prior to the fourth quarter of 2012, when we could express the intent and ability to hold our available-for-sale CMBS securities until maturity, unrealized losses that were, in the judgment of management, other-than-temporarily impaired were bifurcated into (i) the amount related to credit losses and (ii) the amount related to all other factors. The evaluation included a review of the credit status and the performance of the collateral supporting those securities, including key terms of the securities and the effect of local, industry and broader economic trends. The portion of the other-than-temporary impairment related to credit losses was computed by comparing the amortized cost of the investment to the present value of cash flows expected to be collected and was charged against earnings. The portion of the other-than-temporary impairment related to all other factors was recognized as a component of other comprehensive loss. The determination of an other-than-temporary impairment is a subjective process, and different judgments and assumptions could affect the timing of loss realization. We calculated a revised yield based on the current amortized cost of the investment (including any other-than-temporary impairments recognized to date) and the revised yield was then applied prospectively to recognize interest income. Assumptions about future cash flows consider reasonable management judgment about the probability that the holder of an asset will be unable to collect all amounts due.

 

We also assess securities which are not of high credit quality on a quarterly basis to determine whether significant changes in estimated cash flows or unrealized losses on these securities, if any, reflect a decline in value which is other-than-temporary. On a quarterly basis, we review the changes in expected cash flows on these securities, and if there was a material decrease in estimated cash flows and the security was in an unrealized loss position, we recorded an other-than-temporary impairment. If the security was in an unrealized gain position and there was a material decrease or increase in expected cash flows, we prospectively adjusted the yield using the effective yield method.

 

Upon the disposition of a CMBS investment designated as available-for-sale, the unrealized gain or loss recognized in accumulated other comprehensive income is reversed. A realized gain or loss is computed by comparing the amortized cost of the CMBS investment sold to the cash proceeds received, and the resultant gain or loss is recorded in other income.

 

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Rent Expense

 

Rent expense is recognized on a straight-line basis regardless of when payments are due. Accounts payable and accrued expenses in the accompanying Consolidated Balance Sheets as of December 31, 2012 and 2011 includes an accrual for rental expense recognized in excess of amounts due at that time. Rent expense related to leasehold interests is included in property operating expenses, and rent expense related to office rentals is included in management, general and administrative expense.

 

Stock-Based Compensation Plans

 

We have a stock-based compensation plan, described more fully in Note 12. We account for this plan using the fair value recognition provisions. We use the Black-Scholes option-pricing model to estimate the fair value of a stock option award. This model requires inputs such as expected term, expected volatility, and risk-free interest rate. Further, the forfeiture rate also impacts the amount of aggregate compensation cost. These inputs are highly subjective and generally require significant analysis and judgment to develop.

 

Compensation cost for stock options, if any, is recognized ratably over the vesting period of the award. Our policy is to grant options with an exercise price equal to the quoted closing market price of our stock on the business day preceding the grant date. Awards of stock or restricted stock are expensed as compensation on a current basis over the benefit period.

 

The fair value of each stock option granted is estimated on the date of grant for options issued to employees, and quarterly for options issued to non-employees, using the Black-Scholes option pricing model with the following weighted average assumptions for grants in 2012 and 2011.

 

     2012     2011 
Dividend yield   5.0%    5.9% 
Expected life of option   5.0 years    5.0 years 
Risk-free interest rate   0.89%    2.02% 
Expected stock price volatility   80.0%    105.0% 

 

Derivative Instruments

 

In the normal course of business, we use a variety of derivative instruments to manage, or hedge, interest rate risk. We require that hedging derivative instruments be effective in reducing the interest rate risk exposure that they are designated to hedge. This effectiveness is essential for qualifying for hedge accounting. Instruments that meet these hedging criteria are formally designated as hedges at the inception of the derivative contract. We use a variety of commonly used derivative products that are considered “plain vanilla” derivatives. These derivatives typically include interest rate swaps, caps, collars and floors. We expressly prohibit the use of unconventional derivative instruments and using derivative instruments for trading or speculative purposes. Further, we have a policy of only entering into contracts with major financial institutions based upon their credit ratings and other factors.

 

To determine the fair value of derivative instruments, we use a variety of methods and assumptions that are based on market conditions and risks existing at each balance sheet date. For the majority of financial instruments including most derivatives, long-term investments and long-term debt, standard market conventions and techniques such as discounted cash flow analysis, option-pricing models, replacement cost and termination cost are used to determine fair value. All methods of assessing fair value result in a general approximation of value, and such value may never actually be realized.

 

In the normal course of business, we are exposed to the effect of interest rate changes and limit these risks by following established risk management policies and procedures including the use of derivatives. To address exposure to interest rates, we use derivatives primarily to hedge cash flow variability caused by interest rate fluctuations of our liabilities.

 

We recognize all derivatives on the balance sheet at fair value. Derivative instruments that are assets and liabilities of the CDOs are classified as held-for-sale in connection with the disposal of Gramercy Finance. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability or firm commitment through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. Derivative accounting may increase or decrease reported net income and stockholders’ equity prospectively, depending on future levels of LIBOR, swap spreads and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on cash flows, provided the contract is carried through to full term.

 

All hedges held by us are deemed effective based upon the hedging objectives established by our corporate policy governing interest rate risk management. The effect of our derivative instruments on our financial statements is discussed more fully in Note 6.

 

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Income Taxes

 

We elected to be taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code, beginning with our taxable year ended December 31, 2004. To qualify as a REIT, we must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our ordinary taxable income, if any, to stockholders. As a REIT, we generally will not be subject to U.S. federal income tax on taxable income that we distribute to our stockholders. If we fail to qualify as a REIT in any taxable year, we will then be subject to U.S. federal income taxes on our taxable income at regular corporate rates and we will not be permitted to qualify for treatment as a REIT for U.S. federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service grants us relief under certain statutory provisions. Such an event could materially adversely affect our net income and net cash available for distributions to stockholders. However, we believe that we will be organized and operate in such a manner as to qualify for treatment as a REIT and we intend to operate in the foreseeable future in such a manner so that we will qualify as a REIT for U.S. federal income tax purposes. We may, however, be subject to certain state and local taxes. Our TRSs are subject to federal, state and local taxes.

 

For the years ended December 31, 2012, 2011 and 2010, we recorded $3,330, $563, and $966 of income tax expense, respectively. Tax expenses for each year is comprised of federal, state and local taxes. Income taxes, primarily related to our TRSs, are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided if we believe it is more likely than not that all or a portion of a deferred tax asset will not be realized. Any increase or decrease in a valuation allowance is included in the tax provision when such a change occurs.

 

Our policy for interest and penalties, if any, on material uncertain tax positions recognized in the financial statements is to classify these as interest expense and operating expense, respectively. As of December 31, 2012, 2011 and 2010, we did not incur any material interest or penalties.

 

Results of Operations

 

Comparison of the year ended December 31, 2012 to the year ended December 31, 2011

 

Revenues

 

   2012   2011   Change 
Management fees  $34,667   $7,336   $27,331 
Rental revenue    267    -    267 
Investment income   600    -    600 
Operating expense reimbursements    174    -    174 
Other income   1,113    436    677 
Total revenue   $36,821   $7,772   $29,049 
Equity in net income (loss) of joint ventures  $(2,904)  $121   $(3,025)

 

Management fees for the year ended December 31, 2012 are $34,667 and for the year ended December 31, 2011 are $7,336. Management fees are comprised of asset management, property management and administration fees earned pursuant to the Management Agreement which was effective September 1, 2011 and fees earned from our joint venture with Garrison commencing in December 2012.

 

Rental revenue was $267 and $0 for the years ended December 31, 2012 and 2011, respectively. The increase of $267 is due to the acquisition of the Indianapolis Industrial Portfolio in November 2012.

 

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Investment income was primarily generated from a mezzanine loan investment made in connection with the acquisition of the Bank of America Portfolio.

 

Operating expense reimbursements were $174 the year ended December 31, 2012 and were related to the Indianapolis Industrial Portfolio acquired in November 2012.

 

Other income of $1,113 for the year ended December 31, 2012 is primarily comprised of $1,000 payment received related to settlement of a previously defaulted loan investment held outside of our commercial real estate finance segment. The remainder of other income for the year ended December 31, 2012 and 2011 is related to interest earned on cash balances held by us.

 

The equity in net income (loss) of joint ventures of $2,904 for the year ended December 31, 2012 represents our proportionate share of the loss generated by two joint venture interests, including our joint venture with Garrison which contains the Bank of America Portfolio acquired in December 2012. The equity in net income of joint ventures of $121 for the year ended December 31, 2011 represents our proportionate share of the income generated by one joint venture interest. Our proportionate share of the income (loss) generated by our joint venture interests including $669 and $3,219 of real estate-related depreciation and amortization, which when added back, results in a reduction of Funds from Operations, or FFO, of $7,846 for the year ended December 31, 2012 and a contribution to FFO, of $1,242 for the year ended December 31, 2011, including losses of $5,611 and $2,098 classified as discontinued operations, respectively.

  

Expenses

 

   2012   2011   Change 
Property operating expenses  $23,226    5,947   $17,279 
Depreciation and amortization   256    136    120 
Management, general and administrative   25,446    22,150    3,296 
Provision for taxes   3,330    563    2,767 
Total expenses  $52,258   $28,796   $23,462 

 

Property operating expenses increased by $17,279 from the $5,947 recorded in the year ended December 31, 2011 to $23,226 recorded in the year ended December 31, 2012. The increase is attributable to additional costs incurred in connection with management of the KBS portfolio for twelve months of 2012 as compared to only four months in 2011. Property operating expenses in 2011 was also reduced by the reversal of a reserve for litigation of approximately $5,392 which was settled in 2011.

 

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We recorded depreciation and amortization expenses of $256 for the year ended December 31, 2012, compared to $136 for the year ended December 31, 2011. The increase of $120 is primarily due to the acquisition of the Indianapolis Industrial Portfolio in November 2012.

 

Management, general and administrative expenses were $25,446 for the year ended December 31, 2012, compared to $22,150 for the same period in 2011. The increase of $3,296 is primarily related to the write off of $2,615 in costs related to our strategic review process completed in the second quarter of 2012, $111 of include acquisition costs for Indianapolis industrial portfolio, increases of corporate legal fees of $715 and salary and employee benefit costs of $1,201, which are partially offset by reductions in audit fees, other professional fees and insurance of $1,347.

 

The provision for taxes was $3,330 for the year ended December 31, 2012, versus $563 for the year ended December 31, 2011. The increase of $2,767 is primarily related to taxes on our realty asset management business which is conducted in a TRS.

  

Comparison of the year ended December 31, 2011 to the year ended December 31, 2010

 

Revenues

 

   2011   2010   Change 
Management fees  $7,336   $-   $7,336 
Investment income    -    25    (25)
Other income   436    1,172    (736)
Total revenue   $7,772   $1,197   $6,575 
Equity in net income (loss) of joint ventures  $121   $(303)  $424 

 

Management fees for the year ended December 31, 2011 are $7,336 and for the year ended December 31, 2011 are $0. Management fees are comprised of asset management, property management and administration fees earned pursuant to the Management Agreement which was effective September 1, 2011.

 

For the year ended December 31, 2012, other income is primarily related to interest earned on cash balances held by us. Other income of $1,172 for the year ended December 31, 2010 also includes reimbursements of legal costs and ancillary income we received from third-parties.

 

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The equity in net income (loss) of joint ventures of $121 for the year ended December 31, 2011 represents our proportionate share of the income generated by one joint venture interests. The equity in net loss of joint ventures of $1,172 for the year ended December 31, 2010 represents our proportionate share of the income generated by two joint venture interests. Our proportionate share of the income or loss generated by our joint venture interests include $3,219 and $4,347 of real estate-related depreciation and amortization, which when added back, results in a contribution to Funds from Operations, or FFO, of $1,242 and $11,212 for the years ended December 31, 2011 and 2010, respectively, including loss of $2,098 and income of $7,168 classified as discontinued operations, respectively.

  

Expenses

 

   2011   2010   Change 
Property operating expenses  $5,947    4,033   $1,914 
Interest expense   -    280    (280)
Depreciation and amortization   136    174    (38)
Management, general and administrative   22,150    22,369    (219)
Provision for taxes   563    966    (403)
Total expenses  $28,796   $27,822   $974 

 

Property operating expenses increased by $1,914 from the $4,033 recorded in the year ended December 31, 2010 to $5,947 recorded in the year ended December 31, 2011. The increase is primarily attributable to additional costs incurred in connection with the management of the KBS portfolio beginning in September 2011, partially reduced by the reversal of a reserve for litigation of approximately $5,400 which was settled in 2011.

  

Interest expense was $0 for the year ended December 31, 2011 compared to $280 for the year ended December 31, 2010. Decrease in interest expense is due to financing costs being fully amortized during the year ended December 31, 2010.

 

We recorded depreciation and amortization expenses of $136 for the year ended December 31, 2011, compared to $174 for the year ended December 31, 2010. Management, general and administrative expenses were $22,150 for the year ended December 31, 2011, compared to $22,369 for the same period in 2010. The decrease of $219 includes reductions in salaries and benefits of $216, legal and professional fees of $88 and other administrative costs of $513, partially offset by an increase in insurance and other professional fees of $564.

