10-Q 1 a50623352.htm CREXUS INVESTMENT CORP. 10-Q a50623352.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X]             QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED:  MARCH 31, 2013

OR

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

FOR THE TRANSITION PERIOD FROM _______________ TO _________________

COMMISSION FILE NUMBER:  1-34451

CREXUS INVESTMENT CORP.
(Exact name of Registrant as specified in its Charter)
 
 
 MARYLAND  26-2652391
 (State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)
                                                                                                                               
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)

10036
 (Zip Code)

(646) 829-0160
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all documents and 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 þ        No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (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 þ        No o

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

 
Class
Common Stock, $.01 par value
Outstanding at May 6, 2013
76,630,528
 
 

 

CREXUS INVESTMENT CORP.
FORM 10-Q
TABLE OF CONTENTS

 
   
 
   
 
(Derived from the audited financial statements at December 31, 2012)
1
   
 
(Unaudited) 
2
   
 
3
   
4
   
5
   
27
   
44
   
49
   
   
 
   
50
   
50
   
51
   
52
   
CERTIFICATIONS
53
 
 
i

 
 
PART I.             FINANCIAL INFORMATION

 
 
CREXUS INVESTMENT CORP.
 
 
(dollars in thousands, except per share data)
 
             
   
March 31, 2013
   
December 31, 2012
 
   
(unaudited)
   
(1)
 
Assets:
           
Cash and cash equivalents
  $ 164,472     $ 123,543  
Commercial real estate loans net of allowance for loan losses ($0 and $0, respectively)
         
   Senior
    100,179       100,343  
   Subordinate
    39,111       38,954  
   Mezzanine
    541,354       590,525  
Preferred equity held for investment
    39,769       39,769  
Real estate held for sale
    30,077       33,511  
Investment in real estate, net
    33,384       33,655  
Intangible assets, net
    4,989       5,095  
Rents receivable
    325       268  
Accrued interest receivable
    4,946       4,957  
Other assets
    2,866       3,379  
   Total assets
  $ 961,472     $ 973,999  
                 
Liabilities:
               
Mortgages payable
  $ 19,150     $ 19,150  
Participation sold (non-recourse)
    13,706       13,759  
Accounts payable and other liabilities
    2,144       3,363  
Dividends payable
    19,159       24,522  
Intangible liabilities, net
    1,873       1,907  
Investment management fees payable to affiliate
    3,337       3,425  
   Total liabilities
    59,369       66,126  
                 
Stockholders' Equity:
               
Common stock, par value $0.01 per share, 1,000,000,000 shares
               
 authorized, 76,630,528 issued and outstanding
    766       766  
Additional paid-in-capital
    890,862       890,862  
Retained earnings
    10,475       16,245  
   Total stockholders' equity
    902,103       907,873  
   Total liabilities and stockholders' equity
  $ 961,472     $ 973,999  
                 
(1) Derived from the audited financial statements at December 31, 2012.
               
                 
See notes to consolidated financial statements.
               
 
 
1

 
 
CREXUS INVESTMENT CORP.
 
 
(dollars in thousands, except share and per share data)
 
(unaudited)
 
       
   
For the Quarter Ended
 
   
March 31, 2013
   
March 31, 2012
 
             
Net interest income:
           
Interest income
  $ 21,056     $ 23,392  
Interest expense
    (383 )     (360 )
Servicing fees
    (157 )     (115 )
   Net interest income
    20,516       22,917  
                 
Other income:
               
Miscellaneous fee income
    4       349  
Rental income
    832       712  
   Total other income
    836       1,061  
                 
Other expenses:
               
Provision for loan losses, net
    -       2,803  
Management fees to affiliate
    3,337       3,471  
General and administrative expenses
    4,370       2,710  
Amortization expense
    106       123  
Depreciation expense
    270       275  
   Total other expenses
    8,083       9,382  
                 
Income before income tax
    13,269       14,596  
Income tax
    1       1  
Net income from continuing operations
    13,268       14,595  
                 
Net income (loss) from discontinued operations (net of tax expense of $255 and $295, respectively)
    (499 )     1,522  
Gain on sale from discontinued operations
    886       -  
Impairment charges
    (266 )     -  
   Total income (loss) from discontinued operations
    121       1,522  
                 
Net Income
  $ 13,389     $ 16,117  
                 
Net income per average share-basic and diluted, continuing operations
  $ 0.17     $ 0.19  
Total net income per average share-basic and diluted, discontinued operations
    0.00       0.02  
Net income per average share-basic and diluted
  $ 0.17     $ 0.21  
                 
Dividend declared per share of common stock
  $ 0.25     $ 0.27  
                 
Weighted average number of shares outstanding-basic and diluted
    76,630,528       76,620,112  
Comprehensive income:
               
Net income
  $ 13,389     $ 16,117  
Comprehensive income
  $ 13,389     $ 16,117  
                 
See notes to consolidated financial statements.
 
 
 
2

 

CREXUS INVESTMENT CORP.
 
 
(dollars in thousands, except per share data)
 
(unaudited)  
                         
                         
   
Common
   
Additional
             
   
Stock Par
   
Paid-in
   
Retained
       
   
Value
   
Capital
   
Earnings
   
Total
 
Balance, December 31, 2011
  $ 766     $ 890,757     $ 35,634     $ 927,157  
Net income
    -       -       16,117       16,117  
Common dividends declared, $0.27 per share
    -       -       (20,688 )     (20,688 )
Balance, March 31, 2012
  $ 766     $ 890,757     $ 31,063     $ 922,586  
                                 
Balance, December 31, 2012
  $ 766     $ 890,862     $ 16,245     $ 907,873  
Net income
    -       -       13,389       13,389  
Common dividends declared, $0.25 per share
    -       -       (19,159 )     (19,159 )
Balance, March 31, 2013
  $ 766     $ 890,862     $ 10,475     $ 902,103  
                                 
See notes to consolidated financial statements.
                 
 
 
3

 
 
CREXUS  INVESTMENT CORP.
 
 
(dollars in thousands)
 
(unaudited)
 
   
For the Quarter Ended
 
   
March 31, 2013
   
March 31, 2012
 
             
Cash Flows From Operating Activities:
           
Net income
  $ 13,389     $ 16,117  
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
 
     Net amortization of investment premiums and discounts
    (582 )     (10,922 )
     Amortization of origination fees and costs, net
    (120 )     -  
     Realized gain on sale of real estate held for sale
    (886 )     -  
     Provision for loan losses, net
    -       2,803  
     Impairment charges on real estate held for sale
    266       -  
     Unrealized (gain) loss on interest rate swap
    (4 )     41  
     Amortization of intangible assets and liabilities, net
    72       123  
     Depreciation
    270       275  
Changes in operating assets:
               
     Decrease (increase) in accrued interest receivable
    11       (901 )
     Decrease (increase) in other assets
    513       (2,119 )
     Decrease (increase) in rents receivable
    (57 )     (55 )
Changes in operating liabilities:
               
     Increase (decrease) in accounts payable and other liabilities
    (1,094 )     407  
 Increase (decrease) in investment management fee payable to affiliate
    (88     (18
     Increase (decrease) in accrued interest payable
    -       42  
Net cash provided by (used in) operating activities
    11,690       5,793  
Cash Flows From Investing Activities:
               
Loans and preferred equity held for investment portfolio:
               
     Purchases and advances, net of discount
    (922 )     (116,077 )
     Principal payments
    50,682       194,277  
Real estate portfolio:
               
     Purchases of real estate
    -       (5,050 )
     Sale of real estate held for sale
    4,054       -  
Net cash provided by (used in) investing activities
    53,814       73,150  
Cash Flows From Financing Activities:
               
     Proceeds from collateralized mortgage borrowings
    -       2,550  
     Principal repayments on participation sold
    (53 )     -  
     Dividends paid
    (24,522 )     (26,817 )
Net cash (used in) provided by financing activities
    (24,575 )     (24,267 )
Net increase (decrease) in cash and cash equivalents
    40,929       54,676  
Cash and cash equivalents at beginning of period
    123,543       202,814  
Cash and cash equivalents at end of period
  $ 164,472     $ 257,490  
Supplemental disclosure of cash flow information:
               
     Interest paid
  $ 159     $ 48  
     Taxes paid
  $ 1,980     $ 1  
Non cash investing activities:
               
   Reclassification of loans to real estate upon deed in lieu of foreclosure
 -     $ 52,800  
   Rate and term financing
  $ -     $ 15,000  
Non cash financing activities:
               
   Common dividends declared, not yet paid
  $ 19,159     $ 20,688  
                 
See notes to consolidated financial statements.
               
