S-11/A 1 d374998ds11a.htm AMENDMENT NO. 2 TO FORM S-11 Amendment No. 2 to Form S-11
Table of Contents

As filed with the Securities and Exchange Commission on August 31, 2017

Registration No. 333-219415

 

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

AMENDMENT NO. 2

TO

FORM S-11

FOR REGISTRATION

UNDER

THE SECURITIES ACT OF 1933

OF SECURITIES OF CERTAIN REAL ESTATE COMPANIES

 

 

NEXPOINT MULTIFAMILY CAPITAL TRUST, INC.

(Exact name of Registrant as Specified in Governing Instruments)

 

 

300 Crescent Court

Suite 700

Dallas, Texas 75201

(972) 628-4100

(Address, including zip code and telephone number, including area code, of registrant’s principal executive offices)

 

 

Brian Mitts

Chief Financial Officer

300 Crescent Court

Suite 700

Dallas, Texas 75201

(972) 628-4100

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Charles T. Haag

Jones Day

2727 North Harwood Street

Dallas, Texas 75201

(214) 220-3939

  

S. Gregory Cope

Vinson & Elkins L.L.P.

2200 Pennsylvania Avenue NW, Suite 500 West

Washington, DC 20037

(202) 639-6500

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this form will be offered on a delayed or continuous basis in reliance on Rule 415 under the Securities Act, check the following box.  ☐

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box.  ☐

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

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☒  (Do not check if a smaller reporting company)    Smaller reporting company  
     Emerging growth company  

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☒

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of securities to be registered  

Proposed

maximum

aggregate

offering price (1)(2)

 

Amount of

registration fee (1)(3)

Common Stock, par value $0.01 per share

  $ 10,000,000   $ 1,159

 

 

(1) Estimated pursuant to Rule 457(o) under the Securities Act of 1933 solely for the purpose of determining the registration fee.
(2) Includes the aggregate offering price of additional shares that the underwriters have the option to purchase.
(3) Previously paid.

 

 

The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act or until this registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


Table of Contents

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

Subject to Completion, dated August 31, 2017

PRELIMINARY PROSPECTUS

                 Shares

 

LOGO

NEXPOINT REAL ESTATE FINANCE, INC.

Common Stock

 

 

In connection with this offering, NexPoint Multifamily Capital Trust, Inc. intends to change its name to NexPoint Real Estate Finance, Inc. NexPoint Real Estate Finance, Inc., or the Company, is a Maryland corporation that intends to elect to be taxed as a real estate investment trust (“REIT”), commencing with our taxable year ending December 31, 2017. We primarily focus on providing structured financing solutions for properties that exhibit what we believe to be cyclical resilience, tenant diversification, lower outlay of capital expenditures upon tenant turnover and short-term lease opportunities that outperform in a rising interest rate environment, including mid-sized multifamily, self-storage and select-service and extended-stay hospitality real estate properties located in the United States. Additionally, in connection with this offering, our Class A common stock will be reclassified as common stock and our Class T common stock will be eliminated. We are externally managed by NexPoint Real Estate Advisors II, L.P. (our “Advisor”), an affiliate of Highland Capital Management, L.P. (“Highland”).

We are offering                  shares of our common stock in this offering. We expect the public offering price of our common stock to be between $          and $          per share. Currently, our common stock is not traded on a national securities exchange, and this will be our first listed public offering. After pricing of this offering, we expect that our common stock will trade on the New York Stock Exchange (the “NYSE”) under the symbol “NREF.” Concurrently with the closing of this offering, we will sell to Highland and/or its affiliates in a separate private placement shares of our common stock representing an aggregate investment equal to $         million. Highland and/or its affiliates will pay the same price for shares in the private placement as investors who purchase shares in this offering.

We intend to elect to be treated as a REIT for U.S. federal income tax purposes. Shares of our common stock are subject to ownership limitations that are primarily intended to assist us in maintaining our qualification as a REIT. Our charter contains certain restrictions relating to the ownership and transfer of our common stock, including, subject to certain exceptions, a 6.2% ownership limit of common stock by value or number of shares, whichever is more restrictive. Our board of directors may grant waivers from this ownership limit to stockholders and, in connection with this offering, intends to grant Highland and its affiliates a waiver allowing them to own up to 25% of our common stock. See “Description of Capital Stock — Restrictions on Ownership and Transfer” beginning on page 153 of this prospectus.

We are an “emerging growth company” under the federal securities laws and are subject to reduced public company reporting requirements. Investing in our shares of common stock involves a high degree of risk. See “Risk Factors” beginning on page 21 of this prospectus. The most significant risks relating to your investment in our common stock include the following:

 

    Our loans and investments expose us to risks similar to and associated with debt-oriented real estate investments generally.

 

    Commercial real estate-related investments that are secured, directly or indirectly, by real property are subject to delinquency, foreclosure and loss, which could result in losses to us.

 

    Interest rate fluctuations could reduce our ability to generate income on our investments, which could lead to a significant decrease in our results of operations, cash flows and the market value of our investments.

 

    We operate in a competitive market for lending and investment opportunities, and competition may limit our ability to originate or acquire desirable loans and investments in our target assets and could also affect the yields of these assets.

 

    A majority of the loans and/or investments that may comprise our initial portfolio are subject to entry into definitive agreements, and there can be no assurance that the loans and/or investments will close on the terms anticipated, or at all.

 

    The risk that we may not replicate the historical results achieved by other entities managed or sponsored by affiliates of our Advisor, members of our Advisor’s management team or by Highland or its affiliates.

 

    Our Advisor and its affiliates will face conflicts of interest, including significant conflicts created by our Advisor’s compensation arrangements with us, including compensation which may be required to be paid to our Advisor if the advisory agreement with our Advisor is terminated, which could result in decisions that are not necessarily in the long-term best interests of our stockholders.

 

    We are dependent upon our Advisor and its affiliates to conduct our day-to-day operations; thus, adverse changes in their financial health or our relationship with them could cause our operations to suffer.

 

    We will pay substantial fees and expenses to our Advisor and its affiliates, which payments increase the risk that you will not earn a profit on your investment.

 

    We intend to elect to be treated as a REIT. Our failure to qualify as a REIT for federal income tax purposes would reduce the amount of funds we have available for distribution and limit our ability to make distributions to our stockholders.

 

     Per Share      Total  

Price to the public

   $                   $               

Underwriting discounts and commissions (1)

   $      $  

Proceeds, before expenses, to us

   $      $  

 

(1) See “Underwriting” for a detailed description of compensation payable to the underwriters.

We have granted the underwriters an option to purchase up to an additional                  shares of our common stock on the same terms and conditions set forth above within 30 days of the date of this prospectus solely to cover overallotments, if any.

Neither the Securities and Exchange Commission nor any state securities regulator has approved or disapproved of our common stock, determined if this prospectus is truthful or complete or passed on or endorsed the merits of this offering. Any representation to the contrary is a criminal offense.

The underwriters expect to deliver the shares on or about                 , 2017.

The date of this Prospectus is                  , 2017

Compass Point


Table of Contents

TABLE OF CONTENTS

 

     Page  

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

     i  

PROSPECTUS SUMMARY

     1  

RISK FACTORS

     21  

USE OF PROCEEDS

     46  

DISTRIBUTION POLICY

     48  

CAPITALIZATION

     49  

DILUTION

     50  

SELECTED FINANCIAL DATA

     52  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     54  

BUSINESS

     79  

MANAGEMENT

     102  

MANAGEMENT COMPENSATION

     117  

STOCK OWNERSHIP

     120  

CONFLICTS OF INTEREST

     122  

U.S. FEDERAL INCOME TAX CONSIDERATIONS

     127  

CERTAIN ERISA CONSIDERATIONS

     148  

DESCRIPTION OF CAPITAL STOCK

     153  

CERTAIN PROVISIONS OF MARYLAND LAW AND OUR CHARTER AND BYLAWS

     159  

OUR OPERATING PARTNERSHIP AND THE PARTNERSHIP AGREEMENT

     165  

SHARES ELIGIBLE FOR FUTURE SALE

     168  

UNDERWRITING

     171  

LEGAL MATTERS

     175  

EXPERTS

     175  

WHERE YOU CAN FIND MORE INFORMATION

     175  

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1  

You should rely only on the information contained in this prospectus or in any free writing prospectus we may authorize to be delivered to you. Neither we nor the underwriters have authorized anyone to provide you with additional or different information. We and the underwriters are offering to sell, and seeking offers to buy, our common stock only in jurisdictions where offers and sales thereof are permitted. The information in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or any sale of our common stock.


Table of Contents

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that are subject to risks and uncertainties. In particular, statements relating to our business and investment strategies, plans or intentions, our use of proceeds, our liquidity and capital resources, our performance and results of operations contain forward-looking statements. Furthermore, all of the statements regarding future financial performance (including market conditions) are forward-looking statements. We caution investors that any forward-looking statements presented in this prospectus are based on management’s beliefs and assumptions made by, and information currently available to, management. When used, the words “anticipate,” “believe,” “expect,” “intend,” “may,” “might,” “plan,” “estimate,” “project,” “should,” “will,” “would,” “result,” the negative version of these words and similar expressions that do not relate solely to historical matters are intended to identify forward-looking statements.

Forward-looking statements are subject to risks, uncertainties and assumptions and may be affected by known and unknown risks, trends, uncertainties and factors that are beyond our control. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected. We caution you against relying on any of these forward-looking statements.

Some of the risks and uncertainties that may cause our actual results, performance, liquidity or achievements to differ materially from those expressed or implied by forward-looking statements include, among others, the following:

 

    our loans and investments expose us to risks associated with debt-oriented real estate investments generally;

 

    commercial real estate-related investments that are secured, directly or indirectly, by real property are subject to delinquency, foreclosure and loss, which could result in losses to us;

 

    interest rate fluctuations could reduce our ability to generate income on our investments, which could lead to a significant decrease in our results of operations, cash flows and the market value of our investments;

 

    we operate in a competitive market for lending and investment opportunities, and competition may limit our ability to originate or acquire desirable loans and investments in our target assets and could also affect the yields of these assets;

 

    a majority of the loans and/or investments that may comprise our initial portfolio are subject to entry into definitive agreements, and there can be no assurance that the loans and/or investments will close on the terms anticipated, or at all;

 

    the difficulty in deploying the net proceeds from this offering and the concurrent private placement or the repayments of our loans and/or investments;

 

    the risk that we may not replicate the historical results achieved by other entities managed or sponsored by affiliates of NexPoint Real Estate Advisors II, L.P. (our “Advisor”), members of our Advisor’s management team or by Highland Capital Management, L.P. (“Highland”) or its affiliates;

 

    the risks associated with our Advisor’s ability to terminate the advisory agreement;

 

    our ability to change our major policies, operations and targeted investments without stockholder consent;

 

    the substantial fees and expenses we will pay to our Advisor and its affiliates;

 

    the risks associated with the potential internalization of our management functions;

 

    the risk that we may compete with other entities affiliated with our Advisor or Highland;

 

i


Table of Contents
    the conflicts of interest and competing demands for time faced by our Advisor, Highland and their officers and employees;

 

    the failure to qualify as or to maintain our status as a real estate investment trust (“REIT”);

 

    our ability to comply with REIT requirements, which may limit our ability to hedge our liabilities effectively and cause us to forgo otherwise attractive opportunities, liquidate certain of our investments or incur tax liabilities, including realizing gains on our properties if the properties are disposed of within five years of the date we elect to be taxed as a REIT;

 

    the failure of our operating partnership (the “OP”) to qualify as a partnership for federal income tax purposes, causing us to fail to qualify for or to maintain REIT status;

 

    our investments may produce taxable income in excess of cash available for distribution in some years, which may require that we borrow funds to distribute, or pay dividends consisting of a combination of stock and cash, in order to satisfy the REIT distribution requirements;

 

    risks associated with the stock ownership restrictions of the Internal Revenue Code of 1986, as amended (the “Code”) for REITs and the stock ownership limit imposed by our charter;

 

    the ability of the board of directors to revoke our REIT qualification without stockholder approval;

 

    potential legislative or regulatory tax changes or other actions affecting REITs;

 

    the risks associated with the market for our common stock and the general volatility of the capital and credit markets;

 

    the risks associated with our ability to issue additional debt or equity securities in the future; and

 

    any of the other risks included in this prospectus, including those set forth under the heading “Risk Factors.”

 

ii


Table of Contents

PROSPECTUS SUMMARY

This prospectus summary highlights material information contained elsewhere in this prospectus. Because it is a summary, it may not contain all of the information that is important to you. To understand this offering fully, you should read the entire prospectus carefully, including the “Risk Factors” section, before making a decision to invest in our common stock. Except where the context suggests otherwise, the terms:

 

    “we,” “us,” “our,” “NREF” and the “Company” refer to NexPoint Multifamily Capital Trust, Inc., a Maryland corporation, which will be renamed NexPoint Real Estate Finance, Inc. in connection with this offering;

 

    “Advisor” refers to NexPoint Real Estate Advisors II, L.P., a Delaware limited partnership;

 

    “Sponsor” refers to NexPoint Advisors, L.P., a Delaware limited partnership;

 

    “Highland” refers to Highland Capital Management, L.P., a Delaware limited partnership, and its affiliates; and

 

    “OP” refers to NexPoint Multifamily Operating Partnership, L.P., a Delaware limited partnership, which will be renamed NexPoint Real Estate Finance Operating Partnership, L.P. in connection with this offering.

Our Company

NexPoint Real Estate Finance, Inc. (“NREF”) is a Maryland corporation incorporated on November 12, 2013 primarily focused on providing structured financing solutions for properties where our management team has extensive expertise, focusing on mid-market financing solutions for stabilized property types that should outperform during a rising interest rate environment (e.g., multifamily, self-storage and select-service and extended-stay hospitality assets). Currently, there are many sophisticated owners of multifamily real estate properties seeking structured capital senior to their common equity but subordinate to a government-sponsored enterprise (“GSE”) first mortgage. NexPoint Real Estate Advisors, L.P. (“NexPoint”), an affiliate of our Advisor, is a select sponsor of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and preferred sponsor of the Federal National Mortgage Association (“Fannie Mae”) for multifamily loans and investments, which we expect will position us to significantly grow our business. We are externally managed by NexPoint Real Estate Advisors II, L.P., our Advisor, which together with its affiliates has extensive real estate experience, having completed approximately $2.7 billion of gross real estate transactions since 2013. Our Advisor is an affiliate of Highland, which had $13.7 billion in assets under management as of July 31, 2017.

We will primarily focus on the origination and structuring of mezzanine loans, preferred equity and alternative structured financing investments. We believe most publicly traded real-estate debt focused REITs focus on first mortgage bridge lending in gateway markets for assets undergoing some type of redevelopment or transition. We intend to target our structured financings on stabilized properties, primarily located in the top 50 metropolitan statistical areas (“MSAs”) that have been well-maintained, have few deferred maintenance issues and are owned by experienced and high quality operators. We believe that these investment opportunities best meet our primary investment objectives as they contractually provide a high percentage of total return from current pay, are structured to mitigate impairments in the investments, and potentially provide equity-like, long-term total return opportunities, with lower risk than a typical direct equity investment in real estate.

Our Investment Strategy

Our primary investment strategy is to generate attractive, risk-adjusted current income and capital appreciation for our shareholders by investing in a diversified portfolio of structured real estate investments. Through active management, market experience and a robust underwriting process, we believe we will be able to

 



 

1


Table of Contents

preserve our capital investments, while delivering an attractive total return through all market cycles. Over time, we will take advantage of market opportunities by moving within the capital structure of our targeted investments to achieve a superior portfolio-mix. Each investment and the portfolio as a whole is regularly monitored and stress-tested in various scenarios, enabling us to make informed and proactive investment decisions.

We expect the size of our investments will vary significantly, but generally expect them to range in value from $5 million to $20 million. We expect that the underlying properties will generally:

 

    have been institutionally developed and owned prior to our investment;

 

    have stabilized occupancy; and

 

    pass our Advisor’s strict underwriting criteria and stressed market-cycle scenarios.

We intend to, directly or indirectly, make mezzanine loans, preferred equity and alternative structured financing investments based on current market terms that generally:

 

    pay commitment and exit fees from the property owner at funding and repayment/redemption, respectively;

 

    pay a high annual current return; and

 

    pay an additional annualized paid in kind preferred return which compounds monthly and is paid at the time of a triggering event (sale and/or refinancing).

We underwrite each investment opportunity as if we were acquiring the asset itself, and then stress the cash flows under various downside scenarios. The governing investment documents are tailored to provide us with superior protection in circumstances when the interest or preferred returns, as applicable, fail to be paid. We may structure protective provisions, including foreclosure rights, to mitigate risk in the event of default. In the event we take ownership of an asset following a default, our Advisor will manage the property and look to dispose of the property at a point that is accretive to investors, and then recycle the capital into new structured investments post-disposition.

 



 

2


Table of Contents

Structured Investments: How it Works

 

LOGO

Target Investments

The state of the current and future real estate cycles and our investment objectives dictate our target investments. Given our Advisor’s preference for property types that have demonstrated cyclical resilience, tenant diversification, lower capital expenditures upon tenant turnover, shorter-duration lease terms and less vulnerability to technological disruption, we expect the significant majority of our portfolio to be allocated to stabilized multifamily, storage and select-service and extended-stay hospitality assets over the near term. Within this allocation and in a normalized operating environment, we expect to focus our primary investment activity on mezzanine loans, preferred equity and alternative structured financing investments, with the majority of our investment portfolio concentrated in mezzanine or subordinated loans in stabilized multifamily assets.

Our investment guidelines will permit us to originate and invest in mezzanine loans, subordinated loans, preferred equity, alternative structured financing, bridge financing and first mortgage loan investments, which are described below:

 

    Mezzanine and Subordinated Debt: We intend to focus on the origination of structured mezzanine or subordinated debt investments. Structured mezzanine and subordinated debt is structurally senior to common equity and subordinate to the first mortgage loans. The loan to value typically ranges from 50% – 85%. The investment usually carries either a fixed or floating rate component and can be structured with an additional equity-like component. This type of investment generally pays a 7% – 9% annualized current cash component along with a 3% – 5% annualized payment-in-kind that accrues and is due upon maturity of the debt. It generally will be structured with a commitment and exit fee paid by the owner upon funding and exit of the investment. Mezzanine lenders typically have additional rights as compared to more senior lenders, including the right to cure defaults under the senior loan under certain circumstances following a default on the senior loan. Mezzanine debt investments we will originate will be secured by a second lien in the underlying property or by the common equity of the entity we lend to, while subordinated debt investments will generally be secured by a lien in the underlying property. Structured mezzanine and subordinated debt investments have the ability to offer debt-like risk with equity-like returns.

 

   

Preferred Equity: We intend to originate preferred equity investments to the extent allowed under various restrictions we operate under, including our desire to remain exempt from registration as an

 



 

3


Table of Contents
 

investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). Preferred equity is similar to structured mezzanine debt in that it is structurally senior to common equity and subordinate to the first mortgage loans, typically ranges from 50% – 85% of the capital structure, usually carries either a fixed or floating rate component and can be structured with an additional equity-like component. Preferred equity investments also generally pay a 7% – 9% annualized current cash component along with a 3% – 5% annualized payment-in-kind that accrues and is due upon a triggering event. It generally will be structured with a commitment and exit fee paid by the owner upon funding and exit of the investment. The most distinguishable attribute of a preferred equity investment as compared to a structured mezzanine or subordinated debt investment is how the deal is initially structured. We expect that the preferred equity investments will include a put option, a forced-sale right and a “foreclosure option,” which are triggered by the occurrence of a triggering event. A triggering event includes, among other things, the failure to pay the preferred return, a default under a mortgage loan document or failure to redeem the investment upon a sale or refinancing. Upon the occurrence of a triggering event, typically (1) our preferred equity investment will be redeemed and we will receive the amount of our investment plus an agreed upon rate of return or (2) we will acquire the ownership interests of the common holders for minimal consideration. These types of investments have the ability to offer debt-like risk with equity-like returns.

 

    Alternative Structured Financing: We will also look to construct innovative financing solutions in a way that is symbiotic for both parties, similar to the Jernigan Capital, Inc. investment described below. Our intent is to provide flexibility and structured deals that enable counterparties to strategically draw capital when needed or “match funded” commitments. Terms of the deal may entail a maximum commitment over a certain period with monthly minimums in exchange for a preferred equity investment with a stated cash coupon and a back-end payment-in-kind component that is in the form of additional preferred equity or common stock, which provides an additional avenue for substantial value accretion to investors. These types of investments may also be limited such that we are still able to qualify for an exemption under the Investment Company Act.

 

    First Mortgage and Bridge Loans: As market conditions evolve, we may decide that originating and owning first mortgages or bridge loans offers a more attractive risk adjusted return. The loans are secured by real estate, carrying either a fixed or floating interest rate and usually require a balloon payment of principal upon maturity. We would likely look to originate floating rate, shorter-term first mortgages.

Our Initial Portfolio

We have entered into letters of intent with unaffiliated third party sponsors for the loans and investments listed in the table below, which along with our current preferred equity investment and property, may comprise our initial portfolio (our “Initial Portfolio”). The letters of intent are non-binding and remain subject to entry into definitive agreements with respect to the loans and investments. There can be no assurance that the loans and investments will close on the terms anticipated, or at all. We believe the following investments and properties may comprise our Initial Portfolio:

Potential Investments

 

Investment

 

Location

  Property
Type
  Investment
Type
  Amount of
Investment
  Rate

Ashford at Feather Sound

  Clearwater, FL   Multifamily   Mezzanine Debt   $7.3 million   8.25% + 2.75% PIK

City Park Clearwater

  Clearwater, FL   Multifamily   Mezzanine Debt   $5.7 million   8.25% + 2.75% PIK

Floresta

  Jupiter, FL   Multifamily   Mezzanine Debt   $12.3 million   8.25% + 2.75% PIK

Jernigan Capital, Inc.

  Memphis, TN   Self-Storage   Preferred Equity   $35.0 million (1)   7% + PIK dividend (2)

Latitude

  Phoenix, AZ   Multifamily   Mezzanine Debt   $6.0 million   8.5% + 2% PIK

Marbella

  Corpus Christi, TX   Multifamily   Mezzanine Debt   $5.2 million   9% + 4% PIK

Riverside Villas

  Fort Worth, TX   Multifamily   Mezzanine Debt   $2.0 million   8.5%

 



 

4


Table of Contents

 

(1) We expect to invest up to $35.0 million in this investment. The size of our investment will depend on the allocation policy of Highland and our Advisor, the size of this offering and the maintenance of our exemption from registration under the Investment Company Act. We expect our investment in Jernigan to increase or decrease on a pro rata basis in relation to the size of this offering. If there is a 10% increase or decrease in the size of this offering, we expect our investment in Jernigan to increase or decrease by $         million. The total investment in Jernigan under the stock purchase agreement by and between Jernigan Capital, Inc., our Sponsor, as buyer representative, NexPoint Real Estate Capital, LLC and NexPoint Real Estate Opportunities, LLC (the “Jernigan Stock Purchase Agreement”) may be for an amount up to $125.0 million at Jernigan’s option. At least $50.0 million must be invested in Jernigan before July 27, 2018, the date the stock purchase agreement terminates. Investments in Jernigan must be in amounts of (a) no less than $5.0 million, and if greater than $5.0 million, in multiples of $1.0 million (b) no more than $15.0 million in any given calendar month, and (c) no more than $35.0 million in any three-month period. Affiliates of Highland have already invested $10.0 million in Jernigan. The remainder of the investment will be funded by us or other Highland affiliates.
(2) The cash dividend will increase to 8.5% in July 2022. An additional 5% cash dividend is payable upon the occurrence of a change in control and other similar events. The PIK dividend will be equal to the lesser of (a) 25% of the incremental increase in book value plus the incremental increase in net asset value of any income producing real property and (b) an amount that together with the cash dividends would equal a 14% internal rate of return (“IRR”).

We believe each investment will qualify as a real-estate asset for purposes of the REIT asset tests.

Current Investments

 

Investment

 

Location

  Property
Type
  Investment
Type
  Amount of
Investment
  Rate

Stone Oak

  San Antonio, TX   Multifamily   Preferred Equity   $5.25 million   8% + 3% PIK

Estates (1)

  Phoenix, AZ   Multifamily   Property   $48.6 million   N/A

 

(1) We currently have a $26.9 million first mortgage on Estates.

Market Opportunity

We believe there is a significant opportunity to originate structured investments in stabilized real estate assets that have short-term leases and a diversified tenant base such as multifamily, self-storage and hospitality properties. Third-party sponsors of these property types seek gap financing from time to time, which allows them to allocate capital more efficiently while earning a higher return. We have seen demand for gap financing increase as banks have reduced their commercial real estate refinancing due in large part to more onerous underwriting standards and stricter banking regulations.

In particular, we believe multifamily assets currently represent an attractive opportunity for structured investments. With homeownership rates close to 64%, annual apartment rent increases have averaged in excess of 3.0% over the past 10 years with vacancy rates below 6%, which reflects strong demand coupled with limited new supply in most markets.

The multifamily loan market has approximately $1.2 trillion of debt outstanding as of March 31, 2017, with mortgage originations totaling $265 million in 2016. The financing market is heavily supported by Fannie Mae and Freddie Mac, which combined represented 42%, or $112 billion, of loan originations in 2016. We expect most of our multifamily investments will utilize a GSE first mortgage, which follow strict underwriting requirements. The GSEs experienced relatively low delinquency rates throughout the great recession and have been below 10 basis points since 2014.

 



 

5


Table of Contents

LOGO

Our Competitive Strengths

Public Company REIT Experience

Our Advisor’s management team took a private multifamily REIT public in April 2015, which began trading on the NYSE (NYSE: NXRT). Our senior management team will be the same as NXRT’s management team.

Proven Investment Strategy

Our Advisor and its affiliates have invested over $135 million in investments in multifamily properties in the past three years. We expect that similar investments will comprise the majority of our portfolio and provide stable current income, total return potential and downside protection.

Network of Existing Partners Provides Immediately Available Investment Pipeline to NREF

NREF also believes that one of its key success factors is the network of local, regional and national operating partners with which our Advisor and its affiliates do business. Our Advisor and its affiliates work closely with high quality sponsors to forge long-standing relationships so that it is always seen as the “investment partner of choice” when partners are seeking investment in new transactions. Our Advisor has done business with over 75 real estate sponsors.

Scalability, Strength and Experience in Target Sectors

We expect a significant amount of our capital to be deployed in the multifamily sector, a property type in which our Advisor and its affiliates have a large network of relationships and a history of success. Our Advisor and its affiliates have completed approximately $2.7 billion of multifamily transactions since 2013, holding either direct or indirect interests in approximately 21,000 apartment units in the United States.

Financing Solution is Pre-Approved and Complies with Freddie Mac and Fannie Mae Standards

Our Advisor and its affiliates have experience structuring financing solutions behind first mortgage lenders, including banks, life insurance companies and Freddie Mac and Fannie Mae. Our Advisor and its affiliates have successfully tailored financing solutions to property owners in critical ways but also highly symbiotic with a typical Freddie Mac or Fannie Mae first mortgage. Our multifamily loan and investment platform complies with current Freddie Mac and Fannie Mae standards, giving us a unique opportunity to invest alongside quality sponsors and the largest multifamily lenders in the U.S.

 



 

6


Table of Contents

In addition, NexPoint is a “select sponsor” with Freddie Mac and enjoys preferred status with Fannie Mae for multifamily loans and investments, having borrowed over $1 billion from GSEs. We believe our Advisor and its affiliates’ relationship, status and expertise with the GSEs provide proprietary deal flow, unique access and exposure to a superior risk-adjusted, total return investment product not currently offered in the public equity markets.

Our Advisor and its affiliates have also successfully structured investments behind non-agency first mortgage lenders on both hospitality and self-storage real property. Our product is tailored to give sponsors attractively priced capital, while delivering attractive risk-adjusted returns to our investors.

Extensive Infrastructure of our Advisor and Highland’s Real Estate Platform

NexPoint is also an affiliate of Highland and was created to manage Highland’s real estate platform. The dedicated NexPoint real estate team includes 12 individuals and has completed over 90 transactions totaling approximately $2.7 billion invested since 2013. NexPoint’s investment team has a combined 70 years of investment experience with some of the world’s most sophisticated institutions and investors in the following asset classes: real estate, private equity, alternatives, credit and equity.

In addition, our Advisor is also affiliated with NexBank Capital, Inc. (“NexBank”), a financial services company with assets of $6.0 billion and whose primary subsidiary is a commercial bank. NexBank provides commercial banking, mortgage banking, investment banking and corporate advisory services to clients throughout the U.S. NexBank primarily serves institutional clients and financial institutions and is also committed to serving the banking and financial needs of large corporations, middle-market companies and real estate investors. As of July 31, 2017, NexBank’s commercial real estate loan portfolio totaled $751 million, with a pipeline of an additional $150 million.