 

The provision for taxes was $563 for the year ended December 31, 2011, versus $966 for the year ended December 31, 2010. The decrease of $403 is primarily related to state taxes incurred in connection with a gain on extinguishment of debt in the year ended December 31, 2010.

 

Liquidity and Capital Resources

 

Liquidity is a measurement of our ability to meet cash requirements, including ongoing commitments to fund acquisitions of real estate assets, repay borrowings, pay dividends and other general business needs. In addition to cash on hand, our primary sources of funds for short-term (within the next 12 months) liquidity requirements, including working capital, distributions, if any, debt service and additional investments, consist of: (i) cash flow from operations; (ii) proceeds from the sale of our collateral management and sub-special servicing agreements and proceeds from the sale of certain repurchased notes of our CDOs; (iii) proceeds from potential asset sales; and, to a lesser extent; (iv) new financings and; (v) proceeds from additional common or preferred equity offerings. We believe these sources of financing will be sufficient to meet our short-term liquidity requirements. Our future growth will depend, in large part, upon our ability to raise additional capital. In the event we are not able to successfully access new equity or debt capital, we will rely primarily on cash on hand, cash flows from operations, proceeds from the sale of collateral management and sub-special servicing agreements and proceeds from the sale of certain repurchased notes of our CDOs, management fees and proceeds from asset sales to satisfy our liquidity requirements. If we (i) are unable to renew, replace or expand our sources of financing, (ii) are unable to execute asset sales in a timely manner or to receive anticipated proceeds from them or (iii) fully utilize available cash, it may have an adverse effect on our business, results of operations, and ability to make distributions to our stockholders.

 

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A summary of the distributions and fees received from the CDOs, which was our primary source of liquidity for 2012, is presented below:

 

   Collateral Manager Fees and CDO Distributions 
   CDO 2005-1   CDO 2006-1   CDO 2007-1     
   Fees   Distributions   Fees   Distributions   Fees   Distributions   Total 
1Q 2012  $2,399   $3,495   $1,027   $9,160   $172   $-   $16,253 
2Q 2012   3,134    1,907    965    6,311    169    -    12,486 
3Q 2012   332    -    933    8,238    169    -    9,672 
4Q 2012   300    -    380    -    169    -    849 
Total 2012  $6,165   $5,402   $3,305   $23,709   $679   $-   $39,260 

 

Our ability to fund our short-term liquidity needs, including debt service and general operations (including employment related benefit expenses), through cash flow from operations can be evaluated through the Consolidated Statements of Cash Flows included in our financial statements. Beginning with the third quarter of 2008 our board of directors elected not to pay a dividend on our common stock. Additionally our board of directors elected not to pay the Series A preferred stock dividend of $0.50781 per share beginning with the fourth quarter of 2008. As of December 31, 2012 and 2011, we accrued $30,438 and $23,276, respectively, for the Series A preferred stock dividends. Based on current estimates of our taxable loss, we expect that we will have no distribution requirements in order to maintain our REIT status for the 2012 tax year and we expect that we will continue to elect to retain capital liquidity purposes; however, as our new business strategy is implemented and sustainable cash flows grow, we will re-evaluate our dividend policy with the intention of resuming dividends. In accordance with the provisions of our charter, we may not pay any dividends on our common stock until all accrued dividends and the dividend for the then current quarter on the Series A preferred stock are paid in full.

 

Our ability to meet our long-term (beyond the next 12 months) liquidity and capital resource requirements will be subject to obtaining additional debt financing and equity capital. Subsequent to our exit from the commercial real estate finance business, we will have no corporate debt obligations, although we may pursue obtaining a corporate credit facility or line of credit for working capital purposes or to facilitate with the acquisition of property investments. Our inability to renew, replace or expand our sources of financing on substantially similar terms, or any at all may have an adverse effect on our business, results of operations and our ability to make distributions. Any indebtedness we incur will likely be subject to continuing or more restrictive covenants and we will likely be required to make continuing representations and warranties in connection with such debt.

 

Our future borrowings may require us, among other restrictive covenants, to keep uninvested cash on hand, to maintain a certain minimum tangible net worth, to maintain a certain portion of our assets free from liens and to secure such borrowings with assets. These conditions could limit our ability to do further borrowings and may have a material adverse effect on our liquidity, the value of our common stock, and our ability to make distributions to our stockholders.

 

As of the date of this filing, we expect that our cash on hand and cash flow from operations will be sufficient to satisfy our anticipate short-term and long-term liquidity needs as well as our recourse liabilities, if any.

 

To maintain our qualification as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and thereby replenish or increase capital for operations. In accordance with the provisions of our charter, we may not pay any dividends on our common stock until all accrued dividends and the dividend for the then current quarter on the Series A Preferred Stock are paid in full.

 

Cash Flows

 

Net cash provided by operating activities decreased $86,822 to $283 for the year ended December 31, 2012 compared to $87,105 for the same period in 2011. Operating cash flow was generated primarily by management fees, net interest income from our commercial real estate finance segment and net rental income from our investment segment. The decrease in operating cash flow for the year ended December 31, 2012 compared to the same period in 2011 was primarily due to the transfer of the KBS portfolio pursuant to the Settlement Agreement in 2011 and a corresponding decrease in operating assets and liabilities of $22,114.

 

Net cash provided by investing activities for the year ended December 31, 2012 was $248,288 compared to $51,133 during the same period in 2011. The increase in cash flow from investing activities is primarily attributable to the increase in proceeds from real estate sales and loan syndications and a reduction in new originations and funded commitments within our commercial real estate finance segment. These are partially offset by cash payments made to acquire the Indianapolis Industrial Portfolio and the BOA Joint Venture as well as a reduction in principal collections on investments.

 

Net cash used by financing activities for the year ended December 31, 2012 was $306,894 as compared to $195,358 during the same period in 2011. The change is primarily attributable to the decrease in restricted cash within the CDOs, and the increase in repayments of liabilities issued by our CDOs.

  

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Capitalization

 

Our authorized capital stock consists of 125,000,000 shares, $0.001 par value, of which we have authorized the issuance of up to 100,000,000 shares of common stock, $0.001 par value per share, and 25,000,000 shares of preferred stock, par value $0.001 per share. As of December 31, 2012, 60,731,002 shares of common stock and 3,525,822 shares of preferred stock were issued and outstanding.

 

In connection with Mr. Gordon F. DuGan’s agreement to serve as our Chief Executive Officer, on June 7, 2012, Mr. DuGan also agreed to purchase 1,000,000 shares of our common stock on June 29, 2012 for an aggregate purchase price of $2,520 or $2.52 per share. The per share purchase price was equal to the closing price our common stock on the New York Stock Exchange on the day prior to the date Mr. DuGan entered into the subscription agreement with us to purchase such shares of common stock. The issuance of such shares of common stock was a private placement exempt from the registration requirements of the Securities Act.

 

We issued to KBS Acquisition Sub-Owner 2, LLC (i) 2,000,000 shares of our common stock, par value $0.001 per share; (ii) 2,000,000 shares of Class B-1 non-voting common stock, par value $0.001 per share; and (iii) 2,000,000 shares of Class B-2 non-voting common stock, par value $0.001 per share on December 6, 2012. The shares were issued as consideration for our contribution to the joint venture with Garrison in connection with the acquisition of the Bank of America Portfolio on the same date and were valued at $2.75 which was the closing price of our common stock on the New York Stock Exchange on the day prior. Each share of the Class B-1 common stock and Class B-2 common stock will be convertible into one share of our common stock at the option of the holder at any time on or after September 5, 2013 and December 6, 2013, respectively. Each share of Class B-1 common stock and Class B-2 common stock that has not previously been converted and remains outstanding on March 5, 2014 shall, automatically and without any action on the part of the holder thereof, convert into one share of common stock on such date. While outstanding, each share of Class B-1 common stock and Class B-2 common stock will have identical rights to dividends and other distributions as our common stock. The issuance of such shares of common stock was a private placement exempt from the registration requirements of the Securities Act.

 

Preferred Stock

 

In April 2007, we issued 4,600,000 shares of our 8.125% Series A cumulative redeemable preferred stock (including the underwriters’ over-allotment option of 600,000 shares) with a mandatory liquidation preference of $25.00 per share. Holders of the Series A preferred stock are entitled to annual dividends of $2.03125 per share on a quarterly basis and dividends are cumulative, subject to certain provisions. On or after April 18, 2012, we may at our option redeem the Series A preferred stock at par for cash. Net proceeds (after deducting underwriting fees and expenses) from the offering were approximately $111,205.

 

In November 2010, we settled a tender offer to purchase up to 4,000,000 shares of our Series A preferred stock for $15.00 per preferred share, net to seller in cash. In the aggregate, we paid approximately $16,620 to acquire the 1,074,178 shares of the Series A preferred stock tendered and not withdrawn. The shares of Series A preferred stock acquired by us were retired upon receipt and accrued and unpaid dividends of $4,364 or $4.0625 per share of the acquired preferred stock were eliminated. After settlement of the tender offer, 3,525,822 shares of Series A preferred stock remain outstanding for trading on the NYSE.

 

The $13,713 excess of the $30,332 carrying value of the tendered preferred stock, including accrued dividends of $4,364, over the $16,620 of consideration paid was recorded as a decrease to net loss available to common stockholders for the year ended December 31, 2010.

 

Beginning with the fourth quarter of 2008, our board of directors elected not to pay the quarterly Series A preferred stock dividends of $0.50781 per share. As of December 31, 2012 and 2011, we accrued Series A preferred stock dividends of $30,438 and $23,276, respectively.

 

Deferred Stock Compensation Plan for Directors

 

Under our Independent Director’s Deferral Program, which commenced April 2005, our independent directors may elect to defer up to 100% of their annual retainer fee, chairman fees and meeting fees. Unless otherwise elected by a participant, fees deferred under the program shall be credited in the form of phantom stock units. The phantom stock units are convertible into an equal number of shares of common stock upon such directors’ termination of service from the board of directors or a change in control by us, as defined by the program. Phantom stock units are credited to each independent director quarterly using the closing price of our common stock on the applicable dividend record date for the respective quarter. If dividends are declared by us, each participating independent director who elects to receive fees in the form of phantom stock units has the option to have their account credited for an equivalent amount of phantom stock units based on the dividend rate for each quarter or have dividends paid in cash.

 

As of December 31, 2012, there were approximately 462,102 phantom stock units outstanding, of which 457,602 units are vested.

 

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Market Capitalization

 

At December 31, 2012, our CDOs, which are classified as held-for-sale in connection with the disposal of Gramercy Finance, represented 89.1% of our consolidated market capitalization of $2,455,015 (based on a common stock price of $2.94 per share, the closing price of our common stock on the New York Stock Exchange on December 31, 2012). Market capitalization includes our consolidated debt and common and preferred stock.

  

Equity Incentive Plan

 

In connection with the hiring of Gordon F. DuGan, Benjamin Harris, and Nicholas L. Pell, who joined on July 1, 2012 as Chief Executive Officer, President and Managing Director, respectively, we have granted equity awards to these new executives pursuant to a newly adopted outperformance plan, or the 2012 Outperformance Plan. Pursuant to the 2012 Outperformance Plan, these executives, in the aggregate, may earn up to $20,000 of LTIP Units based on our common stock price appreciation over a four-year performance period ending June 30, 2016. The amount of LTIP Units earned under the 2012 Outperformance Plan will range from $4,000 if our common stock price equals a minimum hurdle of $5.00 per share (less any dividends paid during the performance period) to $20,000 if our common stock price equals or exceeds $9.00 per share (less any dividends paid during the performance period) at the end of the performance period. In the event that the performance hurdles are not met on a vesting date, the award scheduled to vest on that vesting date may vest on a subsequent vesting date if the common stock price hurdle is met as of such subsequent vesting date. The executives will not earn any LTIP Units under the 2012 Outperformance Plan to the extent that our common stock price is less than the minimum hurdle.  Messrs. DuGan, Harris and Pell were granted awards under the 2012 Outperformance Plan pursuant to which they may earn up to $10,000, $6,000 and $4,000 of LTIP Units, respectively.During the performance period, the executives may earn up to 12%, 24% and 36% of the maximum amount under the 2012 Outperformance Plan at the end of the first, second and third years, respectively, of the performance period if our common stock price has equaled or exceeded the stock price hurdles as of the end of such years. If the minimum stock price hurdle is met as of the end of any such year, the actual amount earned will range on a sliding scale from 20% of the maximum amount that may be earned as of such date (at the minimum stock price hurdle) to 100% of the maximum amount that may be earned as of such date (at the maximum stock price hurdle). Any LTIP Units earned under the 2012 Outperformance Plan will remain subject to vesting, with 50% of any LTIP Units earned vesting on June 30, 2016 and the remaining 50% vesting on June 30, 2017 based, in each case, on continued employment through the vesting date. The LTIP Units had a fair value of $1,870 on the date of grant. We used a probabilistic valuation approach to estimate the inherent uncertainty that the LTIP Units may have with respect to our common stock. Compensation expense of $210 was recorded for the year ended December 31, 2012 for the 2012 Outperformance Plan. Compensation expense of $1,660 will be recorded over the course of the next 54 months, representing the remaining weighted average vesting period of the LTIP Units as of December 31, 2012. 