 
 
4

 
 
CREXUS INVESTMENT CORP.
FOR THE QUARTER ENDED MARCH 31, 2013
 (unaudited)

 
1.   Organization

CreXus Investment Corp. (the “Company”) was organized in Maryland on January 23, 2008.  The Company commenced operations on September 22, 2009 upon completion of its initial public offering.  The Company, directly or through its subsidiaries, acquires, manages and finances an investment portfolio of commercial real estate loans and other commercial real estate debt, commercial real property, commercial mortgage-backed securities (“CMBS”), other commercial real estate-related assets and Agency residential mortgage-backed securities (“Agency RMBS”) and has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended.  As a REIT, the Company will generally not be subject to U.S. federal or state corporate taxes on its income to the extent that qualifying distributions are made to stockholders and the REIT requirements, including certain asset, income, distribution and stock ownership tests are met. The Company’s wholly-owned subsidiaries, CreXus S Holdings LLC, CreXus S Holdings (Grand Cayman) LLC, CreXus F Asset Holdings LLC, CHPHC Holding Company LLC, CHPHC Hotel I LLC, CHPHC Hotel II LLC, CHPHC Hotel III LLC, CHPHC Hotel IV LLC, CHPHC Hotel V LLC, CHPHC Hotel VI LLC, CHPHC Hotel VII LLC, CHPHC Hotel VIII LLC, CHPHC Hotel IX LLC, CHPHC Hotel X LLC, CHPHC Hotel XI LLC, CHPHC Hotel XII LLC, CreXus Net Lease Holdings LLC, CreXus AZ Holdings 1 LLC, CreXus NV Holdings 1 LLC, and CreXus TALF Holdings, LLC (collectively, the “Subsidiaries”), are qualified REIT subsidiaries.  The Company’s wholly-owned subsidiary, CreXus S Holdings (Holding Co) LLC, is a taxable REIT subsidiary.

At March 31, 2013, Annaly Capital Management, Inc. (“Annaly”) owned approximately 12.4% of the Company’s common shares.  The Company is managed by Fixed Income Discount Advisory Company (“FIDAC”), an investment advisor registered with the Securities and Exchange Commission (“SEC”).  FIDAC is a wholly-owned subsidiary of Annaly.

2.  Summary of the Significant Accounting Policies
 
(a)
Basis of Presentation and Principles of Consolidation
 
The accompanying consolidated financial statements and related notes of the Company have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP").  The Company adopted the provisions of the Financial Accounting Standards Board (“FASB”), Accounting Standards Codification, (the “Codification” or “ASC”), which is the current source of authoritative GAAP.
 
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated in consolidation.In the opinion of management, all adjustments considered necessary for a fair presentation of the Company's financial position, results of operations and cash flows have been included and are of a normal and recurring nature.
 
(b) Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and in money market accounts with original maturities less than 90 days.
 
 
5

 
 
(c) Commercial Real Estate Loans

The Company's commercial real estate mortgages and loans are comprised of fixed-rate and adjustable-rate loans. Commercial real estate mortgages and loans are designated as held for investment and are carried at their outstanding principal balance, plus premiums, less discounts, which are amortized or accreted over the estimated life of the loan, less an estimated allowance for loan losses.  The difference between the face amount of a loan and proceeds at acquisition is recorded as either discount or premium. A discount or premium is also recognized for acquired loans whose coupons are not considered to reflect prevailing rates of interest for comparable loans.  In these circumstances, the Company estimates the prevailing rate of interest to maturity for a note that would have resulted between an independent borrower and lender for a similar transaction under comparable terms and conditions.

(d) Preferred Equity Interests Held for Investment

Preferred equity interests are designated as held for investment and are carried at their outstanding principal balance, plus premiums, less discounts, which are amortized or accreted over the estimated life of the investment, less an estimated allowance for losses.

(e) Investment in Real Estate and Real Estate Held for Sale
 
Investment in real estate is carried at historical cost less accumulated depreciation. Costs directly related to acquisitions deemed to be business combinations are expensed. Ordinary repairs and maintenance which are not reimbursed by the tenants are expensed as incurred. Major replacements and improvements that extend the useful life of the asset are capitalized and depreciated over their useful life.
 
Investments in real estate are depreciated using the straight-line method over the estimated useful lives of the assets, summarized as follows:

Category
 
Term
Building
 
35-40 years
Site improvements
 
2-7 years
 
The Company follows the acquisition method of accounting for acquisitions of operating real estate held for investment, where the purchase price of operating real estate is allocated to tangible assets such as land, building, site improvements and other identified intangibles such as above/below market and in-place leases.
 
The Company evaluates whether real estate acquired in connection with a foreclosure (“REO”), Uniform Commercial Code (“UCC”)/deed in lieu of foreclosure or a consensual modification of a loan (herein collectively referred to as a foreclosure) constitutes a business and whether business combination accounting is applicable. Upon foreclosure of a property, the excess of the carrying value of a loan, if any, over the estimated fair value of the property, less estimated costs to sell, is charged to provision for loan losses.  
 
Investments in real estate, including REO, which do not meet the criteria to be classified as held for sale, are separately presented in the consolidated statements of financial condition as held for investment. Such operating real estate is reported at cost, or in the case of REO, initially at fair value, less accumulated depreciation. Once a property is determined to be held for sale, depreciation is no longer recorded. In addition, the results of operations are reclassified to income (loss) from discontinued operations in the consolidated statements of comprehensive income.
 
 
6

 
 
The Company's real estate portfolio (REO and real estate held for investment) is reviewed on a quarterly basis, or more frequently as necessary, to assess whether there are any indicators that the value of its operating real estate may be impaired or that its carrying value may not be recoverable. A property's value is considered impaired if the Company's estimate of the aggregate future undiscounted cash flows to be generated by the property is less than the carrying value of the property. In conducting this review, the Company considers U.S. macroeconomic factors, including real estate sector conditions, together with asset specific and other factors. To the extent an impairment has occurred and is considered to be other than temporary, the loss will be measured as the excess of the carrying amount of the property over the calculated fair value of the property.  The Company recorded an impairment of $266 thousand on real estate held for sale for the quarter ended March 31, 2013, which is recorded as a component of discontinued operations.    
 
Allowance for Doubtful Accounts
 
Allowances for doubtful accounts for tenant receivables are established based on a periodic review of aged receivables resulting from estimated losses due to the inability of tenants to make required rent and other payments contractually due. Additionally, the Company establishes, on a current basis, an allowance for future tenant credit losses on billed and unbilled rents receivable based upon an evaluation of the collectability of such amounts.
 
Rental Income
 
Rental income from investments in real estate is derived from leasing space to various types of corporate tenants. The leases are for fixed terms of varying length and provide for annual rentals to be paid in monthly installments. Rental income from leases is recognized on a straight-line basis over the term of the respective leases. The excess of straight-line rents over base rents under the lease is included in rents receivable on the Company’s consolidated statement of financial condition and any excess of base rents over the straight-line amount is recorded as a decrease to rents receivable on the Company’s consolidated statement of financial condition.
 
Deferred Costs
 
Deferred costs include deferred financing costs and deferred lease costs and are included in other assets in the consolidated statement of financial condition. Deferred financing costs represent commitment fees, legal and other third-party costs associated with obtaining financing. These costs are amortized to interest expense over the term of the financing. Unamortized deferred financing costs are expensed when the associated borrowing is refinanced or repaid before maturity.
 
Identified Intangibles
 
The Company records acquired identified intangibles, which includes intangible assets (value of the above-market leases, and in-place leases) and intangible liabilities (value of below-market leases), based on estimated fair value. The value allocated to the above or below-market leases is amortized over the remaining lease term as a net adjustment to rental income.  Other intangible assets are amortized on a straight-line basis over the remaining lease term. Identified intangible assets are recorded in intangible assets, net and identified intangible liabilities are recorded in intangible liabilities, net on the consolidated statements of financial condition.  The weighted-average amortization period for intangible assets and liabilities is 7.9 years and 9.6 years as of March 31, 2013 and 8.1 years and 9.7 years as of December 31, 2012, respectively.
 