Our Sponsor

Our Sponsor and its subsidiaries are primarily responsible for managing the real estate investment activities for Highland and its affiliates. Highland is an SEC-registered investment advisor which, together with its affiliates, had $13.7 billion in assets under management as of July 31, 2017, and employs more than 130 investment, accounting, finance, compliance, legal and human resource professionals. Highland’s diversified client base includes public pension plans, foundations, endowments, corporations, financial institutions, fund of funds, governments, and high net-worth individuals. Highland is one of the most experienced global alternative credit managers. The firm invests in various credit and equity strategies through hedge funds, long-only funds, separate accounts, collateralized loan obligations (“CLOs”), non-traded funds, publicly traded funds, closed-end funds, including an interval fund and a business development company, mutual funds and exchange-traded funds (“ETFs”), and manages strategies such as distressed-for-control private equity, oil and gas, direct real estate, real estate credit and originated or structured real estate credit investments. Our senior management team will include James Dondero, Brian Mitts, Matt McGraner, Matthew Goetz and Scott Ellington. The members of our Sponsor’s real estate team, both during their tenure at Highland and in their previous roles before joining Highland, have a long history of investing in real estate and debt related to real estate properties. In addition, NexBank’s mortgage banking volume exceeded $5.0 billion in 2016, while also servicing $4.3 billion of 1-4 family residential loans for Fannie Mae, Freddie Mac, and the Government National Mortgage Association (“Ginnie Mae”), among others.

Tactical Relationship with Highland Capital Management, L.P.

Significant Shareholder Alignment — Investor as well as Advisor

Highland, our Advisor and its affiliates are committed to making a substantial investment in NREF. Concurrently with the closing of this offering, Highland and/or its affiliates will purchase in a separate private

 



 

7


Table of Contents

placement                 shares of our common stock representing an aggregate investment equal to $         million. Highland, our Advisor and its affiliates intend to beneficially own shares representing approximately 25% of our outstanding common stock, which they intend to accumulate over time. At the closing of this offering and the concurrent private placement, taking into account the overallotment option, Highland, our Advisor and its affiliates expect to own approximately 10% of our outstanding common stock.

Highland, our Advisor and its affiliates firmly believe in taking proactive measures intended to align themselves with shareholders by holding substantial stakes in the investment vehicles they manage as well as implementing pro-investor programs further supporting its alignment and being a leading advocate for the investor base.

Leveraging Highland’s and NexBank’s Platforms

We will benefit from our Advisor’s affiliation with Highland and NexBank, which provide access to resources including research capabilities, an extensive relationship network, other proprietary information, and instant scalability. Given our Advisor’s access to these resources, our Advisor is able to research, source, and evaluate opportunities that competitors may not have the bandwidth nor opportunity to pursue.

We firmly believe Highland’s vast network of resources and its and NexBank’s core competencies will benefit NREF in the following key areas:

 

    Highland’s Proven Processes: Highland’s time-tested investment process is rooted in its ability to identify mispricing through robust macro, top-down analysis as well as fundamental, bottoms-up analysis, proactive diligence, monitoring and very nimble trading capabilities. Highland’s investment team is comprised of industry focused research professionals with an average of approximately 11 years of investment experience. These professionals are responsible for reviewing existing investments, evaluating opportunities across issuer capital structures and monitoring trends within those industries. Highland maintains investment thesis and sell-discipline, and strives for active returns by avoidance. Finally, Highland’s active and focused portfolio management process is driven by its bold decision making and has been a key driver of creating active returns over time.

 

    Strategic Partnerships & Robust Third-Party Relationships: Over the years, Highland and its affiliates have forged mutually beneficial relationships and partnerships that have served to provide increased deal flow on attractive real estate with quality sponsors. Its robust relationships have also allowed for more creative financing solutions to better serve its clients and investors.

 

    Immediate Scalability: One of the benefits of being part of a $13.7 billion enterprise is the ability to provide immediate scalability to an investment vehicle. We expect instantaneous cost efficiencies and to achieve economies of scale upon the closing of this offering, which is reflected in NREF’s efficient fee structure by leveraging our first-class back-office groups.

 

    First-Class Back-Office Support: Highland’s back-office was created to cover all functional areas for the on-going support and operations of the firm and its various products. The back-office consists of Accounting, Corporate, Human Resources, Valuation, Operations, Settlement, Trading, and Product Strategy. Each team has its own set of robust processes and policies to ensure consistency, accuracy, and reliability on respective functions. These groups cover and have expertise in a multitude of fund structures, including limited partnerships, separately managed accounts, publicly traded companies, mutual funds, ETFs, closed-end funds and private equity structures. They also have experience servicing various investor types such as large pension funds, high net worth individuals, public investors, and retail mutual fund investors.

 

   

Expertise in Public Filings: Highland’s accounting group includes personnel with extensive experience with public SEC filings, and accounting and tax expertise in real estate accounting and

 



 

8


Table of Contents
 

accounting for loans, mortgages and other credit instruments. An affiliate of our Advisor externally manages a publicly traded REIT, NexPoint Residential Trust, Inc. (NYSE: NXRT); a publicly traded closed-end fund, NexPoint Credit Strategies Fund (NYSE: NHF); and a public, non-traded business development company, NexPoint Capital, Inc. All of these entities are public filers and have personnel dedicated to their accounting with extensive experience with financial statement reporting.

 

    In-House Legal Counsel: Highland utilizes a 14 person in-house Legal/Compliance team comprised of lawyers, paralegals, and compliance experts who have extensive experience in multiple facets of law.

 

    NexBank’s Infrastructure: NexBank will help source and execute investments, provide servicing infrastructure and asset management capabilities. Their credit/underwriting team is comprised of seven individuals, including John Holt, Matt Siekielski and Rhett Miller, with extensive experience in commercial real estate, commercial and industrial, residential real estate, municipal bond and asset based lending underwriting. Once a potential transaction is identified, the team gathers due diligence documents, third party reports, any additional research that is needed, and undergoes a site visit. An underwriting package is then prepared for a weekly investment committee meeting among NexPoint and NexBank representatives.

Financing Strategy

We intend to maintain normal operating leverage in the range of 25%-35% of our corporate enterprise value (excluding the leverage on Estates). We expect this leverage to be in the form of a credit facility, primarily utilized for the purposes of recycling capital when our investments are redeemed, paid off or retired, as applicable. Given that we expect loans and investments in stabilized multifamily assets to make up a majority of our portfolio, we believe this leverage target is prudent given that leverage typically exists at the asset level. By primarily utilizing (and in most cases, helping select) our borrowers’ property-level financing, we can more effectively manage credit risk. We believe that our leverage is appropriate to produce superior total returns to both equity and mortgage REITs, particularly at the later stages of the real estate cycle.

Investment Guidelines

Upon completion of this offering, our board of directors will approve the following investment guidelines:

 

    No investment will be made that would cause us to fail to qualify or maintain our qualification as a REIT under the Code;

 

    No investment will be made that would cause us or any of our subsidiaries to be required to be registered as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”);

 

    Our Advisor will seek to invest our capital in our target assets;

 

    Prior to the deployment of our capital into our target assets, our Advisor may cause our capital to be invested in any short-term investments in money market funds, bank accounts, overnight repurchase agreements with primary Federal Reserve Bank dealers collateralized by direct U.S. government obligations and other instruments or investments determined by our Advisor to be of high quality; and

 

    No more than 25% of our Equity (as defined in our Advisory Agreement (as defined below)) may be invested in any individual investment without the approval of a majority of our independent directors (it being understood, however, that for purposes of the foregoing concentration limit, in the case of any investment that is comprised (whether through a structured investment vehicle or other arrangement) of securities, instruments or assets of multiple portfolio issuers, such investment will be deemed to be multiple investments in such underlying securities, instruments and assets and not the particular vehicle, product or other arrangement in which they are aggregated).

 



 

9


Table of Contents

These investment guidelines may be amended, supplemented or waived pursuant to the approval of our board of directors (which must include a majority of our independent directors) from time to time, but without the approval of our stockholders.

Our Structure

The following chart shows our ownership structure:

 

LOGO

Advisory Agreement

Pursuant to our advisory agreement, NexPoint Real Estate Advisors II, L.P. serves as our Advisor. On the closing of this offering, the advisory agreement will be amended and restated (as amended and restated, the “Advisory Agreement”). Pursuant to the Advisory Agreement, subject to the overall supervision of our board of directors, our Advisor will manage our day-to-day operations, and provide investment management services to us. Under the terms of this agreement, our Advisor will, among other things:

 

    identify, evaluate and negotiate the structure of our investments (including performing due diligence);

 

    find, present and recommend investment opportunities consistent with our investment policies and objectives;

 

    structure the terms and conditions of our investments;

 

    review and analyze financial information for each underlying property of the overall portfolio; and

 

    close, monitor and administer our investments.

 



 

10


Table of Contents

The Advisory Agreement has an initial term of three years, and is automatically renewed thereafter for a one-year term unless earlier terminated. We will have the right to terminate the Advisory Agreement on 30 days’ written notice for cause. The Advisory Agreement can be terminated by us or our Advisor without cause with six months’ written notice to the other party. Our Advisor may also terminate the agreement with 30 days written notice if we have materially breached the agreement and such breach has continued for 30 days. A termination fee will be payable to our Advisor upon termination of our Advisory Agreement for any reason other than a termination by us for cause. The termination fee will be equal to three times the average annual asset management fee (the “Annual Fee”) earned by our Advisor during the two-year period immediately preceding the most recently completed calendar quarter prior to the effective termination date; provided, however, if the Advisory Agreement is terminated prior to the two-year anniversary of the date of the Advisory Agreement, the asset management fee earned during such period will be annualized for purposes of calculating the average annual asset management fee.

The following table summarizes the fees, expense reimbursements, and other amounts that we may pay to our Advisor.

 

Type

  

Description

Asset Management Fee

  

1.5% of Equity per annum, calculated and payable monthly in cash.

 

For purposes of calculating the asset management fee, “Equity” means (a) the sum of (1) total stockholders’ equity immediately prior to the closing of this offering, plus (2) the net proceeds received by NREF from all issuances of NREF’s common stock after the offering, plus (3) NREF’s cumulative Core Earnings (as defined below) from and after the offering to the end of the most recently completed calendar quarter, (b) less (1) any distributions to NREF’s common stockholders from and after the offering to the end of the most recently completed calendar quarter and (2) any amount that NREF has paid to repurchase NREF’s common stock from and after the offering to the end of the most recently completed calendar quarter. For the avoidance of doubt, Equity will include compensation expense relating to any restricted shares of common stock and any other shares of common stock underlying awards granted under one or more of NREF’s equity incentive plans as an adjustment to net income in the calculation of Core Earnings.

 

As used herein, “Core Earnings” means the net income (loss) attributable to our common stockholders computed in accordance with U.S. generally accepted accounting principles (“GAAP”), including realized gains and losses not otherwise included in net income (loss), and excluding (a) amortization of stock-based compensation, (b) depreciation and amortization, and (c) adjustments for noncontrolling interests. Net income (loss) attributable to common stockholders may also be adjusted for one-time events pursuant to changes in GAAP and certain material non-cash income or expense items, in each case after discussions between the Advisor and the independent directors of the board and approved by a majority of the independent directors of the board.

Incentive Fee

   None.

Reimbursement of Expenses

  

 

We will be required to pay directly or reimburse our Advisor for all of the documented “operating expenses” (all out-of-pocket expenses of our Advisor

 



 

11


Table of Contents
   in performing services for us, including but not limited to the expenses incurred by our Advisor in connection with any provision by our Advisor of legal, accounting, financial and due diligence services performed by our Advisor that outside professionals or outside consultants would otherwise perform, compensation expenses under any long term incentive plan adopted by us and approved by our stockholders and our pro rata share of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of our Advisor required for our operations) and “offering expenses” (any and all expenses (other than underwriters’ discounts) paid or to be paid by us in connection with an offering of our securities, including, without limitation, our legal, accounting, printing, mailing and filing fees and other documented offering expenses) paid or incurred by our Advisor or its affiliates in connection with the services it provides to us pursuant to the Advisory Agreement. Reimbursement of operating expenses, plus the Annual Fee, may not exceed 2.5% of gross assets for any calendar year or portion thereof, provided, however, that this limitation will not apply to legal, accounting, financial, due diligence and other service fees incurred in connection with extraordinary litigation and mergers and acquisitions and other events outside the ordinary course of our business or any out-of-pocket acquisition or due diligence expenses incurred in connection with the acquisition or disposition of certain real estate assets. Reimbursements of offering expenses paid or to be paid to our Advisor in connection with this offering may not exceed $1.5 million.

Termination Fee

   Equal to three times the Annual Fee earned by our Advisor during the two-year period immediately preceding the most recently completed calendar quarter prior to the effective termination date; provided, however, if the agreement is terminated prior to the two year anniversary of the date of the agreement, the Annual Fee earned during such period will be annualized for purposes of calculating the Annual Fee. The termination fee will be payable to our Advisor upon termination of our Advisory Agreement for any reason other than a termination by us for cause.

See “Business — Advisory Agreement” and “Management Compensation.”

Risk Factors

An investment in shares of our common stock involves various risks. You should consider carefully the following risks and those under the heading “Risk Factors” before purchasing our common stock:

 

    Our loans and investments expose us to risks similar to and associated with debt-oriented real estate investments generally.

 

    Commercial real estate-related investments that are secured, directly or indirectly, by real property are subject to delinquency, foreclosure and loss, which could result in losses to us.

 

    Interest rate fluctuations could reduce our ability to generate income on our investments, which could lead to a significant decrease in our results of operations, cash flows and the market value of our investments.

 

    We operate in a competitive market for lending and investment opportunities, and competition may limit our ability to originate or acquire desirable loans and investments in our target assets and could also affect the yields of these assets.

 



 

12


Table of Contents
    A majority of the loans and/or investments that may comprise our Initial Portfolio are subject to entry into definitive agreements, and there can be no assurance that the loans and/or investments will close on the terms anticipated, or at all.

 

    The risk that we may not replicate the historical results achieved by other entities managed or sponsored by affiliates of our Advisor, members of our Advisor’s management team or by Highland or its affiliates.

 

    Our Advisor and its affiliates will face conflicts of interest, including significant conflicts created by our Advisor’s compensation arrangements with us, including compensation which may be required to be paid to our Advisor if our Advisor is terminated, which could result in decisions that are not necessarily in the long-term best interests of our stockholders.

 

    We are dependent upon our Advisor and its affiliates to conduct our day-to-day operations; thus, adverse changes in their financial health or our relationship with them could cause our operations to suffer.

 

    We will pay substantial fees and expenses to our Advisor and its affiliates, which payments increase the risk that you will not earn a profit on your investment.

 

    We intend to elect to be treated as a REIT. Our failure to qualify as a REIT for federal income tax purposes would reduce the amount of funds we have available for distribution and limit our ability to make distributions to our stockholders.

If any of the factors enumerated above or in “Risk Factors” occurs, our business, financial condition, liquidity, results of operations and prospects could be materially and adversely affected. In that case, the trading price of our common stock could decline, and you may lose some or all of your investment.

Operating and Regulatory Structure

REIT Qualification

We intend to elect to be taxed as a REIT under the Code, commencing with the current taxable year ending on December 31, 2017. We believe that we have been organized in conformity with the requirements for qualification and taxation as a REIT under the Code, and that our intended manner of operation will enable us to meet the requirements for qualification and taxation as a REIT. We further believe that, after the consummation of this offering, we will satisfy the stock ownership diversity requirement for qualification as a REIT. To qualify as a REIT, we must meet on a continuing basis, through our organization and actual investment and operating results, various requirements under the Code relating to, among other things, the sources of our gross income, the composition and values of our assets, our distribution levels and the diversity of ownership of shares of our stock. If we fail to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal income tax at regular corporate rates and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which we failed to qualify as a REIT. Even if we qualify for taxation as a REIT, we may be subject to some U.S. federal, state and local taxes on our income or property or REIT “prohibited transactions” taxes with respect to certain of our activities. Any distributions paid by us generally will not be eligible for taxation at the preferred U.S. federal income tax rates that apply to certain distributions received by individuals from taxable corporations.

For prior taxable years we have been taxed as a C-corporation for U.S. federal income taxes. Consequently, if we elect to be a REIT beginning in 2017, and if, within five years of January 1, 2017, the effective date of the REIT election, (1) we dispose of either the property or our interest in the limited liability company that we held on such date, or (2) the limited liability company in which we hold an interest disposes of any property it held on such date, we may be subject to federal income tax on the “built-in gain” with respect to such property. For additional information see “Risk Factors — Risks Related to Our Corporate Structure.”

 



 

13


Table of Contents

Investment Company Act Exclusion

We, as well as our subsidiaries, intend to conduct our operations so that we are not required to register as an investment company under the Investment Company Act. Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, which we refer to as the 40% test. Excluded from the term “investment securities,” among other things, are U.S. Government securities and securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exemption from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.

We are organized as a holding company and will conduct our business primarily through our OP and wholly and majority-owned subsidiaries of our OP. We anticipate that our OP will always be at least a majority-owned subsidiary and controlled by us as general partner. We intend to conduct our operations so that neither we nor our OP will hold investment securities in excess of the limit imposed by the 40% test. The securities issued by any wholly owned or majority-owned subsidiaries that we may form in the future that are excepted from the definition of “investment company” based on Section 3(c)(1) or 3(c)(7) of the Investment Company Act, together with any other investment securities we may own, may not have a value in excess of 40% of the value of our total assets on an unconsolidated basis. We will monitor our holdings to ensure continuing and ongoing compliance with this test. In addition, we believe that 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, propose to engage primarily, or hold ourselves out as being engaged primarily, in the business of investing, reinvesting or trading in securities. Rather, we will be primarily engaged in the non-investment company businesses of our subsidiaries.

We anticipate that our OP’s subsidiaries will meet the requirements of the exception from the definition of an investment company set forth in Section 3(c)(5)(C) of the Investment Company Act, which excepts entities primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” To meet this exception, the SEC staff has taken the position that at least 55% of a subsidiary’s assets must be comprised of qualifying assets (as interpreted by the SEC staff under the Investment Company Act) and at least another 25% of assets (subject to reduction to the extent the subsidiary invested more than 55% of its total assets in qualifying assets) must be comprised of real estate-related assets under the Investment Company Act (and no more than 20% comprised of miscellaneous assets). Qualifying assets for this purpose include, without limitation, mortgage loans (first and second) fully secured by real property, and certain junior mortgage loans and mezzanine loans that satisfy various conditions as set forth in SEC staff no-action letters. We intend to treat junior mortgage loans and mezzanine loans that do not satisfy the conditions set forth in the relevant SEC staff no-action letters, and debt and equity securities of companies primarily engaged in real estate businesses that are not within the scope of SEC staff positions and/or interpretations regarding qualifying assets as real estate-related assets. In general, we also expect, with regard to our subsidiaries relying on Section 3(c)(5)(C), to rely on other guidance published by the SEC staff or on our analyses of guidance published with respect to other types of assets to determine which assets are qualifying assets and real estate-related assets. Maintaining the Section 3(c)(5)(C) exception, however, will limit our ability to make certain investments.

In the event that we and/or our OP meet the definition of an investment company, it is anticipated that we and/or our OP will rely on an exclusion under the Investment Company Act, such as Section 3(c)(6) in our case, or Section 3(c)(5)(C) or 3(c)(6) in the case of our OP. Section 3(c)(6), as relevant here, is available for companies that, through majority owned subsidiaries, conduct activities that qualify for the exclusion under Section 3(c)(5)(C).

 



 

14


Table of Contents

In August 2011, the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C), including the nature of the assets that qualify for purposes of the exemption and whether mortgage REITs should be regulated in a manner similar to investment companies. There can be no assurance that the laws and regulations governing the Investment Company Act status of REITs (and/or their subsidiaries), including guidance of the SEC or its staff regarding this exemption, will not change in a manner that adversely affects our operations. To the extent that the SEC or its staff publishes new or different guidance with respect to these matters, we may be required to adjust our strategy accordingly. In addition, we may be limited in our ability to make certain investments, and these limitations could result in the subsidiary holding assets we might wish to sell or not acquiring or selling assets we might wish to hold. Although we intend to monitor the portfolios of our subsidiaries relying on the Section 3(c)(5)(C) exemption periodically and prior to each acquisition, there can be no assurance that such subsidiaries will be able to maintain this exemption. For our subsidiaries that do maintain this exemption, our interests in these subsidiaries will not constitute “investment securities.”

Because we initially own one operating property and expect that none of our majority-owned subsidiaries will be relying on exemptions under either Section 3(c)(1) or 3(c)(7) of the Investment Company Act and because our interests in these subsidiaries will constitute a substantial majority of our assets, we expect to be able to conduct our operations so that we are not required to register as an investment company under the Investment Company Act.

The determination of whether an entity is a majority-owned subsidiary of our company is made by us. The Investment Company Act defines a majority-owned subsidiary of a person as a company 50% or more of the outstanding voting securities of which are owned by such person, or by another company which is a majority-owned subsidiary of such person. The Investment Company Act further defines voting securities as any security presently entitling the owner or holder thereof to vote for the election of directors of a company. We treat companies in which we own at least a majority of the outstanding voting securities as majority-owned subsidiaries for purposes of the 40% test. We have not requested the SEC to approve our treatment of any company as a majority-owned subsidiary, and the SEC has not done so. If the SEC were to disagree with our treatment of one or more companies as majority-owned subsidiaries, we would need to adjust our strategy and our assets in order to continue to pass the 40% test. Any such adjustment in our strategy could have a material adverse effect on us.

To the extent that the SEC staff provides more specific guidance regarding any of the matters bearing upon such exclusions, we may be required to adjust our strategy accordingly. Any additional guidance from the SEC staff could provide additional flexibility to us, or it could further inhibit our ability to pursue the strategies we have chosen.

Restrictions on Ownership and Transfer of Our Common Stock

To assist us in complying with the limitations on the concentration of ownership of a REIT imposed by the Code, among other purposes, our charter prohibits, with certain exceptions, any stockholder from beneficially or constructively owning, applying certain attribution rules under the Code, more than 6.2% by value or number of shares, whichever is more restrictive, of the aggregate of the outstanding shares of our common stock, or 6.2% by value of the aggregate of the outstanding shares of our capital stock. Our board of directors may, in its sole discretion, subject to such conditions as it may determine and the receipt of certain representations and undertakings, waive the 6.2% ownership limit with respect to a particular stockholder if such ownership will not then or in the future jeopardize our qualification as a REIT. In connection with this offering, our board of directors intends to grant Highland and its affiliates a waiver allowing them to own up to 25% of our common stock. Our charter also prohibits any person from, among other things, beneficially or constructively owning shares of our capital stock that would result in our being “closely held” under Section 856(h) of the Code (without regard to whether the ownership interest is held during the last half of a taxable year), or otherwise cause us to fail to qualify as a REIT.

 



 

15


Table of Contents

Our charter provides that any ownership or purported transfer of our capital stock in violation of the foregoing restrictions will result in the shares so owned or transferred being automatically transferred to a charitable trust for the benefit of a charitable beneficiary, and the purported owner or transferee acquiring no rights in such shares. If a transfer of shares of our capital stock would result in our capital stock being beneficially owned by fewer than 100 persons or the transfer to a charitable trust would be ineffective for any reason to prevent a violation of the other restrictions on ownership and transfer of our capital stock, the transfer resulting in such violation will be void ab initio.

Emerging Growth Company Status

We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act (the “JOBS Act”), and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.

The JOBS Act permits an emerging growth company such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we have elected to “opt out” of such extended transition period and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.

We could remain an “emerging growth company” until the earliest of (i) December 31, 2021, the end of the fiscal year following the fifth anniversary of the date of the first sale of our common stock pursuant to an effective registration statement, (ii) the last day of the fiscal year in which our annual gross revenues exceed $1.07 billion, (iii) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iv) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.

Our Corporate Information

Our principal executive offices are located at 300 Crescent Court, Suite 700, Dallas, Texas 75201. Our telephone number is (972) 628-4100. Our website is www.nref.com. The information on our website is not intended to form a part or be incorporated by reference into this prospectus.

 



 

16


Table of Contents

The Offering

 

Common stock offered by us

             shares (plus up to an additional             shares of our common stock that we may issue and sell upon the exercise of the underwriters’ option to purchase additional shares). In connection with this offering, our Class A common stock will be reclassified as common stock and our Class T common stock will be eliminated.

 

Common stock to be outstanding after this offering and the concurrent private placement

             shares (             shares if the underwriters exercise their option to purchase additional shares of common stock in full). Concurrently with the closing of this offering, we will sell to Highland and/or its affiliates in a separate private placement                 shares of our common stock representing an aggregate investment equal to $         million. Highland and/or its affiliates will pay the same price for shares in the private placement as investors who purchase shares in this offering.

 

Use of proceeds

We estimate that we will receive net proceeds from this offering of approximately $         million, or approximately $         million if the underwriters’ option to purchase additional shares is exercised in full, assuming an initial public offering price of $         per share, which is the mid-point of the range set forth on the cover of this prospectus, and after deducting the underwriting discounts and commissions, and estimated expenses of this offering. We will also receive $         million in net proceeds from the concurrent private placement to Highland and/or its affiliates. We plan to use substantially all of the net proceeds from this offering and the concurrent private placement to fund the loans and investments identified and described as our Initial Portfolio, pay down our existing credit facility with KeyBank, N.A. (“KeyBank”), redeem all of the 125 issued and outstanding shares of our Series A preferred stock, and buyout the non-controlling joint venture interest in the Estates on Maryland (“Estates”). Our Initial Portfolio may consist of seven investments, in addition to our current preferred equity investment and property. See “Use of Proceeds” for additional information.

 

Dividend policy

We intend to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its REIT taxable income.

 

Stock Exchange Symbol

“NREF”

 

Ownership and transfer restrictions

To assist us in complying with the limitations on the concentration of ownership of a REIT imposed by the Code, among other purposes, our charter generally prohibits, among other prohibitions, any stockholder from beneficially or constructively owning more than 6.2% by value or number of shares, whichever is more restrictive, of

 



 

17


Table of Contents
 

any of the outstanding shares of our common stock, or 6.2% in value of the aggregate of the outstanding shares of our capital stock. See “Description of Capital Stock — Restrictions on Ownership and Transfer.”

 

Risk Factors

Investing in our common stock involves a high degree of risk. You should carefully read and consider the information set forth under “Risk Factors” and all other information in this prospectus before investing in our common stock.

 



 

18


Table of Contents

SUMMARY HISTORICAL AND PRO FORMA FINANCIAL DATA

The following financial data should be read in conjunction with the accompanying consolidated financial statements and related notes thereto, the unaudited consolidated pro forma financial statement and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The summary historical financial data for the years ended December 31, 2016, 2015 and 2014 and as of December 31, 2016 and 2015 presented below has been derived from our audited consolidated financial statements included elsewhere in this prospectus. The summary historical financial data as of December 31, 2014 presented below has been derived from our audited consolidated financial statements not included elsewhere in this prospectus. The summary historical financial data for the six months ended June 30, 2017 and 2016 and as of June 30, 2017 has been derived from our unaudited consolidated financial statements included elsewhere in this prospectus.

The unaudited consolidated pro forma financial data for the year ended December 31, 2016 gives pro forma effect to: (1) our origination of a preferred equity investment in Bell Midtown that occurred on April 7, 2016; (2) the redemption of our preferred equity investment in Bell Midtown that occurred on December 23, 2016; and (3) our origination of a preferred equity investment in Overlook at Stone Oak (fka Springs at Stone Oak Village) (“Stone Oak”) that occurred on August 19, 2016, as if they each occurred on January 1, 2016, and the related impact on interest costs incurred on debt used to finance the preferred equity investment originations and asset management fees payable to our Advisor. The following unaudited consolidated pro forma financial data is presented for illustrative purposes only and is not necessarily indicative of the operating results that would have occurred if the relevant transactions had been consummated on the date indicated, nor is it indicative of future operating results.