 

In connection with the equity awards made to Messrs. DuGan, Harris and Pell in connection with the hiring of these executives, we adopted the 2012 Inducement Equity Incentive Plan, or the Inducement Plan. Under the Inducement Plan, we may grant equity awards for up to 4.5 million shares of common stock pursuant to the employment inducement award exemption provided by the New York Stock Exchange Listed Company Manual. The Inducement Plan permits us to issue a variety of equity awards, including stock options, restricted stock, phantom shares, dividend equivalent rights and other equity-based awards. All of the shares available under the Inducement Plan were issued or reserved for issuance to Messrs. DuGan, Harris and Pell in connection with the equity awards made upon the commencement of their employment. Equity awards issued under the Inducement Plan had a fair value of $3,830 on the date of grant. Compensation expense of $383 was recorded for year ended December 31, 2012 for the 2012 Inducement Equity Incentive Plan. Compensation expense of $3,447 will be recorded over the course of the next 54 months representing the remaining weighted average vesting period of equity awards issued under the Inducement Plan as of December 31, 2012.

 

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Indebtedness

 

The table below summarizes secured and other debt at December 31, 2012 and 2011:

 

   December 31,
2012
   December 31,
2011
 
         
Collateralized debt obligations  $2,188,597   $2,468,810 
           
Total  $2,188,597   $2,468,810 
           
Cost of debt  LIBOR+0.47%   LIBOR+0.45% 

 

Mortgage and Mezzanine Loans

 

Certain real estate assets were subject to mortgage and mezzanine liens. In September 2011, we entered into the Settlement Agreement for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among us and the mortgage and mezzanine lenders and, subject to certain termination provisions, our continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, we transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that we agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011. The aggregate carrying value for the interests transferred to KBS was approximately $2.63 billion. In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. For further discussion of the impact of the Settlement Agreement and the transfer of the Dana portfolio, see Settlement and Extinguishment of Debt within Note 2 to the Consolidated Financial Statements.

 

Goldman Mortgage Loan

 

On April 1, 2008, certain of our subsidiaries, collectively, the Goldman Loan Borrowers, entered into a mortgage loan agreement, the Goldman Mortgage Loan, with GSMC, Citicorp, and SL Green in connection with a mortgage loan in the amount of $250,000, which is secured by certain properties owned or ground leased by the Goldman Loan Borrowers. The Goldman Mortgage Loan had an initial maturity date of March 9, 2010, with a single one-year extension option. The Goldman Mortgage Loan bore interest at 4.35% over one-month LIBOR. The Goldman Mortgage Loan provided for customary events of default, the occurrence of which could result in an acceleration of all amounts payable under the Goldman Mortgage Loan. The Goldman Mortgage Loan allowed for prepayment under the terms of the agreement, as long as simultaneously therewith a proportionate prepayment of the Goldman Mezzanine Loan (discussed below) was also be pre-paid. In August 2008, an amendment to the loan agreement was entered into for the Goldman Mortgage Loan in conjunction with the bifurcation of the Goldman Mezzanine loan into two separate mezzanine loans. Under this loan agreement amendment, the Goldman Mortgage Loan bore interest at 1.99% over LIBOR. We had accrued interest of $256 and borrowings of $240,523 as of December 31, 2010. 

 

In March 2010, we extended the maturity date of the Goldman Mortgage Loan to March 2011, and amended certain terms of the loan agreement, including, among others, (i) a prohibition on distributions from the Goldman Loan Borrowers to us, other than to cover direct costs related to executing the extension and reimbursement of not more than $2,500 per quarter of corporate overhead actually incurred and allocated to Gramercy Asset Management, (ii) requirement of $5,000 of available cash on deposit in a designated account on the commencement date of the Goldman Mortgage Loan extension term, and (iii) within 90 days after the first day of the Goldman Mortgage Loan extension term, delivery by the Goldman Loan Borrowers to GSMC, Citicorp and SL Green of a comprehensive long-term business plan and restructuring proposal addressing repayment of the Goldman Mortgage Loan. Subsequent to the final maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans, we entered into a series of short term extensions to provide additional time to exchange and consider proposals for an extension, modification, restructuring or refinancing of the Goldman Mortgage Loan and the Goldman Mezzanine Loans and to explore an orderly transition of the collateral to the lenders if such discussions failed. On May 9, 2011, we announced that the scheduled maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans occurred without repayment and without an extension or restructuring of the loans by the lenders.

 

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Notwithstanding the maturity and non-repayment of the loans, we maintained active communications with the lenders and in September 2011, we entered into the Settlement Agreement, for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, Gramercy Asset Management’s senior mezzanine lender, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among us and the mortgage and mezzanine lenders and, subject to certain termination provisions, our continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, we transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that we agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011. The aggregate carrying value for the interests transferred to KBS was approximately $2.63 billion. In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. For further discussion of the impact of the Settlement Agreement and the transfer of the Dana portfolio, see Settlement and Extinguishment of Debt within Note 2 to the Consolidated Financial Statements.

 

Goldman Senior and Junior Mezzanine Loans

 

On April 1, 2008, certain of our subsidiaries, collectively, the Mezzanine Borrowers, entered into a mezzanine loan agreement with GSMC, Citicorp and SL Green in connection with a mezzanine loan in the amount of $600,000, or the Goldman Mezzanine Loan, which was secured by pledges of certain equity interests owned by the Mezzanine Borrowers and any amounts receivable by the Mezzanine Borrowers whether by way of distributions or other sources. The Goldman Mezzanine Loan had an initial maturity date of on March 9, 2010, with a single one-year extension option. The Goldman Mezzanine Loan bore interest at 4.35% over one-month LIBOR. The Goldman Mezzanine Loan provided for customary events of default, the occurrence of which could result in an acceleration of all amounts payable under the Goldman Mezzanine Loan. The Goldman Mezzanine Loan allowed for prepayment under the terms of the agreement, subject to a 1.00% prepayment fee during the first six months, payable to the lender, as long as simultaneously therewith a proportionate prepayment of the Goldman Mortgage Loan was also made on such date. In addition, under certain circumstances the Goldman Mezzanine Loan was cross-defaulted with events of default under the Goldman Mortgage Loan and with other mortgage loans pursuant to which an indirect wholly-owned subsidiary of ours is the mortgagor. In August 2008, the $600,000 mezzanine loan was bifurcated into two separate mezzanine loans, (the Junior Mezzanine Loan and the Senior Mezzanine Loan) by the lenders. Additional loan agreement amendments were entered into for the Goldman Mezzanine Loan and Goldman Mortgage Loan. Under these loan agreement amendments, the Junior Mezzanine Loan bore interest at 6.00% over LIBOR and the Senior Mezzanine Loan bore interest at 5.20% over LIBOR, and the Goldman Mortgage Loan bore interest at 1.99% over LIBOR. The weighted average of these interest rate spreads was equal to the combined weighted average of the interest rates spreads on the initial loans. We had accrued interest of $1,454 and borrowings of $549,713 as of December 31, 2010.

 

In March 2010, we extended the maturity date of the Goldman Mortgage Loan to March 2011, and amended certain terms of the loan agreement, including, among others, (i) a prohibition on distributions from the Goldman Loan Borrowers to us, other than to cover direct costs related to executing the extension and reimbursement of not more than $2,500 per quarter of corporate overhead actually incurred and allocated to Gramercy Asset Management, (ii) requirement of $5,000 of available cash on deposit in a designated account on the commencement date of the Goldman Mortgage Loan extension term, and (iii) within 90 days after the first day of the Goldman Mortgage Loan extension term, delivery by the Goldman Loan Borrowers to GSMC, Citicorp and SL Green of a comprehensive long-term business plan and restructuring proposal addressing repayment of the Goldman Mortgage Loan. Subsequent to the final maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans, we entered into a series of short term extensions to provide additional time to exchange and consider proposals for an extension, modification, restructuring or refinancing of the Goldman Mortgage Loan and the Goldman Mezzanine Loans and to explore an orderly transition of the collateral to the lenders if such discussions failed. On May 9, 2011, we announced that the scheduled maturity of the Goldman Mortgage Loan and the Goldman Mezzanine Loans occurred without repayment and without an extension or restructuring of the loans by the lenders.

 

Notwithstanding the maturity and non-repayment of the loans, we maintained active communications with the lenders and in September 2011, we entered into the Settlement Agreement, for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among us and the mortgage and mezzanine lenders and, subject to certain termination provisions, our continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, we transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that we agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011. The aggregate carrying value for the interests transferred to KBS was approximately $2.63 billion. In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. For further discussion of the impact of the Settlement Agreement and the transfer of the Dana portfolio, see Settlement and Extinguishment of Debt within Note 2 to the Consolidated Financial Statements.

 

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Collateralized Debt Obligations

 

In the fourth quarter of 2012, we classified our CDOs as held-for-sale in connection with the disposal of Gramercy Finance. The outstanding debt is presented as a component of the liabilities related to assets held-for-sale on the Consolidated Balance Sheets.

 

During 2005, we issued approximately $1,000,000 of CDO bonds through two indirect subsidiaries, Gramercy Real Estate CDO 2005-1 Ltd., or the 2005 Issuer, and Gramercy Real Estate CDO 2005-1 LLC, or the 2005 Co-Issuer. At issuance, the CDO consisted of $810,500 of investment grade notes, $84,500 of non-investment grade notes, which were co-issued by the 2005 Issuer and the 2005 Co-Issuer, and $105,000 of preferred shares, which were issued by the 2005 Issuer. The investment grade notes were issued with floating rate coupons with a combined weighted average rate of three-month LIBOR plus 0.49%. We incurred approximately $11,957 of costs related to Gramercy Real Estate CDO 2005-1, which are amortized on a level- yield basis over the average life of the CDO. 

 

During 2006, we issued approximately $1,000,000 of CDO bonds through two indirect subsidiaries, Gramercy Real Estate CDO 2006-1 Ltd., or the 2006 Issuer, and Gramercy Real Estate CDO 2006-1 LLC, or the 2006 Co-Issuer. At issuance, the CDO consisted of $903,750 of investment grade notes, $38,750 of non-investment grade notes, which were co-issued by the 2006 Issuer and the 2006 Co-Issuer, and $57,500 of preferred shares, which were issued by the 2006 Issuer. The investment grade notes were issued with floating rate coupons with a combined weighted average rate of three-month LIBOR plus 0.37%. We incurred approximately $11,364 of costs related to Gramercy Real Estate CDO 2006-1, which are amortized on a level-yield basis over the average life of the CDO.

 

In August 2007, we issued $1,100,000 of CDO bonds through two indirect subsidiaries, Gramercy Real Estate CDO 2007-1 Ltd., or the 2007 Issuer, and Gramercy Real Estate CDO 2007-1 LLC, or the 2007 Co-Issuer. At issuance, the CDO consisted of $1,045,550 of investment grade notes, $22,000 of non-investment grade notes, which were co-issued by the 2007 Issuer and the 2007 Co-Issuer, and $32,450 of preferred shares, which were issued by the 2007 Issuer. The investment grade notes were issued with floating rate coupons with a combined weighted average rate of three-month LIBOR plus 0.46%. We incurred approximately $16,816 of costs related to Gramercy Real Estate CDO 2007-1, which are amortized on a level-yield basis over the average life of the CDO.

 

In connection with the closing of our first CDO in July 2005, pursuant to the collateral management agreement, the Manager agreed to provide certain advisory and administrative services in relation to the collateral debt securities and other eligible investments securing the CDO notes. The collateral management agreement provides for a senior collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to 0.15% per annum of the net outstanding portfolio balance, and a subordinate collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to 0.25% per annum of the net outstanding portfolio balance. Net outstanding portfolio balance is the sum of the (i) aggregate principal balance of the collateral debt securities, excluding defaulted securities, (ii) aggregate principal balance of all principal proceeds held as cash and eligible investments in certain accounts, and (iii) with respect to the defaulted securities, the calculation amount of such defaulted securities. The collateral management agreement for our 2006 CDO provides for a senior collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to 0.15% per annum of the net outstanding portfolio balance, and a subordinate collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to 0.25% per annum of the net outstanding portfolio balance. Net outstanding portfolio balance is the sum of the (i) aggregate principal balance of the collateral debt securities, excluding defaulted securities, (ii) aggregate principal balance of all principal proceeds held as cash and eligible investments in certain accounts, and (iii) with respect to the defaulted securities, the calculation amount of such defaulted securities. The collateral management agreement for our 2007 CDO provides for a senior collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to (i) 0.05% per annum of the aggregate principal balance of the CMBS securities, (ii) 0.10% per annum of the aggregate principal balance of loans, preferred equity securities, cash and certain defaulted securities, and (iii) a subordinate collateral management fee, payable quarterly in accordance with the priority of payments as set forth in the indenture, equal to 0.15% per annum of the aggregate principal balance of the loans, preferred equity securities, cash and certain defaulted securities.