 
7

 
 
The following table summarizes identified intangibles as of March 31, 2013 and December 31, 2012:
 
   
March 31, 2013
   
December 31, 2012
 
   
(dollars in thousands)
 
   
Intangible
Assets In-
place Leases
   
Intangible
Liabilities
Below-market
Leases
   
Intangible
Assets In-
place Leases
   
Intangible
Liabilities
Below-market
Leases
 
Gross amount
  $ 5,535     $ (2,030 )   $ 5,535     $ (2,030 )
Accumulated amortization
    (546 )     157       (440 )     123  
Net book value
  $ 4,989     $ (1,873 )   $ 5,095     $ (1,907 )
 
The Company recorded amortization of acquired below-market leases of $34 thousand and $16 thousand for the quarters ended March 31, 2013 and 2012, respectively. Amortization of other intangible assets was $106 thousand and $123 thousand for the quarters ended March 31, 2013 and 2012, respectively.  
 
(f) Allowance for Loan Losses

The Company evaluates the need for a loan loss reserve on its commercial real estate loans. A provision is established when the Company believes a loan is impaired, which is when it is deemed probable that the Company will be unable to collect principal and interest amounts due according to the contractual terms. A provision for credit losses related to loans , including those accounted for under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”), may be established when it is probable the Company will not collect amounts contractually due or all amounts previously estimated to be collected. Management assesses the credit quality of the portfolio and adequacy of loan loss reserves on a quarterly basis, or more frequently as necessary. Significant judgment is required in this analysis. The Company considers the estimated net recoverable value of the loan as well as other factors, including but not limited to the fair value of any collateral, the amount and the status of any senior debt, the prospects for the borrower and the competitive landscape where the borrower does business. Because this determination is based upon projections of future economic events, which are inherently subjective, the amounts ultimately realized may differ materially from the carrying value as of the consolidated statement of financial condition date.
 
The Company’s methodology for assessing the appropriateness of the allowance for loan losses consists of, but is not limited to, evaluating each loan as follows:  the Company reviews loan to value metrics upon either the origination or the acquisition of a new asset.  The Company generally reviews the most recent financial information produced by the borrower, net operating income (“NOI”), debt service coverage ratios (“DSCR”), property debt yields (net cash flow or NOI divided by the amount of outstanding indebtedness), loan per unit and rent rolls relating to each of its assets, and may consider other factors it deems important. The Company reviews market pricing to determine the ability to refinance the asset.  The Company also reviews economic trends, both macro as well as those directly affecting the property, and the supply and demand of competing projects in the sub-market in which the subject property is located. The Company also evaluates the borrower’s ability to manage and operate the properties.  The Company generally does not review loan to value metrics on a quarterly basis.
 
When a loan is impaired, the amount of provision for loan loss is calculated by comparing the carrying amount of the investment to the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, to the fair value of the collateral if the loan is collateral dependent. 
 
Income recognition is suspended for the loans at the earlier of the date at which payments become 90-days past due or when, in the opinion of the Company, a full recovery of income and principal becomes doubtful. Income is then recorded on a cash basis until an accrual is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. A loan is written off when it is no longer realizable and/or legally discharged.
 
 
8

 
 
Loan performance is evaluated and loans are assigned an internal rating of “Performing Loans,” “Watch List Loans” or “Workout Loans.”  Performing Loans meet all present contractual obligations.  Watch List Loans are defined as performing or nonperforming loans for which the timing of cost recovery is under review.  Workout Loans are defined as loans for which there is likelihood that the Company may not recover its cost basis.
 
(g) Troubled Debt Restructuring
 
Real estate debt investments modified in a troubled debt restructuring ("TDR") are modifications granting a concession to a borrower experiencing financial difficulties where a lender agrees to terms that are more favorable to the borrower than is otherwise available in the current market. Management judgment is necessary to determine whether a loan modification is considered a TDR. Troubled debt that is fully satisfied via foreclosure, repossession or other transfers of assets is included in the definition of TDR. Individual, or pools of loans acquired with deteriorated credit quality that have been modified are not considered a TDR.

(h) Variable Interest Entities

The Company has evaluated all of its investments in order to determine if they qualify as Variable Interest Entities ("VIEs") or as variable interests in VIEs.   A VIE is defined as an entity in which equity investors (i) do not have the characteristics of a controlling financial interest, and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional financial support from other parties. A variable interest is an investment or other interest that will absorb portions of a VIE's expected losses or receive portions of the entity’s expected residual returns. A VIE is required to be consolidated by its primary beneficiary, which is defined as the party that (i) has the power to control the activities that most significantly impact the VIE’s economic performance and (ii) has the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

(i) Revenue Recognition

Interest income is accrued based on the outstanding principal amount of the securities or loans and their contractual terms. Premiums and discounts associated with the purchase of the securities or loans are amortized or accreted into interest income over the projected lives of the securities or loans using the effective interest method based on the estimated recovery value.

The Company recognizes rental revenue on real estate on a straight-line basis over the non-cancelable term of the lease. The excess of straight-line rents over base rents under the lease is included in rents receivable on the Company’s consolidated statement of financial condition and any excess of base rents over the straight-line amount is recorded as a decrease to rents receivable on the Company’s consolidated statement of financial condition.

Fees received relating to origination of loans are included in “Other assets” on the Company’s Consolidated Statements of Financial Condition and are amortized into “Interest income” as an adjustment to loan yield over the life of the loan.

(j) Income Taxes

The Company has elected and is qualified to be taxed as a REIT, and therefore it generally will not be subject to corporate federal or state income tax to the extent that the Company makes qualifying distributions to stockholders and provided the Company satisfies the REIT requirements, including certain asset, income, distribution and stock ownership tests.  If the Company fails to qualify as a REIT and does not qualify for certain statutory relief provisions, the Company would be subject to federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the REIT qualification was lost.

The provisions of FASB ASC 740, Income Taxes (“ASC 740”), clarify the accounting for uncertainty in income taxes recognized in financial statements and prescribe a recognition threshold and measurement attribute for tax positions taken or expected to be taken on a tax return. ASC 740 also requires that interest and penalties related to unrecognized tax benefits be recognized in the financial statements. The Company has no unrecognized tax benefits that would affect its financial position.  Consequently, no accruals for penalties or interest were recorded during the quarters ended March 31, 2013 and 2012.
 
 
9

 
 
The Company files tax returns in several U.S. jurisdictions, including New York State and New York City.  The 2009 through 2011 tax years remain open to U.S. federal, state and local examinations.

(k) Net Income per Share

The Company calculates basic net income per share by dividing net income for the period by the weighted-average shares of its common stock outstanding for that period.  Diluted net income per share takes into account the effect of dilutive instruments, such as stock options, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted average number of shares outstanding.  The Company had no potentially dilutive securities outstanding during the periods presented.

(l) Use of Estimates

The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as well as loan loss provisions.  Actual results could materially differ from those estimates.
 
(m) Derivatives
 
The Company uses derivative instruments primarily to manage interest rate risk exposure and such derivatives are not considered speculative.  The Company has one interest rate swap outstanding which has not been designated as a hedging instrument for accounting purposes.  Changes in the fair value of the interest rate swap are recorded in the consolidated Statements of Comprehensive Income.
 
(n) Reclassifications
 
Certain prior period amounts have been reclassified to conform to the current period presentation.  Origination fees previously reported in miscellaneous fees have been reclassified into interest income in accordance with ASC 310-20, Receivables, Non-Refundable Fees and Other Costs.
 
(o) Recent Accounting Pronouncements

Broad Transactions

Financial Services – Investment Companies (Topic 946)
 
In October 2011, the FASB issued proposed ASU 2011-20, Financial Services-Investment Companies: Amendments to the Scope, Measurement, and Disclosure Requirements, which would amend the criteria in Topic 946 for determining whether an entity qualifies as an investment company for reporting purposes.  As proposed, this ASU would affect the measurement, presentation and disclosure requirements for Investment Companies, as defined, amend the investment company definition in ASC 946, and remove the current exemption for Real Estate Investment Trusts (REITs) from this topic.  If promulgated in its current form, this proposal may result in a material modification to the presentation of the Company’s consolidated financial statements.  

On December 12, 2012, the FASB agreed that the accounting for real estate investments should be considered in a second phase of the Investment Companies project and that all REITs should be exempted from conclusions reached in phase I of the project.  The Board has not yet agreed on the scope of phase II of the project.  The Company is monitoring developments related to this proposal and is evaluating the effects it would have on the Company’s consolidated financial statements.
 