 

     As of December 31,      As of
June 30,
 
     2016 (1)      2015 (1)      2014 (1)      2017  
            (unaudited)  

(Dollars in thousands, except per share amounts)

           

Balance Sheet Data

           

Total net operating real estate investments

   $   39,642      $ 40,035      $   —        $ 38,913  

Preferred equity investment

     5,250        —          —          5,388  

Total assets

     45,826        41,061        200        46,841  

Mortgage payable, net

     26,745        26,697        —          26,770  

Credit facility, net

     10,944        10,000        —          10,970  

Total debt, net

     37,689        36,697        —          37,740  

Total liabilities

     39,182        37,962        —          39,788  

Noncontrolling interests

     647        681        —          608  

Total stockholders’ equity

     6,644        3,099        200        7,053  

 

    Pro Forma
For the Year
Ended
December 31,
    For the Year Ended
December 31,
    For the Six
Months Ended
June 30,
 
    2016(2)     2016 (1)     2015 (1)     2014 (1)     2017     2016  
   

(unaudited)

          (unaudited)  

(Dollars in thousands, except per share amounts)

           

Operating Data

           

Total revenues

  $ 3,884     $ 3,884     $ 1,504     $   —       $ 2,024     $ 1,906  

Net loss

    (1,678     (1,505     (1,810     —         (744     (871

Net loss attributable to common stockholders

    (1,676     (1,503     (1,764     —         (751     (865

Loss per common share — basic and diluted

    (2.47     (2.22     (8.82     —         (0.70     (1.50

Weighted average common shares outstanding — basic

    678       678       200       22       1,071       575  

Weighted average common shares outstanding — diluted

    687       687       200       22       1,082       580  

 



 

19


Table of Contents
     For the Year Ended
December 31,
     For the Six
Months Ended
June 30,
 
     2016 (1)     2015 (1)     2014 (1)      2017     2016  
                       

(unaudited)

 

Cash Flow Data

           

Cash flows provided by operating activities (3)

   $ 767     $ 471     $ —        $ 139     $ 314  

Cash flows used in investing activities (3)

     (6,415     (41,081     —          (93     (6,383

Cash flows provided by financing activities

     5,362       41,379       200        1,122       5,999  

Other Data

           

Distributions declared per common share

   $ 0.251     $ —       $ —        $ 0.297     $ —    

NOI (4)

     2,285       698       —          1,195       1,113  

Core Earnings attributable to common stockholders (4)

     41       (502     —          6       (34

Core Earnings per common share — diluted (5)

     0.06       (2.51     —          0.01       (0.06

CAD attributable to common stockholders (4)

     178       70       —          7       29  

CAD per common share — diluted (5)

     0.26       0.35       —          0.01       0.05  

ACAD attributable to common stockholders (4)

     237       70       —          86       29  

ACAD per common share — diluted

     0.34       0.35       —          0.08       0.05  

 

(1) We had no operating activities before August 12, 2015. In accordance with GAAP, our acquisition of Estates was determined to be a combination of entities under common control. As such, the acquisition of Estates by us was deemed to be made on the date it was purchased by Highland, which was August 5, 2015 (the “Original Acquisition Date”). In the accompanying consolidated financial statements, operations are shown from the Original Acquisition Date, although we did not commence material operations until March 24, 2016.
(2) For further detail regarding the pro forma financial data, See “Pro Forma Consolidated Statement of Operations and Comprehensive Loss” included elsewhere in this prospectus.
(3) We adopted ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, during the fourth quarter of 2016 on a retrospective basis. See Note 2, Summary of Significant Accounting Policies, to our audited consolidated financial statements included in this prospectus for a description of this ASU and the impact of its adoption.
(4) NOI, Core Earnings, CAD and ACAD are non-GAAP measures. For definitions of these non-GAAP measures, as well as an explanation of why we believe these measures are useful and reconciliations to the most directly comparable GAAP financial measures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(5) Dilutive shares were excluded from the computation if the shares were antidilutive.

 



 

20


Table of Contents

RISK FACTORS

An investment in our common stock involves various risks and uncertainties. You should carefully consider the following material risk factors in conjunction with the other information contained in this prospectus before purchasing our common stock. The risks discussed in this prospectus can adversely affect our business, operating results, prospects and financial condition. This could cause the value of our common stock to decline and could cause you to lose all or part of your investment. The risks and uncertainties described below are not the only ones we face, but represent those risks and uncertainties that we believe are material to our business, operating results, prospects and financial condition. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business.

Risks Relating to Our Business

Our loans and investments expose us to risks similar to and associated with debt-oriented real estate investments generally.

We seek to invest primarily in debt in or relating to, and preferred equity investments in, real estate-related businesses, assets or interests. Any deterioration of real estate fundamentals generally, and in the United States in particular, could negatively impact our performance by making it more difficult for entities in which we have an investment, or “borrower entities,” to satisfy debt payment obligations, increasing the default risk applicable to borrower entities, and/or making it relatively more difficult for us to generate attractive risk-adjusted returns. Changes in general economic conditions will affect the creditworthiness of borrower entities and may include economic and/or market fluctuations, changes in environmental, zoning and other laws, casualty or condemnation losses, regulatory limitations on rents, decreases in property values, changes in the appeal of properties to tenants, changes in supply and demand, fluctuations in real estate fundamentals, energy supply shortages, various uninsured or uninsurable risks, natural disasters, changes in government regulations (such as rent control), changes in real property tax rates and operating expenses, changes in interest rates, changes in the availability of debt financing and/or mortgage funds which may render the sale or refinancing of properties difficult or impracticable, increased mortgage defaults, increases in borrowing rates, negative developments in the economy that depress travel activity, demand and/or real estate values generally and other factors that are beyond our control. The value of securities of companies that service the real estate business sector may also be affected by such risks.

We cannot predict the degree to which economic conditions generally, and the conditions for loans and investments in real estate, will continue to improve or whether they will deteriorate further. Declines in the performance of the U.S. and global economies or in the real estate debt markets could have a material adverse effect on our business, financial condition and results from operations. In addition, market conditions relating to real estate debt and preferred equity investments have evolved since the global financial crisis, which has resulted in a modification to certain structures and/or market terms. Any such changes in structures and/or market terms may make it relatively more difficult for us to monitor and evaluate our loans and investments.

Commercial real estate-related investments that are secured, directly or indirectly, by real property are subject to delinquency, foreclosure and loss, which could result in losses to us.

Commercial real-estate related instruments (e.g., mortgages, mezzanine loans and preferred equity) that are secured by commercial property or have a similar foreclosure right are subject to risks of delinquency and foreclosure and risks of loss that are greater than similar risks associated with loans made on the security of single-family residential property. The ability of a borrower entity to repay a loan or pay a dividend on an investment secured by an income-producing property typically is dependent primarily upon the successful operation of the property rather than upon the existence of independent income or assets of the borrower entity. If the net operating income of the property is reduced, the borrower entity’s ability to repay the investment may be impaired. Net operating income of an income-producing property can be affected by, among other things:

 

    tenant mix and tenant bankruptcies;

 

21


Table of Contents
    success of tenant businesses;

 

    property management decisions, including with respect to capital improvements, particularly in older building structures;

 

    property location and condition;

 

    competition from other properties offering the same or similar services;

 

    changes in laws that increase operating expenses or limit rents that may be charged;

 

    any need to address environmental contamination at the property;

 

    changes in national, regional or local economic conditions and/or specific industry segments;

 

    declines in regional or local real estate values;

 

    declines in regional or local rental or occupancy rates;

 

    changes in interest rates and in the state of the debt and equity capital markets, including diminished availability or lack of debt financing for commercial real estate;

 

    changes in real estate tax rates and other operating expenses;

 

    changes in governmental rules, regulations and fiscal policies, including environmental legislation; and

 

    acts of God, terrorism, social unrest and civil disturbances, which may decrease the availability of or increase the cost of insurance or result in uninsured losses; and

 

    adverse changes in zoning laws.

In addition, we are exposed to the risk of judicial proceedings with our borrower entities we invest in, including bankruptcy or other litigation, as a strategy to avoid foreclosure or enforcement of other rights by us as a lender or investor. In the event that any of the properties or entities underlying or collateralizing our loans or investments experiences any of the foregoing events or occurrences, the value of, and return on, such investments, our results of operations and financial condition, could be adversely affected.

Interest rate fluctuations could reduce our ability to generate income on our investments, which could lead to a significant decrease in our results of operations, cash flows and the market value of our investments.

Our primary interest rate exposures will relate to the yield on our investments and the financing cost of our debt, as well as our interest rate swaps that we may utilize for hedging purposes. Changes in interest rates will affect our net income from loans and other investments, which is the difference between the interest and related income we earn on our interest-earning investments and the interest and related expense we incur in financing these investments. Interest rate fluctuations resulting in our interest and related expense exceeding interest and related income would result in operating losses for us. Changes in the level of interest rates also may affect our ability to make loans or investments, the value of our loans and investments and our ability to realize gains from the disposition of assets. Changes in interest rates may also affect borrower default rates.

Our operating results will depend, in part, on differences between the income earned on our investments, net of credit losses, and our financing costs. For any period during which our investments are not match-funded, the income earned on such investments may respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may immediately and significantly decrease our results of operations and cash flows and the market value of our investments.

Mezzanine loans and other investments that are subordinated or otherwise junior in an issuer’s capital structure and that involve privately negotiated structures will expose us to greater risk of loss.

We may from time to time originate or acquire mezzanine loans and other investments that are subordinated or otherwise junior in an issuer’s capital structure (such as preferred equity) and that involve privately negotiated

 

22


Table of Contents

structures. To the extent we invest in subordinated debt or mezzanine tranches of an entity’s capital structure, such investments and our remedies with respect thereto, including the ability to foreclose on any collateral securing such investments, will be subject to the rights of holders of more senior tranches in the issuer’s capital structure and, to the extent applicable, contractual intercreditor and/or participation agreement provisions. Significant losses related to such loans or investments could adversely affect our results of operations and financial condition.

Mezzanine loans are by their nature structurally subordinated to more senior property-level financings. If a borrower defaults on our mezzanine loan or on debt senior to our loan, or if the borrower is in bankruptcy, our mezzanine loan will be satisfied only after the property-level debt and other senior debt is paid in full. As a result, a partial loss in the value of the underlying collateral can result in a total loss of the value of the mezzanine loan. In addition, even if we are able to foreclose on the underlying collateral following a default on a mezzanine loan, we would be substituted for the defaulting borrower and, to the extent income generated on the underlying property is insufficient to meet outstanding debt obligations on the property, may need to commit substantial additional capital and/or deliver a replacement guarantee by a creditworthy entity, which could include us, to stabilize the property and prevent additional defaults to lenders with existing liens on the property.

The lack of liquidity in certain of our target assets may adversely affect our business.

The illiquidity of certain of our target assets may make it difficult for us to sell such investments if the need or desire arises. Certain target assets such as mortgages, mezzanine and other loans (including participations) and preferred equity, in particular, are relatively illiquid investments due to their short life, their potential unsuitability for securitization and the greater difficulty of recovery in the event of a borrower entity’s default. In addition, certain of our investments may become less liquid after our investment as a result of periods of delinquencies or defaults or turbulent market conditions, which may make it more difficult for us to dispose of such assets at advantageous times or in a timely manner. Moreover, many of the loans and securities we invest in will not be registered under the relevant securities laws, resulting in prohibitions against their transfer, sale, pledge or their disposition except in transactions that are exempt from registration requirements or are otherwise in accordance with such laws. As a result, we expect many of our investments will be illiquid, and if we are required to liquidate all or a portion of our portfolio quickly, for example as a result of margin calls, we may realize significantly less than the value at which we have previously recorded our investments. Further, we may face other restrictions on our ability to liquidate an investment to the extent that we or our Advisor and/or its affiliates has or could be attributed as having material, non-public information regarding such business entity. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.

Prepayment rates may adversely affect the value of our portfolio of assets.

The value of our assets may be affected by prepayment rates on loans. If we originate or acquire mortgage-related securities or a pool of mortgage securities, we anticipate that the underlying mortgages will prepay at a projected rate generating an expected yield. If we purchase assets at a premium to par value, when borrowers prepay their loans faster than expected, the corresponding prepayments on the mortgage-related securities may reduce the expected yield on such securities because we will have to amortize the related premium on an accelerated basis. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their loans slower than expected, the decrease in corresponding prepayments on the mortgage-related securities may reduce the expected yield on such securities because we will not be able to accrete the related discount as quickly as originally anticipated. Prepayment rates on loans may be affected by a number of factors including, but not limited to, the availability of mortgage credit, the relative economic vitality of the area in which the related properties are located, the servicing of the loans, possible changes in tax laws, other opportunities for investment, and other economic, social, geographic, demographic and legal factors and other factors beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks. In periods of declining interest rates, prepayment rates on loans

 

23


Table of Contents

generally increase. If general interest rates decline at the same time, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets that were prepaid. In addition, as a result of the risk of prepayment, the market value of the prepaid assets may benefit less than other fixed income securities from declining interest rates.

A majority of the loans and investments that may comprise our Initial Portfolio are subject to entry into definitive agreements, and there can be no assurance that the loans and investments will close on the terms anticipated, or at all.

We have included in “Prospectus Summary — Our Initial Portfolio” a description of non-binding letters of intent we have executed with respect to an aggregate of approximately $         million in potential loan and investment commitments. We have not executed binding commitment letters or definitive documentation with respect to these potential loans and investments, and each proposed loan and investment is still subject to one or more of the following: satisfactory completion of our due diligence investigation and investment process, approval of our Advisor’s investment committee, market conditions, available liquidity, our final agreement with the borrowing entity on the terms and structure of such loan and/or investment, and the execution and delivery of satisfactory transaction documentation. As a result, we cannot provide any assurances that we will close any of these proposed loans and investments. The failure to close these loans and investments on the terms we anticipate, or at all, could have a material adverse effect on our business.

Difficulty in deploying the net proceeds from this offering and the concurrent private placement or the repayments of our loans and investments may cause our financial performance and returns to investors to suffer.

In light of our investment strategy and the need to be able to deploy capital quickly to capitalize on potential investment opportunities, we may from time to time maintain cash pending deployment into investments, which may at times be significant. Such cash may be held in an account of ours for the benefit of stockholders or may be invested in money market accounts or other similar temporary investments. While the expected duration of such holding period is expected to be relatively short, in the event we are unable to find suitable investments, these cash positions may be maintained for longer periods. It is not anticipated that the temporary investment of such cash into money market accounts or other similar temporary investments pending deployment into investments will generate significant interest, and such low interest payments on the temporarily invested cash may adversely affect our financial performance and returns to investors.

Any distressed loans or investments we make, or loans and investments that later become distressed, may subject us to losses and other risks relating to bankruptcy proceedings.

Our loans and investments may include making distressed investments from time to time (e.g., investments in defaulted, out-of-favor or distressed bank loans and debt securities) or may involve investments that become “non-performing” following our acquisition thereof. Certain of our investments may include properties that typically are highly leveraged, with significant burdens on cash flow and, therefore, involve a high degree of financial risk. During an economic downturn or recession, loans or securities of financially or operationally troubled borrowers or issuers are more likely to go into default than loans or securities of other borrowers or issuers. Loans or securities of financially or operationally troubled issuers are less liquid and more volatile than loans or securities of borrowers or issuers not experiencing such difficulties. The market prices of such securities are subject to erratic and abrupt market movements, and the spread between bid and asked prices may be greater than normally expected. Investment in the loans or securities of financially or operationally troubled borrowers or issuers involves a high degree of credit and market risk.

In certain limited cases (e.g., in connection with a workout, restructuring and/or foreclosing proceedings involving one or more of our investments), the success of our investment strategy with respect thereto will depend, in part, on our ability to effectuate loan modifications and/or restructure and improve the operations of the borrower entities. The activity of identifying and implementing successful restructuring programs and

 

24


Table of Contents

operating improvements entails a high degree of uncertainty. There can be no assurance that we will be able to identify and implement successful restructuring programs and improvements with respect to any distressed loans or investments we may have from time to time.

These financial difficulties may not be overcome and may cause borrower entities to become subject to bankruptcy or other similar administrative proceedings. There is a possibility that we may incur substantial or total losses on our loans and investments and, in certain circumstances, become subject to certain additional potential liabilities that may exceed the value of our original investment therein. For example, under certain circumstances, a lender that has inappropriately exercised control over the management and policies of a debtor may have its claims subordinated or disallowed or may be found liable for damages suffered by parties as a result of such actions. In any reorganization or liquidation proceeding relating to our investments, we may lose our entire investment, may be required to accept cash or securities with a value less than our original investment and/or may be required to accept different terms, including payment over an extended period of time. In addition, under certain circumstances, payments to us may be reclaimed if any such payment or distribution is later determined to have been a fraudulent conveyance, preferential payment, or similar transaction under applicable bankruptcy and insolvency laws. Furthermore, bankruptcy laws and similar laws applicable to administrative proceedings may delay our ability to realize on collateral for loan positions held by us, may adversely affect the economic terms and priority of such loans through doctrines such as equitable subordination or may result in a restructuring of the debt through principles such as the “cramdown” provisions of the bankruptcy laws.

We may not have control over certain of our loans and investments.

Our ability to manage our portfolio of loans and investments may be limited by the form in which they are made. In certain situations, we may:

 

    acquire investments subject to rights of senior classes and servicers under intercreditor or servicing agreements;

 

    acquire only a minority and/or a non-controlling participation in an underlying investment;

 

    co-invest with others through partnerships, joint ventures or other entities, thereby acquiring non-controlling interests; or

 

    rely on independent third party management or servicing with respect to the management of an asset.

Therefore, we may not be able to exercise control over all aspects of our loans or investments. Such financial assets may involve risks not present in investments where senior creditors, junior creditors, servicers or third parties controlling investors are not involved. Our rights to control the process following a borrower default may be subject to the rights of senior or junior creditors or servicers whose interests may not be aligned with ours. A partner or co-venturer may have financial difficulties resulting in a negative impact on such asset, may have economic or business interests or goals that are inconsistent with ours, or may be in a position to take action contrary to our investment objectives. In addition, we may, in certain circumstances, be liable for the actions of our partners or co-venturers.

We may make preferred equity investments in partnerships or limited liability companies over which we will not have voting control. We intend to ensure that the terms of our investments require that the partnerships and limited liability companies take all actions necessary to preserve our REIT status and avoid taxation at the REIT level. However, because we will not control such entities, they may cause us to fail one or more of the REIT tests. In that event, we intend to take advantage of all available provisions in the REIT statutes and regulations to cure any such failure, which provisions may require payments of penalties. We believe that we will be successful in maintaining our REIT status, but no assurances can be given.

 

25


Table of Contents

Our success depends on the availability of attractive loans and investments and our Advisor’s ability to identify, structure, consummate, leverage, manage and realize returns on our loans and investments.

Our operating results are dependent upon the availability of, as well as our Advisor’s ability to identify, structure, consummate, leverage, manage and realize returns on our loans and investments. In general, the availability of favorable investment opportunities and, consequently, our returns, will be affected by the level and volatility of interest rates, conditions in the financial markets, general economic conditions, the demand for loan and investment opportunities in our target assets and the supply of capital for such opportunities. We cannot make any assurances that our Advisor will be successful in identifying and consummating loans and investments that satisfy our rate of return objectives or that such loans and investments, once made, will perform as anticipated.

Real estate valuation is inherently subjective and uncertain.

The valuation of real estate and therefore the valuation of any underlying security relating to loans and/or investments made by us is inherently subjective due to, among other factors, the individual nature of each property, its location, the expected future rental revenues from that particular property and the valuation methodology adopted. As a result, the valuations of the real estate assets against which we will make loans and/or investments are subject to a large degree of uncertainty and are made on the basis of assumptions and methodologies that may not prove to be accurate, particularly in periods of volatility, low transaction flow or restricted debt availability in the commercial or residential real estate markets.

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

Some or all of our portfolio investments may be in the form of positions or securities that are not publicly traded. The fair value of investments that are not publicly traded may not be readily determinable. Our Advisor will value these investments at fair value which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of our assets may fluctuate over short periods of time and our Advisor’s determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. Our results of operations and financial condition could be adversely affected if our Advisor’s determinations regarding the fair value of these investments were materially higher than the values that we ultimately realize upon their disposal.

We may experience a decline in the fair value of our assets.

A decline in the fair value of our assets may require us to recognize an “other-than-temporary” impairment against such assets under GAAP if we were to determine that, with respect to any assets in unrealized loss positions, we do not have the ability and intent to hold such assets to maturity or for a period of time sufficient to allow for recovery to the original acquisition cost of such assets. If such a determination were to be made, we would recognize unrealized losses through earnings and write down the amortized cost of such assets to a new cost basis, based on the fair value of such assets on the date they are considered to be other-than-temporarily impaired. Such impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or sale of such assets could further affect our future losses or gains, as they are based on the difference between the sale price received and adjusted amortized cost of such assets at the time of sale. If we experience a decline in the fair value of our assets, it could adversely affect our results of operations and financial condition.

We operate in a competitive market for lending and investment opportunities, and competition may limit our ability to originate or acquire desirable loans and investments in our target assets and could also affect the yields of these assets.

A number of entities compete with us to make the types of loans and investments that we seek to make. Our profitability depends, in large part, on our ability to originate or acquire our target assets on attractive terms. In

 

26


Table of Contents

originating or acquiring our target assets, we compete with a variety of institutional lenders and investors, including other REITs, specialty finance companies, public and private funds (including other funds managed by affiliates of our Advisor and Highland), commercial and investment banks, commercial finance and insurance companies and other financial institutions. Several other REITs have raised, or are expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create additional competition for lending and investment opportunities. Some competitors may have a lower cost of funds and access to funding sources that are not available to us. Many of our competitors are not subject to the operating constraints associated with REIT compliance or maintenance of an exclusion from regulation under the Investment Company Act. 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, offer more attractive pricing or other terms and establish more relationships than us. Furthermore, competition for originations of and investments in our target assets may lead to the yields of such assets decreasing, which may further limit our ability to generate satisfactory returns. We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, desirable loans and investments in our target assets may be limited in the future, and we may not be able to take advantage of attractive lending and investment opportunities from time to time, as we can provide no assurance that we will be able to identify and originate loans or make investments that are consistent with our investment objectives.

Our loans and investments may be concentrated in terms of geography, asset types and sponsors.

We are not required to observe specific diversification criteria, except as may be set forth in the investment guidelines adopted by our board of directors. Therefore, our investments in our target assets may at times be concentrated in certain property types that are subject to higher risk of default or foreclosure, or secured by properties concentrated in a limited number of geographic locations.

To the extent that our portfolio is concentrated in any one region or type of asset, downturns relating generally to such region or type of asset may result in defaults on a number of our investments within a short time period, which could adversely affect our results of operations and financial condition.

The due diligence process that our Advisor undertakes in regard to loan and investment opportunities may not reveal all facts that may be relevant in connection with a loan and investment and if our Advisor incorrectly evaluates the risks of our loans and investments, we may experience losses.

Before making loans and investments for us, our Advisor will conduct due diligence that it deems reasonable and appropriate based on the facts and circumstances relevant to each potential loan and investment. When conducting due diligence, our Advisor may be required to evaluate important and complex business, financial, tax, accounting, environmental and legal issues. Outside consultants, legal advisors, accountants and investment banks may be involved in the due diligence process in varying degrees depending on the type of potential loan and investment. Relying on the resources available to it, our Advisor will evaluate our potential loans and investments based on criteria it deems appropriate for the relevant loan and investment. Our Advisor’s loss estimates may not prove accurate, as actual results may vary from estimates. If our Advisor underestimates the asset-level losses relative to the price we pay for a particular loan and investment, we may experience losses with respect to such loan and investment.

NexPoint’s failure to remain a select sponsor with Freddie Mac or to maintain its preferred status with Fannie Mae may materially and adversely affect us.

Through numerous investments across the Highland platform, NexPoint is a select sponsor with Freddie Mac and enjoys preferred status with Fannie Mae for multifamily loans and investments. Our Advisor leveraged these relationships to create the multifamily mezzanine loan structure that we utilize as our primary investment strategy. There is no assurance that NexPoint will be able to remain a select sponsor with Freddie Mac or to

 

27


Table of Contents

maintain its preferred status with Fannie Mae. NexPoint’s failure to remain a select sponsor with Freddie Mac or to maintain its preferred status with Fannie Mae could reduce our access to proprietary deal flow, which could have a material adverse effect on us.

Insurance on loans and real estate securities collateral may not cover all losses.

There are certain types of losses, generally of a catastrophic nature, such as earthquakes, floods, hurricanes, terrorism or acts of war, which may be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations and other factors, including terrorism or acts of war, also might result in insurance proceeds insufficient to repair or replace a property if it is damaged or destroyed. Under these circumstances, the insurance proceeds received with respect to a property relating to one of our investments might not be adequate to restore our economic position with respect to our investment. Any uninsured loss could result in the corresponding nonperformance of or loss on our investment related to such property.

We may need to foreclose on certain of the loans and/or exercise our “foreclosure option” under the terms of our investments we originate or acquire, which could result in losses that harm our results of operations and financial condition.

We may find it necessary or desirable to foreclose on certain of the loans and/or exercise our “foreclosure option” under the terms of our investments we originate or acquire, and this process may be lengthy and expensive. We cannot assure you as to the adequacy of the protection of the terms of the applicable loan or investment, including the validity or enforceability of the loan and/or investments and the maintenance of the anticipated priority and perfection of the applicable security interests, if any. Furthermore, claims may be asserted by lenders or borrowers that might interfere with enforcement of our rights. Borrowers may resist foreclosure actions by asserting numerous claims, counterclaims and defenses against us, including, without limitation, lender liability claims and defenses, even when the assertions may have no basis in fact, in an effort to prolong the foreclosure action and seek to force the lender into a modification of the loan or a favorable buy-out of the borrower’s position in the loan. In some states, foreclosure actions can take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the foreclosure process and potentially result in a reduction or discharge of a borrower’s debt. Foreclosure may create a negative public perception of the related property, resulting in a diminution of its value. Even if we are successful in foreclosing on a loan and/or investment, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our cost basis in the loan and/or investment, resulting in a loss to us. Furthermore, any costs or delays involved in the foreclosure of the loan and/or investment or a liquidation of the underlying property will further reduce the net proceeds and, thus, increase the loss.

Liability relating to environmental matters may impact the value of properties that we may acquire upon foreclosure of the properties underlying our loans and investments.

To the extent we foreclose on properties with respect to which we have extended loans and/or invested in, we may be subject to environmental liabilities arising from such foreclosed properties. 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 foreclose on any properties underlying our loans and investments, the presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs, thus harming our financial condition. The discovery of material environmental liabilities attached to such properties could adversely affect our results of operations and financial condition.

 

28


Table of Contents

We may be subject to lender liability claims, and if we are held liable under such claims, we could be subject to losses.

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. We cannot assure prospective investors that such claims will not arise or that we will not be subject to significant liability if a claim of this type did arise.

Any investments we make in structured finance investments would pose additional risks, including the risks of the securitization process and the risk that any special servicer may take actions that could adversely affect our interests.

We may from time to time invest in commercial mortgage-backed securities, CLOs, collateralized debt obligations and other similar securities, which are subordinated classes of securities in a structure of securities secured by a pool of mortgages or loans. Accordingly, such securities are the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Thus, there is generally only a nominal amount of equity or other debt securities junior to such positions, if any, issued in such structures. The estimated fair values of such subordinated interests tend to be much more sensitive to adverse economic downturns and underlying borrower developments than more senior securities. A projection of an economic downturn, for example, could cause a decline in the price of lower credit quality structured finance investments because the ability of borrowers to make principal and interest payments on the mortgages or loans underlying such securities may be impaired, as has occurred throughout the recent economic recession and weak recovery.

Subordinate interests and similar structured finance investments generally are not actively traded and are relatively illiquid investments, and volatility in these markets may cause the value of these investments to decline. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as a result, less collateral value is available to satisfy interest and principal payments and any other fees in connection with the trust or other conduit arrangement for such securities, we may incur significant losses.

With respect to the structured finance investments in which we may invest, control over the related underlying loans will be exercised through a special servicer or collateral manager designated by a “directing certificateholder” or a “controlling class representative,” or otherwise pursuant to the related securitization documents. We may acquire structured finance investments for which we may not have the right to appoint the directing certificateholder or otherwise direct the special servicing or collateral management. With respect to the management and servicing of those loans, the related special servicer or collateral manager may take actions that could adversely affect our interests.

Any credit ratings assigned to our loans and investments will be subject to ongoing evaluations and revisions, and we cannot assure you that those ratings will not be downgraded.

Our loans and investments may be rated by rating agencies such as Moody’s Investors Service, Fitch Ratings or Standard & Poor’s. Any credit ratings on our investments are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating agencies assign a lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our loans and investments in the future, the value and liquidity of our investments could significantly decline, which would adversely affect the value of our portfolio and could result in losses upon disposition.

 

29


Table of Contents

Some of our investments and investment opportunities may be in synthetic form.

Synthetic investments are contracts between parties whereby payments are exchanged based upon the performance of another security or asset, or “reference asset.” In addition to the risks associated with the performance of the reference asset, these synthetic interests carry the risk of the counterparty not performing its contractual obligations. Market standards, GAAP accounting methodology, regulatory oversight and compliance requirements, tax and other regulations related to these investments are evolving, and we cannot be certain that their evolution will not adversely impact the value or sustainability of these investments. Furthermore, our ability to invest in synthetic investments, other than through taxable REIT subsidiaries (“TRSs”), may be severely limited by the REIT qualification requirements because synthetic investment contracts generally are not qualifying assets and do not produce qualifying income for purposes of the REIT asset and income tests.

We may invest in derivative instruments, which would subject us to increased risk of loss.