 

We retained all non-investment grade securities, the preferred shares and the ordinary shares in the Issuer of each CDO. The Issuers and Co-Issuers in each CDO holds assets, consisting primarily of whole loans, subordinate interests in whole loans, mezzanine loans, preferred equity investments and CMBS, which serve as collateral for the CDO. Each CDO may be replenished, pursuant to certain rating agency guidelines relating to credit quality and diversification, with substitute collateral using cash generated by debt investments that are repaid during the reinvestment periods (generally, five years from issuance) of the CDO. Thereafter, the CDO securities will be retired in sequential order from senior-most to junior-most as debt investments are repaid. The financial statements of the Issuer of each CDO are consolidated in our financial statements. The securities originally rated as investment grade at time of issuance are treated as a secured financing, and are non-recourse to us. Proceeds from the sale of the securities originally rated as investment grade in each CDO were used to repay substantially all outstanding debt under our repurchase agreements and to fund additional investments. Loans and other investments are owned by the Issuers and the Co-Issuers, serve as collateral for our CDO securities, and the income generated from these investments is used to fund interest obligations of our CDO securities and the remaining income, if any, is retained by us.

 

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Substantially all of our loans and other investments serve as collateral for our CDO securities, and the income generated from these investments is used to fund interest obligations of our CDO securities and the remaining income, if any, is retained by us. The CDO indentures contain minimum interest coverage and asset overcollateralization covenants that must be satisfied in order for us to receive cash flow on the interests retained by us in our CDOs and to receive the subordinate collateral management fee earned. If some or all of our CDOs fail these covenants, all cash flows from the applicable CDO other than senior collateral management fees would be diverted to repay principal and interest on the most senior outstanding CDO securities, and we may not receive some or all residual payments or the subordinate collateral management fee until the applicable CDO regained compliance with such tests. Our 2005 CDO failed its overcollateralization test at the January 2013 distribution date, the most recent distribution date, and previously failed its overcollateralization tests at the October 2012, July 2012, October 2011, April 2011 and January 2011 distribution dates. Our 2006 CDO failed its asset overcollateralization tests as of the January 2013 distribution date, and previously failed its overcollateralization test as of the October 2012 distribution date. Our 2007 CDO failed its overcollateralization test beginning with the November 2009 distribution date. It is unlikely that the 2005, 2006 and 2007 CDO’s overcollateralization tests will be satisfied in the foreseeable future. During periods when the overcollateralization tests for the CDOs are not met, our business, financial condition, and results of operations are materially and adversely affected.

 

On March 14, 2012, an interest payment due on a CMBS investment owned by our 2007 CDO was not received for the third consecutive interest payment date, which caused the CMBS investment to be classified as a Defaulted Security under our 2007 CDO’s indenture. This classification caused the Class A/B Par Value Ratio for the 2007 CDO notes to fall to 88.86% in breach of the Class A/B overcollateralization test threshold of 89%. This breach constitutes an event of default under the operative documents for our 2007 CDO. Pursuant to a letter dated in March 2012, a majority of the controlling class of senior note holders waived the related event of default and further agreed to waive any subsequent event of default related to the Class A/B overcollateralization test that may occur hereafter until the earlier of January 30, 2014 or the date that written instructions to the contrary are provided by such majority of the controlling class to the Trustee. The majority of the controlling class has reserved the right to revoke or extend such waiver at any time.

 

During the year ended December 31, 2012, we repurchased no bonds previously issued by any of our three CDOs. During the year ended December 31, 2011, we repurchased, at a discount, $49,259 of notes previously issued by two of our three CDOs. We recorded a net gain on the early extinguishment of debt of $15,275 for the year ended December 31, 2011, in connection with the repurchase of notes of such Issuers.

 

Contractual Obligations

 

Combined aggregate principal maturities of our CDOs, and operating leases as of December 31, 2012 are as follows:

 

   CDOs   Interest
Payments
   Total 
2013  $-   $69,958   $69,958 
2014   -    68,643    68,643 
2015   -    69,418    69,418 
2016   -    72,813    72,813 
2017   -    55,700    55,700 
Thereafter   2,188,597    6,725    2,195,322 
Total  $2,188,597   $342,257   $2,531,854 

 

Additionally, one of our subsidiaries is a borrower under a $31,449 mortgage loan with our 2005 CDO and 2006 CDO acting as lenders, which bears interest at 5.0% and matures in June 2012. These intercompany borrowings are eliminated upon consolidation and therefore do not appear on our Consolidated Balance Sheet.

 

Leasing Agreements

 

Future minimum rental income under non-cancelable leases including properties held-for-sale in connection with the disposal of Gramercy Finance and excluding reimbursements for operating expenses, as of December 31, 2012 are as follows:

 

   Operating
Leases
 
2013  $3,779 
2014   3,865 
2015   3,897 
2016   3,799 
2017   3,668 
Thereafter   15,467 
Total minimum rental income  $34,475 

  

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Off-Balance-Sheet Arrangements

 

We have off-balance-sheet investments, including joint ventures. These investments all have varying ownership structures. Substantially all of our joint venture arrangements are accounted for under the equity method of accounting as we have the ability to exercise significant influence, but not control over the operating and financial decisions of these joint venture arrangements. Our off-balance-sheet arrangements are discussed in Note 6 in the accompanying financial statements.

 

Dividends

 

To maintain our qualification as a REIT, we must pay annual dividends to our stockholders of at least 90% of our REIT taxable income, determined before taking into consideration the dividends paid deduction and net capital gains. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, which would only be paid out of available cash, we must first meet both our operating requirements and scheduled debt service on our mortgages and loans payable. In accordance with the provisions of our charter, we may not pay any dividends on our common stock until all accrued dividends and the dividend for the then current quarter on the Series A preferred stock are paid in full.

 

Beginning with the third quarter of 2008, our board of directors elected not to pay a dividend on our common stock. Our board of directors also elected not to pay the Series A preferred stock dividend of $0.50781 per share beginning with the fourth quarter of 2008. The unpaid preferred stock dividends have been accrued for seventeen quarters as of December 31, 2012. Based on current estimates of taxable loss, we believe we will have no distribution requirement in order to maintain our REIT status for the 2012 tax year.

 

Inflation

 

A majority of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our performance more so than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.

 

Further, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors based primarily on our net income as calculated for tax purposes, in each case, our activities and balance sheet are measured with reference to historical costs or fair market value without considering inflation.

 

Related Party Transactions

 

The Chief Executive Officer of SL Green Realty Corp. (NYSE: SLG), or SL Green, is one of our directors. An affiliate of SL Green provides special servicing services with respect to a limited number of loans owned by our CDOs that are secured by properties in New York City, or in which we and SL Green are co-investors. For the years ended December 31, 2012, 2011 and 2010 we incurred expense of $0, $3,058 and $477, respectively, pursuant to the special servicing arrangement.

 

Commencing in May 2005, we are party to a lease agreement with SLG Graybar Sublease LLC, an affiliate of SL Green, for our corporate offices at 420 Lexington Avenue, New York, New York. The lease is for approximately 7,300 square feet and carries a term of 10 years with rents of approximately $249 per annum for year one rising to $315 per annum in year ten. In May and June 2009, we amended our lease with SLG Graybar Sublease LLC to increase the leased premises by approximately 2,260 square feet. The additional premises is leased on a co-terminus basis with the remainder of our leased premises and carries rents of approximately $103 per annum during the initial year and $123 per annum during the final lease year. On June 25, 2012, the lease was amended to reduce the leased premises by approximately 600 square feet and to reduce rents by approximately $29 per annum during the initial year and $38 per annum during the final lease year. All other terms of the lease remain unchanged, except we now have the right to cancel the lease with 90 days notice. For the years ended December 31, 2012, 2011 and 2010 we paid $361, $307 and $339 under this lease, respectively.

  

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In April 2007, we purchased for $103,200 a 45% Tenant-in-Common, or TIC, interest to acquire the fee interest in a parcel of land located at 2 Herald Square, located along 34th Street in New York, New York. The acquisition was financed with $86,063 10-year fixed rate mortgage loan. The property is subject to a long-term ground lease with an unaffiliated third-party for a term of 70 years. The remaining TIC interest is owned by a wholly-owned subsidiary of SL Green. The TIC interests are pari-passu. We sold our 45% interest in December 2010 to a wholly-owned subsidiary of SL Green for net proceeds of $25,350, resulting in a loss of $11,885. We recorded our pro rata share of net income of $5,078 for the years ended December 31, 2010, within discontinued operations.

 

In July 2007, we purchased for $144,240 an investment in a 45% TIC interest to acquire a 79% fee interest and 21% leasehold interest in the fee position in a parcel of land located at 885 Third Avenue, on which is situated The Lipstick Building. The transaction was financed with a $120,443 10-year fixed rate mortgage loan. The property is subject to a 70-year leasehold ground lease with an unaffiliated third-party. The remaining TIC interest is owned by a wholly-owned subsidiary of SL Green. The TIC interests are pari passu. We sold our 45% interest in December 2010 to a wholly-owned subsidiary of SL Green for net proceeds of $38,911, resulting in a loss of $15,407. We recorded our pro rata share of net income of $5,926 for the years ended December 31, 2010, within discontinued operations.

 

In December 2010, we sold our interest in a parcel of land located at 292 Madison Avenue in New York, New York to a wholly-owned subsidiary of SL Green. We received proceeds of $16,765 and recorded an impairment charge of $9,759, within discontinued operations.

 

Funds from Operations

 

We present FFO because we consider it an important supplemental measure of our operating performance and believe that it is frequently used by securities analysts, investors and other interested parties in the evaluation of REITS. We also use FFO as one of several criteria to determine performance-based incentive compensation for members of our senior management, which may be payable in cash or equity awards. The revised White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts, or NAREIT, defines FFO as net income (loss) (determined in accordance with GAAP), excluding impairment write-downs of investments in depreciable real estate and investments in in-substance real estate investments, gains or losses from debt restructurings and sales of depreciable operating properties, plus real estate-related depreciation and amortization (excluding amortization of deferred financing costs), less distributions to non-controlling interests and gains/losses from discontinued operations and after adjustments for unconsolidated partnerships and joint ventures. FFO does not represent cash generated from operating activities in accordance with GAAP and should not be considered as an alternative to net income (determined in accordance with GAAP), as an indication of our financial performance, or to cash flow from operating activities (determined in accordance with GAAP) as a measure of our liquidity, nor is it entirely indicative of funds available to fund our cash needs, including our ability to make cash distributions. Our calculation of FFO may be different from the calculation used by other companies and, therefore, comparability may be limited.

 

FFO for the years ended December 31, 2012, 2011 and 2010 are as follows:

 

   For the Year Ended December 31, 
   2012   2011   2010 
Net income (loss) available to common shareholders  $(178,710)  $330,315   $(968,773)
Add:               
Depreciation and amortization   5,205    70,215    115,051 
FFO adjustments for unconsolidated joint ventures   669    3,219    4,347 
Non-cash impairment of real estate investments   35,043    1,296    923,885 
Less:               
Non real estate depreciation and amortization   (4,059)   (7,044)   (7,925)
Gain on sale   (15,915)   (2,713)   (13,302)
Funds from operations  $(157,767)  $395,288   $53,283 
Funds from operations per share - basis  $(3.04)  $7.87   $1.07 
Funds from operations per share - diluted  $(3.04)  $7.75   $1.07 

  

Recently Issued Accounting Pronouncements 

 

In July 2010, FASB issued guidance which outlines specific disclosures that will be required for the allowance for credit losses and all finance receivables. Finance receivables includes loans, lease receivables and other arrangements with a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset on an entity’s statement of financial position. This guidance will require companies to provide disaggregated levels of disclosure by portfolio segment and class to enable users of the financial statement to understand the nature of credit risk, how the risk is analyzed in determining the related allowance for credit losses and changes to the allowance during the reporting period. Required disclosures under this guidance as of the end of a reporting period are effective for the Company’s December 31, 2010. In January 2011, the FASB delayed the effective date of the new disclosures about troubled debt restructurings to allow the FASB the time needed to complete its deliberations about on what constitutes a troubled debt restructuring. The effective date of the new disclosures about and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. The guidance is effective for our September 30, 2011 reporting period. We have applied this update to our Consolidated Financial Statements for the period ended December 31, 2012.

  

57
 

 

In December 2010, the FASB issued guidance on the disclosure of supplementary pro forma information for business combinations. The guidance specifies that if a public entity enters into business combinations that are material on an individual or aggregate basis and presents comparative financial statements, the entity must present pro forma revenue and earnings of the combined entity as though the business combination that occurred during the current period had occurred as of the beginning of the comparable annual period only. The adoption of this guidance for our annual reporting period ending December 31, 2012 will not have a material impact on our Consolidated Financial Statements.

 

In April 2011, the FASB issued updated guidance on a creditor’s determination of whether a restructuring will be a troubled debt restructuring, which establishes new guidelines in evaluating whether a loan modification meets the criteria of a troubled debt restructuring. This guidance is effective as of the third quarter of 2011, applied retrospectively to the beginning of the fiscal year as required, and its adoption did not have a material effect on our Consolidated Financial Statements. 

  

In May 2011, the FASB issued updated guidance on fair value measurement which amends U.S. GAAP to conform to International Financial Reporting Standards, or IFRS, measurement and disclosure requirements. The amendment changes the wording used to describe the requirements in U.S. GAAP for measuring fair value, changes certain fair value measurement principles and enhances disclosure requirements. This guidance is effective as of January 1, 2012, applied prospectively, and its adoption did not have a material effect on our Consolidated Financial Statements.