 
10

 

 3. Cash and Cash Equivalents

The Company had $164.5 million and $123.5 million of cash held at independent national banking institutions at March 31, 2013 and December 31, 2012, respectively, and earned $3 thousand in interest income on the Company’s cash balances for the quarters ended March 31, 2013 and 2012, respectively.

4.  Commercial Real Estate Loans Held for Investment

The following tables represent the Company's commercial mortgage loans classified as held for investment at March 31, 2013 and December 31, 2012, which are carried at their principal balance outstanding less an allowance for loan losses:
 
   
March 31, 2013
   
December 31, 2012
 
               
Percentage
               
Percentage
 
   
Outstanding
   
Carrying
   
of Loan
   
Outstanding
   
Carrying
   
of Loan
 
   
Principal
   
Value
   
Portfolio(1)
   
Principal
   
Value
   
Portfolio(1)
 
   
(dollars in thousands)
 
Senior mortgages
  $ 100,927     $ 100,179       14.7 %   $ 100,995     $ 100,343       13.7 %
Subordinate notes
    41,321       39,111       6.0 %     41,410       38,954       5.6 %
Mezzanine loans
    545,217       541,354       79.3 %     594,820       590,525       80.7 %
Total
  $ 687,465     $ 680,644       100.0 %   $ 737,225     $ 729,822       100.0 %
                                                 
(1) Based on outstanding principal.
                                         
 
The following table represents a summary of the changes in the carrying value of the Company’s commercial real estate loans held for investment for the quarter ended March 31, 2013:
 
   
March 31, 2013
 
   
Senior
   
Subordinate
   
Mezzanine
   
   
Mortgages
   
Notes
   
Loans
   
Total
 
   
(dollars in thousands)
 
Beginning principal balance,
   net of allowance for loan losses
  $ 100,995     $ 41,410     $ 594,820     $ 737,225  
Purchases\advances, principal balance
    -       -       922       922  
Remaining discount
    (748 )     (2,210 )     (3,863 )     (6,821 )
Principal payments
    (68 )     (89 )     (50,525 )     (50,682 )
Principal write-off
    -       -       -       -  
Transfers to real estate held for sale
    -       -       -       -  
      100,179       39,111       541,354       680,644  
Recovery (allowance) for loan losses
    -       -       -       -  
Commercial mortgage loans held for investment
  $ 100,179     $ 39,111     $ 541,354     $ 680,644  
 
At March 31, 2013 and December 31, 2012 the Company had no loans remaining in its portfolio that were acquired with evidence of a deterioration in credit quality accounted for pursuant to ASC Subtopic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality.
 
 
11

 

The following table presents the accretable yield, or the amount of discount estimated to be realized over the life of the loans, and the carrying value, related to the Company’s commercial real estate loan portfolio for the quarters ended March 31, 2013 and 2012, respectively, which were accounted for pursuant to ASC Subtopic 310-30:
 
   
Accretable Yield
 
   
March 31, 2013
   
March 31, 2012
 
   
Accretable
Yield
   
Carrying Value
of the Loans
   
Accretable
Yield
   
Carrying Value
of the Loans
 
   
(dollars in thousands)
             
Beginning balance
  $ -     $ -     $ 13,259     $ 257,065  
Accretion
    -       -       (8,030 )     8,030  
Collections
    -       -       -       (154,000 )
Disposition/transfers
    -       -       (1,126 )     (53,865 )
Decrease in cashflow estimates
    -       -       (2,933 )     -  
Ending balance
  $ -     $ -     $ 1,170     $ 57,230  
 
The following table summarizes the changes in the allowance for loan losses for the commercial mortgage loan portfolio for the three months and year ended March 31, 2013 and December 31, 2012, respectively.
 
   
March 31, 2013
   
December 31, 2012
 
   
(dollars in thousands)
 
             
Balance, beginning of period
  $ -     $ 369  
Reversal
    -       (369 )
Provision for loan loss
    -       3,172  
Charge-offs
    -       (3,172 )
                 
Balance, end of period
  $ -     $ -  
 
The following tables present certain characteristics of the Company’s commercial mortgage loan portfolio as of March 31, 2013 and December 31, 2012, respectively.
 
 
12

 
 
March 31, 2013
 
Geographic Distribution
             
Property
Top 5 States
 
Remaining Balance
 
% of Loans (1)
 
Count
          (dollars in thousands)  
Texas
  $ 150,598     21.9 %     167  
New York
    88,800     12.9 %     9  
Illinois
    83,352     12.1 %     125  
Georgia
    62,044     9.0 %     65  
California
    58,832     8.6 %     152  
                       
December 31, 2012
 
Geographic Distribution
               
Property
Top 5 States
 
Remaining Balance
 
% of Loans (1)
 
Count
          (dollars in thousands)  
Texas
  $ 155,505     21.1 %     170  
New York
    90,453     12.3 %     10  
Illinois
    85,691     11.6 %     128  
Georgia
    64,325     8.7 %     69  
California
    63,461     8.6 %     156  
 
(1)
Percentages based on outstanding principal balance of the commercial real estate loan portfolio of $687.5 million and $737.2 million at March 31, 2013 and December 31, 2012, respectively.
 
March 31, 2013
 
                   
Property Type
 
Number of
Assets
 
Outstanding
Principal
 
% of Total
 
   
(dollars in thousands)
 
Retail
    8     $ 224,383       33 %
Office
    13       242,609       35 %
Hotel
    5       107,000       15 %
Industrial
    4       100,500       15 %
Condominium
    1       12,973       2 %
       Total
    31     $ 687,465       100 %
                         
December 31, 2012
 
                         
Property Type
 
Number of
Assets
 
Outstanding
Principal
 
% of Total
 
   
(dollars in thousands)
 
Retail
    9     $ 264,652       36 %
Office
    13       252,100       34 %
Hotel
    5       107,000       14 %
Industrial
    4       100,500       14 %
Condominium
    1       12,973       2 %
       Total
    32     $ 737,225       100 %
 
 
13

 
 
On a quarterly basis, the Company evaluates the adequacy of its allowance for loan losses.  Based on this analysis, the Company determined that no loan loss provision is necessary as of March 31, 2013 and December 31, 2012.  At March 31, 2013, two loans were designated as Watch List.  The following table presents the loan type and internal ratings for the loans as of March 31, 2013 and December 31, 2012.
 
March 31, 2013
 
   
         
Percentage
   
Internal Ratings
 
   
Outstanding
 
of Loan
   
Performing
   
Watch List
   
Workout
 
Investment type
 
Principal
   
Portfolio
   
Loans
   
Loans
   
Loans
 
   
(dollars in thousands)
 
Senior mortgages
  $ 100,927       14.7 %   $ 87,954     $ 12,973  (1)   $ -  
Subordinate notes
    41,321       6.0 %     41,321       -       -  
Mezzanine loans
    545,217       79.3 %     501,217       44,000       -  
    $ 687,465       100.0 %   $ 630,492     $ 56,973     $ -  
 
(1) Loan on non-accrual status. Amount represents recorded investment in the loan.
 
December 31, 2012
 
   
           
Percentage
   
Internal Ratings
 
   
Outstanding
 
of Loan
   
Performing
   
Watch List
   
Workout
 
Investment type
 
Principal
   
Portfolio
   
Loans
   
Loans
   
Loans
 
   
(dollars in thousands)
 
Senior mortgages
  $ 100,995       13.7 %   $ 88,022     $ -     $ 12,973  (1)
Subordinate notes
    41,410       5.6 %     41,410       -       -  
Mezzanine loans
    594,820       80.7 %     550,820       44,000       -  
    $ 737,225       100.0 %   $ 680,252     $ 44,000     $ 12,973  
 
(1) Loan on non-accrual status. Amount represents recorded investment in the loan.
 
5. Preferred Equity Held for Investment
 
The following table represents the Company's preferred equity held for investment at March 31, 2013 and December 31, 2012, which is carried at its principal balance outstanding less an allowance for losses:
 
   
March 31, 2013
  December 31, 2012
   
(dollars in thousands)
 
Beginning balance
  $ 39,769     $ -  
Purchases, principal balance
    -       39,769  
                 
Preferred equity held for investment
  $ 39,769     $ 39,769  
 
The Company had no allowance for losses related to its preferred equity investment at March 31, 2013 and December 31, 2012.