Subject to maintaining our qualification as a REIT, we may invest in derivative instruments. Derivative instruments, especially when purchased in large amounts, may not be liquid in all circumstances, so that in volatile markets we may not be able to close out a position without incurring a loss. The prices of derivative instruments, including swaps, futures, forwards and options, are highly volatile, and such instruments may subject us to significant losses. The value of such derivatives also depends upon the price of the underlying instrument or commodity. Such derivatives and other customized instruments also are subject to the risk of non-performance by the relevant counterparty. In addition, actual or implied daily limits on price fluctuations and speculative position limits on the exchanges or over-the-counter markets in which we may conduct our transactions in derivative instruments may prevent prompt liquidation of positions, subjecting us to the potential of greater losses. Derivative instruments that may be purchased or sold by us may include instruments not traded on an exchange. The risk of nonperformance by the obligor on such an instrument may be greater, and the ease with which we can dispose of or enter into closing transactions with respect to such an instrument may be less than in the case of an exchange-traded instrument. In addition, significant disparities may exist between “bid” and “asked” prices for derivative instruments that are traded over-the-counter and not on an exchange. Such over-the-counter derivatives are also typically not subject to the same type of investor protections or governmental regulation as exchange-traded instruments.

In addition, we may invest in derivative instruments that are neither presently contemplated nor currently available, but which may be developed in the future, to the extent such opportunities are both consistent with our investment objectives and legally permissible. Any such investments may expose us to unique and presently indeterminate risks, the impact of which may not be capable of determination until such instruments are developed and/or we determine to make such an investment.

Rapid changes in the values of our real estate-related investments may make it more difficult for us to maintain our qualification as a REIT or exclusion from regulation under the Investment Company Act.

If the market value or income potential of real estate-related investments declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exclusion from the Investment Company Act regulation. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of any non-qualifying assets that we may own. We may have to make investment decisions that we otherwise would not make absent the REIT and Investment Company Act considerations.

As a consequence of our seeking to avoid the need to register under the Investment Company Act on an ongoing basis, we and/or our subsidiaries may be restricted from making certain investments or may structure investments in a manner that would be less advantageous to us than would be the case in the absence of such requirements. In particular, a change in the value of any of our assets could negatively affect our ability to avoid

 

30


Table of Contents

the need to register under the Investment Company Act and cause the need for a restructuring of our investment portfolio. For example, these restrictions may limit our and our subsidiaries’ ability to invest directly in mortgage-backed securities that represent less than the entire ownership in a pool of senior loans, debt and equity tranches of securitizations and certain asset-backed securities, non-controlling equity interests in real estate companies or in assets not related to real estate. In addition, seeking to avoid the need to register under the Investment Company Act may cause us and/or our subsidiaries to acquire or hold additional assets that we might not otherwise have acquired or held or dispose of investments that we and/or our subsidiaries might not have otherwise disposed of, which could result in higher costs or lower proceeds to us than we would have paid or received if we were not seeking to comply with such requirements. Thus, avoiding registration under the Investment Company Act may hinder our ability to operate solely on the basis of maximizing profits.

There can be no assurance that we and our subsidiaries will be able to successfully avoid operating as an unregistered investment company. If it were established that we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the Securities and Exchange Commission (the “SEC”), that we would be unable to enforce contracts with third parties, that third parties could seek to obtain rescission of transactions undertaken during the period it was established that we were an unregistered investment company, and that we would be subject to limitations on corporate leverage that would have an adverse impact on our investment returns.

If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to use borrowings), management, operations, transactions with affiliated persons (as defined in the Investment Company Act) and portfolio composition, including disclosure requirements and restrictions with respect to diversification and industry concentration and other matters. Compliance with the Investment Company Act would, accordingly, limit our ability to make certain investments and require us to significantly restructure our business plan, which could materially adversely affect our ability to pay distributions to our stockholders.

See “Prospectus Summary — Operating and Regulatory Structure — Investment Company Act Exclusion.”

Risks Related to Our Corporate Structure

We depend upon key personnel of our Advisor and its affiliates.

We are externally managed and therefore we do not have any internal management capacity. We will depend to a significant degree on the diligence, skill and network of business contacts of the management team and other key personnel of our Advisor, including Messrs. Dondero, Mitts, McGraner, Goetz and Ellington, all of whom may be difficult to replace. We expect that our Advisor will evaluate, negotiate, structure, close and monitor our loans and investments in accordance with the terms of the Advisory Agreement.

We will also depend upon the senior professionals of our Advisor to maintain relationships with sources of potential loans and investments, and we intend to rely upon these relationships to provide us with potential investment opportunities. We cannot assure you that these individuals will continue to provide indirect investment advice to us. If these individuals, including the members of the management team of our Advisor, do not maintain their existing relationships with our Advisor, maintain existing relationships or develop new relationships with other sources of investment opportunities, we may not be able to grow our investment portfolio. In addition, individuals with whom the senior professionals of our Advisor have relationships are not obligated to provide us with investment opportunities. Therefore, we can offer no assurance that these relationships will generate investment opportunities for us.

Our Advisor will rely on Highland to provide investment research and operational support to our Advisor, including services in connection with research, due diligence of actual or potential investments, the execution of investment transactions approved by our Advisor and certain back-office and administrative services. If Highland does not provide these services to our Advisor, there can be no assurances that our Advisor would be able to find a substitute service provider with the same experience or on the same terms as Highland.

 

31


Table of Contents

We are dependent upon our Advisor and its affiliates to conduct our day-to-day operations; thus, adverse changes in their financial health or our relationship with them could cause our operations to suffer.

We are dependent on our Advisor and its affiliates to manage our operations and originate, structure and manage our loans and investments. All of our investment decisions will be made by our Advisor, subject to general oversight by our Advisor’s investment committee and our board of directors. Any adverse changes in the financial condition of our Advisor or its affiliates, or our relationship with our Advisor, could hinder our Advisor’s ability to successfully manage our operations and our portfolio of loans and investments, which could materially adversely affect our business, results of operations, financial condition and ability to make distributions to our stockholders.

Our Advisor manages our portfolio pursuant to very broad investment guidelines and is not required to seek the approval of our board of directors for each investment, financing, asset allocation or hedging decision made by it, which may result in our making riskier investments and which could materially and adversely affect us.

Our Advisor is authorized to follow very broad investment guidelines that provide it with substantial discretion in investment, financing, asset allocation and hedging decisions. Our board of directors will periodically review our investment guidelines and our portfolio but will not, and will not be required to, review and approve in advance all of our proposed investments or our Advisor’s financing, asset allocation or hedging decisions. In addition, in conducting periodic reviews, our directors may rely primarily on information provided, or recommendations made, to them by our Advisor or its affiliates. Subject to maintaining our REIT qualification and our exclusion from regulation under the Investment Company Act, our Advisor has significant latitude within the broad investment guidelines in determining the types of investments it makes for us, and how such investments are financed or hedged, which could result in investment returns that are substantially below expectations or losses, which could materially and adversely affect us.

We may not replicate the historical results achieved by other entities managed or sponsored by affiliates of our Advisor, members of our Advisor’s management team or by Highland or its affiliates.

Our primary focus in making loans and investments generally differs from that of existing investment funds, accounts or other investment vehicles that are or have been managed by affiliates of our Advisor, members of our Advisor’s management team or sponsored by Highland or its affiliates. Past performance is not a guarantee of future results, and there can be no assurance that we will achieve comparable results of those Highland affiliates. In addition, investors in our common stock are not acquiring an interest in any such investment funds, accounts or other investment vehicles that are or have been managed by members of our Advisor’s management team or sponsored by Highland or its affiliates. We also cannot assure you that we will replicate the historical results achieved by members of the management team, and we caution you that our investment returns could be substantially lower than the returns achieved by them in prior periods. Additionally, all or a portion of the prior results may have been achieved in particular market conditions which may never be repeated.

Our Advisor can resign on 180 days’ notice from its role as Advisor or terminate the Advisory Agreement upon 30 days notice if we materially breach the agreement, and we may not be able to find a suitable replacement within that time, resulting in a disruption in our operations that could adversely affect our financial condition, business, and results of operations and cash flows.

Our Advisor may terminate the Advisory Agreement upon 180 days’ prior notice or upon 30 days notice if we materially breach the agreement. If the Advisory Agreement is terminated and no suitable replacement is found, we may not be able to execute our business plan. In addition, the coordination of our internal management and investment activities is likely to suffer if we are unable to identify and reach an agreement with a single institution or group of executives having the expertise possessed by our Advisor and its affiliates. Even if we are

 

32


Table of Contents

able to retain comparable management, the integration of such management and its lack of familiarity with our investment objectives may result in additional costs and time delays that may adversely affect our business, financial condition, results of operations and cash flows. Furthermore, we may incur certain costs in connection with a termination of the Advisory Agreement, including a termination fee equal to three times the Advisor’s Annual Fee (unless the Advisory Agreement is terminated for cause).

Our Advisor maintains a contractual as opposed to a fiduciary relationship with us. Our Advisor’s liability is limited under the Advisory Agreement, and we have agreed to indemnify our Advisor against certain liabilities.

Our Advisor maintains a contractual as opposed to a fiduciary relationship with us. Under the terms of the Advisory Agreement, our Advisor and its affiliates and their respective partners, members, officers, directors, employees and agents will not be liable to us (including but not limited to (i) any act or omission in connection with the conduct of our business that is determined in good faith to be in or not opposed to our best interests, (ii) any act or omission based on the suggestions of certain professional advisors, (iii) any act or omission by us, or (iv) any mistake, negligence, misconduct or bad faith of certain brokers or other agents), unless any act or omission constitutes bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of duties. We have also agreed to indemnify our Advisor and its affiliates and their respective partners, members, officers, directors, employees and agents from and against any and all claims, liabilities, damages, losses, costs and expenses that are incurred and arise out of or in connection with our business or investments, or the performance by the indemnitee of its responsibilities under the Advisory Agreement, provided that the conduct at issue did not constitute bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of duties. As a result, we could experience poor performance or losses for which our Advisor would not be liable.

Under the terms of the Advisory Agreement, our Advisor will indemnify and hold harmless us, our subsidiaries and the OP from all claims, liabilities, damages, losses, costs and expenses, including amounts paid in satisfaction of judgments, in compromises and settlements, as fines and penalties and legal or other costs and expenses of investigating or defending against any claim or alleged claim, of any nature whatsoever, known or unknown, liquidated or unliquidated, that are incurred by reason of our Advisor’s bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of its duties; provided, however, that our Advisor will not be held responsible for any action of our board of directors in following or declining to follow any written advice or written recommendation given by our Advisor. However, the aggregate maximum amount that our Advisor may be liable to us or the OP pursuant to the Advisory Agreement will, to the extent not prohibited by law, never exceed the amount of the management fees received by our Advisor under the Advisory Agreement prior to the date that the acts or omissions giving rise to a claim for indemnification or liability have occurred. In addition, our Advisor will not be liable for special, exemplary, punitive, indirect, or consequential loss, or damage of any kind whatsoever, including without limitation lost profits. The limitations described in the preceding two sentences will not apply, however, to the extent such damages are determined in a final binding non-appealable court or arbitration proceeding to result from the bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of our Advisor’s duties.

We may change our targeted investments without stockholder consent.

We expect our portfolio of investments will consist primarily of mezzanine loans, preferred equity and structured financing solutions for properties benefiting from significant tenant diversification and short-term leases, including mid-sized multifamily, storage and select-service and extended-stay hospitality real estate properties. Though this is our current target portfolio, we may make adjustments to our target portfolio based on real estate market conditions and investment opportunities, and we may change our targeted investments and investment guidelines at any time without the consent of our stockholders. Any such change could result in our making investments that are different from, and possibly riskier than, the investments described in this prospectus. These policies may change over time. A change in our targeted investments or investment guidelines,

 

33


Table of Contents

which may occur without notice to you or without your consent, may increase our exposure to interest rate risk, default risk and real estate market fluctuations, all of which could adversely affect the value of our common stock and our ability to make distributions to you. We intend to disclose any changes in our investment policies in our next required periodic report.

We will pay substantial fees and expenses to our Advisor and its affiliates, which payments increase the risk that you will not earn a profit on your investment.

Pursuant to the Advisory Agreement, we will pay significant fees to our Advisor and its affiliates. Those fees include asset management fees and obligations to reimburse our Advisor and its affiliates for expenses they incur in connection with their providing services to us, including certain personnel services. Additionally, we have adopted a long-term incentive plan that we will use to grant awards to employees of our Advisor and its affiliates. For additional information on these fees and the fees paid to our Advisor, see “Management Compensation” and “Management — NexPoint Real Estate Finance, Inc. 2017 Long Term Incentive Plan.”

If we internalize our management functions, the percentage of our outstanding common stock owned by our other stockholders could be reduced, and we could incur other significant costs associated with being self-managed.

In the future, the board may consider internalizing the functions performed for us by our Advisor by, among other methods, acquiring our Advisor’s assets. The method by which we could internalize these functions could take many forms. There is no assurance that internalizing our management functions will be beneficial to us and our stockholders. An acquisition of our Advisor could result in dilution of your interests as a stockholder and could reduce earnings per share. Additionally, we may not realize the perceived benefits or we may not be able to properly integrate a new staff of managers and employees or we may not be able to effectively replicate the services provided previously by our Advisor or its affiliates. Internalization transactions, including, without limitation, transactions involving the acquisition of affiliated advisors have also, in some cases, been the subject of litigation. Even if these claims are without merit, we could be forced to spend significant amounts of money defending claims which would reduce the amount of funds available for us to invest and to pay distributions. All of these factors could have a material adverse effect on our results of operations, financial condition and ability to pay distributions.

There are significant potential conflicts of interest that could affect our investment returns.

As a result of our arrangements with Highland and our Advisor, there may be times when Highland and our Advisor or their affiliated persons have interests that differ from those of our stockholders, giving rise to a conflict of interest.

Our directors and management team serve or may serve as officers, directors or principals of entities that operate in the same or a related line of business as we do, or of investment funds managed by our Advisor or its affiliates. Similarly, our Advisor or its affiliates may have other clients with similar, different or competing investment objectives, including NexPoint Residential Trust, Inc. In serving in these multiple capacities, they may have obligations to other clients or investors in those entities, the fulfillment of which may not be in the best interests of us or our stockholders. For example, the management team of our Advisor has, and will continue to have, management responsibilities for other investment funds, accounts or other investment vehicles managed or sponsored by our Advisor and its affiliates. Our investment objectives may overlap with the investment objectives of such affiliated investment funds, accounts or other investment vehicles. As a result, those individuals may face conflicts in the allocation of investment opportunities among us and other investment funds or accounts advised by or affiliated with our Advisor and its affiliates. Our Advisor will seek to allocate investment opportunities among eligible accounts in a manner consistent with its allocation policy. However, we can offer no assurance that such opportunities will be allocated to us fairly or equitably in the short-term or over time. See “Conflicts of Interest.”

 

34


Table of Contents

We may compete with other entities affiliated with our Advisor and Highland for investments.

Neither our Advisor nor Highland and their affiliates are prohibited from engaging, directly or indirectly, in any other business or from possessing interests in any other business ventures that compete with ours. Our Advisor, Highland and/or their affiliates may provide financing to similar situated properties. Our Advisor and Highland may face conflicts of interest when evaluating investment opportunities for us, and these conflicts of interest may have a negative impact on our ability to make attractive investments. See “Conflicts of Interest.”

Our Advisor, Highland and their officers and employees face competing demands relating to their time, and this may cause our operating results to suffer.

Our Advisor and Highland and their officers and employees and their respective affiliates are key personnel, general partners, sponsors, managers, owners and advisors of other real estate investment programs, including Highland-sponsored investment products, some of which have investment objectives and legal and financial obligations similar to ours and may have other business interests as well. Because these persons have competing demands on their time and resources, they may have conflicts of interest in allocating their time between our business and these other activities. If this occurs, the returns on our investments may suffer.

Our Advisor and its affiliates will face conflicts of interest, including significant conflicts created by our Advisor’s compensation arrangements with us, including compensation which may be required to be paid to our Advisor if our Advisory Agreement is terminated, which could result in actions that are not necessarily in the long-term best interests of our stockholders.

Under our Advisory Agreement, our Advisor or its affiliates will be entitled to fees based on our “Equity.” Because performance is only one aspect of our Advisor’s compensation (as a component of “Equity”), our Advisor’s interests are not wholly aligned with those of our stockholders. In that regard, our Advisor could be motivated to recommend riskier or more speculative investments that would entitle our Advisor to a higher fee. For example, because asset management fees payable to our Advisor are based in part on the amount of equity raised, our Advisor may have an incentive to raise additional equity capital in order to increase its fees.

We intend to elect to be treated as a REIT commencing with our taxable year ending December 31, 2017. Our failure to qualify or maintain our qualification as a REIT for federal income tax purposes would reduce the amount of funds we have available for distribution and limit our ability to make distributions to our stockholders.

We intend to elect to be treated as a REIT commencing with our taxable year ending December 31, 2017. Our qualification as a REIT will depend upon our ability to meet requirements regarding our organization and ownership, distributions of our income, the nature and diversification of our income and assets and other tests imposed by the Code. For prior taxable years we have been treated as a C-corporation for U.S. federal income tax purposes. Consequently, if we elect to be a REIT for 2017, and if, within five years of January 1, 2017, the effective date of the REIT election, (1) we dispose of either the property or our interest in the limited liability company that we held on such date, or (2) the limited liability company in which we hold an interest disposes of any property it held on such date, we may be subject to federal income tax on the “built-in gain” with respect to such property. For example, we may be liable for federal, state, and local income tax on a portion of the gain we realize on the Estates property if we dispose of our preferred equity interest, or the partnership disposes of the underlying property, before January 1, 2022. The REIT qualification requirements are extremely complex and interpretation of the U.S. federal income tax laws governing qualification as a REIT is limited. For a discussion of the REIT qualification tests and other considerations relating to our election to be taxed as REIT, see “U.S. Federal Income Tax Considerations.” Furthermore, future legislative, judicial or administrative changes to the federal income tax laws could be applied retroactively, which could result in our disqualification as a REIT.

If we were to fail to qualify as a REIT for any taxable year after electing REIT status, we would be subject to federal income tax on our taxable income at regular corporate rates, and dividends paid to our stockholders

 

35


Table of Contents

would not be deductible by us in computing our taxable income. Any resulting corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of shares of our common stock. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from taxation as a REIT and would not be allowed to re-elect REIT status for the four taxable years following the year in which we failed to qualify as a REIT.

Even if we qualify as a REIT for federal income tax purposes, we may be subject to other tax liabilities that reduce our cash flow and our ability to make distributions to you.

Even if we qualify as a REIT for federal income tax purposes, we may be subject to some federal, state and local taxes on our income or property. For example, net income from a “prohibited transaction” will be subject to a 100% tax. In addition, as noted above, if we were to sell, in a taxable transaction, any asset held by us on the effective date of our REIT election within five years of such effective date, we could be subject to federal income tax on the lesser of (i) the excess of the fair market value of such asset over our basis in the asset on such effective date, and (ii) the gain we recognize on such sale. Further, if a partnership or limited liability company in which we held an interest on the effective date of our REIT election makes a taxable disposition of an asset that it held on such effective date, we could be subject to federal income tax on our share of the excess of the fair market value over the basis of the asset on such date, limited to the amount of built-in gain in the partnership or limited liability company interest on the effective date of our REIT election. Moreover, we may not be able to make sufficient distributions to avoid excise taxes applicable to REITs. We may also decide to retain income we earn from the sale or other disposition of our real estate assets and pay income tax directly on such income. We may also be subject to state and local taxes on our income or property, either directly or at the level of the companies through which we indirectly own our assets. In addition, our TRSs or any TRS we form will be subject to federal income tax and applicable state and local taxes on their net income. Any federal or state taxes we pay will reduce our cash available for distribution to you.

To qualify as a REIT we must meet annual distribution requirements, which may force us to forgo otherwise attractive opportunities, borrow funds during unfavorable market conditions, or pay dividends in the form of a mixture of stock and cash. This could delay or hinder our ability to meet our investment objectives, reduce your overall return, potentially cause you to realize taxable income on the receipt of a stock dividend, and place downward pressure on the market price of our common stock.

In order to qualify and maintain our qualification as a REIT, we must distribute annually to our stockholders at least 90% of our REIT taxable income (which does not equal net income as calculated in accordance with GAAP), determined without regard to the deduction for dividends paid and excluding net capital gain. We will be subject to U.S. federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (a) 85% of our ordinary income, (b) 95% of our capital gain net income and (c) 100% of our undistributed income from prior years. These requirements could cause us to distribute amounts that otherwise would be spent on investments in real estate assets, and it is possible that we might be required to borrow funds, possibly at unfavorable rates, or sell assets to fund these distributions. We may not always be able to make distributions sufficient to meet the annual distribution requirements and to avoid U.S. federal income and excise taxes on our earnings while we qualify as a REIT. In addition, if the excess of taxable income over cash is sufficiently great, we may find it impossible to avoid paying the 4% nondeductible excise tax on some portion of our income.

In addition, some of our investments, notably our mezzanine debt and our preferred equity investments, are expected to require us to report taxable income in amounts that exceed the cash flow produced by such investments. As a result, in order to satisfy the REIT distribution requirement, we may distribute taxable dividends that are payable in cash and common stock at the election of each stockholder. The Internal Revenue Service (“IRS”) recently issued a revenue procedure authorizing publicly traded REITs to make elective cash/stock dividends, if the distributions adhere to certain parameters. If we made such a distribution, we expect to structure it so as to comply with the revenue procedure.

 

36


Table of Contents

If we made a taxable dividend payable in cash and common stock, 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, as determined for U.S. federal income tax purposes. As a result, stockholders may be required to pay income tax with respect to such dividends in excess of the cash dividends received. If a U.S. stockholder sells the common stock that 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 common stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. federal income tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in common stock. If we made a taxable dividend payable in cash and our common stock and 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. We do not currently intend to pay taxable dividends of our common stock and cash, although we may choose to do so in the future.

The failure of a mezzanine loan to qualify as a real estate asset could adversely affect our ability to qualify as a REIT.

The IRS has issued Revenue Procedure 2003-65, which provides a safe harbor pursuant to which a mezzanine loan that is secured by interests in a pass-through entity will be treated by the IRS as a real estate asset for purposes of the REIT tests, and interest derived from such a loan will be treated as qualifying mortgage interest for purposes of the 75% gross income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We will likely originate and acquire mezzanine loans that do not satisfy all of the requirements for reliance on the safe harbor set forth in the Revenue Procedure. Consequently, there can be no assurance that the IRS will not successfully challenge the tax treatment of such loans, which could jeopardize our ability to qualify as a REIT.

There is a lack of clear authority governing the characterization of our preferred equity investments for REIT qualification purposes.

To qualify and maintain our qualification as a REIT, we must meet a quarterly asset test that requires, among other things, that (i) at least 75% of our assets qualify as real estate assets, and (ii) the securities of any one issuer (other than securities qualifying as real estate assets) not make up more than 5% of our total assets. For this purpose, we will be deemed to own our proportionate share of assets held by any partnership in which we own a partnership interest. In addition, although debt secured by a mortgage on real property generally qualifies as a real estate asset, debt that is not secured by real estate assets generally does not so qualify.

We intend to make preferred equity investments in entities that are considered partnerships for federal income tax purposes. Although we believe that such investments will constitute partnership interests for purposes of the REIT asset test, and intend to take that position, there is no clear guidance on the point, and there can be no assurance that our position will be upheld. If the preferred equity investments were recharacterized as debt of the partnership, the recharacterization could cause us to fail the asset and income test. In this event, we intend to take advantage of provisions in the Code allowing us to remedy such failure, but those provisions may require us to dispose of any nonqualifying assets at disadvantageous prices, and to pay an excise tax equal to the greater of (i) $50,000, and (ii) a tax determined by multiplying the highest effective corporate tax rate then in effect by the income produced by the income generated by the nonqualifying assets.

We may fail to qualify as a REIT because of the activities and assets of the entities that issue preferred equity investments.

Our preferred equity investments will be in the form of limited partner or non-managing member interests in partnerships and limited liability companies. For purposes of the REIT income and asset tests, we will be treated as receiving our proportionate share of the income earned by those partnerships and limited liability companies

 

37


Table of Contents

and as owning our proportionate share of assets for those entities. Although the character of our income and assets for purposes of REIT income and asset tests will depend upon those partnerships’ and limited liability companies’ income and assets, we will typically have limited control over the operations of the partnerships and limited liability companies in which we own preferred equity investments. If a partnership or limited liability company in which we own an interest takes or expects to take actions that could jeopardize our qualification as a REIT or require us to pay tax, we may be forced to dispose of our interest in such entity. In addition, a partnership or limited liability company could take an action that could cause us to fail a REIT gross income or asset test, and we may not become aware of such action in time to dispose of our interest in the partnership or limited liability company or take other corrective action on a timely basis. In that case, we could fail to qualify as a REIT unless we are able to qualify for a statutory REIT “savings” provision, which may require us to pay a significant penalty tax to maintain our REIT qualification.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

To qualify and maintain our qualification as a REIT, we must ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets, including certain mortgage loans and certain mortgage-backed securities. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and no more than 25% of the value of our total assets (20% for taxable years beginning on or after January 1, 2018) can be represented by securities of one or more TRSs. Further, no more than 25% of our total assets can consist of debt issued by publicly traded REITs unless such debt otherwise qualifies as a real estate asset for purposes of the REIT rules. See “U.S. Federal Income Tax Considerations — Requirements for Qualification — General.” If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution to our stockholders.

If our OP failed to qualify as a partnership or is not otherwise disregarded for U.S. federal income tax purposes, we would cease to qualify as a REIT.

If the IRS was to successfully challenge the status of our OP as a partnership or disregarded entity for tax purposes, it would be taxable as a corporation. In such event, this would reduce the amount of distributions that the operating partnership could make to us. This also would result in our failing to qualify as a REIT, and becoming subject to a corporate level tax on our income. This would substantially reduce our cash available to pay distributions and the yield on your investment.

Dividends payable by REITs generally do not qualify for the reduced tax rates available for some dividends.

Currently, the maximum tax rate applicable to qualified dividend income payable to U.S. stockholders that are individuals, trusts and estates is 20%. Dividends payable by REITs, however, generally are not eligible for this reduced rate. Although this does not adversely affect the taxation of REITs or dividends payable by REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our common stock. Tax rates could be changed in future legislation.

 

38


Table of Contents

The share ownership restrictions of the Code for REITs and the 6.2% share ownership limit in our charter may inhibit market activity in shares of our stock and restrict our business combination opportunities.

In order to qualify as a REIT, five or fewer individuals, as defined in the Code, may not own, actually or constructively, more than 50% in value of our issued and outstanding shares of stock at any time during the last half of each taxable year, other than the first year for which a REIT election is made. Attribution rules in the Code determine if any individual or entity actually or constructively owns shares of our common stock under this requirement. Additionally, at least 100 persons must beneficially own shares of our common stock during at least 335 days of a taxable year for each taxable year, other than the first year for which a REIT election is made. To help insure that we meet these tests, among other purposes, our charter restricts the acquisition and ownership of shares of our common stock.

Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary or appropriate to preserve our qualification as a REIT while we so qualify. Unless exempted by our board of directors (prospectively or retroactively), for so long as we qualify as a REIT, our charter prohibits, among other limitations on ownership and transfer of shares of our stock, any person from beneficially or constructively owning (applying certain attribution rules under the Code) more than 6.2% in value of the aggregate of the outstanding shares of our capital stock and more than 6.2% (in value or in number of shares, whichever is more restrictive) of the outstanding shares of our common stock. Our board of directors may not grant an exemption from these restrictions to any proposed transferee whose ownership in excess of the 6.2% ownership limit would result in our failing to qualify as a REIT. The board intends to grant waivers from the ownership limits for certain existing stockholders, if necessary, including to Highland and its affiliates and may grant additional waivers in the future. These waivers will be subject to certain initial and ongoing conditions designed to protect our status as a REIT. These restrictions on transferability and ownership will not apply, however, if our board of directors determines that it is no longer in our best interest to qualify as a REIT or that compliance with the restrictions is no longer required in order for us to so qualify as a REIT.

These ownership limits could delay or prevent a transaction or a change in control that might involve a premium price for our common stock or otherwise be in the best interest of the stockholders.

Complying with REIT requirements may limit our ability to hedge our liabilities effectively and may cause us to incur tax liabilities.

The REIT provisions of the Code may limit our ability to hedge our liabilities. Any income from a hedging transaction we enter into to manage risk of interest rate changes, price changes or currency fluctuations with respect to borrowings made or to be made to acquire or carry real estate assets, if properly identified under applicable Treasury Regulations, does not constitute “gross income” for purposes of the 75% or 95% gross income tests. To the extent that we enter into other types of hedging transactions, the income from those transactions will likely be treated as non-qualifying income for purposes of both of the gross income tests. As a result of these rules, we may need to limit our use of advantageous hedging techniques or implement those hedges through a TRS. This could increase the cost of our hedging activities because our TRSs would be subject to tax on gains or expose us to greater risks associated with changes in interest rates than we would otherwise want to bear. In addition, losses in a TRS generally will not provide any tax benefit, except for being carried forward against future taxable income of such TRS.