 

In June 2011, the FASB issued updated guidance on comprehensive income which amends U.S. GAAP to conform to the disclosure requirements of IFRS. The amendment eliminates the option to present components of other comprehensive income as part of the statement of stockholders’ equity and non-controlling interests and requires a separate Statements of Comprehensive Income or two consecutive statements in the Statements of Operations and in a separate Statements of Comprehensive Income (loss). This guidance also requires the presentation of reclassification adjustments for each component of other comprehensive income on the face of the financial statements rather than in the notes to the financial statements. This guidance is effective as of January 1, 2012, except for the disclosure of reclassification adjustments which was postponed for re-deliberation by the FASB, and early adoption is permitted, and its adoption did not have a material effect on our Consolidated Financial Statements. 

 

In February 2013, the FASB issued additional guidance on comprehensive income which requires the provision of information about the amounts reclassified out of accumulated other comprehensive income by component. This guidance also requires presentation on the Consolidated Statements of Operations and Comprehensive Income (Loss) or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, a cross-reference must be provided to other disclosures required under U.S. GAAP that provide additional detail about those amounts. This update is effective for reporting periods beginning after December 15, 2012 with early adoption permitted. We have not elected early adoption, and while its adoption is not expected to have a material effect on our Consolidated Financial Statements.

 

58
 

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

Market Risk

 

Market risk includes risks that arise from changes in interest rates, credit, commodity prices, equity prices and other market changes that affect market sensitive instruments. In pursuing our business plan, we expect that the primary market risks to which we will be exposed are real estate, interest rate and credit risks. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors that are beyond our control.

 

Real Estate Risk

 

Commercial property values and net operating income derived from such properties are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions, local real estate conditions (such as an oversupply of retail, industrial, office or other commercial or multi-family space), changes or continued weakness in specific industry segments, construction quality, age and design, demographic factors, retroactive changes to building or similar codes, and increases in operating expenses (such as energy costs). We may seek to mitigate these risks by employing careful business selection, rigorous underwriting and credit approval processes and attentive asset management.

 

Interest Rate Risk

 

Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Our operating results will depend in large part on differences between the income from our assets and our borrowing costs. Most of our commercial real estate finance assets and borrowings are variable-rate instruments that we finance with variable rate debt. The objective of this strategy is to minimize the impact of interest rate changes on the spread between the yield on our assets and our cost of funds. We seek to enter into hedging transactions with respect to all liabilities relating to fixed rate assets. If we were to finance fixed rate assets with variable rate debt and the benchmark for our variable rate debt increased, our net income would decrease. Our real estate assets generate income principally from fixed long-term leases and we are exposed to changes in interest rates primarily from floating rate borrowing arrangements. We expect that we will primarily finance our investment in commercial real estate with fixed rate, non-recourse mortgage financing, however, to the extent that we use floating rate borrowing arrangements, our net income from our real estate investments will generally decease if LIBOR increases. We have used, and may continue to use, interest rate caps or swaps to manage our exposure to interest rate changes. The following chart shows a hypothetical 100 basis point increase in interest rates along the entire interest rate curve:

 

Change in LIBOR  Projected Increase
(Decrease) in Net Income
 
Base case     
+100 bps  $(10,972)
+200 bps  $(20,303)
+300 bps  $(28,302)

 

We currently do not have an unsecured corporate credit facility, however, we may pursue obtaining such a facility for working capital purposes or to facilitate acquisitions of investments and accordingly, in the future, we may be exposed to additional effects of interest rate changes.

 

Credit Risk

 

Credit risk refers to the ability of each tenant in our portfolio of real estate investments to make contractual lease payments on the scheduled due dates. We seek to reduce credit risk of our real estate investments by entering into long-term leases with tenants after a careful evaluation of credit worthiness as part of our property acquisition process. If defaults occur, we employ our asset management resources to mitigate the severity of any losses and seek to relet the property. In the event of a significant rising interest rate environment and/or economic downturn, tenant delinquencies and defaults may increase and result in credit losses that would materially and adversely affect our business, financial condition and results of operations. 

 

59
 

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Index to Financial Statements and Schedules

 

GRAMERCY CAPITAL CORP.  
Report of Independent Registered Public Accounting Firm 62
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting 63
Consolidated Balance Sheets as of December 31, 2012 and 2011 64
Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2012, 2011 and 2010 65
Consolidated Statements of Stockholders’ Equity (Deficit) and Non-controlling Interests for the years ended December 31, 2012, 2011 and 2010 66
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010 67
Notes to Consolidated Financial Statements 68
Schedules
Schedule III Real Estate and Accumulated Depreciation as of December 31, 2012 120
Schedule IV Mortgage Loans on Real Estate as of December 31, 2012 122

 

All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto.

 

60
 

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of Gramercy Capital Corp.

 

We have audited the accompanying consolidated balance sheets of Gramercy Capital Corp. (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity and non-controlling interests, and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Gramercy Capital Corp. at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Gramercy Capital Corp.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 18, 2013 expressed an unqualified opinion thereon.

 

/s/ ERNST & YOUNG LLP
New York, New York
March 18, 2013

 

61
 

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of Gramercy Capital Corp.

 

We have audited Gramercy Capital Corp.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Gramercy Capital Corp.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

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

 

In our opinion, Gramercy Capital Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2012 consolidated financial statements of Gramercy Capital Corp. and our report dated March 18, 2013 expressed an unqualified opinion thereon.

 

/s/ ERNST & YOUNG LLP

New York, New York
March 18, 2013

  

62
 

 

  

 

Gramercy Capital Corp.
Consolidated Balance Sheets
(Amounts in thousands, except share and per share data)

 

   December 31,   December 31, 
   2012   2011 
Assets:          
Real estate investments, at cost:          
Land  $1,800   $2,241 
Building and improvements   21,359    5,964 
Less: accumulated depreciation   (50)   (574)
Total real estate investments, net   23,109    7,631 
           
Cash and cash equivalents    105,402    163,725 
Restricted cash   12    24 
Loans and other lending investments, net   73    828 
Investment in joint ventures   72,742    496 
Assets held-for-sale, net (includes consolidated VIEs of $1,913,353 and $1,990,826, respectively)   1,952,264    2,078,146 
Tenant and other receivables, net   4,123    1,820 
Derivative instruments, at fair value   -    6 
Acquired lease assets, net of accumulated amortization of $42 and $32   4,386    73 
Deferred costs, net of accumulated amortization of $2,033 and $2,137   415    1,891 
Other assets   6,310    3,690 
Total assets  $2,168,836   $2,258,330 
           
Liabilities and Equity:          
Liabilities:          
Accounts payable and accrued expenses  $8,908   $13,010 
Dividends payable   30,438    23,276 
Deferred revenue   33    569 
Below-market lease liabilities, net of accumulated amortization of $4 and $0   458    - 
Liabilities related to assets held-for-sale (includes consolidated VIEs of $2,374,516 and $2,654,109, respectively)   2,380,162    2,661,278 
Other liabilities   665    627 
Total liabilities   2,420,664    2,698,760 
Commitments and contingencies   -    - 
           
Equity:          
Common stock, Class A-1, par value $0.001, 100,000,000 shares authorized, 56,731,002 and 51,086,266 shares issued and outstanding at December 31, 2012 and 2011, respectively.   57    50 
Common stock, Class B-1, par value $0.001, 2,000,000  and 0 shares authorized, issued and outstanding at December 31, 2012 and 2011, respectively.   2    - 
Common stock, Class B-2, par value $0.001, 2,000,000 and 0 shares authorized, issued and outstanding at December 31, 2012 and 2011, respectively.   2    - 
Series A cumulative redeemable preferred stock, par value $0.001, liquidation preference $115,000, 4,600,000 shares authorized, 3,525,822 shares issued and outstanding at December 31, 2012 and 2011   85,235    85,235 
Additional paid-in-capital   1,102,227    1,080,600 
Accumulated other comprehensive loss   (95,265)   (440,939)
Accumulated deficit   (1,344,989)   (1,166,279)
Total Gramercy Capital Corp. stockholders' equity   (252,731)   (441,333)
Non-controlling interest   903    903 
Total equity   (251,828)   (440,430)
Total liabilities and equity  $2,168,836   $2,258,330 

 

The accompanying notes are an integral part of these financial statements.

 

63
 

 

Gramercy Capital Corp.

Consolidated Statements of Operations and Comprehensive Income (Loss)
(Amounts in thousands, except share and per share data)

 

   Year Ended December 31, 
   2012   2011   2010 
Revenues               
Management fees  $34,667   $7,336   $- 
Rental revenue   267    -    - 
Investment income   600    -    25 
Operating expense reimbursements   174    -    - 
Other income   1,113    436    1,172 
Total revenues   36,821    7,772    1,197 
Expenses               
Property operating expenses:               
Property management expenses   21,380    10,099    3,471 
Property operating expenses   1,846    (4,152)   562 
Total property operating expenses   23,226    5,947    4,033 
Interest expense   -    -    280 
Depreciation and amortization   256    136    174 
Management, general and administrative   25,446    22,150    22,369 
Total expenses   48,928    28,233    26,856 
Loss from continuing operations before equity in income (loss)  from joint ventures and provisions for taxes   (12,107)   (20,461)   (25,659)
Equity in net income (loss) of joint ventures   (2,904)   121    (303)
Loss from continuing operations before provision for taxes, gain on extinguishment of debt and discontinued operations   (15,011)   (20,340)   (25,962)
Provision for taxes   (3,330)   (563)   (966)
Net loss from continuing operations   (18,341)   (20,903)   (26,928)
Net income (loss) from discontinued operations   (169,174)   70,034    (912,222)
Net loss from discontinued operations with a related party   -    -    (9,759)
Loss on sale of joint venture interests to a related party   -    -    (27,292)
Gain on settlement of debt   -    285,634    - 
Net gains from disposals   15,967    2,712    2,658 
Total net income (loss) from discontinued operations   (153,207)   358,380    (946,615)
Net income (loss)   (171,548)   337,477    (973,543)
Net (income) attributable to non-controlling interest   -    -    (145)
Net income (loss) attributable to Gramercy Capital Corp.   (171,548)   337,477    (973,688)
Accrued preferred stock dividends   (7,162)   (7,162)   (8,798)
Excess of carrying amount of tendered preferred stock over consideration paid   -    -    13,713 
Net income (loss) available to common stockholders  $(178,710)  $330,315   $(968,773)
Other comprehensive income:               
Unrealized gain (loss) on available for sale securities and derivative instruments:               
Unrealized holding gains (losses) arising during period  $345,674   $(280,154)  $(64,747)
Other comprehensive income (loss)   345,674    (280,154)   (64,747)
Comprehensive income (loss) attributable to Gramercy Capital Corp.  $174,126   $57,323   $(1,038,435)
Comprehensive income (loss) attributable to common stockholders  $166,964   $50,161   $(1,033,520)
Basic earnings per share:               
Net loss from continuing operations, after preferred dividends  $(0.49)  $(0.55)  $(0.44)
Net income (loss) from discontinued operations   (2.95)   7.13    (18.96)
Net income (loss) available to common stockholders  $(3.44)  $6.58   $(19.40)
Diluted earnings per share:               
Net loss from continuing operations, after preferred dividends  $(0.49)  $(0.55)  $(0.44)
Net income (loss) from discontinued operations   (2.95)   7.13    (18.96)
Net income (loss) available to common stockholders  $(3.44)  $6.58   $(19.40)
Basic weighted average common shares outstanding   51,976,462    50,229,102    49,923,930 
Diluted weighted average common shares and common share equivalents outstanding   51,976,462    50,229,102    49,923,930 

 

The accompanying notes are an integral part of these financial statements.