The Company’s preferred equity portfolio had a principal balance outstanding of $39.8 million as of March 31, 2013, that consisted of one investment secured by the equity in ten multifamily properties located in the suburban Baltimore and Washington, D.C. area.
 
 
14

 
 
6. Investment in Real Estate, Net and Real Estate Held for Sale
 
At March 31, 2013 and December 31, 2012, investment in real estate, net consists of the following:

   
March 31, 2013
   
December 31, 2012
   
(dollars in thousands)
 
             
Land
  $ 7,490     $ 7,490  
Buildings and improvements
    27,304       27,305  
Subtotal
    34,794       34,795  
Less: Accumulated depreciation
    (1,410 )     (1,140 )
Investments in real estate, net
  $ 33,384     $ 33,655  
 
       For the quarters ended March 31, 2013, and 2012, depreciation expense was $270 thousand, and $275 thousand, respectively.
 
Real Estate Acquisitions
 
The Company did not acquire real estate during the quarter ended March 31, 2013.  During the quarter ended March 31, 2012 the Company finalized the purchase price allocation related to the following real estate acquisitions:
 
Date of acquisition
Type
Location
 
Purchase Price
 
       
(dollars in thousands)
November 2011
Warehouse/distribution center
Phoenix, AZ
  $ 33,250  
February 2012
Warehouse
Las Vegas, NV
    5,050  
        $ 38,300  
 
The Company estimated the fair value of the assets and liabilities at the date of acquisition.  The allocation of the purchase price for the warehouse/distribution center in Phoenix was finalized during the quarter ended March 31, 2012 and resulted in the Company recording $5.2 million in intangible assets and $1.6 million of intangible liabilities.  In connection with the acquisition during the quarter ended March 31, 2012, the Company recorded $318 thousand in intangible assets and $421 thousand of intangible liabilities.
 
The supplemental pro forma financial information set forth below is based upon the Company's historical consolidated statements of comprehensive income for quarter ended March 31, 2012 to give effect to the above transactions as of January 1, 2012.
 
   
Business Combinations Actual
       
   
For the Quarter Ended March 31,
   
Proforma Consolidated for
 
   
2013
   
2012
   
The Quarter Ended March 31, 2012
 
   
(dollars in thousands, except per share data)
 
Revenues
  $ 832     $ 712     $ 23,978  
Net income
  $ 250     $ 120     $ 16,237  
Net income per average common
  share - basic/diluted
  $ 0.00     $ 0.00     $ 0.21  
 
The supplemental pro forma financial information above is presented for informational purposes only and may not be indicative of what actual results of operations would have been had the transaction occurred January 1, 2012, nor does it purport to represent the results of future operations.
 
 
15

 
 
For the quarter ended March 31, 2012, the Company acquired the following real estate in connection with a deed-in-lieu of foreclosure:
 
Date
 
Type
 
Location
 
  Carrying Value of
Loan at Time of REO
              (dollars in thousands)
February 2012
 
Hotels
 
Various
  $
                        55,973
       
Real estate acquired via deed in lieu of foreclosure during the quarter ended March 31, 2012 is classified as real estate held for sale, and is unencumbered by contractual debt obligations.  The working capital related to assets classified as held for sale is comprised of $3.9 million in current assets and $2.6 million in current liabilities at March 31, 2013.  The net working capital of $1.3 million is included in other assets in the consolidated statement of financial condition.  
 
During the quarter ended March 31, 2012, the Company recognized a $3.2 million provision for loan loss in connection with taking possession of the collateral underlying loans via a deed in lieu of foreclosure.
 
Discontinued Operations
 
The operations of real estate classified as held for sale on the consolidated statements of financial condition are reported as discontinued operations.  The following table summarizes the components of income from discontinued operations for the quarters ended March 31, 2013 and 2012:
 
   
Quarter Ended
 
   
March 31, 2013
   
March 31, 2012
 
Revenue:
 
(dollars in thousands)
 
Operating income
  $ 3,661     $ 6,679  
                 
Expenses:
               
Property operating expenses
    3,905       4,862  
                 
Pretax (loss) earnings
    (244 )     1,817  
                 
Income tax
    255       295  
                 
Total net (loss) income from discontinued operations
  $ (499 )   $ 1,522  
 
 During the quarter ended March 31, 2013 the Company recognized approximately $266 thousand of impairment charges related to two assets classified as held for sale.  The impairment charges are measured as the excess of the carrying value of the individual asset over the estimated sale price less estimated costs to sell.  
 
Disposition of Assets Held for Sale
 
During the quarter ended March 31, 2013, the Company sold one hotel resulting in proceeds of approximately $4.1 million.  The sale transaction resulted in a net pre-tax gain of approximately $886 thousand.
 
7.  Fair Value Measurements
 
The Company applies the fair value guidance in accordance with U.S. GAAP to account for its financial instruments.  The Company categorizes its financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy.  The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).  If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument. Financial assets and liabilities recorded at fair value on the consolidated statements of financial condition or disclosed in the related notes are categorized based on the inputs to the valuation techniques as follows:
 
 
16

 
 
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets and liabilities in active markets.
 
Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
 
Level 3 – inputs to the valuation methodology are unobservable and significant to fair value.
 
The following describes the methodologies utilized by the Company to estimate the fair value of its financial instruments by instrument class.
 
Short-Term Instruments

The carrying value of cash and cash equivalents, accrued interest receivable, dividends payable, accounts payable and other liabilities, and accrued interest payable generally approximates estimated fair value due to the short term nature of these financial instruments.

Interest Rate Swap

Interest rate swaps are valued using internal pricing models that are corroborated using third party quotes.  The Company incorporates common market pricing methods, including a spread measurement to the Treasury curve, in its estimates of fair value.  Management ensures that current market conditions are reflected in its estimates of fair value. 

The Company's financial assets and liabilities carried at fair value on a recurring basis are as follows:
 
   
March 31, 2013
 
       
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
 
Liabilities:
                 
   Interest Rate Swap
  $ -     $ 85     $ -  
                         
   
December 31, 2012
 
       
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
 
Liabilities:
                       
   Interest Rate Swap
  $ -     $ 89     $ -  

Financial Asset and Liabilities Measured at Fair Value on a Non-Recurring Basis

GAAP requires disclosure of fair value information about financial instruments, whether or not recognized in the financial statements, for which it is practical to estimate the value. In cases where quoted market prices are not available, fair values are based upon discounted cash flows using market yields or other valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair value. Accordingly, fair values are not necessarily indicative of the amount the Company could realize on disposition of the financial instruments. The use of different market assumptions or estimation methodologies could have a material effect on the estimated fair value amounts.
 
 
17

 
 
The carrying value of commercial real estate loans totaled $680.6 million and $729.8 million at March 31, 2013 and December 31, 2012, respectively.  These loans are held for investment and are recorded at amortized cost less an allowance for losses. The estimated fair value of these loans is $690.6 million and $736.6 million as of March 31, 2013 and December 31, 2012, respectively.  Such estimates take into consideration expected changes in interest rates and changes in the underlying collateral cash flows.  The fair value of commercial real estate loans is based on the loan’s contractual cash flows and estimated changes in the yield curve.  The fair value also reflects consideration of changes in credit risk since the loan was originated or purchased.

Preferred equity investments totaled $39.8 million at March 31, 2013 and December 31, 2012.  The preferred equity investment is recorded at amortized cost less an allowance for losses. The estimated fair value of this investment is $39.1 million and $39.3 million as of March 31, 2013 and December 31, 2012, respectively. The fair value of preferred equity is based on the underlying cash flows and estimated changes in the yield curve.  The fair value also reflects consideration of changes in credit risk since the time of initial investment.

The carrying value of participations sold is based on the loan’s amortized cost.  The fair value of participations sold is based on the fair value of the underlying related commercial loan.

The carrying value of mortgages payable totaled $19.2 million, and $19.2 million at March 31, 2013 and 2012, respectively.  The fair value of the Company’s mortgage loans at March 31, 2013 and 2012 totaled $19.4 million, and $19.4 million, respectively.  The fair value of mortgages payable is based on the related contractual cash flows and estimated changes in the yield curve from the time of origination.  The fair value of mortgages payable also reflects consideration of the value of the underlying collateral and changes in credit risk from the time the debt was originated.