Certain of our business activities are potentially subject to the prohibited transaction tax, which could reduce the return on your investment.

For so long as we qualify as a REIT, our ability to dispose of assets during the first few years following acquisition may be restricted to a substantial extent as a result of our REIT qualification. Under applicable provisions of the Code regarding prohibited transactions by REITs, while we qualify as a REIT, we will be subject to a 100% penalty tax on any gain recognized on the sale or other disposition of any assets (other than

 

39


Table of Contents

foreclosure property) that we own or hold an interest in, directly or indirectly through any subsidiary entity, including our OP, but generally excluding TRSs, that is deemed to be inventory or property held primarily for sale to customers in the ordinary course of a trade or business. Whether property is inventory or otherwise held primarily for sale to customers in the ordinary course of a trade or business depends on the particular facts and circumstances surrounding each property. During such time as we qualify as a REIT, we intend to avoid the 100% prohibited transaction tax by (a) conducting activities that may otherwise be considered prohibited transactions through a TRS (but such TRS will incur corporate rate income taxes with respect to any income or gain recognized by it), (b) conducting our operations in such a manner so that no sale or other disposition of an asset we own or hold an interest in, directly or through any subsidiary, will be treated as a prohibited transaction, or (c) structuring certain dispositions to comply with the requirements of the prohibited transaction safe harbor available under the Code that, among other requirements, have been held for at least two years. No assurance can be given that any particular asset that we own or hold an interest in, directly or through any subsidiary entity, including our OP, but generally excluding TRSs, will not be treated as inventory or property held primarily for sale to customers in the ordinary course of a trade or business.

The ability of the board to revoke our REIT qualification without stockholder approval may cause adverse consequences to our stockholders.

Our board may revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. If we cease to be a REIT, we will not be allowed a deduction for dividends paid to stockholders in computing our taxable income and will be subject to U.S. federal income tax at regular corporate rates and state and local taxes, which may have adverse consequences on our total return to our stockholders.

New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to remain qualified as a REIT or have other adverse effects on us.

The present U.S. federal income tax treatment of REITs may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in us. The U.S. federal income tax rules dealing with REITs are constantly under review by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations. According to publicly released statements, a top legislative priority of the new Congress and administration may be to enact significant reform of the Code, including significant changes to taxation of business entities and the deductibility of interest expense and capital investment. There is a substantial lack of clarity around the likelihood, timing and details of any such tax reform and the impact of any potential tax reform on us or an investment in our common stock. Any such changes to the tax laws or interpretations thereof, with or without retroactive application, could materially and adversely affect our stockholders or us. We cannot predict how changes in the tax laws might affect our stockholders or us. New legislation, U.S. Treasury Regulations, administrative interpretations or court decisions could significantly and negatively affect our ability to continue to qualify as a REIT, or the U.S. federal income tax consequences to our stockholders and us of such qualification, or could have other adverse consequences including with respect to ownership of our common stock. For example, lower revised tax rates for corporations, or for individuals, trusts and estates, might cause current or potential stockholders to perceive investments in REITs to be relatively less attractive than is the case under current law.

Risks Related to the Ownership of our Common Stock

There are no established trading markets for our common stock and broad market fluctuations could negatively impact the market price of our stock.

Currently, there is no established trading market for our common stock. We intend to list shares of our common stock on the NYSE under the symbol “NREF,” to be effective upon completion of this offering. We

 

40


Table of Contents

cannot assure you that, if accepted, an active trading market for our common stock will develop after this offering or if one does develop, that it will be sustained.

Even if an active trading market develops, the market price of our common stock may be volatile. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some of the factors that could affect our stock price or result in fluctuations in the price or trading volume of our common stock include:

 

    actual or anticipated variations in our quarterly operating results, financial condition, cash flow and liquidity, or changes in investment strategy or prospects;

 

    changes in our operations or earnings estimates or publication of research reports about us or the real estate industry;

 

    loss of a major funding source or inability to obtain new favorable funding sources in the future;

 

    our financing strategy and leverage;

 

    actual or anticipated accounting problems;

 

    changes in market valuations of similar companies;

 

    increases in market interest rates that lead purchasers of our shares to demand a higher yield;

 

    adverse market reaction to any increased indebtedness we incur in the future;

 

    additions or departures of key management personnel;

 

    actions by institutional stockholders;

 

    speculation in the press or investment community;

 

    the realization of any of the other risk factors presented in this prospectus;

 

    the extent of investor interest in our securities;

 

    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 underlying asset value;

 

    investor confidence and price and volume fluctuations in the stock and bond markets, generally;

 

    changes in laws, regulatory policies or tax guidelines, or interpretations thereof, particularly with respect to REITs;

 

    future equity issuances by us, or share resales by our stockholders, or the perception that such issuances or resales may occur;

 

    failure to meet income estimates;

 

    failure to meet and maintain REIT qualifications or exclusion from Investment Company Act regulation or listing on the NYSE; and

 

    general market and economic conditions.

In the past, class-action litigation has often been instituted against companies following periods of volatility in the price of their common stock. This type of litigation could result in substantial costs and divert our management’s attention and resources, which could have an adverse effect on our financial condition, results of operations, cash flow and trading price of our common stock.

 

41


Table of Contents

The form, timing and/or amount of dividend distributions in future periods may vary and be impacted by economic and other considerations.

The form, timing and/or amount of dividend distributions will be declared at the discretion of the board and will depend on actual cash from operations, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Code and other factors as the board may consider relevant. The board may modify our dividend policy from time to time.

We may be unable to make distributions at expected levels, which could result in a decrease in the market price of our common stock.

If sufficient cash is not available for distribution from our operations, we may have to fund distributions from working capital, borrow to provide funds for such distributions, reduce the amount of such distributions, or issue stock dividends. To the extent we borrow to fund distributions, our future interest costs would increase, thereby reducing our earnings and cash available for distribution from what they otherwise would have been. If cash available for distribution generated by our assets is less than we expect, our inability to make the expected distributions could result in a decrease in the market price of our common stock. In addition, if we make stock dividends in lieu of cash distributions it may have a dilutive effect on the holdings of our stockholders.

All distributions will be made at the discretion of the board and will be based upon, among other factors, our historical and projected results of operations, financial condition, cash flows and liquidity, maintenance of our REIT qualification and other tax considerations, and other expense obligations, debt covenants, contractual prohibitions or other limitations and applicable law and such other matters as the board may deem relevant from time to time. We may not be able to make distributions in the future, and our inability to make distributions, or to make distributions at expected levels, could result in a decrease in the market price of our common stock.

Our charter permits the board to issue stock with terms that may subordinate the rights of our common stockholders or discourage a third party from acquiring us in a manner that could otherwise result in a premium price to our stockholders.

The board may classify or reclassify any unissued shares of common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications and terms or conditions of redemption of any such stock. Thus, the board could authorize the issuance of preferred stock with terms and conditions that could have priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Such preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price to holders of our common stock.

You will experience immediate and substantial dilution from the purchase of our common stock in this offering.

If you purchase common stock in this offering, you will experience immediate dilution of approximately $             per share of our common stock, based upon an assumed initial public offering price of $             per share, which is the mid-point of the price range indicated on the cover of this prospectus, and assuming no exercise by the underwriters of their option to purchase additional shares of our common stock. This means that investors that purchase shares of our common stock in this offering will pay a price per share that exceeds our as further adjusted net tangible book value per share of our common stock after giving effect to the completion of this offering and the use of proceeds therefrom. See “Dilution.”

 

42


Table of Contents

Future issuances of debt securities and equity securities may negatively affect the market price of shares of our common stock and, in the case of equity securities, may be dilutive to existing stockholders and could reduce the overall value of your investment.

In the future, we may issue debt or equity securities or incur other financial obligations, including stock dividends and shares that may be issued in exchange for common stock. Upon liquidation, holders of our debt securities and other loans and preferred stock will receive a distribution of our available assets before common stockholders. We are not required to offer any such additional debt or equity securities to existing stockholders on a preemptive basis. Therefore, additional common stock issuances, directly or through convertible or exchangeable securities (including common stock and convertible preferred stock), warrants or options, will dilute the holdings of our existing common stockholders and such issuances or the perception of such issuances may reduce the market price of shares of our common stock. Any convertible preferred stock would have, and any series or class of our preferred stock would likely have, a preference on distribution payments, periodically or upon liquidation, which could eliminate or otherwise limit our ability to make distributions to common stockholders.

Existing stockholders do not have preemptive rights to any shares we issue in the future. Our charter will authorize us to issue 600,000,000 shares of capital stock, of which 500,000,000 shares will be designated as common stock and 100,000,000 shares will be designated as preferred stock. In connection with this offering, our Class A common stock will be reclassified as common stock and our Class T common stock will be eliminated. The board may increase the number of authorized shares of capital stock without stockholder approval. After this offering, the board may elect to (1) sell additional shares in future public offerings; (2) issue equity interests in private offerings; (3) issue shares of our common stock under a long-term incentive plan to our non-employee directors or to employees of our Advisor or its affiliates; (4) issue shares to our Advisor, its successors or assigns, in payment of an outstanding fee obligation or as consideration in a related-party transaction; or (5) issue shares of our common stock in connection with an exchange of limited partnership interests of our OP. To the extent we issue additional equity interests after this offering, your percentage ownership interest in us will be diluted. Further, depending upon the terms of such transactions, most notably the offering price per share, existing stockholders may also experience a dilution in the book value of their investment in us.

Common stock eligible for future sale may have adverse effects on our share price.

We are offering                 shares of our common stock as described in this prospectus (excluding the underwriters’ overallotment option to purchase up to an additional                 shares). Concurrently with the closing of this offering, we will sell to Highland and/or its affiliates in a separate private placement                 shares of our common stock representing an aggregate investment equal to $         million.

Assuming no exercise of the underwriters’ overallotment option to purchase additional shares, approximately           % of our common stock outstanding upon completion of this offering will be subject to lock-up agreements. When this lock-up period expires, these shares of common stock will become eligible for sale, in some cases subject to the requirements of Rule 144 under the Securities Act of 1933 and potentially under a registration statement pursuant to the registration rights agreement described under “Management—Related Party Transactions.” For additional information, see “Shares Eligible for Future Sale.”

We cannot predict the effect, if any, of future sales of our common stock, or the availability of shares for future sales, on the market price of our common stock. The market price of our common stock may decline significantly when the restrictions on resale by certain of our stockholders lapse.

Sales of substantial amounts of common stock or the perception that such sales could occur may adversely affect the prevailing market price for our common stock.

After the completion of this offering and the concurrent private placement, we may issue additional shares in subsequent public offerings or private placements to make new investments or for other purposes. We are not

 

43


Table of Contents

required to offer any such shares to existing stockholders on a preemptive basis. Therefore, it may not be possible for existing stockholders to participate in such future share issuances, which may dilute the existing stockholders’ interests in us.

Our rights and the rights of our stockholders to recover claims against our independent directors are limited, which could reduce your and our recovery against them if they negligently cause us to incur losses.

Maryland law provides that a director has no liability in the capacity as a director if he or she performs his or her duties in good faith, in a manner he or she reasonably believes to be in the company’s best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances. As permitted by the Maryland General Corporation Law (the “MGCL”) our charter limits the liability of our directors and officers to the Company and our stockholders for money damages, except for liability resulting from:

 

    actual receipt of an improper benefit or profit in money, property or services; or

 

    a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

In addition, our charter authorizes us to obligate the Company, and our bylaws require us, to indemnify our directors and officers for actions taken by them in those capacities and to pay or reimburse their reasonable expenses in advance of final disposition of a proceeding to the maximum extent permitted by Maryland law, and we have also entered into indemnification agreements with our directors and executive officers. As a result, we and our stockholders may have more limited rights against our directors and officers than might otherwise exist under common law. Accordingly, in the event that actions taken by any of our directors or officers are immune or exculpated from, or indemnified against, liability but which impede our performance, our stockholders’ ability to recover damages from that director or officer will be limited.

Our charter and bylaws contain provisions that may delay, defer or prevent an acquisition of our common stock or a change in control.

Our charter and bylaws contain a number of provisions, the exercise or existence of which could delay, defer or prevent a transaction or a change in control that might involve a premium price for our stockholders or otherwise be in their best interests, including the following:

 

   

Our Charter Contains Restrictions on the Ownership and Transfer of Our Stock. In order for us to qualify, and elect to be taxed, as a REIT, no more than 50% of the value of outstanding shares of our stock may be owned, beneficially or constructively, by five or fewer individuals at any time during the last half of each taxable year other than the first year for which we elect to be taxed as a REIT. Subject to certain exceptions, our charter prohibits any stockholder from owning beneficially or constructively more than 6.2% in value or in number of shares, whichever is more restrictive, of the outstanding shares of our common stock, or 6.2% in value of the aggregate of the outstanding shares of all shares of our capital stock. We refer to these restrictions collectively as the “ownership limits.” The constructive ownership rules under the Code are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 6.2% of our outstanding shares of common stock or the outstanding shares of all classes or series of our stock by an individual or entity could cause that individual or entity or another individual or entity to own constructively in excess of the relevant ownership limits. Our charter also prohibits any person from owning shares of our stock that would result in our being “closely held” under Section 856(h) of the Code or otherwise cause us to fail to qualify as a REIT. Any attempt to own or transfer shares of our common stock or of any of our other capital stock in violation of these restrictions may result in the shares being automatically transferred to a charitable trust or may be void. These ownership limits may prevent a third party from acquiring control of us if the board

 

44


Table of Contents
 

does not grant an exemption from the ownership limits, even if our stockholders believe the change in control is in their best interests. The board intends to grant waivers from the ownership limits applicable to holders of our common stock to certain existing stockholders, if necessary, including to Highland and may grant additional waivers in the future. These waivers will be subject to certain initial and ongoing conditions designed to protect our status as a REIT.

 

    The Board Has the Power to Cause Us to Issue Additional Shares of Our Stock without Stockholder Approval. Our charter authorizes us to issue additional authorized but unissued shares of common or preferred stock. In addition, the board may, without stockholder approval, amend our charter to increase the aggregate number of shares of our common stock or the number of shares of stock of any class or series that we have authority to issue and classify or reclassify any unissued shares of common or preferred stock and set the preferences, rights and other terms of the classified or reclassified shares. As a result, the board may establish a series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for our shares of common stock or otherwise be in the best interests of our stockholders. See “Description of Capital Stock—Power to Increase or Decrease Authorized Shares of Stock, Reclassify Unissued Shares of Stock and Issue Additional Shares of Common and Preferred Stock.”

Certain provisions of Maryland law may limit the ability of a third party to acquire control of us.

Certain provisions of the MGCL may have the effect of inhibiting a third party from acquiring us or of impeding a change of control under circumstances that otherwise could provide our common stockholders with the opportunity to realize a premium over the then-prevailing market price of such shares, including:

 

    “business combination” provisions that, subject to limitations, prohibit certain business combinations between an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding shares of voting stock or an affiliate or associate of the corporation who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of the then outstanding stock of the corporation) or an affiliate of any interested stockholder and us for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes two super-majority stockholder voting requirements on these combinations; and

 

    “control share” provisions that provide that holders of “control shares” of our Company (defined as voting shares of stock that, if aggregated with all other shares of stock owned or controlled by the acquirer, would entitle the acquirer to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of issued and outstanding “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all of the votes entitled to be cast on the matter, excluding all interested shares.

Pursuant to the Maryland Business Combination Act and in connection with the completion of this offering, our board will by resolution exempt from the provisions of the Maryland Business Combination Act all business combinations (i) between our Advisor or its respective affiliates and us and (ii) between any other person and us, provided that such business combination is first approved by the board (including a majority of our directors who are not affiliates or associates of such person). Our bylaws contain a provision exempting from the Maryland Control Share Acquisition Act any and all acquisitions by any person of shares of our stock. There can be no assurance that these exemptions or resolutions will not be amended or eliminated at any time in the future.

Additionally, Title 3, Subtitle 8 of the MGCL permits the board, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to implement certain takeover defenses, such as a classified board, some of which we do not have.

 

45


Table of Contents

USE OF PROCEEDS

We estimate that the net proceeds we will receive from this offering will be approximately $         million after deducting underwriting discounts and commissions of $         million and estimated offering expenses of approximately $         (or, if the underwriters exercise their option to purchase additional shares of common stock in full, approximately $         million after deducting underwriting discounts and commissions of $         million and estimated offering expenses of approximately $         ). We will also receive $         million in net proceeds from the concurrent private placement to Highland and/or its affiliates.

We plan to use substantially all of the net proceeds from this offering and the concurrent private placement to make the following loans and/or investments:

 

Investment

  

Investment Type

   Amount of Investment    Rate
Ashford at Feather Sound   

Mezzanine Debt

   $7.3 million    8.25% + 2.75% PIK
City Park Clearwater    Mezzanine Debt    $5.7 million    8.25% + 2.75% PIK
Floresta   

Mezzanine Debt

   $12.3 million    8.25% + 2.75% PIK
Jernigan Capital, Inc.   

Preferred Equity

   $35.0 million (1)    7% + PIK dividend (2)
Latitude   

Mezzanine Debt

   $6.0 million    8.5% + 2% PIK
Marbella   

Mezzanine Debt

   $5.2 million    9% + 4% PIK

Riverside Villas

  

Mezzanine Debt

   $2.0 million    8.5%
Total       $73.5 million   

 

(1) We expect to invest up to $35.0 million in this investment. The size of our investment will depend on the allocation policy of Highland and our Advisor, the size of this offering and the maintenance of our exemption from registration under the Investment Company Act . We expect our investment in Jernigan to increase or decrease on a pro rata basis in relation to the size of this offering. If there is a 10% increase or decrease in the size of this offering, we expect our investment in Jernigan to increase or decrease by $         million. The total investment in Jernigan under the Jernigan Stock Purchase Agreement may be for an amount up to $125.0 million at Jernigan’s option. At least $50.0 million must be invested in Jernigan before July 27, 2018, the date the stock purchase agreement terminates. Investments in Jernigan must be in amounts of (a) no less than $5.0 million, and if greater than $5.0 million, in multiples of $1.0 million (b) no more than $15.0 million in any given calendar month, and (c) no more than $35.0 million in any three-month period. Affiliates of Highland have already invested $10.0 million in Jernigan. The remainder of the investment will be funded by us or other Highland affiliates.
(2) The cash dividend will increase to 8.5% in July 2022. An additional 5% cash dividend is payable upon the occurrence of a change in control and other similar events. The PIK dividend will be equal to the lesser of (a) 25% of the incremental increase in book value plus the incremental increase in net asset value of any income producing real property and (b) an amount that together with the cash dividends would equal a 14.00% IRR.

We believe each investment will qualify as a real-estate asset for purposes of the REIT asset tests.

For additional information regarding these investments, see “Business — Our Initial Portfolio.”

We will also use the net proceeds of the offering and the concurrent private placement to:

 

    pay down approximately $11.0 million, the outstanding balance, on our existing credit facility with KeyBank. The credit facility accrues interest at an annual rate of 4% plus one-month LIBOR and matures on October 2, 2017;

 

    redeem for approximately $125,000 all of the 125 issued and outstanding shares of our Series A preferred stock; and

 

    buyout the non-controlling joint venture interest in Estates for approximately $2.5 million.

 

46


Table of Contents

Pending the permanent use of the net proceeds of this offering and the concurrent private placement, our Advisor may invest the net proceeds from this offering and the concurrent private placement in money market funds, bank accounts, overnight repurchase agreements with primary federal reserve bank dealers collateralized by direct U.S. government obligations and other instruments or investments reasonably determined by our Advisor to be of high quality and that are consistent with our intention to qualify as a REIT and maintain our exclusion from regulation under the Investment Company Act. These investments are expected to provide a lower net return than we seek to achieve from our target assets.

 

47


Table of Contents

DISTRIBUTION POLICY

Our Policy

Following the completion of this offering, we intend to make regular quarterly distributions to our stockholders, consistent with our intention to continue to qualify as a REIT for U.S. federal income tax purposes. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its REIT taxable income. As a result, in order to satisfy the requirements for us to continue to qualify as a REIT and generally not be subject to U.S. federal income and excise tax, we intend to make regular quarterly distributions of all or substantially all of our REIT taxable income to our stockholders out of assets legally available therefor. REIT taxable income as computed for purposes of the foregoing tax rules will not necessarily correspond to our net income as determined for financial reporting purposes.

Distributions to our stockholders, if any, will be authorized by our board of directors in its sole discretion out of funds legally available therefor and will be dependent upon a number of factors, including our historical and projected results of operations, cash flows and financial condition, any financing covenants, the annual distribution requirements under the REIT provisions of the Code, our REIT taxable income, applicable provisions of the MGCL and such other factors as our board of directors deems relevant. Our results of operations, liquidity and financial condition will be affected by various factors, including the amount of our net interest income, our operating expenses and any other expenditures.

To the extent that our cash available for distribution is less than the amount required to be distributed under the REIT provisions of the Internal Revenue Code, we may be required to fund distributions from working capital or through equity, equity-related or debt financings or, in certain circumstances, asset sales, as to which our ability to consummate transactions in a timely manner on favorable terms, or at all, cannot be assured. In addition, we may choose to make a portion of a required distribution in the form of a taxable stock dividend to preserve our cash balance.

Currently, we have no intention to use any net proceeds from this offering or the concurrent private placement to make distributions to our stockholders or to make distributions to our stockholders using shares of our stock.

Distributions to our stockholders, if any, will be generally taxable to them as ordinary income, although a portion of our distributions may be designated by us as capital gain or qualified dividend income, or may constitute a return of capital. We will furnish annually to each of our stockholders a statement setting forth the amount of distributions paid during the preceding year and their characterization as ordinary income, return of capital, qualified dividend income or capital gain.

Distributions Declared

For information with respect to the per share cash dividends declared on our common stock since inception, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Distributions.”

 

48


Table of Contents

CAPITALIZATION

The following table sets forth our cash and cash equivalents and capitalization as of June 30, 2017:

 

    on an actual basis;

 

    on an as adjusted basis to give effect to (1) the sale of shares of common stock in this offering at an assumed initial public offering price of $          per share, the midpoint of the range set forth on the cover of this prospectus, and after deducting underwriting discounts and commissions and estimated fees and expenses payable by us and (2) the concurrent private placement of $         million of shares of our common stock to Highland and/or its affiliates at an assumed offering price of $         per share.

You should read the following table in conjunction with “Use of Proceeds,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

(dollars in thousands)    As of June 30, 2017  
     Actual     As Adjusted (1)  
     (unaudited)  

Cash and cash equivalents

   $ 1,628     $               
  

 

 

   

 

 

 

Total debt (2)

     37,740    

Stockholders’ equity:

    

Preferred stock, par value $0.01

     —         —    

Common stock, par value $0.01 (3)

     11    

Class T Common stock, par value $0.01 (3)

     —         —    

Additional paid-in capital

     11,002    

Accumulated deficit

     (4,543  

Accumulated other comprehensive loss

     (25  
  

 

 

   

 

 

 

Total stockholders’ equity

     7,053    
  

 

 

   

 

 

 

Total capitalization

   $ 46,841     $  
  

 

 

   

 

 

 

 

(1) A $1.00 increase (decrease) in the assumed initial public offering price of $         per share, the midpoint of the range set forth on the cover of this prospectus, would increase (decrease) cash and cash equivalents, total stockholders’ equity and total capitalization by $         million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.
(2) Includes $11.0 million outstanding under our existing credit facility with KeyBank, which matures on October 2, 2017.
(3) In connection with this offering, our Class A common stock will be reclassified as common stock and our Class T common stock will be eliminated.

 

49


Table of Contents

DILUTION

If you invest in shares of our common stock in this offering, your ownership interest in us will be diluted to the extent of the difference between the offering price per share of our common stock and the as further adjusted net tangible book value per share of our common stock immediately after the completion of this offering and the concurrent private placement.

Our net tangible book value as of June 30, 2017 was approximately $         million, or $         per share of our common stock. We calculate net tangible book value per share by taking the amount of our total tangible assets, reduced by the amount of our total liabilities and noncontrolling interests, and then dividing that amount by shares of our common stock that were outstanding on June 30, 2017.

After giving effect to our dividend payment of $         million, or $         per share of common stock subsequent to June 30, 2017, our as adjusted net tangible book value before completing this offering and the concurrent private placement as of June 30, 2017 would have been $         million, or $         per share of our common stock. We refer to these items as the “as adjusted items” in the table below.

After giving effect to (1) the sale of shares of common stock in this offering at an assumed initial public offering price of $         per share, the midpoint of the initial public offering price range set forth on the cover of this prospectus, after deducting estimated underwriting discounts and commissions and offering expenses payable by us and the concurrent private placement, and (2) the redemption of all of the 125 issued and outstanding shares of our Series A preferred stock upon the completion of this offering, our as further adjusted net tangible book value as of June 30, 2017 would have been $         million, or $         per share of our common stock. This amount represents an immediate decrease in net tangible book value of $         per share to existing stockholders and an immediate dilution of $         per share to new investors purchasing shares in this offering at the assumed initial public offering price.

The following table illustrates this dilution on a per share basis:

 

Assumed initial offering price per share

   $               

Net tangible book value per share as of June 30, 2017

  

Decrease in net tangible book value per share attributable to as adjusted items described above

  

As adjusted net tangible book value per share without giving effect to the further adjustments described above

  

Decrease in net tangible book value per share after giving effect to the further adjustments described above

  

As further adjusted net tangible book value per share after giving effect to the further adjustments described above

  

Dilution per share to new investors

  

Dilution is determined by subtracting as further adjusted net tangible book value per share after giving effect to this offering from the assumed initial public offering price per share.

If the underwriters exercise in full their option to purchase additional shares, the as further adjusted net tangible book value per share would be $         per share of our common stock. This represents a decrease in net tangible book value of $         per share to the existing stockholders and results in dilution of $         per share to new investors.

Assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, after deducting estimated underwriting discounts and commissions and offering expenses payable by us, a $         increase or decrease in the assumed initial public offering price of $         per share, the midpoint of the

 

50


Table of Contents

initial public offering price range set forth on the cover of this prospectus, would increase or decrease the as further adjusted net tangible book value attributable to new investors purchasing shares in this offering by $         per share and would increase or decrease the dilution to new investors by $         per share.

The following table summarizes, as of June 30, 2017, the as further adjusted basis described above, the differences between the number of shares purchased from us, the total consideration paid to us, and the average price per share paid by existing stockholders and by new investors. As the table shows, new investors purchasing shares of common stock in this offering will pay an average price per share higher than our existing stockholders paid. The table below assumes an initial public offering price of $         per share, the midpoint of the initial public offering price range set forth on the cover of this prospectus, for shares purchased in this offering and excludes estimated underwriting discounts and commissions and offering expenses payable by us:

 

     Shares Purchased      Total Consideration      Average Price
Per Share
 
     Number      Percentage      Number      Percentage     

Existing Stockholders

              

New Investors

              

Total

              

If the underwriters were to fully exercise the underwriters’ option to purchase up to additional shares of our common stock, the percentage of shares of our common stock held by existing stockholders would be     % and the percentage of shares of our common stock held by new investors would be     %.

Assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, a $         increase or decrease in the assumed initial public offering price of $         per share, the midpoint of the initial public offering price range set forth on the cover of this prospectus, would increase or decrease total consideration paid by new investors and total consideration paid by all stockholders by $         million.

To the extent that outstanding equity awards vest, or other issuances of common stock, or grants of options, restricted stock awards, restricted stock units or other equity-based awards are made, there will be further dilution to new investors.

 

51


Table of Contents

SELECTED FINANCIAL DATA

The following financial data should be read in conjunction with the accompanying consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The financial data for the years ended December 31, 2016, 2015 and 2014 and as of December 31, 2016 and 2015 presented below has been derived from our audited consolidated financial statements included elsewhere in this prospectus. The financial data as of December 31, 2014 presented below has been derived from our audited consolidated financial statements not included elsewhere in this prospectus. The financial data for the six months ended June, 30, 2017 and 2016 and as of June, 30, 2017 has been derived from our unaudited consolidated financial statements included elsewhere in this prospectus.