 

64
 

 

Gramercy Capital Corp.
Consolidated Statements of Stockholders’ Equity (Deficit) and Non-controlling Interests
(Amounts in thousands, except share data)

 

   Common Stock, Class A-1   Common Stock, Class B-1   Common Stock, Class B-2   Series A Preferred    Additional   Accumulated Other Comprehensive   Retained Earnings / (Accumulated    Total Gramercy Capital    Non-controlling     
   Shares   Par Value   Shares   Par Value   Shares   Par Value    Stock   Paid-In-Capital   Income (Loss)   Deficit)   Corp   interest    Total  
Balance at December 31, 2009   49,884,500   $50    -   $-    -   $-   $111,205   $1,078,784   $(96,038)  $(527,821)  $566,180    $1,338   567,518 
Net loss   -    -    -    -    -    -    -    -    -    (973,688)   (973,688)   145    (973,543)
Change in net unrealized loss on derivative instruments   -    -    -    -    -    -    -    -    (70,603)   -    (70,603)   -    (70,603)
Reclassification of adjustments of net unrealized loss on securities previously available for sale   -    -    -    -    -    -    -    -    5,856    -    5,856    -    5,856 
Issuance of stock - stock purchase plan   25,211    -    -    -    -    -    -    26    -    -    26    -    26 
Stock based compensation - fair value   74,848    -    -    -    -    -    -    1,068    -    -    1,068    -    1,068 
Acquisition of non-controlling interest   -    -    -    -    -    -    -    (1,680)   -    -    (1,680)   (580)   (2,260)
Tender of Series A Preferred Stock   -    -    -    -    -    -    (25,970)   -    -    13,713    (12,257)   -    (12,257)
Dividends accrued on preferred stock   -    -    -    -    -    -    -    -    -    (8,798)   (8,798)   -    (8,798)
Balance at December 31, 2010   49,984,559    50    -    -    -    -    85,235    1,078,198    (160,785)   (1,496,594)   (493,896)  $903   $(492,993)
Net loss   -    -    -    -    -    -    -    -    -    337,477    337,477    -    337,477 
Change in net unrealized loss on derivative instruments   -    -    -    -    -    -    -    -    (19,334)   -    (19,334)   -    (19,334)
Change in net unrealized loss on securities available-for-sale   -    -    -    -    -    -    -    -    (260,820)   -    (260,820)   -    (260,820)
Issuance of stock - stock purchase plan   20,448    -    -    -    -    -    -    -    -    -    -    -    - 
Stock based compensation - fair value   1,081,259    -    -    -    -    -    -    2,402    -    -    2,402    -    2,402 
Dividends accrued on preferred stock   -    -    -    -    -    -    -    -    -    (7,162)   (7,162)   -    (7,162)
Balance at December 31, 2011   51,086,266    50    -    -    -    -    85,235    1,080,600    (440,939)   (1,166,279)   (441,333)  $903   $(440,430)
Net loss   -    -    -    -    -    -    -    -    -   (171,548)  (171,548)   -   (171,548)
Change in net unrealized loss on derivative instruments   -    -    -    -    -    -    -    -    2,146    -    2,146    -    2,146 
Change in net unrealized loss on securities available-for-sale   -    -    -    -    -    -    -    -    343,528    -    343,528    -    343,528 
Issuance of stock - stock purchase plan   36,324    1    -    -    -    -    -    185    -    -    186    -    186 
Stock based compensation - fair value   2,608,412    3    -    -    -    -    -    2,429    -    -    2,432    -    2,432 
Issuance of stock   3,000,000    3    2,000,000    2    2,000,000    2    -    19,013    -    -    19,020    -    19,020 
Dividends accrued on preferred stock   -    -    -    -    -    -    -    -    -    (7,162)   (7,162)   -    (7,162)
Balance at December 31, 2012   56,731,002   $57    2,000,000   $2    2,000,000   $2   $85,235   $1,102,227   $(95,265)  $(1,344,989)  $(252,731  $903   $251,828 

 

The accompanying notes are an integral part of these financial statements.

 

65
 

Gramercy Capital Corp.

 

Consolidated Statements of Cash Flows
(Amounts in thousands)

 

   Year ended December 31, 
   2012   2011   2010 
Operating Activities               
Net income (loss)  $(171,548)  $337,477   $(973,543)
Adjustments to net cash provided by operating activities:               
Depreciation and amortization   1,195    69,430    114,485 
Amortization of leasehold interests   -    (2,698)   (2,727)
Amortization of acquired leases to rental revenue   (188)   (54,420)   (68,507)
Amortization of deferred costs   3,719    4,749    7,732 
Amortization of discount and other fees   (25,704)   (33,312)   (28,140)
Payment of capitalized tenant leasing costs   (61)   (2,072)   (2,939)
Straight- line rent adjustment   (188)   (6,772)   26,289 
Non-cash impairment charges   206,122    19,492    963,497 
Non-cash impairment charges with related party   -    -    9,759 
Net gain on sale of properties and lease terminations   (15,915)   (2,712)   (2,737)
Impairment on business acquisition, net   -    (59)   2,722 
Net realized gain on loans   108    (16,643)   1,483 
Equity in net loss of joint ventures   8,515    1,977    (6,865)
Gain on extinguishment of debt   -    (300,909)   (19,443)
Amortization of stock compensation   2,433    2,243    1,094 
Provision for loan losses   (7,181)   48,180    84,392 
Unrealized gain on derivative instruments   -    16    - 
Net realized loss on sale of joint venture investment to a related party   -    -    27,292 
Changes in operating assets and liabilities:               
Restricted cash   412    2,803    15,942 
Tenant and other receivables   (2,803)   27,693    4,576 
Accrued interest   12,393    1,097    37 
Other assets   (11,285)   8,896    1,517 
Management and incentive fees payable   -    -    - 
Accounts payable, accrued expenses and other liabities   777    22,306    1,909 
Deferred revenue   (518)   (39,657)   (40,994)
Net cash provided by operating activities   283    87,105    116,831 
                
Investing Activities               
Capital expenditures and leasehold costs   (2,649)   (7,752)   (19,084)
Payment for acquistions of real estate investments   (27,125)   -    (4,550)
Proceeds from sale of joint venture investment   -    387    - 
Proceeds from sale of securities available for sale   -    65,584    - 
Proceeds from sale of joint venture investment to a related party   -    -    64,203 
Proceeds from sale of real estate   77,257    22,895    37,709 
Proceeds from sale of real estate to a related party   -    -    16,765 
New investment originations and funded commitments   (19,295)   (293,450)   (121,447)
Principal collections on investments   254,789    329,975    221,975 
Proceeds from loan syndications   15,300    -    25,617 
Investment in commercial mortgage-backed securities   (535)   (84,871)   (63,562)
Distribution received from joint venture   411    668    - 
Investment in joint venture   (58,911)   372    (3,168)
Change in accrued interest income   -    71    (11)
Sale of marketable investments, net   -    6,560    6,139 
Change in restricted cash from investing activities   7,887    8,268    (5,881)
Deferred investment costs   1,159    2,423    - 
Net cash provided by investing activities   248,288    51,133    154,707 
                
Financing Activities               
Repayments of repurchase facilities   -    -    (85)
Purchase of interest rate caps   -    (1,277)   (3,162)
Repayment of collateralized debt obligations   (282,548)   (164,977)   - 
(Repurchase) issuance of collateralized debt obligations   -    (33,997)   (19,557)
Payment for exchange of junior subordinate note   -    -    (5,000)
Repayment of mortgage notes   -    (33,315)   (43,529)
Proceeds from stock options excerised   -    160    - 
Cash transfer pursuant to Settlement Agreement   -    (37,148)   - 
Deferred financing costs and other liabilities   -    (3,742)   (6,698)
Net proceeds of sale of common stock   2,555    -    - 
Redemption of preferred stock   -    -    (16,620)
Change in restricted cash from financing activities   (26,901)   78,938    (94,387)
Net cash used for financing activities   (306,894)   (195,358)   (189,038)
Net (decrease) increase in cash and cash equivalents   (58,323)   (57,120)   82,500 
Cash and cash equivalents at beginning of period   163,725    220,845    138,345 
Cash and cash equivalents at end of period  $105,402   $163,725   $220,845 
                
Non-cash activity               
Deferred gain (loss) and other non-cash activity related to derivatives  $-   $(19,334)  $(70,707)
Mortgage loans, mezzanine loans and related interest satisfied in connection with deed-in-lieu of foreclosure and settlement agreement  $-  $721,404   $- 
Non-cash assets transferred in connection with deed-in-lieu of foreclosure and settlement agreement  $-   $2,776,447   $- 
Mortgages and liabilities transferred in connection with deed-in-lieu of foreclosure and settlement agreement  $-   $2,378,324   $- 
Supplemental cash flow disclosures               
Interest paid  $67,110   $140,687   $205,441 
Income taxes paid  $5,624   $955   $591 

 

The accompanying notes are an integral part of these financial statements.

66
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

1. Business and Organization

 

Gramercy Capital Corp., or the Company or Gramercy, is a self-managed, integrated commercial real estate investment and asset management company. The Company was formed in April 2004 and commenced operations upon the completion of its initial public offering in August 2004. In June 2012, following a strategic review process completed by a special committee of the Company’s Board of Directors, the Company announced it will focus on deploying the Company's capital into income-producing net leased real estate. The Company’s new investment criteria focuses on single tenant net lease investments across a variety of industries in markets across the United States. The Company has acquired and now owns, directly or in joint venture, a portfolio of 116 office and industrial buildings totaling approximately 4.9 million square feet, net leased on a long-term basis to tenants, including Bank of America, Nestlé Waters, Philips Electronics and others. The Company also has an asset and property management business which operates under the name Gramercy Asset Management and currently manages for third-parties, approximately $1,700,000 of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. Additionally, the Company has a commercial real estate finance business which operates under the name Gramercy Finance and manages approximately $1,700,000 of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity, and commercial mortgage-backed securities, or CMBS, which are financed through three non-recourse collateralized debt obligations, or Gramercy Real Estate CDO 2005-1, Ltd., a Cayman Island company, Gramercy Real Estate CDO 2006-1, Ltd., a Cayman Island company, and Gramercy Real Estate CDO 2007-1, Ltd., a Cayman Island company, or collectively, the CDOs. As described herein, in March 2013, the Company exited the commercial real estate finance business and sold its collateral management and sub-special servicing agreements for the Company’s CDOs which will result in the deconsolidation of Gramercy Finance from the Company’s Balance Sheets. The Company has classified the assets and liabilities of the Gramercy Finance segment as assets held-for-sale and has reported the results of operations of Gramercy Finance in discontinued operations. Neither Gramercy Finance nor Gramercy Asset Management is a separate legal entity but are divisions of the Company through which the Company’s commercial real estate finance and asset and property management businesses are conducted.

 

The Company has elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and generally will not be subject to U.S. federal income taxes to the extent it distributes its taxable income, if any, to its stockholders. The Company has in the past established, and may in the future establish taxable REIT subsidiaries, or TRSs, to effect various taxable transactions. Those TRSs would incur U.S. federal, state and local taxes on the taxable income from their activities.

 

 The Company conducts substantially all of its operations through its operating partnership, GKK Capital LP, or the Operating Partnership. The Company is the sole general partner of the Operating Partnership. The Operating Partnership conducts its finance business primarily through two private REITs, Gramercy Investment Trust and Gramercy Investment Trust II; its commercial real estate investment business through various wholly-owned entities; and its realty management business through a wholly-owned TRS.

 

In connection with the Company’s efforts to exit Gramercy Finance, on January 30, 2013, the Company entered into a purchase and sale agreement to transfer the collateral management and sub-special servicing agreements for its three Collateralized Debt Obligations, CDO 2005-1, CDO 2006-1 and CDO 2007-1, to CWCapital Investments LLC or CWCapital, for approximately $9,900, less certain adjustments and closing costs. Wells Fargo Securities LLC was the Company’s investment advisor for the sale. The Company retained its subordinate bonds, preferred shares, and ordinary shares in the three CDOs, which may provide the potential to recoup additional proceeds over the remaining life of the CDOs based upon resolution of underlying assets within the CDOs, however, there is no guarantee that the Company will realize any proceeds from its equity position, or what the timing of these proceeds might be. The transaction closed in March 2013. In February 2013, the Company also sold a portfolio of repurchased notes previously issued by two of its three CDOs, generating cash proceeds of $34,381. In addition, the Company expects to receive additional cash proceeds for past CDO servicing advances of approximately $14,000 when specific assets within the CDOs are liquidated. Immediately subsequent to the transfer of the collateral management and sub-special serving agreements, the assets and liabilities of the CDOs will be deconsolidated from the Company’s Consolidated Financial Statements.

 

In August 2012, the Company formed a joint venture, or the Joint Venture, with an affiliate of Garrison Investment Group, or Garrison. Subsequently, in December 2012, the Company contributed $59,061 in cash plus the issuance of 6,000,000 shares of the Company’s common stock, valued at $15,000, representing a 50% equity interest in the Joint Venture’s acquisition of an office portfolio of 113 properties, or the Bank of America Portfolio, from KBS Real Estate Investment Trust, Inc. or KBS. The acquisition was financed with a $200,000 two-year, floating rate, interest-only mortgage loan with a spread to 30-day LIBOR of 4.15%, collateralized by 67 properties of the portfolio. The mortgage contains three one-year extensions, conditional upon the satisfaction of certain terms. The Bank of America Portfolio was previously part of the Gramercy Asset Management division, beneficial ownership of which was transferred to KBS pursuant to a collateral transfer and settlement agreement, or the Settlement Agreement, dated September 1, 2011. The Bank of America Portfolio totals approximately 4.2 million rentable square feet and is 84% leased to Bank of America, N.A., under a master lease expiring in 2023, with a total portfolio occupancy of approximately 89%. The Joint Venture’s asset strategy for this portfolio acquisition is to sell non-core multi-tenant assets and retain a core net-lease portfolio of high quality assets in primary and strong secondary markets, primarily leased to Bank of America. In addition to the Company’s pro rata share of the net income of the portfolio, pursuant to the joint venture agreement, the Company will receive an asset management fee as well as a performance based fee for the portfolio management. At December 31, 2012, the Company’s 50% interest in the Bank of America Portfolio had a carrying value of $72,541.

 

67
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

1. Business and Organization - (continued)

 

In November 2012, the Company also acquired two class A industrial properties located near Indianapolis, Indiana, or the Indianapolis Industrial Portfolio, totaling approximately 540 thousand square feet for a purchase price of $27,125. The Indianapolis Industrial Portfolio is 100% leased to three tenants for an average lease term of approximately 10.2 years.