The following table summarizes the estimated fair value for all financial assets and liabilities as of March 31, 2013 and December 31, 2012.
 
         
March 31, 2013
   
December 31, 2012
 
         
Carrying Value
   
Fair Value
   
Carrying Value
   
Fair Value
 
   
Level in Fair Value
   
(dollars in thousands)
 
Financial assets:
  Hierarchy                          
Cash and cash equivalents
  1     $ 164,472     $ 164,472     $ 123,543     $ 123,543  
Commercial real estate investments:
                                 
   Senior
  3       100,179       101,495       100,343       99,999  
   Subordinate
  3       39,111       41,879       38,954       42,078  
   Mezzanine
  3       541,354       547,178       590,525       594,554  
Preferred equity
  3       39,769       39,060       39,769       39,256  
                                       
Financial liabilities:
                                     
Mortgage payable
  2       19,150       19,447       19,150       19,407  
Participations sold
  3       13,706       14,373       13,759       14,525  
Interest rate swap liability
  2       85       85       89       89  
 
Considerable judgment is necessary to interpret market data and develop estimated fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value assumptions.

Nonfinancial Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis

Real estate held for sale totaled $30.1 million at March 31, 2013 and is recorded at its estimated fair value less costs to sell (considered to be Level 3 in the fair value hierarchy).  During the quarter ended March 31, 2013, the Company recognized impairment charges of approximately $266 thousand related to two hotels.  The fair value and related impairment of these hotels was based on an executed purchase and sale agreement.
 
 
18

 
 
8.  Income Taxes

For the quarter ended March 31, 2013 the Company is qualified to be taxed as a REIT.  To maintain qualification as a REIT, the Company must distribute at least 90% of its annual REIT taxable income to its shareholders and meet certain other requirements including certain asset, income and stock ownership tests. It is generally the Company’s policy to distribute to its shareholders all of the Company’s taxable income.  It is assumed that the Company will retain its REIT status by complying with the REIT regulations and distribution requirements in the future. The state and city tax jurisdictions for which the Company is subject to tax filing obligations recognize the Company’s status as a REIT.  In December of 2011, the Company created a taxable REIT subsidiary (“TRS”) to hold those assets which represent non-qualified REIT assets.

During the quarters ended March 31, 2013 and 2012, the Company recorded estimated federal and state income tax expense related to earnings of its TRS in the amount of $309 thousand and $295 thousand, respectively, which is primarily attributable to income from discontinued operations of hotels acquired during 2012 via deed in lieu of foreclosure.  This amount is recorded as a component of net income (loss) from discontinued operations in the accompanying consolidated statement of comprehensive income.

The Company files tax returns in several U.S. jurisdictions, including New York State and New York City.  The 2009 through 2011 tax years remain open to U.S. federal, state and local tax examinations.

During February of 2012 the Company took possession of a portfolio of hotels in connection with a deed-in-lieu of foreclosure and recorded a deferred tax asset (“DTA”) of approximately $900 thousand for the difference between the tax and GAAP basis of the related assets.  At that time the Company recorded a valuation allowance against the entire DTA due to uncertainty regarding the Company’s ability to realize the DTA.  During the fourth quarter of 2012, based on updated available information, the Company determined that the remaining DTA, as reduced during the year for sales of hotels, was realizable, and the Company reversed the entire remaining valuation allowance of approximately $600 thousand.  This resulted in the recognition of an income tax benefit of approximately $600 thousand during the fourth quarter of 2012, which is recorded as a component of net income (loss) from discontinued operations in the consolidated statement of comprehensive income.

During the quarter ended March 31, 2013, the DTA was increased by $54 thousand as a result of the sale of a hotel and the recognition of impairment on two of the remaining unsold hotels during the quarter.  This resulted in the recognition of a net $54 thousand income tax benefit during the quarter ended March 31, 2013, which is recorded as a component of net income (loss) from discontinued operations in the consolidated statement of comprehensive income.

9.  Common Stock
 
During the quarter ended March 31, 2013, the Company declared dividends to common shareholders totaling $19.2 million or $0.25 per share which was paid to shareholders on April 25, 2013.  During the quarter ended March 31, 2012, the Company declared dividends to common shareholders totaling $20.7 million or $0.27 per share which was paid to shareholders on April 26, 2012.   Dividends declared and paid to common shareholders for the quarters ended March 31, 2013 and 2012 are expected to be characterized as ordinary income for federal tax purposes.

10.  Equity Incentive Plan

The Company has adopted an equity incentive plan to provide incentives to its independent directors, employees of FIDAC and its affiliates, including Annaly, and other service providers to stimulate their efforts toward the Company’s continued success, long-term growth and profitability and to attract, reward and retain personnel.  The equity incentive plan is administered by the compensation committee of the board of directors.  Unless terminated earlier, the equity incentive plan will terminate in 2019, but will continue to govern unexpired awards.  The equity incentive plan provides for grants of restricted common stock and other equity-based awards up to an aggregate amount, at the time of the award, of (i) 2.5% of the issued and outstanding shares of the Company’s common stock less (ii) 250,000 shares, subject to an aggregate ceiling of 25,000,000 shares available for issuance under the plan.
 
 
19

 
 
The Company issued approximately 10,000 shares, approximating $105 thousand, to the independent members of the Board of Directors during the year ended December 31, 2012.  The shares were granted and vested on May 24, 2012.

The independent directors of the Company receive fees for their service as a director of the Company or as the chairman of the Board or a Board committee. Any member of the Board who is also an employee of the Manager is not considered independent and does not receive additional compensation for serving on the Board.  For 2012, the equity compensation portion of the compensation for serving on the Board consisted of an equity grant of in the form of deferred stock units with a value of $35,000 per independent director.  For 2013, the equity compensation portion of the compensation for serving on the Board will be a $50,000 equity grant per independent director; however, any equity-based compensation will be settled in cash at the closing of the Merger (as defined below), if applicable.

11.  Debt Obligations

The Company has two first mortgages outstanding with aggregate principal balances as of March 31, 2013 and December 31, 2012 as follows:
 
           
Outstanding Balance
 
Maturity
Type
 
Fixed Interest
rate/spread over
1 Month LIBOR (1)
   
March 31, 2013
   
December 31, 2012
 
           
(dollars in thousands)
 
2016
Fixed
    3.50     $ 16,600     $ 16,600  
                           
2017 (2)
Variable
    2.20       2,550       2,550  
              $ 19,150     $ 19,150  
                           
(1) Applicable for variable rate loans.
                 
(2) The Company has entered into an interest rate swap to hedge against increases in interest rates. Refer to footnote 15 for more detail.
 
The first mortgages are collateralized by two distribution/warehouse centers.  Interest expense relating to the mortgages payable, including amortized mortgage costs and the effect of the interest rate swap associated with one loan, for the quarters ended March 31, 2013 and 2012 was $173 thousand and $186 thousand, respectively.

12.  Management Agreement and Related Party Transactions

Management Agreement

The Company has entered into a management agreement with FIDAC, a wholly owned subsidiary of Annaly, which provides for an initial term through December 31, 2013 with an automatic one year extension option and is subject to certain termination rights.  The Company pays FIDAC a quarterly management fee equal to 1.50% per annum of its stockholders’ equity which is equal to the sum of net proceeds from any issuance of the Company’s equity securities since inception, consolidated retained earnings (excluding non-cash equity compensation), less any amount the Company pays for repurchases of its common stock, unrealized gains, or losses or other items that do not affect realized income, as adjusted to exclude one-time events pursuant to changes in GAAP and certain non-cash charges of the Company.  Management fees accrued and subsequently paid to FIDAC were $3.3 million, and $3.4 million, respectively, for the quarters ended March 31, 2013 and 2012.
 