 

     As of December 31,      As of June 30,  
     2016 (1)      2015 (1)      2014 (1)      2017  
            (unaudited)  

(Dollars in thousands, except per share amounts)

           

Balance Sheet Data

           

Total net operating real estate investments

   $   39,642      $ 40,035      $   —        $   38,913  

Preferred equity investment

     5,250        —          —          5,388  

Total assets

     45,826        41,061        200        46,841  

Mortgage payable, net

     26,745        26,697        —          26,770  

Credit facility, net

     10,944        10,000        —          10,970  

Total debt, net

     37,689        36,697        —          37,740  

Total liabilities

     39,182        37,962        —          39,788  

Noncontrolling interests

     647        681        —          608  

Total stockholders’ equity

     6,644        3,099        200        7,053  

 

     For the Year Ended
December 31,
     For the Six
Months Ended
June 30,
 
     2016 (1)     2015 (1)     2014 (1)      2017     2016  
                        (unaudited)  

(Dollars in thousands, except per share amounts)

           

Operating Data

           

Total revenues

   $ 3,884     $ 1,504     $   —        $   2,024     $ 1,906  

Net loss

     (1,505     (1,810     —          (744     (871

Net loss attributable to common stockholders

     (1,503     (1,764     —          (751     (865

Loss per common share — basic and diluted

     (2.22     (8.82     —          (0.70     (1.50

Weighted average common shares outstanding — basic

     678       200       22        1,071       575  

Weighted average common shares outstanding — diluted

     687       200       22        1,082       580  

Cash Flow Data

           

Cash flows provided by operating activities (2)

   $ 767     $ 471     $ —        $ 139     $ 314  

Cash flows used in investing activities (2)

     (6,415     (41,081     —          (93     (6,383

Cash flows provided by financing activities

     5,362       41,379       200        1,122       5,999  

Other Data

           

Distributions declared per common share

   $ 0.251     $ —       $ —        $ 0.297     $ —    

NOI (3)

     2,285       698       —          1,195       1,113  

Core Earnings attributable to common stockholders (3)

     41       (502     —          6       (34

Core Earnings per common share — diluted (4)

     0.06       (2.51     —          0.01       (0.06

CAD attributable to common stockholders (3)

     178       70       —          7       29  

CAD per common share — diluted (4)

     0.26       0.35       —          0.01       0.05  

ACAD attributable to common stockholders (3)

     237       70       —          86       29  

ACAD per common share — diluted

     0.34       0.35       —          0.08       0.05  

 

52


Table of Contents

 

(1) We had no operating activities before August 12, 2015. In accordance with GAAP, our acquisition of Estates was determined to be a combination of entities under common control. As such, the acquisition of Estates by us was deemed to be made on the Original Acquisition Date. In the accompanying consolidated financial statements, operations are shown from the Original Acquisition Date, although we did not commence material operations until March 24, 2016.
(2) We adopted ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, during the fourth quarter of 2016 on a retrospective basis. See Note 2, Summary of Significant Accounting Policies, to our audited consolidated financial statements included in this prospectus for a description of this ASU and the impact of its adoption.
(3) NOI, Core Earnings, CAD and ACAD are non-GAAP measures. For definitions of these non-GAAP measures, as well as an explanation of why we believe these measures are useful and reconciliations to the most directly comparable GAAP financial measures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(4) Dilutive shares were excluded from the computation if the shares were antidilutive.

 

53


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this prospectus. As used herein, the terms “we,” “our” and “us” refer to NexPoint Real Estate Finance, Inc., a Maryland corporation, and, as required by context, NexPoint Real Estate Finance Operating Partnership, L.P., a Delaware limited partnership, which we refer to as the “OP,” and to its subsidiaries. Unless otherwise defined herein, capitalized terms used herein shall have the same meanings as set forth in our consolidated financial statements and the notes thereto included in this prospectus.

Overview

We are a Maryland corporation incorporated on November 12, 2013 that intends to elect to be taxed as a REIT commencing with our taxable year ending December 31, 2017. We are primarily focused on providing structured financing solutions for properties benefiting from significant tenant diversification and short-term leases, including mid-sized multifamily, storage and select-service and extended-stay hospitality real estate properties and companies located in the United States.

On August 12, 2015, the SEC declared our registration statement effective related to a continuous offering of our shares (the “Continuous Offering”). During the Continuous Offering, NREF was a “non-traded REIT” or “NTR” in that our shares were publicly registered, but not listed on a stock exchange, and we filed reports with the SEC. NTRs typically sell shares on a continuous basis to retail shareholders through an independent broker-dealer network. As such, the structure of the shares differ from those typically sold in an initial public offering, such as the shares being registered and sold in this offering. In our Continuous Offering, we publicly offered two classes of shares of common stock, Class A shares and Class T shares, in any combination up to the maximum offering amount. In the Continuous Offering, as of June 30, 2017 we raised gross proceeds of $6.2 million and issued a total of 1,103,268 Class A shares. We did not sell any Class T shares. In connection with this offering, we are eliminating our Class T Shares and will only have one class of common stock. On July 21, 2017, the Company filed a post-effective amendment to its registration statement relating to the Continuous Offering to terminate the Continuous Offering and deregister all of the unsold shares. The post-effective amendment was declared effective by the SEC on July 26, 2017.

The share classes contained different selling commissions, which included an ongoing distribution fee with respect to the primary offering of Class T shares. The initial offering price for the shares in the primary offering was $10.00 per Class A share and $9.58 per Class T share. We also offered up to $100 million in shares of common stock pursuant to our distribution reinvestment plan (the “DRIP”) at an initial price of $9.50 per Class A share and $9.10 per Class T share, which is 95% of the primary offering price.

Pursuant to the terms of our Continuous Offering, offering proceeds were held in an escrow account until we met the minimum offering amount of $2.0 million. On March 24, 2016, we raised the minimum offering amount and the Continuous Offering proceeds held in escrow were released to us. As of June 30, 2017, we had issued 1,103,268 shares of Class A common stock in our Continuous Offering, which consisted of the issuance of 434,783 shares to acquire a 95% interest in Estates and the issuance of 668,485 shares, including 43,456 shares issued pursuant to the DRIP, resulting in gross offering proceeds of approximately $6.2 million plus the 95% ownership interest in Estates, including approximately $412,700 of distributions reinvested through the DRIP. In connection with our incorporation and prior to the effectiveness of the Continuous Offering, we sold approximately 22,222 shares of our common stock to our Advisor for an aggregate purchase price of $200,000, at $9.00 per share, reflecting the fact that selling commissions and dealer manager fees in effect at the time of the purchase were not paid in connection with the sale. These shares were subsequently renamed as shares of Class A common stock.

 

54


Table of Contents

On July 21, 2017, we filed a post-effective amendment to the registration statement to terminate the Continuous Offering and deregister all of our unsold shares of Class A common stock and Class T common stock. The post-effective amendment was declared effective by the SEC on July 26, 2017.

On January 26, 2017, we sold 125 shares of 12.5% Series A Cumulative Non-Voting Preferred Stock, $0.01 par value per share (the “Series A Preferred Shares”), for $1,000 per Series A Preferred Share, pursuant to a private placement to 125 accredited investors, for aggregate gross proceeds of $125,000 (the “Private Offering”). We paid approximately $6,250 in commissions in connection with the sale of the Series A Preferred Shares in the Private Offering. We did not use general solicitation or advertising to market the Series A Preferred Shares. The outstanding Series A Preferred Shares are subject to redemption, at our election. In addition, the Series A Preferred Shares have a distribution and liquidation preference senior to our shares of common stock.

We intend to elect to be taxed as a REIT under Sections 856 through 860 of the Code commencing with our taxable year ending December 31, 2017, and expect to qualify as a REIT thereafter. To qualify as a REIT, we must meet a number of organizational and operational requirements, including requirements to pass the “closely-held test” and to distribute at least 90% of our “REIT taxable income,” as defined by the Code, to our stockholders. As a REIT, we will be subject to federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (a) 85% of our ordinary income, (b) 95% of our capital gain net income and (c) 100% of our undistributed income from prior years. We believe we operate in such a manner so as to qualify for taxation as a REIT under the Code, and we intend to continue to operate in such a manner, but no assurance can be given that we will operate in a manner so as to qualify as a REIT.

Components of Our Revenues and Expenses

Revenues

Net interest income. Net interest income includes income derived from mezzanine, bridge facility, and mortgage investments, reduced by the cost of the leverage used to fund these investments.

Origination and disposition fee income. Origination and disposition fee income includes income derived from loan investments and the origination of preferred equity and the disposition and prepayment penalties paid by borrowers when they repay preferred equity and loan investments.

Rental income. Rental income includes rental revenue from our multifamily properties. We anticipate that the leases we enter into for our multifamily properties will typically be for one year or less.

Other income. Other income includes ancillary income earned from tenants such as application fees, late fees, laundry fees, utility reimbursements, and other rental related fees charged to tenants.

Expenses

Provision for loan losses. Provision for loan losses includes losses on investments we believe are impaired and in jeopardy of not receiving the full amount of income we have accrued in regard to that investment.

Property operating expenses. Property operating expenses include property maintenance costs, salary and employee benefit costs, utilities and other property operating costs.

Real estate taxes and insurance. Real estate taxes include the property taxes assessed by local and state authorities depending on the location of each property. Insurance includes the cost of commercial, general liability, and other needed insurance for each property.

Property management fees. Property management fees include fees paid to BH Management Services, LLC (“BH”) or other third party management companies for managing each property.

 

55


Table of Contents

Asset management fees. Asset management fees include the fees paid to our Advisor for managing our assets pursuant to the Advisory Agreement.

Corporate general and administrative expenses. Corporate general and administrative expenses include, but are not limited to, audit, legal, filing and tax fees, directors’ and officers’ liability insurance and board of director fees as well as equity-based compensation paid to our directors and officers through any long-term incentive plans approved by our board. Corporate general and administrative expenses and the asset management fee paid to our Advisor will not exceed 2.5% of gross assets per calendar year (or part thereof that the Advisory Agreement is in effect), calculated in accordance with the Advisory Agreement. This expense cap does not limit the reimbursement by the Company of expenses related to securities offerings paid by the Advisor. The cap also does not apply to legal, accounting, financial, due diligence, and other service fees incurred in connection with mergers and acquisitions, extraordinary litigation, or other events outside the Company’s ordinary course of business or any out-of-pocket acquisition or due diligence expenses incurred in connection with the acquisition or disposition of certain real estate assets.

Property general and administrative expenses. Property general and administrative expenses include the costs of marketing, professional fees, general office supplies, and other administrative related costs of each property.

Depreciation and amortization. Depreciation and amortization costs primarily include depreciation of our multifamily properties and amortization of acquired in-place leases.

Other Income and Expense

Interest expense. Interest expense costs primarily includes the cost of interest expense on debt and the amortization of deferred financing costs. Interest expense does not include the financing costs associated with debt used to finance our investments in mezzanine, bridge and first mortgage loans, as it is included in net interest income.

Equity in income of preferred equity investments. Equity in income of preferred equity investments includes income earned on a stated investment return from preferred equity investments we originate. Equity in income on our preferred equity investments is recorded under the equity method of accounting.

Results of Operations for the Years Ended December 31, 2016, 2015 and 2014 and Six Months Ended June 30, 2017 and 2016

On August 12, 2015, the SEC declared effective our registration statement on Form S-11 (Registration No. 333-200221) related to the Continuous Offering, as described above. We had no operating activities before August 12, 2015. In accordance with GAAP, our acquisition of Estates on April 7, 2016 was determined to be a combination of entities under common control. As such, the acquisition of Estates was deemed to be made on the Original Acquisition Date. In the accompanying consolidated financial statements, operations are shown from the Original Acquisition Date, although we did not commence material operations until March 24, 2016, the date we broke escrow in the Continuous Offering, enabling us to commence material operations. On April 7, 2016, we acquired a preferred equity investment in Bell Midtown; on August 19, 2016, we originated a preferred equity investment in Stone Oak; both multifamily properties. On December 23, 2016, our preferred equity investment in Bell Midtown was redeemed in full by the entity that directly owned Bell Midtown.

As of June 30, 2017, we owned a majority interest in one multifamily property, Estates, that encompasses 330 units of apartment space that was approximately 93.3% leased with an average monthly effective rent per occupied unit of $963; we also had one preferred equity investment in a multifamily property, Springs at Stone Oak Village, that was approximately 91.7% leased with an average monthly effective rent per occupied unit of $1,095. Our preferred equity investment has a minimum monthly preferred return of 8.0% annualized and an additional preferred return of 3.0% annualized, which accrues monthly on a compounding basis if not paid. Our preferred equity investment is accounted for under the equity method of accounting.

 

56


Table of Contents

The following table sets forth a summary of our operating results for the years ended December 31, 2016, 2015 and 2014 and six months ended June 30, 2017 and 2016 (in thousands):

 

     For the Year Ended
December 31,
     For the Six Months Ended
June 30,
 
     2016     2015     2014            2017                 2016        
                        (unaudited)  

Total revenues

   $     3,884     $     1,504     $     —        $      2,024     $      1,906  

Total expenses

     4,605       2,885       —          2,330       2,293  

Operating loss

     (721     (1,381     —          (306     (387

Interest expense

     (1,511     (429     —          (726     (650

Equity in income of preferred equity investments

     727       —         —          288       166  

Net loss

     (1,505     (1,810     —          (744     (871

Net loss attributable to noncontrolling interests

     (2     (46     —          —         (6

Net income attributable to preferred stockholders

     —         —         —          7       —    

Net loss attributable to common stockholders

   $ (1,503   $ (1,764   $ —          (751     (865

The change in our net loss for the year ended December 31, 2016 as compared to the net loss for the year ended December 31, 2015 primarily relates to the timing of which our acquisition of Estates was deemed to be made, which is August 5, 2015, and the realization of equity in income on our two preferred equity investments we had during the year ended December 31, 2016, which was partially offset by a full period of corporate general and administrative expenses incurred in 2016. We did not have any preferred equity investments in 2015 and we did not begin to incur corporate general and administrative expenses until the fourth quarter of 2015. As mentioned above, we did not have any operations during the year ended December 31, 2014. The change in our net loss for the six months ended June 30, 2017 as compared to the net loss for the six months ended June 30, 2016 primarily relates to an increase in the realization of equity in income on our preferred equity investment during the period in 2017, and was partially offset by increases in asset management fees and interest expense.

Our results of operations for the six months ended June 30, 2017 and June 30, 2016 and for the years ended December 31, 2016 and 2015 are not indicative of those expected in future periods. We expect to make future investments, which would have a significant impact on our future results of operations. In general, we expect that our income and expenses related to our portfolio will increase in future periods as a result of anticipated future investments.

Revenues

Net interest income. Net interest income was $0 for the years ended December 31, 2016 and 2015. For the six months ended June 30, 2017 and 2016, net interest income was $0.

Disposition fee income. Disposition fee income was $0 for the years ended December 31, 2016 and 2015. For the six months ended June 30, 2017 and 2016, disposition fee income was $0.

Rental income. Rental income was $3.4 million for the year ended December 31, 2016 compared to $1.4 million for the year ended December 31, 2015, which was an increase of approximately $2.0 million. This increase was due to owning Estates for the entire year in 2016 as compared to only half of the year in 2015. For the six months ended June 30, 2017 and 2016, rental income was $1.8 million and $1.7 million, respectively, which was an increase of approximately $0.1 million.

Other income. Other income was $0.4 million for the year ended December 31, 2016 compared to $0.1 million for the year ended December 31, 2015, which was an increase of approximately $0.3 million. For the six months ended June 30, 2017 and 2016, other income remained flat at $0.2 million.

 

57


Table of Contents

Expenses

Provision for loan losses. For the years ended December 31, 2016 and 2015 and for the six months ended June 30, 2017 and 2016, we incurred no provision for loan losses.

Property operating expenses. Property operating expenses were $0.9 million for the year ended December 31, 2016 compared to $0.4 million for the year ended December 31, 2015, which was an increase of approximately $0.5 million. This increase was due to owning Estates for the entire year in 2016 as compared to owning Estates for half of the year in 2015. For the six months ended June 30, 2017 and 2016, property operating expenses was $0.5 million and $0.4 million, respectively, which was an increase of less than $0.1 million.

Acquisition costs. We did not incur any acquisition costs during the year ended December 31, 2016. Acquisition costs of $0.1 million were expensed for the year ended December 31, 2015, which related to the acquisition of Estates. Acquisition costs depend on the specific circumstances of each closing and are one-time costs associated with each acquisition. We expect to capitalize future acquisition costs under Accounting Standards Update 2017-01, which we adopted October 1, 2016.

Real estate taxes and insurance. Real estate taxes and insurance costs were $0.4 million for the year ended December 31, 2016 compared to $0.2 million for the year ended December 31, 2015, which was an increase of approximately $0.2 million. For the six months ended June 30, 2017 and 2016, real estate taxes and insurance costs remained flat at $0.2 million. The costs for property taxes incurred in the first year of ownership may be significantly less than subsequent years since the purchase price of the property may trigger a significant increase in assessed value by the taxing authority in subsequent years, increasing the costs of real estate taxes.

Property management fees. Property management fees were $0.1 million for the year ended December 31, 2016 compared to less than $0.1 million for the year ended December 31, 2015, which was an increase of less than $0.1 million. For the six months ended June 30, 2017 and 2016, property management fees remained flat at $0.1 million.

Asset management fees. Asset management fees were $0.3 million for the year ended December 31, 2016. We did not incur any asset management fees during the year ended December 31, 2015 as we did not manage any assets during the period. For the six months ended June 30, 2017 and 2016, asset management fees were $0.2 million and $0.1 million, respectively, which was an increase of approximately $0.1 million. We did not incur any asset management fees for the three months ended March 31, 2016 as we did not have any real estate assets during the period.

Corporate general and administrative expenses. Corporate general and administrative expenses were $1.1 million for the year ended December 31, 2016 compared to $0.3 million for the year ended December 31, 2015, which was an increase of approximately $0.8 million. The increase between periods primarily relates to us incurring a full period of corporate general and administrative expenses in 2016 compared to only part of the year in 2015. For the six months ended June 30, 2017 and 2016, corporate general and administrative expenses remained flat at $0.5 million.

Fees to affiliates. We did not incur any fees to affiliates during the year ended December 31, 2016. Fees to affiliates were $0.4 million for the year ended December 31, 2015 and consisted of an acquisition fee payable to our Advisor in connection with the acquisition of Estates. For the six months ended June 30, 2017 and 2016, fees to affiliates was $0 million.

Organization expenses. Organization expenses were less than $0.1 million for the year ended December 31, 2016. We did not recognize any organization expenses during the year ended December 31, 2015, as we did not break escrow until 2016. For the six months ended June 30, 2017 and 2016, organization expenses remained flat at less than $0.1 million.

 

58


Table of Contents

Property general and administrative expenses. Property general and administrative expenses remained flat at $0.1 million for the year ended December 31, 2016 and 2015. For the six months ended June 30, 2017 and 2016, property general and administrative expenses remained flat at $0.1 million.

Depreciation and amortization. Depreciation and amortization costs were $1.6 million for the year ended December 31, 2016 compared to $1.3 million for the year ended December 31, 2015, which was an increase of approximately $0.3 million. For the six months ended June 30, 2017 and 2016, depreciation and amortization was $0.8 million and $0.9 million, respectively, which was a decrease of approximately $0.1 million.

Other Income and Expense

Interest expense. Interest expense costs were $1.5 million for the year ended December 31, 2016 compared to $0.4 million for the year ended December 31, 2015, which was an increase of approximately $1.1 million. For the six months ended June 30, 2017 and 2016, interest expense was flat at $0.7 million. We expect interest expense costs to increase in future periods as a result of future investments. The following is a table that details the various costs included in interest expense for the years ended December 31, 2016, 2015 and 2014 and the six months ended June 30, 2017 and 2016 (in thousands):

 

     For the Year Ended
December 31,
     For the Six Months Ended
June 30,
 
     2016      2015      2014            2017                  2016        

Interest on debt

   $     1,319      $     409      $     —        $         644      $         586  

Amortization of deferred financing costs

     192        20        —          81        64  

Interest rate cap expense

     —          —          —          1        —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,511      $ 429      $ —        $     726      $     650  

Equity in income of preferred equity investments. Equity in income of preferred equity investments was $0.7 million for the year ended December 31, 2016. We did not have any preferred equity investments during the year ended December 31, 2015. For the six months ended June 30, 2017 and 2016, equity in income of preferred equity investments was $0.3 million and $0.2 million, respectively, which was an increase of approximately $0.1 million. Equity in income of preferred equity investments may increase in future periods as a result of future originations of preferred equity investments.

Non-GAAP and Key Financial Measures and Indicators

As a real estate specialty finance company, we believe the key financial measures and indicators for our business are Core Earnings, CAD, ACAD, NOI and adjusted book value per share.

We believe providing Core Earnings, cash available for distributions (“CAD”), adjusted cash available for distributions (“ACAD”) and net operating income for real estate owned (“NOI”), which are non-GAAP measures of performance, on a supplemental basis to our net income as determined in accordance with GAAP is helpful to stockholders in assessing the overall performance of our business. We believe providing adjusted book value per share, which is a non-GAAP measure, on a supplemental basis is helpful to stockholders in assessing the overall performance of our business. The key financial measures and indicators should not be considered as a substitute for GAAP net income. We caution that our methodology for calculating these key financial measures and indicators may differ from the methodologies employed by other REITs to calculate the same or similar supplemental performance measures, and as a result, our reported key financial measures and indicators may not be comparable to similar measures presented by other REITs.

 

59


Table of Contents

Adjusted Book Value per Share

We believe that adjusted book value per share, which is a non-GAAP measure, is helpful to stockholders in evaluating the growth of our company as we have scaled our equity capital base and continue to invest in our target assets. We calculate adjusted book value per share by adding accumulated depreciation on real estate owned back to stockholders’ equity and adjusting for preferred stockholders noncontrolling interests. The following table calculates our adjusted book value per share of common stock (amounts in thousands, except share and per share data):

 

    As of
December 31,
    As of
June 30,
 
    2016     2015     2014     2017  
                      (Unaudited)  

Stockholders’ equity

  $     5,997     $     2,418     $     200     $     6,445  

Accumulated depreciation

    1,927       1,328       —         2,708  

Adjustment for preferred stockholders

    —         —         —         (125

Adjustment for noncontrolling interests

    (96     (66     —         (135

Adjusted book value

  $ 7,828     $ 3,680     $ 200     $ 8,893  

Shares:

       

Common stock

    976       457       22       1,128  

Restricted shares

    12       —         —         9  

Total shares, diluted

    988       457       22       1,137  

Adjusted book value per share, diluted

  $ 7.92     $ 8.05     $ 9.09     $ 7.82  

Core Earnings

Core Earnings is a non-GAAP financial measure of performance used to measure the performance of preferred equity, structured finance, mezzanine, bridge financing, and mortgage investments. We believe that Core Earnings provides meaningful information that is used by investors, analysts and our management to evaluate and compare the performance of our investments to other comparable investments, to determine trends in earnings and to compute the fair value of our investments as Core Earnings is not affected by certain transactions and GAAP adjustments that we believe are not necessarily indicative of our current portfolio and operations. Additionally, Core Earnings will be used in the calculation of asset management fees payable to our Advisor. Core Earnings does not represent net income or cash flows from operating activities and should not be considered as an alternative to GAAP net income, an indication of our GAAP cash flows from operating activities, a measure of our liquidity or an indication of funds available for our cash needs. In addition, our methodology for calculating Core Earnings may differ from the methodologies employed by other companies to calculate the same or similar supplemental performance measures and, accordingly, our reported Core Earnings may not be comparable to the Core Earnings reported by other companies. We calculate Core Earnings by adjusting net loss attributable to common stockholders by adding back incentive compensation expenses related to our long-term incentive plan (the “LTIP”), depreciation calculated on real estate owned and noncontrolling interests.

 

60


Table of Contents

The following table provides a reconciliation of Core Earnings to GAAP net loss attributable to common stockholders, the most directly comparable GAAP financial measure (dollars in thousands, except per share data):

 

    For the Year Ended
December 31,
    For the Six Months Ended
June 30,
 
    2016     2015     2014           2017                 2016        

Net loss attributable to common stockholders (a)

  $ (1,503   $ (1,764   $     —       $ (751   $ (865

Adjustments:

         

Amortization of stock-based compensation

    21       —         —         15       6  

Depreciation and amortization

    1,603           1,328       —         781                868  

Adjustment for noncontrolling interests

    (80     (66     —         (39     (43

Core earnings attributable to common stockholders

  $ 41     $ (502   $ —       $ 6     $ (34

Weighted average number of common shares outstanding (b):

         

Basic

    678       200       22       1,071       575  

Diluted

    687       200       22             1,082       580  

Core earnings per common share:

         

Basic

  $ 0.06     $ (2.51   $ —       $ 0.01     $ (0.06

Diluted

  $       0.06     $ (2.51   $ —       $ 0.01     $ (0.06

 

(a) Represents net loss attributable to holders of our common stock.
(b) Weighted average number of shares outstanding includes shares of our common stock.

Cash Available for Distributions (“CAD”)

CAD is a non-GAAP financial measure. We believe that CAD provides meaningful information that is used by investors, analysts and our management to evaluate and determine trends in cash flow as CAD is not affected by non-cash items. CAD is also a useful measure used by our board to determine our dividend and the long-term viability of the current dividend. CAD does not represent net income or cash flows from operating activities and should not be considered as an alternative to GAAP net income, an indication of our GAAP cash flows from operating activities, a measure of our liquidity or an indication of funds available for our cash needs. In addition, our methodology for calculating CAD may differ from the methodologies employed by other companies to calculate the same or similar supplemental performance measures and, accordingly, our reported CAD may not be comparable to the CAD reported by other companies.

We calculate CAD by adjusting net income (loss) attributable to common shareholders by adding back depreciation and amortization on real estate, acquisition costs, fees paid to affiliates, amortization of deferred financing costs, amortization of equity-based compensation and changes in the fair value of our financial instruments and by removing noncash equity in income of preferred equity investments and adjustments for noncontrolling interests.

 

61


Table of Contents

The following table provides a reconciliation of CAD to GAAP net loss attributable to common shareholders, the most directly comparable GAAP financial measure (in thousands, except per share amounts):

 

     For the Year Ended
December 31,
     For the Six Months Ended
June 30,
 
     2016     2015     2014            2017                 2016        

Net loss attributable to common stockholders

   $ (1,503   $ (1,764   $ —        $ (751   $ (865

Depreciation and amortization

     1,603       1,328       —        $ 781     $ 868  

Acquisition costs

     —         147       —          —         —    

Fees to affiliates

     —         396       —        $ —       $ —    

Amortization of deferred financing costs

     192       20       —          81       64  

Noncash equity in income of preferred equity investments

     (59     —         —          (79     —    

Amortization of stock-based compensation

     21       —         —          15       6  

Changes in fair value on derivative instruments included in interest expense

     7       19       —          1       —    

Adjustment for noncontrolling interests

     (83     (76     —          (41     (44

CAD attributable to common stockholders

   $ 178     $ 70     $ —        $ 7     $ 29  

Weighted average number of common shares outstanding (a):

           

Basic

     678       200       22        1,071       575  

Diluted

     687       200       22        1,082       580  

CAD per common share — basic

   $ 0.26     $ 0.35     $ —        $ 0.01     $ 0.05  

CAD per common share — diluted

   $       0.26     $       0.35     $     —        $ 0.01     $ 0.05  

 

(a) Weighted average number of shares outstanding includes shares of our common stock.

Adjusted Cash Available for Distributions (“ACAD”)

ACAD is a non-GAAP financial measure that further adjusts CAD. We believe that ACAD provides meaningful information that is used by investors, analysts and our management to evaluate and determine longer-term trends in cash flow as ACAD adds back the non-cash equity in income of preferred equity investments and origination and disposition fee income to CAD. ACAD is also a useful measure used by our board to determine longer-term viability of the current dividend. ACAD does not represent net income or cash flows from operating activities and should not be considered as an alternative to GAAP net income, an indication of our GAAP cash flows from operating activities, a measure of our liquidity or an indication of funds available for our cash needs. In addition, our methodology for calculating ACAD may differ from the methodologies employed by other companies to calculate the same or similar supplemental performance measures and, accordingly, our reported ACAD may not be comparable to the ACAD reported by other companies.

We calculate ACAD by modifying CAD by adding back noncash equity in income of preferred equity investments.

 

62


Table of Contents

The following table provides a reconciliation of ACAD to net loss attributable to common stockholders, the most directly comparable GAAP financial measure (in thousands, except per share amounts):

 

     For the Year Ended
December 31,
     For the Six Months Ended
June 30,
 
     2016     2015     2014            2017                 2016        

Net loss attributable to common stockholders

   $ (1,503   $ (1,764   $ —        $ (751   $ (865

Depreciation and amortization

     1,603       1,328       —        $ 781     $ 868  

Acquisition costs

     —         147       —          —         —    

Fees to affiliates

     —         396       —        $ —       $ —    

Amortization of deferred financing costs

     192       20       —          81       64  

Noncash equity in income of preferred equity investments

     (59     —         —          (79     —    

Amortization of stock-based compensation

     21       —         —          15       6  

Changes in fair value on derivative instruments included in interest expense

     7       19       —          1       —    

Adjustment for noncontrolling interests

     (83     (76     —          (41     (44

CAD attributable to common stockholders

   $ 178     $ 70     $ —        $ 7     $ 29  

Noncash equity in income of preferred equity investments

     59       —         —          79       —    

ACAD attributable to common stockholders

   $ 237     $ 70     $ —          86       29  

Weighted average number of common shares outstanding (a):

           

Basic

     678       200       22        1,071       575  

Diluted

     687       200       22        1,082       580  

ACAD per common share — basic

   $ 0.35     $ 0.35     $ —        $ 0.08     $ 0.05  

ACAD per common share — diluted

   $       0.34     $       0.35     $     —        $     0.08     $     0.05  

 

(a) Weighted average number of shares outstanding includes shares of our common stock.