 

In 2011, the Company’s Gramercy Asset Management business changed from being primarily an owner of commercial properties to being primarily a third-party manager of commercial properties. The scale of Gramercy Asset Management’s revenues declined as a substantial portion of rental revenues from properties owned by the Company were replaced with fee revenues of a substantially smaller scale for managing properties for third-parties. In September 2011, the Company entered into the Settlement Agreement for an orderly transition of substantially all of Gramercy Asset Management’s assets to KBS, Gramercy Asset Management’s senior mezzanine lender, in full satisfaction of Gramercy Asset Management’s obligations with respect to the Goldman Mortgage Loan and the Goldman Mezzanine Loans, in exchange for a mutual release of claims among the Company and the mortgage and mezzanine lenders and, subject to certain termination provisions, the Company’s continued management of Gramercy Asset Management’s assets on behalf of KBS for a fixed fee plus incentive fees. On September 1, 2011 and on December 1, 2011, the Company transferred to KBS or its affiliates, interests in entities owning 317 and 116, respectively, of the 867 Gramercy Asset Management properties that the Company agreed to transfer pursuant to the Settlement Agreement and the remaining ownership interests were transferred to KBS by December 15, 2011. The aggregate carrying value for the interests transferred to KBS was $2,631,902. In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure.

 

In September 2011, the Company entered into an asset management arrangement upon the terms and conditions set forth in the Settlement Agreement, or the Interim Management Agreement, to provide for the Company’s continued management of the transferred properties, or the KBS portfolio, through December 31, 2013 for a fixed fee of $10,000 annually, plus the reimbursement of certain costs. The Settlement Agreement obligated the parties to negotiate in good faith to replace the Interim Management Agreement with a more complete and definitive management services agreement on or before March 31, 2012 and on March 30, 2012, the Company entered into an Asset Management Services Agreement, or the Management Agreement, with KBS Acquisition Sub, LLC, or KBSAS, a wholly-owned subsidiary of KBS Real Estate Investment Trust, Inc., or KBS REIT, pursuant to which the Company will provide asset management services to KBSAS with respect to the KBS Portfolio. The Management Agreement provides for continued management of the KBS Portfolio by GKK Realty Advisors, LLC, or the Manager, through December 31, 2015 for (i) a base management fee of $12,000 per year, payable monthly, plus the reimbursement of all property related expenses paid by Manager on behalf of KBSAS, subject to deferral of $167 per month at KBSAS’s option until the accrued amount equals $2,500 or June 30, 2013, whichever is earlier, and (ii) an incentive fee, or the Threshold Value Profits Participation, in an amount equal to the greater of: (a) $3,500 or (b) 10% of the amount, if any, by which the portfolio equity value exceeds $375,000 (as adjusted for future cash contributions into, and distributions out of, KBSAS by KBS REIT). In December 2012, concurrently with the sale of the Bank of America Portfolio the base management fee was reduced by $3,000 per year to $9,000 per year, which will be partially offset by the asset management fee the Company receives from Garrison. In any event, the Threshold Value Profits Participation is capped at a maximum of $12,000. The Threshold Value Profits Participation is payable 60 days after the earlier to occur of June 30, 2014 (or March 31, 2015 upon satisfaction of certain extension conditions, including the payment by KBSAS to Manager of a $750 extension fee) and the date on which KBSAS, directly or indirectly, sells, conveys or otherwise transfers at least 90% of the KBS Portfolio (by value).

 

The Company may terminate the Management Agreement (i) without any KBSAS default under the Management Agreement, on or after December 31, 2012, upon 90 days’ prior written notice or (ii) at any time by five business days’ prior written notice in the event of a KBSAS default under the Management Agreement. The Management Agreement may be terminated by KBSAS, (i) without Cause (as defined in the Management Agreement), with an effective termination date of March 31 or September 30 of any year but at no time prior to September 30, 2013, upon 90 days’ prior written notice or (ii) at any time after April 1, 2013 for Cause. In the event of a termination of the Management Agreement by KBSAS after April 1, 2013 but prior to December 31, 2015, the Company will be entitled to receive a declining balance termination fee, ranging from $5,000 to $2,000, calculated as specified in the Management Agreement.

  

68
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies

 

Reclassification

 

Certain prior year balances have been reclassified to conform with the current year presentation for assets classified as discontinued operations. Certain reclassifications were made to the Consolidated Balance Sheets, Consolidated Statements of Operations and Comprehensive Income (Loss) and footnote disclosures for all periods presented to reflect held-for-sale and discontinued operations as of December 31, 2012. Additionally, the Company has changed the format of its Consolidated Balance Sheets for all periods presented to present the assets and liabilities of the consolidated Variable Interest Entities, or VIEs, parenthetically on the Consolidated Balance Sheets.  This change in format did not have any effect on any of the reported line items within the Consolidated Balance Sheets, other than presenting the combined assets and combined liabilities for each of the respective line items previously presented under the assets and liabilities of the VIEs and those assets and liabilities not in the VIEs.

 

Principles of Consolidation

 

The Consolidated Financial Statements include the Company’s accounts and those of the Company’s subsidiaries which are wholly-owned or controlled by the Company, or entities which are variable interest entities, or VIEs, in which the Company is the primary beneficiary. The primary beneficiary is the party that absorbs a majority of the VIE’s anticipated losses and/or a majority of the expected returns. The Company has evaluated its investments for potential classification as variable interests by evaluating the sufficiency of each entity’s equity investment at risk to absorb losses, and determined that the Company is the primary beneficiary for three VIEs and has included the accounts of these entities in the Consolidated Financial Statements.

 

Entities which the Company does not control and entities which are VIEs, but where the Company is not the primary beneficiary, are accounted for under the equity method. All significant intercompany balances and transactions have been eliminated. 

 

Gramercy Finance

 

In connection with the purchase and sale agreement of the collateral management and sub-special servicing agreements for the Company’s CDOs the Company classified the assets and liabilities of Gramercy Finance as held-for-sale and has reported the results of operations of Gramercy Finance in discontinued operations. As of December 31, 2012, the Company had assets of Gramercy Finance classified as held-for-sale of $1,952,264. The Company recorded impairment charges of $27,180 within discontinued operations on loans and real estate investments to adjust the carrying value to the lower of cost or fair value and other-than-temporary impairments of $128,087 within discontinued operations as the Company no longer could express the intent to hold CMBS investments until the recovery of amortized cost for all CMBS in an unrealized loss position. For a further discussion regarding the measurement of financial instruments and real estate assets of the Gramercy Finance segment see Note 11, “Fair Value of Financial Instruments”, Note 3 “Dispositions and Assets Held for Sale” and Note 6 “Liabilities Related to Assets Held-for-Sale”.

 

Variable Interest Entities

 

The following is a summary of the Company’s involvement with VIEs as of December 31, 2012:

 

   Company
carrying
value-assets
   Company
carrying value-
liabilities
   Face value of
assets held by
theVIE
   Face value of 
liabilities
issued by the
VIE
 
Consolidated VIEs                    
Collateralized debt obligations  $1,913,353(1)  $2,374,516   $2,469,856   $2,593,392 

 

(1)Collateralized debt obligations are a component of liabilities related to assets held-for-sale on the Consolidated Balance Sheets.

 

The following is a summary of the Company’s involvement with VIEs as of December 31, 2011:

 

   Company
carrying
value-assets
   Company
carrying value-
liabilities
   Face value of
assets held by
the VIE
   Face value of
liabilities
issued by the
VIE
 
Consolidated VIEs                    
Collateralized debt obligations  $1,990,826   $2,654,109   $2,927,748   $2,880,953 
Unconsolidated VIEs                    
CMBS-controlling class  $-(1)  $-   $624,592   $624,592 

 

(1)CMBS are assets held by the collateralized debt obligations classified on the Consolidated Balance Sheets as an asset of Consolidated VIEs.

 

Consolidated VIEs

 

As of December 31, 2012, the Consolidated Balance Sheets includes $1,913,353 of assets and $2,374,516 of liabilities related to three consolidated VIEs, which are included in Gramercy Finance and classified as held-for-sale. Due to the non-recourse nature of these VIEs, and other factors discussed below, the Company’s net exposure to loss from investments in these entities is limited to its beneficial interests in these VIEs.

 

69
 

 

Gramercy Capital Corp.

 

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

Collateralized Debt Obligations

 

The Company consolidates three collateralized debt obligations, or CDOs, that are VIEs and which are included in Gramercy Finance and are classified as held-for-sale. Since the Company is the collateral manager of the three CDOs and can make decisions related to the collateral that would most significantly impact the economic outcome of the CDOs, the Company has concluded that it is the primary beneficiary of the CDOs as of December 31, 2012. These CDOs invest in commercial real estate debt instruments, the majority of which the Company originated within the CDOs, and are financed by the debt and equity issued. The Company is named as collateral manager of all three CDOs. As a result of consolidation, the Company’s subordinate debt and equity ownership interests in these CDOs have been eliminated, and the Consolidated Balance Sheets reflect both the assets held and debt issued by these CDOs to third-parties. Similarly, the operating results and cash flows include the gross amounts related to the assets and liabilities of the CDOs, as opposed to the Company’s net economic interests in these CDOs. Refer to Note 6 for further discussion of fees earned related to the management of the CDOs.

 

The Company’s interest in the assets held by these CDOs is restricted by the structural provisions of these entities, and the recovery of these assets will be limited by the CDOs’ distribution provisions, which are subject to change due to non-compliance with covenants, which are described further in Note 6. The liabilities of the CDO trusts are non-recourse, and can generally only be satisfied from the respective asset pool of each CDO.

 

The Company is not obligated to provide any financial support to these CDOs. As of December 31, 2012, the Company has no exposure to loss as a result of the investment in these CDOs.

 

Unconsolidated VIEs

 

Investment in CMBS

 

The Company has investments in certain CMBS, which are considered to be VIEs. The Company’s securities portfolio, with an aggregate face amount of $1,179,802, is financed by the Company’s CDOs, which are included in Gramercy Finance and are classified as held-for-sale. The Company has not consolidated the aforementioned CMBS investments due to the determination that based on the structural provisions and nature of each investment, the Company does not directly control the activities that most significantly impact the VIEs’ economic performance. The Company’s exposure to loss is limited to its interests in the consolidated CDOs described above.

 

Real Estate Investments

 

The Company records acquired real estate investments at cost. Costs directly related to the acquisition of such investments are expensed as incurred. The Company allocates the purchase price of real estate to land, building and intangibles, such as the value of above-, below- and at-market leases and origination costs associated with the in-place leases at the acquisition date. The values of the above- and below-market leases are amortized and recorded as either an increase in the case of below-market leases or a decrease in the case of above-market leases to rental income over the remaining term of the associated lease. The values associated with in-place leases are amortized over the expected term of the associated lease. The Company assesses the fair value of the leases at acquisition based upon estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known trends, and market/economic conditions that may affect the property. To the extent acquired leases contain fixed rate renewal options that are below-market and determined to be material, the Company amortizes such below-market lease value into rental income over the renewal period.

 

Certain improvements are capitalized when they are determined to increase the useful life of the building. Depreciation is computed using the straight-line method over the shorter of the estimated useful life of the capitalized item or 40 years for buildings, five to ten years for building equipment and fixtures, and the lesser of the useful life or the remaining lease term for tenant improvements and leasehold interests. Maintenance and repair expenditures are charged to expense as incurred.

 

70
 

 

Gramercy Capital Corp.

 

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

In leasing office space, the Company may provide funding to the lessee through a tenant allowance. In accounting for tenant allowances, the Company determines whether the allowance represents funding for the construction of leasehold improvements and evaluates the ownership of such improvements. If the Company is considered the owner of the leasehold improvements, the Company capitalizes the amount of the tenant allowance and depreciates it over the shorter of the useful life of the leasehold improvements or the lease term. If the tenant allowance represents a payment for a purpose other than funding leasehold improvements, or in the event the Company is not considered the owner of the improvements for accounting purposes, the allowance is considered to be a lease incentive and is recognized over the lease term as a reduction of rental revenue. Factors considered during this evaluation usually include (i) who holds legal title to the improvements, (ii) evidentiary requirements concerning the spending of the tenant allowance, and (iii) other controlling rights provided by the lease agreement (e.g. unilateral control of the tenant space during the build-out process). Determination of the accounting for a tenant allowance is made on a case-by-case basis, considering the facts and circumstances of the individual tenant lease.

 

The Company also reviews the recoverability of the property’s carrying value when circumstances indicate a possible impairment of the value of a property. The review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as changes in strategy resulting in an increased or decreased holding period, expected future operating income, market and other applicable trends and residual value, as well as the effects of leasing demand, competition and other factors. If management determines impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property for properties to be held and used and for assets held for sale, an impairment loss is recorded to the extent that the carrying value exceeds the fair value less estimated cost to dispose for assets held-for-sale. These assessments are recorded as an impairment loss in the Consolidated Statements of Operations and Comprehensive Income (Loss) in the period the determination is made. The estimated fair value of the asset becomes its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated or amortized over the remaining useful life of that asset.

 

During 2012, the Company recorded impairment charges for properties classified as held for sale of $35,043 of which $26,298 was related to the disposal of Gramercy Finance. During 2011, the Company recorded impairment charges for properties classified as held for investment of $1,237. These properties were reclassified as discontinued operations as part of the settlement agreement.