 
20

 
 
Upon termination without cause, the Company will pay FIDAC a termination fee.  The Company may also terminate the management agreement with 30-days prior notice from the Company’s board of directors, without payment of a termination fee, for cause, which is defined as: (i) FIDAC, its agents or its assignees materially breaching any provision of the management agreement and such breach continuing for a period of thirty (30) days after written notice thereof specifying such breach and requesting that the same be remedied in such 30-day period (or forty-five (45) days after written notice of such breach if FIDAC takes steps to cure such breach within thirty (30) days of the written notice), (ii) FIDAC engaging in any act of fraud, misappropriation of funds, or embezzlement against the Company or any subsidiary, or (iii) an event of any gross negligence on the part of FIDAC in the performance of its duties under the management agreement, or upon a change of control, which is defined as (i) the sale, lease or transfer, in one or a series of related transactions, of all or substantially all of the assets of FIDAC, taken as a whole, or Annaly, taken as a whole, to any person other than Annaly (in the case of FIDAC) or any of its respective affiliates; or (ii) the acquisition by any person or group (within the meaning of Section 13(d)(3) or Section 14(d)(2) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or any successor provision), including any group acting for the purpose of acquiring, holding or disposing of securities (within the meaning of Rule 13d-5(b)(1) under the Exchange Act), other than Annaly or any of its respective affiliates, in a single transaction or in a related series of transactions, by way of merger, consolidation or other business combination or purchase of beneficial ownership (within the meaning of Rule 13d-3 under the Exchange Act, or any successor provision) of 50% or more of the total voting power of the voting capital interests of FIDAC or Annaly.  FIDAC may terminate the management agreement if the Company or any of its subsidiaries become required to register as an investment company under the Investment Company Act of 1940, as amended, or the 1940 Act, with such termination deemed to occur immediately before such event, in which case the Company would not be required to pay a termination fee.  FIDAC may also decline to renew the management agreement by providing the Company with 180-days written notice, in which case the Company would not be required to pay a termination fee.

The Company is obligated to reimburse FIDAC for its costs incurred under the management agreement.  In addition, the management agreement permits FIDAC to require the Company to pay for its pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of FIDAC incurred in the operation of the Company.  These expenses are allocated between FIDAC and the Company based on the ratio of the Company’s proportion of gross assets compared to all remaining gross assets managed by FIDAC as calculated at each quarter end.   FIDAC and the Company will modify this allocation methodology, subject to the Company’s board of directors’ approval if the allocation becomes inequitable (i.e., if the Company becomes very highly leveraged compared to FIDAC’s other funds and accounts).  FIDAC has waived its right to request reimbursement from the Company of these expenses until such time as it determines to rescind that waiver.

Amendment to the Management Agreement
 
On January 30, 2013, the Company and FIDAC entered into an amendment to the management agreement pursuant to which, FIDAC has agreed to, among other things, in good faith facilitate and assist the Company in its efforts to actively seek and solicit acquisition proposals during the Transaction Solicitation Period (as defined in the Merger Agreement (as defined below)) and, following the conclusion of the Transaction Solicitation Period, in good faith facilitate and assist the Company’s discussions, negotiations, providing of information and any other permissible action with respect to possible acquisition proposals under the terms of the Merger Agreement. The amendment also shortens the notice provision for the Company’s termination of the management agreement from 180 days to 60 days’ notice at any time during the first six months following the acquisition by a third party of a majority of the Company’s stock or assets.
 
Agreement and Plan of Merger
 
 On January 30, 2013, the Company entered into the Agreement and Plan of Merger (or the Merger Agreement), among the Company, Annaly and CXS Acquisition Corporation (a wholly-owned subsidiary of Annaly) (or Acquisition), pursuant to which, among other things, Acquisition would commence a tender offer (or the Offer) to purchase all of the outstanding shares of the Company’s common stock, par value $0.01 per share (or the Shares), that Acquisition or Annaly did not own at a price per share of $13.05206, which reflects a price of $13.00 in cash, plus a cash payment to reflect a pro-rated quarterly dividend for the quarter in which the Offer was consummated, subject to the terms and conditions set forth in the Merger Agreement.
 
 
21

 

As of March 31, 2013 and December 31, 2012 Annaly owned approximately 12.4% of the Company’s outstanding shares.

RCap Securities Inc.

The Company uses RCap Securities, Inc. (“RCap”), a SEC registered broker-dealer and a wholly-owned subsidiary of Annaly, to settle trades.  RCap receives customary, market-based fees and charges in return for such services.   For the periods ended March 31, 2013 and 2012 the Company paid RCap approximately $9 thousand and $8 thousand, respectively, for its services.

13.  Commitments and Contingencies

From time to time, the Company may become involved in various claims and legal actions arising in the ordinary course of business.  In the opinion of management, the ultimate disposition of these matters will not have a material effect on the Company’s consolidated financial statements and therefore no accrual is required under ASC 450, Contingencies, as of March 31, 2013 and December 31, 2012.

The Company agreed to pay the underwriters of the Company’s initial public offering $0.15 per share for each share sold in the initial public offering if during any full four calendar quarter period during the 24 full calendar quarters after the Company’s initial public offering certain performance hurdles were met.  During the year ended December 31, 2012 the Company paid the underwriters $2.0 million, representing the full amount due, as a result of meeting the required hurdle.

The Special Committee of the Board of Directors of the Company has retained Lazard Frères & Co LLC (“Lazard”) to act as the sole investment banker to the Special Committee of the Board of Directors of the Company with respect to a variety of matters, including without limitation any transaction in which the Company engages in a merger, sale, divestiture, spinoff or liquidation of the Company (a “Transaction”).  The Company has agreed to pay Lazard a fee for such services in the amount of 0.65% of the aggregate consideration (as defined in Lazard’s engagement letter) in the Transaction, $250,000 of which was paid to Lazard as a retainer, $1,500,000 of which was paid to Lazard upon the rendering of Lazard’s opinion and the remainder of which is contingent upon the closing of the Transaction.

14.  Participations Sold
 
Participations sold represent interests in loans that the Company purchased and subsequently sold to third-parties that did not qualify as sales under ASC 860, Transfers. The Company presents these participations sold as both assets and non-recourse liabilities because these arrangements do not qualify as sales under GAAP. Generally, participations sold are recorded as assets and liabilities in equal amounts on the consolidated statements of financial condition, and an equivalent amount of interest income and interest expense is recorded on the consolidated statements of comprehensive income. However, impaired loan assets, if any, must be reduced through the provision for loans losses while the associated non-recourse liability cannot be reduced until the participation has been contractually extinguished.  This can result in a difference between the loan participations sold asset and liability.  The Company has no economic exposure to these liabilities.
 
 
22

 
 
The following table summarizes the Company’s participations sold assets and liabilities as of March 31, 2013 and December 31, 2012:

   
March 31, 2013
   
December 31, 2012
 
   
(dollars in thousands)
 
Participations sold assets
           
Gross carrying value
  $ 13,706     $ 13,759  
Less: Provision for loan losses
    -       -  
Net book value of assets
  $ 13,706     $ 13,759  
                 
Liabilities
               
Net book value of liabilities
  $ 13,706     $ 13,759  
Net impact to shareholders' equity
  $ -     $ -  
 
15. Risk Management and Derivative Activities
 
Derivatives
 
The Company uses derivative instruments primarily to manage interest rate risk exposure and such derivatives are not considered speculative. These derivative instruments are strictly in the form of interest rate swap agreements and the primary objective is to minimize interest rate risks associated with the Company's investment and financing activities. The counterparties of these arrangements are financial institutions with which the Company may also have other financial relationships. The Company is exposed to credit risk in the event of non-performance by these counterparties and it monitors their financial condition; however, the Company currently does not anticipate that any of the counterparties will fail to meet their obligations.  
 
As of March 31, 2013 and December 31, 2012, the Company had one interest rate swap outstanding which has not been designated as a hedging instrument for accounting purposes.
 
The following table presents the fair value of the Company's derivative instrument, its classification on the consolidated statements of financial condition and the consolidated statement of comprehensive income as of March 31, 2013, and the amount of income (expense) recognized during the year ended December 31, 2012:
 
   
Location in Consolidated
Statements of Financial
Condition
Location in Consolidated
Statements of
Comprehensive Income
 
Notional Amount
 
Fair Value
Net Asset
(Liability)
 
Interest Income
(Expense) on
Interest Rate
Swaps
 
Unrealized Gains
(Losses) on
Interest Rate
Swaps
 
   
(dollars in thousands)
 
March 31, 2013
 
Accounts payable and other liabilities
Interest Expense
    2,550       (85 )     (5 )     (85 )
                                       
December 31, 2012
 
Accounts payable and other liabilities
Interest Expense
    2,550       (89 )     (29 )     (89 )
 
The Company's counterparty held no cash margin as collateral against the Company's derivative contract as of March 31, 2013 and December 31, 2012.
 