Net Operating Income for Real Estate Owned (NOI)

Net Operating Income (“NOI”) is a non-GAAP financial measure used to measure performance for our direct property interests. We believe that NOI provides meaningful information that is used by investors, analysts and our management to evaluate and compare the performance of our properties to other comparable properties, to determine trends in earnings and to compute the fair value of our properties as NOI is not affected by the cost of funds, non-operating fees to affiliates, the impact of depreciation and amortization expenses as well as gains or losses from the sale of operating real estate assets that are included in net income computed in accordance with GAAP, corporate general and administrative expenses, other gains and losses that are specific to us, equity in income recognized on unconsolidated joint ventures, and expenses that are not reflective of the ongoing operations of the properties or are incurred on our behalf at the property for expenses such as legal, professional and franchise tax fees.

NOI is a measure of the operating performance of our properties but does not measure our performance as a whole. NOI is therefore not a substitute for net income (loss) as computed in accordance with GAAP. This measure should be analyzed in conjunction with net income (loss) computed in accordance with GAAP and discussions elsewhere in “— Results of Operations for the Years Ended December 31, 2016, 2015 and 2014 and Six Months Ended June 30, 2017 and 2016” regarding the components of net income (loss) that are eliminated in the calculation of NOI. Other companies may use different methods for calculating NOI or similarly entitled measures and, accordingly, our NOI may not be comparable to similarly entitled measures reported by other companies that do not define the measure exactly as we do.

However, the usefulness of NOI is limited because it excludes corporate general and administrative expenses, interest expense, interest income and other expense, acquisition costs, certain fees to affiliates,

 

63


Table of Contents

depreciation and amortization expense, gains or losses from the sale of properties, equity in income from unconsolidated joint ventures, other gains and losses as stipulated by GAAP, and the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties, all of which are significant economic costs or factors. NOI may fail to capture significant trends in these components of net income (loss) which further limits its usefulness.

We calculate NOI by adjusting net income (loss) attributable to shareholders by adding back asset management fees, corporate general and administrative expenses, fees paid to affiliates, organization expenses, property general and administrative expenses, depreciation and amortization, interest expense and origination and disposition fee income and by removing equity in income of preferred equity investments.

The following table, which has not been adjusted for the effects of any noncontrolling interests, provides a reconciliation of NOI to net loss, the most directly comparable GAAP financial measure (in thousands):

 

    For the Year Ended
December 31,
    For the Six Months Ended
June 30,
 
    2016     2015     2014           2017                  2016        

Net loss

  $ (1,505   $ (1,810   $ —       $ (744    $ (871

Adjustments to reconcile net loss to NOI:

          

Asset management fees

    273       —         —         173        82  

Corporate general and administrative expenses

    1,084       337       —         524        531  

Fees to affiliates

    —         396       —         —          —    

Organization expenses

    41       —         —         14        15  

Property general and administrative expenses (1)

    5       18       —         9        4  

Depreciation and amortization

    1,603       1,328       —         781        868  

Interest expense

    1,511       429       —         726        650  

Equity in income of preferred equity investments

    (727     —         —         (288      (166
 

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

NOI

  $       2,285     $       698     $     —       $     1,195      $     1,113  

 

(1) Adjustment to net loss excludes expenses that are not reflective of the ongoing operations of the property or were incurred on our behalf at the property for expenses such as legal and other professional fees.

Liquidity and Capital Resources

Our principal demands for funds are for mezzanine debt, preferred equity, bridge financing, first mortgage loans and alternative structured financing investments, for the payment of operating expenses and distributions, and for the payment of principal and interest on any outstanding indebtedness. Generally, cash needs for items other than originations are met from operations, and cash needs for originations will be funded by proceeds from this offering and the concurrent private placement and debt.

There may be a delay between the sale of our shares and originations of mezzanine loans, other structured financing investment and preferred equity which could result in a delay in the benefits to our stockholders, if any, of returns generated from our investment operations. We do not expect our target leverage ratio to exceed 25%-35% of our mezzanine debt, preferred equity and other structured financing investments.

Our Advisor evaluates potential investments and engages in negotiations with sellers and lenders on our behalf. After a purchase contract is executed that contains specific terms, the investment will not be made until the successful completion of due diligence, which includes review of the title insurance commitment, an appraisal and an environmental analysis. In some instances, the proposed investment will require the negotiation

 

64


Table of Contents

of final binding agreements, which may include financing documents. During this period, we may decide to temporarily invest any unused proceeds from this offering and the concurrent private placement in certain investments that could yield lower returns than investments we intend to make. These lower returns may affect our ability to make distributions.

Potential future sources of capital include proceeds from secured or unsecured financings from banks or other lenders, proceeds from the sale of properties, the repayment or redemption of our investments and undistributed cash flow. If necessary, we may use financings or other sources of capital in cases of unforeseen significant capital expenditures. We have not identified any sources of such financing.

Cash Flows

The following table presents selected data from our consolidated statements of cash flows for the years ended December 31, 2016, 2015 and 2014 and for the six months ended June 30, 2017 and June 30, 2016 (in thousands):

 

     For the Year Ended
December 31,
     For the Six Months Ended
June 30,
 
     2016     2015     2014            2017                 2016        

Net cash provided by operating activities

   $ 767     $ 471     $     —        $ 139     $ 314  

Net cash used in investing activities

     (6,415     (41,081     —          (93     (6,383

Net cash provided by financing activities

     5,362       41,379       200        1,122            5,999  

Net increase (decrease) in cash and restricted cash

     (286     769       200        1,168       (70

Cash and restricted cash, beginning of period

     969       200       —          683       969  

Cash and restricted cash, end of period

   $ 683     $ 969     $ 200      $     1,851     $ 899  

On August 12, 2015, the SEC declared our registration statement related to the Continuous Offering effective, as described above. We had no operating activities before August 12, 2015. In accordance with GAAP, our acquisition of Estates on April 7, 2016 was determined to be a combination of entities under common control. As such, the acquisition of Estates was deemed to be made on the Original Acquisition Date by Highland. In the accompanying consolidated financial statements, operations are shown from the Original Acquisition Date, although we did not commence material operations until March 24, 2016, the date we broke escrow in the Continuous Offering, enabling us to commence material operations. On April 7, 2016, we acquired a preferred equity investment in Bell Midtown; on August 19, 2016, we originated a preferred equity investment in Stone Oak; both multifamily properties. On December 23, 2016, our preferred equity investment in Bell Midtown was redeemed in full by the entity that owned Bell Midtown. Our overall cash flows from operating, investing, and financing activities for the years ended December 31, 2016 and 2015 and for the six months ended June 30, 2017 and 2016 are not indicative of those expected in future periods. We expect to continue to raise additional capital, increase our borrowings and make future investments, which would have a significant impact on our future results of operations and overall cash flows.

Cash Flows from Operating Activities

During the year ended December 31, 2016, net cash provided by operating activities was $0.8 million compared to net cash provided by operating activities of $0.5 million for the year ended December 31, 2015 and $0 million for the year ended December 31, 2014. The increase in net cash from operating activities was mainly due to changes in net loss and non-cash contributions, offset by changes in depreciation and amortization. During the six months ended June 30, 2017, net cash provided by operating activities was approximately $0.1 million compared to net cash provided by operating activities of $0.3 million for the six months ended June 30, 2016. The change in cash flows from operating activities was mainly due to changes in working capital.

 

65


Table of Contents

Cash Flows from Investing Activities

During the year ended December 31, 2016, net cash used in investing activities was $6.4 million compared to net cash used in investing activities of $41.1 million for the year ended December 31, 2015 and $0 million for the year ended December 31, 2014. The change in cash flows from investing activities was mainly due to the origination of two preferred equity investments for a combined $11.25 million, partially offset by the redemption of the preferred equity investments of $6.0 million in Bell Midtown, during the period in 2016, compared to the acquisition of one property for a purchase price of $41.2 million during the period in 2015. Our cash used in investing activities will vary based on our acquisitions of properties and originations of preferred equity investments. During the six months ended June 30, 2017, net cash used in investing activities was approximately $0.1 million compared to net cash used in investing activities of $6.4 million for the six months ended June 30, 2016. The change in cash flows from investing activities was mainly due to the origination of a preferred equity investment of $6.0 million in Bell Midtown during the period in 2016, compared to no originations of preferred equity investments during the period in 2017.

Cash Flows from Financing Activities

During the year ended December 31, 2016, net cash provided by financing activities was $5.4 million compared to net cash provided by financing activities of $41.4 million for the year ended December 31, 2015 and $0.2 million for the year ended December 31, 2014. The change in cash flows from financing activities was mainly due $4.6 million of proceeds received in the Continuous Offering during the period in 2016 compared to the acquisition of one property for a purchase price of $41.2 million during the period in 2015, which was funded through debt and capital contributions compared to the sale of $0.2 million of our common stock to our Advisor in 2014. During the six months ended June 30, 2017, net cash provided by financing activities was $1.1 million compared to net cash provided by financing activities of $6.0 million for the six months ended June 30, 2016. The change in cash flows from financing activities was mainly due to an increase in net debt proceeds of approximately $4.1 million during the period in 2016, compared to no debt activity during the period in 2017. The change in cash flows from financing activities was also due to $1.1 million of proceeds received in the Continuous Offering during the period in 2017 compared to $2.0 million during the period in 2016.

Mortgage Indebtedness

As of June 30, 2017, one of our subsidiaries had mortgage indebtedness to a third party of approximately $26.9 million at an interest rate of 3.12%. For additional information regarding our mortgage indebtedness, see Note 7 to our unaudited consolidated financial statements.

We entered into and expect to continue to enter into interest rate cap agreements with various third parties to cap the variable interest rates on a majority of floating rate mortgage indebtedness we may incur. These agreements generally have a term of three to four years and cover the outstanding principal amount of the underlying indebtedness. Under these agreements, we pay a fixed fee in exchange for the counterparty to pay any interest above a maximum rate. At June 30, 2017, we had one interest rate cap agreement that covered our $26.9 million of outstanding floating rate mortgage indebtedness. This interest rate cap agreement caps the related variable interest rate of our mortgage indebtedness at 6.0%.

Our subsidiary has a separate non-recourse mortgage, which is secured only by Estates. This non-recourse mortgage has standard scope non-recourse carve outs required by the agency lender and calls for protection by the borrower and the guarantor against losses by the lender for so-called “bad acts,” such as misrepresentations, and may include full recourse liability for more significant events such as bankruptcy. An affiliate of our property manager, BH, provided a non-recourse carve out guarantee for this mortgage.

We expect that future investments, including any improvements or renovations of current or newly-acquired properties, will depend on and will be financed by, in whole or in part, our existing cash, future borrowings and

 

66


Table of Contents

proceeds from this offering and the concurrent private placement. In addition, we may seek financing from U.S. government agencies, including through Freddie Mac and Fannie Mae, and the U.S. Department of Housing and Urban Development, in appropriate circumstances in connection with the acquisition or refinancing of existing mortgage loans.

Although we expect to be subject to restrictions on our ability to incur indebtedness, we expect that we will be able to refinance existing indebtedness or incur additional indebtedness for investments or other purposes, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

Furthermore, following the completion of any value-add and capital expenditures programs we may implement and depending on the interest rate environment at the applicable time, we may seek to refinance any floating rate mortgage debt into longer-term fixed rate debt at lower leverage levels.

Credit Facility

As of June 30, 2017, we, through our OP, had $11.0 million outstanding under the Credit Facility at an interest rate of 5.22%. On April 7, 2017, our OP and Highland amended the Credit Facility to extend the maturity date to June 30, 2017 and terminate the revolving feature of the Credit Facility. We paid an amendment fee of $27,500 in connection with the Second Amendment. On June 30, 2017, our OP and Highland amended the Credit Facility to extend the maturity date to October 2, 2017. In conjunction with the amendment on June 30, 2017, the affiliate of BH Equity was released and discharged of the guarantee it had previously provided on the Credit Facility. We continue to be in discussions with KeyBank to further extend the maturity date, alleviating the need to repay the Credit Facility in full on October 2, 2017. If we are unable to extend the maturity date of the Credit Facility, are unable to complete this offering prior to October 2, 2017, or we do not have sufficient cash on hand to repay the outstanding principal balance on the maturity date, there is sufficient liquid collateral, in the form of registered equity securities (the “Collateral”), pledged from an affiliate of Highland to satisfy our obligations. The Collateral had a fair market value of approximately $23.4 million as of June 30, 2017. If the Collateral were used to satisfy our obligations on the Credit Facility, we may issue shares of our common stock in an amount equal to the obligations that are relieved from the application of the Collateral. We do not believe there is a scenario where repayment of the Credit Facility would create a going concern issue for us whereby we would not be able to fund our operations for the next 12 months.

The Credit Facility agreement, as amended, contains customary provisions with respect to events of default, covenants and borrowing conditions. Certain prepayments may be required upon a breach of covenants or borrowing conditions. As of June 30, 2017, we believe we are in compliance with all covenant provisions. For more information regarding the Credit Facility, see Note 7 to our unaudited consolidated financial statements.

Debt-to-Equity Ratio and Total Leverage Ratio

The following table presents our debt-to-equity ratio and total leverage ratio:

 

     As of December 31,      As of June 30,  
     2016      2015      2014      2017      2016  

Debt-to-equity ratio (1)

     6.02x        14.47x        —          5.53x        9.93x  

Total leverage ratio (2)

     6.02x        14.47x        —          5.53x        9.93x  

 

(1) Represents (1) total outstanding borrowings under secured debt agreements, less cash to (2) total stockholders’ equity, in each case at period end.
(2) Represents (1) total outstanding borrowings under secured debt agreements plus non-consolidated senior interests (if any), less cash, to (2) total stockholders’ equity, in each case at period end.

 

67


Table of Contents

Obligations and Commitments

The following table summarizes our contractual obligations and commitments for the next five calendar years as of June 30, 2017. Interest expense due by period on our floating rate debt is based on one-month LIBOR, which was 1.2239% as of June 30, 2017.

 

     Payments Due by Period (in thousands)  
     Total      2017      2018      2019      2020      2021      Thereafter  

Mortgage Debt

                    

Principal payments

   $     26,919      $         —        $     —        $     —        $     26,919      $     —        $     —    

Interest expense

     2,706        430        853     

 

853

 

     570        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 29,625      $ 430      $ 853      $ 853      $ 27,489      $ —        $ —    

Credit Facility

                    

Principal payments

   $ 11,000      $ 11,000      $ —        $ —        $ —        $ —        $ —    

Interest expense

     150        150        —          —          —          —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 11,150      $ 11,150      $ —        $ —        $ —        $ —        $ —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations and commitments

   $ 40,775      $ 11,580      $ 853      $ 853      $ 27,489      $ —        $ —    

Income Taxes

We intend to elect to be taxed as a REIT for U.S. federal income tax purposes commencing with our taxable year ending December 31, 2017, and we intend to operate in a manner that will permit us to qualify as a REIT. To qualify as a REIT, we must meet certain organizational and operational requirements, including requirements to pass the “closely-held test” and to distribute at least 90% of our annual REIT taxable income to stockholders. As a REIT, we will be subject to federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (a) 85% of our ordinary income, (b) 95% of our capital gain net income and (c) 100% of our undistributed income from prior years. If we fail to qualify as a REIT in any taxable year, we will be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate income tax rates, and dividends paid to our stockholders would not be deductible by us in computing taxable income. Any resulting corporate liability could be substantial and could materially and adversely affect our net income and net cash available for distribution to stockholders. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from re-electing to be taxed as a REIT for the four taxable years following the year in which we failed to qualify to be taxed as a REIT.

We evaluate the accounting and disclosure of tax positions taken or expected to be taken in the course of preparing our tax returns to determine whether the tax positions are “more-likely-than-not” (greater than 50 percent probability) of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold would be recorded as a tax benefit or expense in the current year. Our management is required to analyze all open tax years, as defined by the statute of limitations, for all major jurisdictions, which include federal and certain states. We have no examinations in progress and none are expected at this time.

If we do not meet the qualifications to be taxed as a REIT, we will be taxed as a corporation for U.S. federal income tax purposes. For prior taxable years we have been treated as a C-corporation for U.S. federal income tax purposes. Therefore, we provide for income taxes for that year using the asset and liability method under ASC 740. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and

 

68


Table of Contents

their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize our tax positions and evaluate them by determining whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. We will determine the amount of benefit to recognize and record the amount that is more likely than not to be realized upon ultimate settlement. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.

We had no material unrecognized tax benefit or expense, accrued interest or penalties as of June 30, 2017. Our subsidiaries and us may be subject to federal income tax as well as income tax of various state and local jurisdictions. When applicable, we recognize interest and/or penalties related to uncertain tax positions on our consolidated statements of operations and comprehensive loss.

Deferred Tax Assets

Deferred income taxes arise principally from temporary differences between book and tax recognition of income, expenses, and losses relating to financing and other transactions. As of December 31, 2016 and June 30, 2017, we recognized total deferred tax assets, net of valuation allowances, based on the fact that we intend not to elect to be taxed as a REIT for the 2016 tax year. The deferred income taxes on the accompanying consolidated balance sheets at December 31, 2016 and June 30, 2017 (unaudited) are comprised of the following (in thousands):

 

     December 31, 2016      June 30, 2017  

Net operating loss

   $ 309      $ 497  

Partnership temporary differences

     75        148  

Unreimbursed expenses

     32        32  
  

 

 

    

 

 

 

Total deferred tax assets

     416        677  

Valuation allowance

     (416      (677
  

 

 

    

 

 

 

Net deferred tax assets

   $ —        $ —    
  

 

 

    

 

 

 

The valuation allowances at December 31, 2016 and June 30, 2017 were primarily related to incurring cumulative net operating losses without generating sufficient future taxable income to recover the deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable losses and projections for future taxable income over the periods in which the deferred tax assets are deductible. Management believes it is more likely than not that the Company will not realize the benefits of these deductible differences at June 30, 2017.

Distributions

Our board of directors has declared daily distributions on our Class A common stock through September 30, 2017 that are paid on a monthly basis. We expect to pay distributions quarterly after the close of this offering unless our results of operations, our general financial condition, general economic conditions or other factors prohibit us from doing so.

 

69


Table of Contents

The common stock distributions declared and paid since inception and ended June 30, 2017, along with the amount of distributions reinvested pursuant to the DRIP were as follows:

 

                   Distributions Paid (3)  

Period (Year ended December 31)

   Distributions
Declared (1)
     Distributions
Declared Per
Share (2)
     Cash      Reinvested      Total  

Third Quarter 2016

   $ 69,700      $ 0.100      $ 10,800      $ 22,700      $ 33,500  

Fourth Quarter 2016

     134,300        0.151        1,200        117,000        118,200  

First Quarter 2017

     153,000        0.148        3,300        143,700        147,000  

Second Quarter 2017

     168,400        0.149        35,300        129,300        164,600  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $     525,400      $     0.548      $     50,600      $     412,700      $     463,300  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes distributions due, which are payable in cash upon vesting, on the 12,000 restricted shares of common stock we have granted pursuant to our restricted share plan, 9,000 of which remain unvested as of June 30, 2017.
(2) Based on number of days each share was issued and outstanding during the period presented.
(3) Distributions are paid on a monthly basis. Distributions for all record dates of a given month are paid approximately three days following month end.

For the six months ended June 30, 2017, we paid aggregate distributions on our shares of common stock of approximately $311,600, including approximately $38,600 of distributions paid in cash and 28,747 shares of our common stock issued pursuant to our DRIP for approximately $273,000. For the six months ended June 30, 2017, our net loss was approximately $0.7 million, and we had net cash provided by operating activities of approximately $0.1 million. We funded approximately $139,000, or 44%, of total distributions paid, including shares issued pursuant to our DRIP, from net cash provided by operating activities and approximately $179,300, or 56%, from net public offering proceeds.

On July 26, 2017, in connection with the termination of the Continuous Offering, the DRIP was terminated. As a result of the termination of the DRIP, beginning with the distributions declared by our board of directors for the month of July 2017, and continuing until such time as our board of directors may approve the resumption of the DRIP, if ever, all distributions declared by our board of directors will be paid to our stockholders in cash.

We expect to begin paying distributions to our stockholders quarterly subsequent to this offering. Distributions are paid to our stockholders when and if authorized by the board of directors and declared by us out of legally available funds. Distributions are authorized at the discretion of the board of directors, which is influenced in part by its intention to comply with the REIT requirements of the Code. We intend to make distributions sufficient to meet the annual distribution requirement and to avoid U.S. federal income and excise taxes on our earnings; however, it may not always be possible to do so. The funds we receive from operations that are available for distribution may be affected by a number of factors, including the following:

 

    the amount of time required for us to invest the funds received in the offering and the concurrent private placement;

 

    our operating and interest expenses;

 

    operating results of our properties;

 

    the amount of distributions or dividends received by us from our indirect real estate investments;

 

    our ability to keep our properties occupied;

 

    our ability to maintain or increase rental rates when renewing or replacing current leases;

 

    capital expenditures and reserves for such expenditures;

 

70


Table of Contents
    the issuance of additional shares; and

 

    financings and refinancings.

We must annually distribute at least 90% of our REIT taxable income (which does not equal net income as calculated in accordance with GAAP), determined without regard to the deduction for dividends paid and excluding net capital gain, in order to meet the requirements for qualification as a REIT under the Code. The board of directors may authorize distributions in excess of this percentage as it deems appropriate. Because we may receive income or rents at various times during our fiscal year, distributions may not reflect our income earned in that particular distribution period, but may be made in anticipation of cash flow that we expect to receive during a later period and may be made in advance of actual receipt of funds in an attempt to make distributions relatively uniform. To allow for such differences in timing between the receipt of income and the payment of expenses, and the effect of required debt payments, among other things, we could be required to borrow funds from third parties on a short-term basis, issue new securities, or sell assets to meet the distribution requirements that are necessary to achieve the tax benefits associated with qualifying as a REIT. These methods of obtaining funding could affect future distributions by increasing operating costs and decreasing available cash. In addition, such distributions may constitute a return of capital.

Distributions in kind will not be permitted, except for:

 

    distributions of readily marketable securities;

 

    distributions of beneficial interests in a liquidating trust established for our dissolution and the liquidation of our assets in accordance with the terms of our charter; or

 

    distributions of in-kind property, so long as, with respect to such in-kind property, the board of directors advises each stockholder of the risks associated with direct ownership of the property, offers each stockholder the election of receiving in-kind property distributions, and distributes in-kind property only to those stockholders who accept the directors’ offer.

Off-Balance Sheet Arrangements

As of June 30, 2017, we had no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. As of June 30, 2017, we own an interest in one joint venture that is accounted for under the equity method as we exercise significant influence over, but do not control, the investee.

Critical Accounting Policies

The following are our critical accounting policies and estimates.

Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires our management to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate these judgments, assumptions and estimates for changes that would affect the reported amounts. These estimates are based on management’s historical industry experience and on various other judgments and assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these judgments, assumptions and estimates. Our significant judgments, assumptions and estimates include the evaluation and consolidation of variable interest entities (“VIEs”), the allocation of the purchase price of acquired properties, the evaluation of our investments for impairment, the classification and income recognition for noncontrolling interests and the determination of fair value.

 

71


Table of Contents

Principles of Consolidation and Basis of Presentation

Our accompanying consolidated financial statements were prepared in accordance with GAAP. The accompanying consolidated financial statements include our account and the accounts of the OP and its subsidiaries. Because we are the sole general partner and a limited partner of the OP and have unilateral control over its management and major operating decisions (even if additional limited partners are admitted to the OP), the accounts of the OP are consolidated in our consolidated financial statements. We consolidate entities in which we control more than 50% of the voting equity. Investments in real estate joint ventures over which we have the ability to exercise significant influence, but for which we do not have financial or operating control, are accounted for using the equity method of accounting. We have one investment accounted for using the equity method of accounting that is reflected on our accompanying consolidated financial statements as “Preferred equity investment.” All intercompany balances and transactions are eliminated in consolidation.

In addition, we evaluate relationships with other entities to identify whether there are variable interest entities (“VIEs”) as required by FASB ASC 810, Consolidation (“FASB ASC 810”), and to assess whether we are the primary beneficiary of such entities. If the determination is made that we are the primary beneficiary, then that entity is included in the consolidated financial statements in accordance with FASB ASC 810.

On January 1, 2016, we adopted Accounting Standards Update (“ASU”) No. 2015-02, Amendments to the Consolidation Analysis (“ASU 2015-02”), which amends the current consolidation guidance affecting both the VIE and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or VOE, but rather enhances the way we assess some of these characteristics. The OP meets the criteria as a VOE, and as we hold a majority of the voting interest of the OP, we consolidate the OP. Substantially all of our assets and liabilities represent those assets and liabilities of the OP. All of our debt is an obligation of the OP.

In the opinion of our management, the accompanying consolidated financial statements include all adjustments and eliminations, consisting only of normal recurring items necessary for their fair presentation in conformity with GAAP. The financial statements of our subsidiaries are prepared using accounting policies consistent with our accounting policies. There have been no significant changes to our significant accounting policies during the six months ended June 30, 2017.

Net Interest Income

Net interest income is recognized based on the contractual interest rate and the outstanding principal balance of the investments we originate or acquire and adjusts for the amortization of origination discounts or premiums and direct costs and is reduced by the cost of debt related to investments we originate that pay a stated rate of interest.

Equity in Income

We recognize equity in income earned on a stated investment return from preferred equity investments we originate. Equity in income on our preferred equity investments is recorded under the equity method of accounting. We do not accrue a receivable for our equity in income earned on our preferred equity investments if there is a reason to doubt our ability to collect such income.

Disposition Fee Income

Disposition fee income is recognized when paid by a borrower upon repayment of a preferred equity investment or loan.

Real Estate Owned and Structured Finance Investments

Mezzanine, bridge financing and mortgages are recorded at the stated principal amount of the investment net of any discounts or premiums and are monitored quarterly for impairment and loss reserves. Preferred equity

 

72


Table of Contents

investments are recorded at the value invested by us at the date of origination and accounted for under the equity method of accounting.

Real estate assets, including land, buildings, improvements, furniture, fixtures and equipment, and intangible lease assets acquired through exercising our rights under our structured finance investments are stated at historical cost less accumulated depreciation and amortization, unless the value is impaired below the net historical cost, as determined by our Advisor. Costs associated with the development and improvement of our real estate assets are capitalized as incurred. Costs incurred in making repairs and maintaining real estate assets are expensed as incurred. Real estate-related depreciation and amortization are computed on a straight-line basis over the estimated useful lives as described in the following table:

 

Land    Not depreciated
Buildings    30 years
Improvements    15 years
Furniture, fixtures, and equipment    3 years
Intangible lease assets    6 months

Impairment

Real estate owned property assets are reviewed for impairment periodically whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In such cases, we will evaluate the recoverability of such real estate asset based on estimated future cash flows and the estimated liquidation value of such real estate asset, and provide for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the real estate asset. If impaired, the real estate asset will be written down to its estimated fair value.

For the years ended December 31, 2016 and 2015 and for the six months ended June 30, 2017, we did not record any impairment charges related to real estate owned property assets.

Other-Than-Temporary Impairment

We consider various factors to determine if a decrease in the value of our equity method investments is other-than-temporary. These factors include, but are not limited to, age of the investment, our intent and ability to retain our investment in the entity, the financial condition and long-term prospects of the entity, and the relationships with the other joint venture partners and its lenders. After determining an other-than-temporary decrease in the value of an equity method investment has occurred, we estimate the fair value of our investment by estimating the proceeds we would receive upon a hypothetical liquidation of the investment at the date of measurement.

For the years ended December 31, 2016 and 2015 and for the six months ended June 30, 2017, we did not record any impairment charges related to equity method investments.

Allowance for Losses

We perform a quarterly evaluation of our investments classified as held-for-investment for impairment on an investment-by-investment basis. If we deem that it is probable that we will be unable to collect all amounts owed according to the contractual terms of an investment, impairment of that investment is indicated. If we consider an investment to be impaired, we establish an allowance for losses, through a valuation provision in earnings that reduces the carrying value of the investment to the present value of expected future cash flows discounted at the investment’s contractual effective rate or the fair value of the collateral, if repayment is expected solely from the collateral. Significant judgment is required in determining impairment and in estimating the resulting loss allowance, and actual losses, if any, could materially differ from those estimates.