 

During 2010, the Company recorded impairment charges of $933,884 related to its investments in real estate, including $85,294 of impairments on intangible assets. Impairment charges for properties classified as held for investment were $913,648 and impairments for properties reclassified as discontinued operations were $20,236. The Company recorded impairment charges totaling $912,147 in continuing operations during 2010 to reduce the carrying value of 692 properties to the estimated fair value. All of the impaired properties served as collateral for the Goldman Mezzanine Loans and were part of the Gramercy Asset Management portfolio. The Company also recorded impairment charges on three leasehold properties totaling $1,501 based on the difference between estimated cash flow shortfalls over the sub-tenants’ lease term. No other real estate assets in the portfolio were determined to be impaired as of December 31, 2010 as a result of the analysis. The estimated fair values for the properties serving as collateral for the Goldman Mezzanine loans were calculated using discounted cash flows based on internally developed models and residual values calculated with capitalization rates utilizing a study completed by a third-party property management provider for similar types of buildings. The Company used a range of possible future outcomes or a probability-weighted approach to determine the proper timing of the impairment. The Company determined that, as of December 31, 2010, based on the likelihood of the range of possible outcomes and the probability-weighted cash flows, its investments in real estate were impaired.

 

71
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

Investments in Joint Ventures

 

The Company accounts for its investments in joint ventures under the equity method of accounting since it exercises significant influence, but does not unilaterally control the entities, and is not considered to be the primary beneficiary. In the joint ventures, the rights of the other investors are protective and participating. Unless the Company is determined to be the primary beneficiary, these rights preclude it from consolidating the investments. The investments are recorded initially at cost as an investment in joint ventures, and subsequently are adjusted for equity in net income (loss) and cash contributions and distributions. Any difference between the carrying amount of the investments on the Consolidated Balance Sheets and the underlying equity in net assets is evaluated for impairment at each reporting period. None of the joint venture debt is recourse to the Company. As of December 31, 2012 and 2011, the Company had investments of $131,986 and $496 in unconsolidated joint ventures, respectively, of which $59,244 were classified as held-for-sale in connection with the disposal of Gramercy Finance at December 31, 2012.

 

Cash and Cash Equivalents

 

The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents.

 

Restricted Cash

 

Restricted cash at December 31, 2012 consists of $61,305 on deposit with the trustee of the Company’s collateralized debt obligations, or CDOs, that is classified as held-for-sale in connection with the disposal of Gramercy Finance, and $92 related to real estate assets held-for-sale which represents amounts escrowed pursuant to mortgage agreements securing the Company’s real estate investments and CTL investments for insurance, taxes, repairs and maintenance, tenant improvements, interest, and debt service and amounts held as collateral under security and pledge agreements relating to leasehold interests.

 

Assets Held for Sale

  

In connection with the Company’s efforts to exit Gramercy Finance and the commercial real estate finance business, the Company classified the assets and liabilities of Gramercy Finance as held-for-sale. As of December 31, 2012, the Company had assets classified as held-for-sale of $1,952,264 related to the disposal of Gramercy Finance. The Company recorded impairment charges of $27,180 within discontinued operations on loans and real estate investments owned to adjust the carrying value to the lower of cost or fair value and other-than-temporary impairments of $128,087 within discontinued operations as the Company no longer could express the intent to hold CMBS investments until the recovery of amortized cost for all CMBS in an unrealized loss position. For a further discussion regarding the measurement of financial instruments and real estate assets of the Gramercy Finance segment see Note 11, “Fair Value of Financial Instruments” and Note 3 “Dispositions and Assets Held-for-Sale”.

 

Real estate investments to be disposed of are reported at the lower of carrying amount or estimated fair value, less cost to sell. Once an asset is classified as held-for-sale, depreciation expense is no longer recorded and current and prior periods are reclassified as “discontinued operations.” As of December 31, 2012 and 2011, the Company had real estate investments held-for-sale of $49,062 and $42,965, respectively. The Company recorded impairment charges of $35,043, $1,237 and $20,236 during the years ended December 31, 2012, 2011 and 2010, respectively, related to real estate investments classified as held-for-sale.

 

Settlement of Debt

 

A gain on settlement of debt is recorded when the carrying amount of the liability settled exceeds the fair value of the assets transferred to the lender or special servicer.

 

In 2012, the Company did not recognize any gain on settlement of debt.

 

72
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

Pursuant to the execution of the Settlement Agreement, the transfer of 867 Gramercy Asset Management properties, with an aggregate carrying value of $2,631,902 and associated mortgage, mezzanine and other liabilities of $2,843,345, occurred in September and December 2011 and the Company recognized a gain on settlement of debt of $285,634 in connection with such transfer as part of discontinued operations on the Consolidated Statements of Operations and Comprehensive Income (Loss). The gain on settlement of debt includes $54,083 of gain on disposal of assets. During the year ended December 31, 2011, the Company recorded $2,489 of legal and professional fees related to the restructuring of the Goldman Mortgage Loan and the Goldman Mezzanine Loans in the Consolidated Statements of Operations and Comprehensive Income (Loss).

 

In July 2011, the Dana portfolio, which consisted of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. The Company recognized gain on settlement of debt of $74,191 year ended December 31, 2011 as part of discontinued operations on the Consolidated Statements of Operations and Comprehensive Income (Loss). The Company realized a $15,892 gain on the disposal the assets, which is included in the gain on settlement of debt.

 

Tenant and Other Receivables

 

Tenant and other receivables are primarily derived from the rental income that each tenant pays in accordance with the terms of its lease, which is recorded on a straight-line basis over the initial term of the lease. Since many leases provide for rental increases at specified intervals, straight-line basis accounting requires the Company to record a receivable, and include in revenues, unbilled rent receivables that will only be received if the tenant makes all rent payments required through the expiration of the initial term of the lease. Tenant and other receivables also include receivables related to tenant reimbursements for common area maintenance expenses and certain other recoverable expenses that are recognized as revenue in the period in which the related expenses are incurred.

 

Tenant and other receivables are recorded net of the allowances for doubtful accounts which as of December 31, 2012 and 2011, were $211 and $280, respectively. The Company continually reviews receivables related to rent, tenant reimbursements and unbilled rent receivables and determines collectability by taking into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectability of a receivable is in doubt, the Company increases the allowance for doubtful accounts or records a direct write-off of the receivable in the Consolidated Statements of Operations and Comprehensive Income (Loss).

 

Intangible Assets

 

The Company follows the purchase method of accounting for business combinations. The Company allocates the purchase price of acquired properties to tangible and identifiable intangible assets acquired based on their respective fair values. Tangible assets include land, buildings and improvements on an as-if vacant basis. The Company utilizes various estimates, processes and information to determine the as-if vacant property value. Estimates of value are made using customary methods, including data from appraisals, comparable sales, discounted cash flow analyses and other methods. Identifiable intangible assets include amounts allocated to acquired leases for above- and below-market lease rates and the value of in-place leases.

 

73
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

Above-market and below-market lease values for properties acquired are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between the contractual amount to be paid pursuant to each in-place lease and management’s estimate of the fair market lease rate for each such in-place lease, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. The capitalized below-market lease values are amortized as an increase to rental income over the initial term of the respective leases. If a tenant vacates its space prior to the contractual termination of the lease and no rental payments are being made on the lease, any unamortized balance of the related intangible will be written off.

 

The aggregate value of intangible assets related to in-place leases is primarily the difference between the property valued with existing in-place leases adjusted to market rental rates and the property valued as-if vacant. Factors considered by management in its analysis of the in-place lease intangibles include an estimate of carrying costs during the expected lease-up period for each property taking into account current market conditions and costs to execute similar leases. In estimating carrying costs, management includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the anticipated lease-up period, which is expected to average six months. Management also estimates costs to execute similar leases including leasing commissions, legal and other related expenses. The value of in-place leases is amortized to expense over the initial term of the respective leases, which range primarily from one to 20 years. In no event does the amortization period for intangible assets exceed the remaining depreciable life of the building. If a tenant terminates its lease, the unamortized portion of the in-place lease value is charged to expense.

 

In making estimates of fair values for purposes of allocating purchase price, the Company utilizes a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence, as well as subsequent marketing and leasing activities, in estimating the fair value of the tangible and intangible assets acquired and intangible liabilities assumed.

 

Intangible assets and acquired lease obligations consist of the following:

 

   December 31,
2012
   December 31,
2011
 
Intangible assets:          
In-place leases, net of accumulated amortization of $359 and $1,388  $3,639   $4,305 
Above-market leases, net of accumulated amortization of $48 and $153   935    672 
Amounts related to assets held for sale, net of accumulated amortization of $365 and $1,509   (188)   (4,904)
Total intangible assets  $4,386   $73 
           
Intangible liabilities:          
Below-market leases, net of accumulated amortization of $1,395 and $1,469  $2,161   $3,207 
Amounts related to liabilities held for sale, net of accumulated amortization of $1,391 and $1,469   (1,703)   (3,207)
Total intangible liabilities  $458   $- 

 

74
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

The following table provides the weighted-average amortization period as of December 31, 2012 for intangible assets and liabilities and the projected amortization expense for the next five years.

 

   Weighted-
Average
Amortization
Period
   2013   2014   2015   2016   2017 
In-Place Leases   10.0   $382   $382   $382   $382   $382 
Total to be included in Depreciation and Amorization Expense       $382   $382   $382   $382   $382 
                               
Above-Market Lease Assets   6.7   $147   $147   $147   $147   $147 
Below-Market Lease Liabilities   10.4    (216)   (216)   (216)   (216)   (211)
                               
Total to be included in Rental Revenue       $(69)  $(69)  $(69)  $(69)  $(64)

 

The Company recorded $80, $23,374 and $44,413 of amortization of intangible assets as part of depreciation and amortization, including $50, $23,374 and $44,413 within discontinued operations for the years ended December 2012, 2011, and 2010, respectively. The Company recorded $188, $54,420 and $68,507 of amortization of intangible assets and liabilities as an increase to rental revenue, including $196, $54,420 and $58,507 within discontinued operations for the years ended December 2012, 2011, and 2010, respectively.

 

Deferred Costs

 

Deferred costs include deferred financing costs that represent commitment fees, legal and other third-party costs associated with obtaining commitments for financing which result in a closing of such financing. These costs are amortized over the terms of the respective agreements and the amortization is reflected as interest expense. Unamortized deferred financing costs are expensed when the associated debt is refinanced or repaid before maturity. Costs incurred in seeking financing transactions that do not close are expensed in the period in which it is determined that the financing will not close. Deferred costs also consist of fees and direct costs incurred to originate new investments and are amortized using the effective yield method over the related term of the investment.

 

The Company has deferred certain expenditures related to the leasing of certain properties. Direct costs of leasing including internally capitalized payroll costs associated with leasing activities are deferred and amortized over the terms of the underlying leases.

 

Other Assets

 

The Company makes payments for certain expenses such as insurance and property taxes in advance of the period in which it receives the benefit. These payments are classified as other assets and amortized over the respective period of benefit relating to the contractual arrangement. The Company also escrows deposits related to pending acquisitions and financing arrangements, as required by a seller or lender, respectively. Costs prepaid in connection with securing financing for a property are reclassified into deferred financing costs at the time the transaction is completed.

 

Asset Retirement Obligation

 

Accounting for asset retirement obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation is recognized when incurred — generally upon acquisition, construction, or development and (or) through the normal operation of the asset. The Company assessed the cost associated with its legal obligation to remediate asbestos in its properties known to contain asbestos and recorded the present value of the asset retirement obligation. As of December 31, 2012 and December 31, 2011 the Company has recorded a liability of approximately $0 and $814, respectively. The Company recorded an expense of $0, $139, and $122 for the years ended December 31, 2012, 2011, and 2010, respectively, within discontinued operations.

 

75
 

 

Gramercy Capital Corp.

Notes To Consolidated Financial Statements
(Amounts in thousands, except share and per share data)
December 31, 2012

 

2. Significant Accounting Policies – (continued)

 

Valuation of Financial Instruments

 

ASC 820-10, “Fair Value Measurements and Disclosures,” among other things, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, fair values are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. Financial instruments with readily available actively quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and will require a lesser degree of judgment to be utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have less, or no, pricing observability and will require a higher degree of judgment to be utilized in measuring fair value. Pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair value amounts.

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. The level of pricing observability generally correlates to the degree of judgment utilized in measuring the fair value of financial instruments. The less judgment utilized in measuring fair value financial instruments such as with readily available active quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability. Conversely, financial instruments rarely traded or not quoted have less observability and are measured at fair value using valuation models that require more judgment. Impacted by a number of factors, pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.

 

The three broad levels defined are as follows:

 

Level I — This level is comprised of financial instruments that have quoted prices that are available in active markets for identical assets or liabilities. The type of financial instruments included in this category are highly liquid instruments with actively quoted prices.

 

Level II — This level is comprised of financial instruments that have pricing inputs other than quoted prices in active markets that are either directly or indirectly observable. The nature of these financial instruments includes instruments for which quoted prices are available but traded less frequently and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.

 

Level III — This level is comprised of financial instruments that have little to no pricing observability as of the