Credit Risk Concentrations
 
Concentrations of credit risk arise when a number of borrowers, tenants, operators or issuers related to the Company's investments are engaged in similar business activities or located in the same geographic location to be similarly affected by changes in economic conditions. The Company monitors its portfolio to identify potential concentrations of credit risks. The Company has no one borrower, tenant or operator that generates 10% or more of its total revenue.
 
 
23

 
 
16. Stockholders' Equity
 
Earnings Per Share
 
Earnings per share for the quarters ended March 31, 2013 and 2012, respectively, are computed as follows:
 
   
For the Quarter Ended
 
       
   
March 31, 2013
   
March 31, 2012
 
   
(dollars in thousands)
 
Numerator:
           
Net income
  $ 13,389     $ 16,117  
Effect of dilutive securities:
    -       -  
Dilutive net income  available to stockholders
  $ 13,389     $ 16,117  
                 
Denominator:
               
Weighted average shares available to common stockholders
    76,630,528       76,620,112  
Weighted Average Dilutive Shares
    -       -  
Net income  per average share attributable to common stockholders - Basic/Diluted
  $ 0.17     $ 0.21  
 
17. Segment Reporting

ASC 280, Segment Reporting (ASC 280), establishes the manner in which public entities report information about operating segments in annual and interim financial reports issued to shareholders.  ASC 280 defines a segment as a component of an enterprise about which separate financial information is available and that is evaluated regularly to allocate resources and assess performance. The Company conducts its business through two segments: debt investments and investment in real estate. For segment reporting purposes, the Company does not allocate interest income on short-term investments or general and administrative expenses.  The quarter ended December 31, 2011 is the first quarter the Company was required to report more than one segment due to the purchase of two warehouse and distribution facilities in Arizona.  Below are the operating results for the quarters ended March 31, 2013 and 2012, respectively.
 
 
24

 
 
   
For the Quarter Ended March 31, 2013
 
                         
   
Corporate/
Unallocated
   
Debt
Investments
   
Real Estate
Investments
   
Consolidated
Total
 
               
(dollars in thousands)
 
Net interest income:
                       
Interest income
  $ -     $ 21,056     $ -     $ 21,056  
Interest expense
    -       (209 )     (174 )     (383 )
Servicing fees
    -       (157 )     -       (157 )
   Net interest income (expense)
    -       20,690       (174 )     20,516  
                                 
Other income:
                               
Miscellaneous fee income
    -       4       -       4  
Rental income
    -       -       832       832  
   Total other income
    -       4       832       836  
                                 
Other expenses:
                               
Management fees to affiliate
    3,337       -       -       3,337  
General and administrative expenses
    4,128       7       235       4,370  
Amortization Expense
    -       -       106       106  
Depreciation expense
    -       -       270       270  
   Total other expenses
    7,465       7       611       8,083  
                                 
                                 
Net (loss) income before income tax
    (7,465 )     20,687       47       13,269  
                                 
Income tax
    1       -       -       1  
                                 
(Loss) income from continuing operations
    (7,466 )     20,687       47       13,268  
                                 
Net (loss) income from discontinued operations
 (net of tax expense of $255)
    -       -       (499 )     (499 )
Gain on sale from discontinued operations
    -       -       886       886  
Impairment charges
    -       -       (266 )     (266 )
   Total (loss) income from discontinued operations
    -       -       121       121  
                                 
Net (loss) income
  $ (7,466 )   $ 20,687     $ 168     $ 13,389  
                                 
Total assets
  $ 491     $ 881,964     $ 79,017     $ 961,472  
                                 
                                 
   
For the Quarter Ended March 31, 2012
 
       
   
Corporate/
Unallocated
   
Debt
Investments
   
Real Estate
Investments
   
Consolidated
Total
 
                   
(dollars in thousands)
 
Net interest income:
                               
Interest income
  $ -     $ 23,392     $ -     $ 23,392  
Interest expense
    -       (174 )     (186 )     (360 )
Servicing fees
    -       (115 )     -       (115 )
   Net interest income (expense)
    -       23,103       (186 )     22,917  
                                 
Other income:
                               
Rental income
    -       -       712       712  
Miscellaneous fee income
    -       349       -       349  
   Total other income
    -       349       712       1,061  
                                 
Other expenses:
                               
Provision loan losses, net
    -       2,803       -       2,803  
Management fees to affiliate
    3,471       -       -       3,471  
General and administrative expenses
    1,229       1,379       102       2,710  
Depreciation expense
    -       -       275       275  
Amortization Expense
    -       -       123       123  
   Total other expenses
    4,700       4,182       500       9,382  
                                 
Net (loss) income before income tax
    (4,700 )     19,270       26       14,596  
                                 
Income tax
    1       -       -       1  
                                 
(Loss) income from continuing operations
    (4,701 )     19,270       26       14,595  
                                 
Net (loss) income from discontinued operations
 (net of tax expense of $295)
    -       -       1,522       1,522  
                                 
Net (loss) income
  $ (4,701 )   $ 19,270     $ 1,548     $ 16,117  
                                 
Total assets
  $ 618     $ 887,726     $ 99,047     $ 987,391  
 
 
25

 
 
18. Subsequent Events

Pursuant to the terms of the Merger Agreement, on March 18, 2013, Annaly commenced the Offer to purchase all of the outstanding shares that Acquisition or Annaly did not own at a price per share of $13.05206, which reflects a price of $13.00 in cash, plus a cash payment to reflect a pro-rated quarterly dividend for the quarter in which the Offer was consummated, subject to the terms and conditions set forth in the Merger Agreement.
 
The Offer expired at 5:00 p.m., New York City Time on April 16, 2013.  The depository for the Offer has advised Annaly and Acquisition that, as of such time, an aggregate of approximately 55,225,336 Shares were tendered into, and not withdrawn from, the Offer (including 2,318,138 Shares tendered by notices of guaranteed delivery) representing approximately 82.3% of the outstanding Shares not previously held by Annaly.  Acquisition accepted for payment all Shares that were validly tendered and not properly withdrawn, and payment was made promptly, in accordance with the terms of the Offer.  The depository subsequently informed the Company that only 2,153,224 of the 2,318,138 Shares tendered by notices of guaranteed delivery were actually delivered.  This resulted in a total number of 55,060,422 Shares being tendered into, and not withdrawn from, the Offer representing approximately 82.1% of the outstanding Shares not previously held by Annaly.
 
Following the expiration of the Offer, Acquisition exercised the percentage increase option, pursuant to the terms of the Merger Agreement, to purchase directly from the Company the number of Shares that represent the number of Shares sufficient, when added to the number of Shares purchased by Acquisition in the Offer, to give Acquisition ownership of one Share more than 90% of the Company’s then outstanding Shares.
 
Acquisition will be merged with and into the Company in a transaction in which each share of the Company's common stock that was not tendered, except shares owned by the Company or Acquisition, will be converted into the right to receive $13.05206, in cash, subject to any required withholding taxes.  Because Annaly will own, through Acquisition, more than 90% of the stock of the Company, the merger will not have to be approved by the Company’s stockholders. The Company intends to complete the merger with Acquisition on May 23, 2013.
 
As of May 6, 2013, Annaly, through Acquisition, owns approximately 84.3% of the Company’s outstanding shares.
 
 
26

 
 
Item 2.                      Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Special Note Regarding Forward-Looking Statements

We make forward-looking statements in this report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. When we use the words ‘‘believe,’’ ‘‘expect,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘plan,’’ ‘‘continue,’’ ‘‘intend,’’ ‘‘should,’’ ‘‘may,’’ ‘‘would,’’ “will,” or similar expressions, we intend to identify forward-looking statements.  Statements regarding the following subjects, among others, are forward-looking by their nature:

 
our business and strategy;
 
 
our ability to consummate the transaction contemplated by the agreement and plan of merger with Annaly Capital Management, Inc. and its subsidiary CXS Acquisition Corporation, pursuant to which Annaly would purchase all of our outstanding shares of common stock (other than shares owned by Annaly);
 
 
our ability to obtain and maintain financing arrangements and the terms of such arrangements;
 
 
financing and advance rates for our targeted assets;
 
 
general volatility of the markets in which we acquire assets;
 
 
the implementation, timing and impact of, and changes to, various government programs;
 
 
our expected assets;
 
 
changes in the value of our assets;
 
 
market trends in our industry, interest rates, the debt securities markets or the general economy;