 

73


Table of Contents

We perform a quarterly review of our portfolio. In conjunction with this review, we assess the risk factors of each investment, including, without limitation, LTV, debt yield, property type, geographic and local market dynamics, physical condition, cash flow volatility, leasing and tenant profile, loan structure and exit plan, and project sponsorship.

We consider investments to be past due when a monthly payment is due and unpaid for 60 days or more. Investments are placed on nonaccrual status and considered non-performing when full payment of principal and interest is in doubt, which generally occurs when they become 120 days or more past due unless the investment is both well secured and in the process of collection. We may return an investment to accrual status when repayment of principal and interest is reasonably assured under the terms of the restructured investment. We did not place any investments on nonaccrual status or otherwise considered past due during the periods covered by the consolidated financial statements included elsewhere in this prospectus.

Additionally, as part of our Advisor’s quarterly review of our investments for possible impairment, our Advisor evaluates the risk of each investment and assigns a risk rating based on a variety of factors, grouped as follows to include (without limitation): (i) loan and credit structure, including LTV and structural features; (ii) quality and stability of real estate value and operating cash flow, including debt yield, property type, dynamics of the geographic, property-type and local market, physical condition, stability of cash flow, leasing velocity and quality and diversity of tenancy; (iii) performance against underwritten business plan; and (iv) quality, experience and financial condition of sponsor, borrower and guarantor(s). Based on a 5-point scale, our loans are rated “1” through “5,” from least risk to greatest risk, respectively, which ratings are defined as follows:

 

  1. Outperform: Exceeds performance metrics (for example, technical milestones, occupancy, rents, net operating income) included in the original or current credit underwriting / business plan;

 

  2. Meets or Exceeds Expectations: Collateral performance meets or exceeds substantially all performance metrics included in the original or current underwriting / business plan;

 

  3. Satisfactory: Collateral performance meets or is on track to meet underwriting; business plan is met or can reasonably be achieved;

 

  4. Underperformance: Collateral performance falls short of original underwriting, and material differences exist from business plan; technical milestones have been missed; defaults may exist, or may soon occur absent material improvement; and

 

  5. Risk of Impairment/Default: Collateral performance is significantly worse than underwriting; major variance from business plan; loan covenants or technical milestones have been breached; timely exit from loan via sale or refinancing is questionable.

Our determination of asset-specific loan loss reserves relies on material estimates regarding the fair value of any loan collateral. The estimation of ultimate losses, provision expenses and loss reserves is a complex and subjective process. As such, there can be no assurance that our judgment will prove to be correct and that reserves will be adequate over time to protect against losses inherent in our portfolio at any given time. Such losses could be caused by various factors, including, but not limited to, unanticipated adverse changes in the economy or events adversely affecting specific assets, borrowers, industries in which our borrowers operate or markets in which our borrowers or their properties are located. If our reserves for loan losses prove inadequate, we may suffer losses, which could have a material adverse effect on us.

Fair Value Measurements

Fair value measurements are determined based on the assumptions that market participants would use in pricing an asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB ASC 820, Fair Value Measurement and Disclosures, establishes a fair value hierarchy that

 

74


Table of Contents

distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy):

 

    Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access.

 

    Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates and yield curves that are observable at commonly quoted intervals.

 

    Level 3 inputs are the unobservable inputs for the asset or liability, which are typically based on an entity’s own assumption, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on input from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.

Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability. We utilize an independent third party to perform the allocation of value analysis for each property acquisition and have established policies, as described above, processes and procedures intended to ensure that the valuation methodologies for investments are fair and consistent as of the measurement date.

Recent Accounting Pronouncements

Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 13(a) of the Exchange Act for complying with new or revised accounting standards applicable to public companies. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we have elected to “opt out” of such extended transition period. Therefore, we intend to comply with new or revised accounting standards on the applicable dates on which the adoption of standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.

In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which amends several aspects of the accounting for share-based payment transactions, including the income tax consequences, accrual of compensation cost, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for annual and interim periods in fiscal years beginning after December 15, 2016. The amendments in this standard must be applied prospectively, retrospectively, or as of the beginning of the earliest comparative period presented in the year of adoption, depending on the type of amendment. We will implement the provisions of ASU 2016-09 as of January 1, 2017 and have determined the new standard will not have a material impact on our consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-01, which clarifies the definition of a business and provides further guidance for evaluating whether a transaction will be accounted for as an acquisition of an asset or a business. ASU 2017-01 provides a test to determine when a set of assets and activities acquired is not a business. When substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not a business. Under the updated guidance, an

 

75


Table of Contents

acquisition of a single property will likely be treated as an asset acquisition as opposed to a business combination and associated transaction costs will be capitalized rather than expensed as incurred. Additionally, assets acquired, liabilities assumed, and any noncontrolling interest will be measured at their relative fair values. ASU 2017-01 is effective for annual and interim periods in fiscal years beginning after December 15, 2017, with early adoption permitted. The amendments in this standard must be applied prospectively. We will implement the provisions of ASU 2017-01 as of January 1, 2017 and have determined the new standard will not have a material impact on our consolidated financial statements. We believe most of our future acquisitions of properties will qualify as asset acquisitions and most future transaction costs associated with these acquisitions will be capitalized.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. An entity should also disclose sufficient quantitative and qualitative information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers – Deferral of the Effective Date, which amends ASU 2014-09 to defer the effective date by one year. The new standard is effective for annual and interim periods in fiscal years beginning after December 15, 2017. We will implement the provisions of ASU 2014-09 as of January 1, 2018 at which time we expect to adopt the updated standard using the modified retrospective approach. However, as the majority of our revenue is from rental income related to leases, we do not expect ASU 2014-09 to have a material impact on our consolidated financial statements and related disclosures.

In January 2016, the FASB issued ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which changes certain recognition, measurement, presentation, and disclosure requirements for financial instruments. ASU 2016-01 requires all equity investments, except those accounted for under the equity method of accounting or resulting in consolidation, to be measured at fair value with changes in fair value recognized in net income. ASU 2016-01 also simplifies the impairment assessment for equity investments without readily determinable fair values, amends the presentation requirements for changes in the fair value of financial liabilities, requires presentation of financial instruments by measurement category and form of financial asset, and eliminates the requirement to disclose the methods and significant assumptions used in estimating the fair value of financial instruments. ASU 2016-01 is effective for annual and interim periods in fiscal years beginning after December 15, 2017. We will implement the provisions of ASU 2016-01 as of January 1, 2018. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). ASU 2016-15 addresses specific cash flow items with the objective of reducing existing diversity in practice, including the treatment of distributions received from equity method investees. ASU 2016-15 is effective for annual and interim periods in fiscal years beginning after December 15, 2017 and must be applied retrospectively to all periods presented; early adoption is permitted. We will implement the provisions of ASU 2016-15 as of January 1, 2018 and have determined the new standard will not have a material impact on our consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, Leases. The standard amends the existing lease accounting guidance and requires lessees to recognize a lease liability and a right-of-use asset for all leases (except for short-term leases that have a duration of one year or less) on their balance sheets. Lessees will continue to recognize lease expense in a manner similar to current accounting. For lessors, accounting for leases under the new guidance is substantially the same as in prior periods, but eliminates current real estate-specific provisions and changes the treatment of initial direct costs. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparable period presented, with an option to elect certain transition relief. Full retrospective application is prohibited. The standard will be

 

76


Table of Contents

effective for us on January 1, 2019, with early adoption permitted. Based on a preliminary assessment, we expect most of our operating lease commitments will be subject to the new guidance and recognized as operating lease liabilities and right-of-use assets upon adoption, resulting in an immaterial increase in the assets and liabilities on our consolidated balance sheets.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. The standard requires entities to estimate a lifetime expected credit loss for most financial assets, including trade and other receivables, held-to-maturity debt securities, loans and other financial instruments, and to present the net amount of the financial instrument expected to be collected. The updated standard will be effective for us on January 1, 2020; early adoption is permitted on January 1, 2019. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

Reportable Segments

The Company has two reportable segments, with activities related to owning and operating multifamily properties and originating preferred equity investments. The Company organizes and analyzes the operations and results of each of these segments independently, due to inherently different considerations for each segment. For more information regarding the Company’s reportable segments, see Note 3 to our consolidated financial statements.

Upon a successful completion of the Underwritten Offering and deployment of the net proceeds, the Company expects to have a third reportable segment, with activities related to originating mezzanine, bridge, and mortgage loans and alternative structured investments in multifamily, self-storage and select-service and extended stay hospitality properties.

Inflation

Consistent with the multifamily property focus, the majority of the leases we enter into for multifamily apartment homes are for terms of typically one year or less. These terms provide us with maximum flexibility to implement rental increases when the market will bear such increases and may provide us with a hedge against inflation.

Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors affect our performance more so than inflation, although inflation rates can often have a meaningful influence over the direction of interest rates. Furthermore, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors primarily based on our taxable income, and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation. See “— Quantitative and Qualitative Disclosures About Market Risk.”

Quantitative and Qualitative Disclosures about Market Risk

Market risk is the adverse effect on the value of assets and liabilities that results from a change in market conditions. Our primary market risk exposure is interest rate risk with respect to our indebtedness. As of June 30, 2017, we had total indebtedness of $37.9 million, which is floating rate debt with a variable interest rate.

An increase in interest rates could make the financing of any acquisition by us costlier. Rising interest rates could also limit our ability to refinance our debt when it matures or cause us to pay higher interest rates upon refinancing and increase interest expense on refinanced indebtedness. We may manage, or hedge, interest rate risks related to our borrowings by means of derivative financial instruments, such as interest rate swaps, interest rate caps and rate lock arrangements. As of June 30, 2017, an interest rate cap agreement covered $26.9 million of the $37.9 million of our total outstanding indebtedness. This interest rate cap agreement caps the related

 

77


Table of Contents

floating rate debt at 6.00% for the term of the agreement, which is 3 years. We also expect to manage our exposure to interest rate risk by maintaining a mix of fixed and variable rates for our indebtedness. Increasing rates may make fundraising more difficult if potential investors perceive a rise in rates as a negative for multifamily, storage or hospitality fundamentals.

As of June 30, 2017, the weighted average interest rate of our total indebtedness was 3.73%. Until the interest rate on our $26.9 million of floating rate mortgage debt reaches the cap provided by its interest rate cap agreement, each increase of 25 basis points to the interest rate would result in an approximate increase to our total annual interest expense of the amounts illustrated in the table below for our indebtedness as of June 30, 2017 (in thousands):

 

Change in Interest Rates    Annual Increase to Interest Expense  
0.25%      $  95  
0.50%      $190  
0.75%      $285  
1.00%      $380  

There is no assurance that we would realize such expense as such changes in interest rates could alter our liability positions or strategies in response to such changes.

We may also be exposed to credit risk in such derivative financial instruments we use. Credit risk is the failure of the counterparty to perform under the terms of the derivative financial instrument. We seek to minimize the credit risk in derivative financial instruments by entering into transactions with high-quality counterparties.

 

78


Table of Contents

BUSINESS

Our Company

NexPoint Real Estate Finance, Inc., or NREF, is a Maryland corporation incorporated on November 12, 2013 primarily focused on providing structured financing solutions for properties where our management team has extensive expertise, focusing on mid-market financing solutions for stabilized property types that should outperform during a rising interest rate environment (e.g., multifamily, self-storage and select- service and extended-stay hospitality assets). Currently, there are many sophisticated owners of multifamily real estate properties seeking structured capital senior to their common equity but subordinate to a GSE first mortgage. NexPoint is a select sponsor of Freddie Mac and preferred sponsor of Fannie Mae for multifamily loans and investments, which we expect will position us to significantly grow our business. We are externally managed by NexPoint Real Estate Advisors II, L.P., our Advisor, which together with its affiliates has extensive real estate experience, having completed approximately $2.7 billion of gross real estate transactions since 2013. Our Advisor is an affiliate of Highland, which had $13.7 billion in assets under management as of July 31, 2017.

We will primarily focus on the origination and structuring of mezzanine loans, preferred equity and alternative structured financing investments. We believe most publicly traded real-estate debt focused REITs focus on first mortgage bridge lending in gateway markets for assets undergoing some type of redevelopment or transition. We intend to target our structured financings on stabilized properties, primarily located in the top 50 MSAs that have been well-maintained, have few deferred maintenance issues and are owned by experienced and high quality operators. We believe that these investment opportunities best meet our primary investment objectives as they contractually provide a high percentage of total return from current pay, are structured to mitigate impairments in the investments, and potentially provide equity-like, long-term total return opportunities, with lower risk than a typical direct equity investment in real estate.

The investment strategy from April 2016 until May 2017 was to originate primarily preferred equity investments, and to a lesser extent, mezzanine loans, bridge loans and first mortgages, as well as purchase directly Class A, core plus multifamily properties located in the Southeastern and Southwestern United States. The preferred equity originations were to be focused on multifamily properties located in the same markets. We would invest in multifamily properties directly when we felt the prices and cap rates were sensible based on the real estate cycle. When at the top part of the cycle, we would invest more conservatively by originating preferred equity investments in the same types of assets, but higher in the capital structure, and at what we felt would be a similar or better IRR than purchasing the property directly. In other words, we would allocate capital tactically and dynamically within the capital structure based on where we felt the best risk-adjusted returns were to be found at that point in the real estate cycle using a hybrid strategy that included both direct property investments as well as structured finance investments, primarily in the form of preferred equity.

We intended to use proceeds from the Continuous Offering for these investments. With proceeds from the Continuous Offering, in addition to capital from the Credit Facility (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Credit Facility” for additional information regarding the Credit Facility), we raised capital to originate two preferred equity investments. The first preferred equity investment was for $6.0 million and was invested in April 2016, which owned 16% of a Class A multifamily property named Bell Midtown, located in Nashville, Tennessee. The second preferred equity investment was for $5.3 million and was invested in August 2016, which owned 35% of a Class A multifamily property named Stone Oak, located in San Antonio.

Starting in July 2017, we endeavored to facilitate the growth of the company and offer our non-affiliated shareholders an opportunity to gain liquidity by listing our shares on the NYSE and raise additional capital in our first listed offering. In order to facilitate this, we determined it was in our and our shareholder’s best interest to simplify our strategy to prudently allocate capital to senior tranches of the capital stack and appeal to a broader base of retail and institutional investors. Therefore, we have eliminated the direct investment in properties component of our strategy to focus on originating structured finance opportunities, primarily focused on

 

79


Table of Contents

mezzanine loans, preferred equity and other structured finance investments for stabilized assets. We also broadened our target assets from targeting structured finance investments in multifamily properties to also include self-storage and select-service and extended-stay hospitality assets. The multifamily, self-storage and select-service property types all exhibit cyclical resilience, tenant diversification, lower outlay of capital expenditures upon tenant turnover and short-term lease opportunities, which we feel is prudent in a longer-term rising interest rate environment. We will continue to own real estate directly but typically only when we are forced to take control of a property in the event of default. For tax efficiency purposes, we intend to continue holding the Estates property.

Our Investment Strategy

Our primary investment strategy is to generate attractive, risk-adjusted current income and capital appreciation for our shareholders by investing in a diversified portfolio of structured real estate investments. Through active management, market experience and a robust underwriting process, we believe we will be able to preserve our capital investments, while delivering an attractive total return through all market cycles. Over time, we will take advantage of market opportunities by moving within the capital structure of our targeted investments to achieve a superior portfolio-mix. Each investment and the portfolio as a whole is regularly monitored and stress-tested in various scenarios, enabling us to make informed and proactive investment decisions.

We expect the size of our investments will vary significantly, but generally expect them to range in value from $5 million to $20 million. We expect that the underlying properties will generally:

 

    have been institutionally developed and owned prior to our investment;

 

    have stabilized occupancy; and

 

    pass our Advisor’s strict underwriting criteria and stressed market-cycle scenarios.

We intend to, directly or indirectly, make mezzanine loans, preferred equity and alternative structured financing investments based on current market terms that generally:

 

    pay commitment and exit fees from the property owner, paid at funding and repayment/redemption, respectively;

 

    pay a high annual current return; and

 

    pay an additional annualized paid in kind preferred return which compounds monthly and is paid at the time of a triggering event (sale and/or refinancing).

We underwrite each investment opportunity as if we were acquiring the asset itself, and then stress the cash flows under various downside scenarios. The governing investment documents are tailored to provide us with superior protection in circumstances when interest or preferred returns, as applicable, fail to be paid. We may structure protective provisions, including foreclosure rights, to mitigate risk in the event of default. In the event we take ownership of an asset following a default, our Advisor will manage the property and look to dispose of the property at a point that is accretive to investors, and then recycle the capital into new structured investments post-disposition.

 

80


Table of Contents

Structured Investments: How it Works

 

LOGO

Target Investments

The state of the current and future real estate cycles and our investment objectives dictate our target investments. Given our Advisor’s preference for property types that have demonstrated cyclical resilience, tenant diversification, lower capital expenditures upon tenant turnover, shorter-duration lease terms and less vulnerability to technological disruption, we expect the significant majority of our portfolio to be allocated to stabilized multifamily, storage and select-service and extended-stay hospitality assets over the near term. Within this allocation and in a normalized operating environment, we expect to focus our primary investment activity on mezzanine or subordinated loans, preferred equity and alternative structured financing investments, with the majority of our investment portfolio concentrated in mezzanine loans in stabilized multifamily assets.

Our investment guidelines will permit us to originate and invest in mezzanine loans, subordinated loans, preferred equity, alternative structured financing, bridge financing and first mortgage loan investments, which are described below:

 

    Mezzanine and Subordinated Debt: We intend to focus on the origination of structured mezzanine or subordinated debt investments. Structured mezzanine and subordinated debt is structurally senior to common equity and subordinate to the first mortgage loans. The loan to value typically ranges from 50% – 85%. The investment usually carries either a fixed or floating rate component and can be structured with an additional equity-like component. This type of investment generally pays a 7% – 9% annualized current cash component along with a 3% – 5% annualized payment-in-kind that accrues and is due upon maturity of the debt. It generally will be structured with a commitment and exit fee paid by the owner upon funding and exit of the investment. Mezzanine lenders typically have additional rights as compared to more senior lenders, including the right to cure defaults under the senior loan under certain circumstances following a default on the senior loan. Mezzanine debt investments we will originate will be secured by a second lien in the underlying property or by the common equity of the entity we lend to, while subordinated debt investments will generally be secured by a lien in the underlying property. Structured mezzanine and subordinated debt investments have the ability to offer debt-like risk with equity-like returns.

 

   

Preferred Equity: We intend to originate preferred equity investments to the extent allowed under various restrictions we operate under, including our desire to remain exempt from registration as an investment company under the Investment Company Act of 1940. Preferred equity is similar to

 

81


Table of Contents
 

structured mezzanine debt in that it is structurally senior to common equity and subordinate to the first mortgage loans, typically ranges from 50% – 85% of the capital structure, usually carries either a fixed or floating rate component and can be structured with an additional equity-like component. Preferred equity investments also generally pay a 7% – 9% annualized current cash component along with a 3% – 5% annualized payment-in-kind that accrues and is due upon a triggering event. It generally will be structured with a commitment and exit fee paid by the owner upon funding and exit of the investment. The most distinguishable attribute of a preferred equity investment as compared to a structured or subordinated mezzanine debt investment is how the deal is initially structured. We expect that the preferred equity investments will include a put option, a forced-sale right and a “foreclosure option,” which are triggered by the occurrence of a triggering event. A triggering event includes, among other things, the failure to pay the preferred return, a default under a mortgage loan document or failure to redeem the investment upon a sale or refinancing. Upon the occurrence of a triggering event, typically (1) our preferred equity investment will be redeemed and we will receive the amount of our investment plus an agreed upon rate of return or (2) we will acquire the ownership interests of the common holders for minimal consideration. These types of investments have the ability to offer debt-like risk with equity-like returns.

 

    Alternative Structured Financing: We will also look to construct innovative financing solutions in a way that is symbiotic for both parties, similar to the Jernigan Capital, Inc. investment described below. Our intent is to provide flexibility and structured deals that enable counterparties to strategically draw capital when needed or “match funded” commitments. Terms of the deal may entail a maximum commitment over a certain period with monthly minimums in exchange for a preferred equity investment with a stated cash coupon and a back-end payment-in-kind component that is in the form of additional preferred equity or common stock, which provides an additional avenue for substantial value accretion to investors. These types of investments may also be limited such that we are still able to qualify for an exemption under the Investment Company Act.

 

    First Mortgage and Bridge Loans: As market conditions evolve, we may decide that originating and owning first mortgages or bridge loans offers a more attractive risk adjusted return. The loans are secured by real estate, carrying either a fixed or floating interest rate and usually require a balloon payment of principal upon maturity. We would likely look to originate floating rate, shorter-term first mortgages.

Our Competitive Strengths

Public Company REIT Experience

Our Advisor’s management team took a private multifamily REIT public in April 2015, which began trading on the NYSE (NYSE: NXRT). Despite not raising capital since listing the shares, deleveraging the balance sheet and repurchasing shares, management has grown the equity value of NXRT from $262 million, which was the private REIT’s total contributed capital prior to the spin-off on March 31, 2015, to $530 million as of June 30, 2017. NXRT management has recycled capital accretively and grown net operating income, funds from operations and core funds from operations since listing its shares on the NYSE. NXRT delivered a 79.5% total return to shareholders in 2016, outperformed the RMZ in 2016 by 70.9%, and has delivered a 90.6% total return to shareholders since NXRT’s listing in April 2015. Total return to shareholders assumes the reinvestment of all cash dividends paid by NXRT on its common stock in additional shares of NXRT common stock. We believe that the RMZ is a benchmark that is commonly used by investors for purposes of comparing stock performance and stockholder returns of REITs, and, therefore, is an appropriate benchmark for the performance of NXRT. However, comparison of the return performance of NXRT to the performance of the RMZ may be limited due to the differences between NXRT and the companies represented in the RMZ, including with respect to size, asset type, geographic concentration and investment strategy.

 

82


Table of Contents

LOGO

Source: Bloomberg — Total Return Data from January 1, 2016 through December 31, 2016

Proven Investment Strategy

Our Advisor and its affiliates have invested over $135 million in investments in multifamily properties in the past three years. We expect that similar investments will comprise the majority of our portfolio and provide stable current income, total return potential and downside protection. Our Advisor and its affiliates’ investment track record in this strategy has, since inception, realized unleveraged IRRs of approximately 13%, with no defaults.

Network of Existing Partners Provides Immediately Available Investment Pipeline to NREF

NREF also believes that one of its key success factors is the network of local, regional and national operating partners with which our Advisor and its affiliates do business. Our Advisor and its affiliates work closely with high quality sponsors to forge long-standing relationships so that it is always seen as the “investment partner of choice” when partners are seeking investment in new transactions. Our Advisor has done business with over 75 real estate sponsors.

Scalability, Strength and Experience in Target Sectors

We expect a significant amount of our capital to be deployed in the multifamily sector, a property type in which our Advisor and its affiliates have a large network of relationships and a history of success. Our Advisor and its affiliates have completed approximately $2.7 billion of multifamily transactions since 2013, holding either direct or indirect interests in approximately 21,000 apartment units in the United States. To date, our Advisor and its affiliates have generated an average levered IRR of approximately 43% on their direct investments in the multifamily sector that have been sold, and an average unlevered IRR of 13% on their preferred equity investments.

Financing Solution is Pre-Approved and Complies with Freddie Mac and Fannie Mae Standards

Our Advisor and its affiliates have experience structuring financing solutions behind first mortgage lenders, including banks, life insurance companies and Freddie Mac and Fannie Mae. Our Advisor and its affiliates have successfully tailored financing solutions to property owners in critical ways but also highly symbiotic with a typical Freddie Mac or Fannie Mae first mortgage. Our multifamily loan and investment platform complies with current Freddie Mac and Fannie Mae standards, giving us a unique opportunity to invest alongside quality sponsors and the largest multifamily lenders in the U.S.

In addition, NexPoint is a “select sponsor” with Freddie Mac and enjoys preferred status with Fannie Mae for multifamily loans and investments, having borrowed over $1 billion from GSEs. We believe our Advisor and

 

83


Table of Contents

its affiliates’ relationship, status and expertise with the GSEs provide proprietary deal flow, unique access and exposure to a superior risk-adjusted, total return investment product not currently offered in the public equity markets.

Our Advisor and its affiliates have also successfully structured investments behind non-agency first mortgage lenders on both hospitality and self-storage real property. Our product is tailored to give sponsors attractively priced capital, while delivering attractive risk-adjusted returns to our investors.

Extensive Infrastructure of our Advisor and Highland’s Real Estate Platform

NexPoint is also an affiliate of Highland and was created to manage Highland’s real estate platform. The dedicated NexPoint real estate team includes 12 individuals and has completed over 90 transactions totaling approximately $2.7 billion invested since 2013. NexPoint’s investment team has a combined 70 years of investment experience with some of the world’s most sophisticated institutions and investors in the following asset classes: real estate, private equity, alternatives, credit and equity.

In addition, our Advisor is also affiliated with NexBank, a financial services company with assets of $6.0 billion and whose primary subsidiary is a commercial bank. NexBank provides commercial banking, mortgage banking, investment banking and corporate advisory services to clients throughout the U.S. NexBank primarily serves institutional clients and financial institutions and is also committed to serving the banking and financial needs of large corporations, middle-market companies and real estate investors. As of July 31, 2017, NexBank’s commercial real estate loan portfolio totaled $751 million, with a pipeline of an additional $150 million.

Our Initial Portfolio

We have entered into letters of intent with unaffiliated third party sponsors for the loans and investments listed in the table below, which along with our current preferred equity investment and property, may comprise our Initial Portfolio. The letters of intent are non-binding and remain subject to entry into definitive agreements with respect to the loans and investments. There can be no assurance that the loans and investments will close on the terms anticipated, or at all. We believe the following investments and properties may comprise our Initial Portfolio:

 

Property Name

  Status   Location   Effective Rent
Per Unit as of
June 30, 2017
    # of
Units
    Rentable
Square
Footage

(in thousands)
    Occ.
as of
June 30,
2017
    Year
Built/Renovated
 

Ashford at Feather Sound

  LOI   Clearwater, FL   $ 1,121       276       229       94.2     1985  

City Park Clearwater

  LOI   Clearwater, FL   $  1,224       228       230       91.2     1990  

Floresta

  LOI   Jupiter, Fl   $ 1,705       311       372       90.7     2004  

Jernigan Capital, Inc.

  LOI   Memphis, TN          

Latitude

  LOI   Phoenix, AZ   $ 680       672       530       91.8     1979  

Marbella

  LOI   Corpus Christi, TX   $ 755       783       520       74.9     1978  

Riverside Villas

  LOI   Fort Worth, TX   $ 1,105       192       183       94.3     2009  

Stone Oak

  Owned   San Antonio, TX   $ 1,095       360       355       91.7     2014  

Estates

  Owned   Phoenix, AZ   $ 963       330       324       93.3     2000  

We believe each investment will qualify as a real-estate asset for purposes of the REIT asset tests.

 

84


Table of Contents

Potential Investments

The following is a summary of the investments we intend to acquire in connection with the completion of this offering:

 

Investment

  Property
Type
  Investment Type   Amount of
Investment
  Rate
Ashford at Feather Sound   Multifamily   Mezzanine Debt   $7.3 million   8.25% + 2.75% PIK
City Park Clearwater   Multifamily   Mezzanine Debt   $5.7 million   8.25% + 2.75% PIK
Floresta   Multifamily   Mezzanine Debt   $12.3 million   8.25% + 2.75% PIK
Jernigan Capital, Inc.   Self-Storage   Preferred Equity   $35.0 million (1)   7% + PIK dividend (2)
Latitude   Multifamily   Mezzanine Debt   $6.0 million   8.5% + 2% PIK
Marbella   Multifamily   Mezzanine Debt   $5.2 million   9% + 4% PIK
Riverside Villas   Multifamily   Mezzanine Debt   $2.0 million   8.5%

 

(1) We expect to invest up to $35.0 million in this investment. The size of our investment will depend on the allocation policy of Highland and our Advisor, the size of this offering and the maintenance of our exemption from registration under the Investment Company Act. We expect our investment in Jernigan to increase or decrease on a pro rata basis in relation to the size of this offering. If there is a 10% increase or decrease in the size of this offering, we expect our investment in Jernigan to increase or decrease by $         million. The total investment in Jernigan under the Jernigan Stock Purchase Agreement may be for an amount up to $125.0 million at Jernigan’s option. At least $50.0 million must be invested in Jernigan before July 27, 2018, the date the stock purchase agreement terminates. Investments in Jernigan must be in amounts of (a) no less than $5.0 million, and if greater than $5.0 million, in multiples of $1.0 million (b) no more than $15.0 million in any given calendar month, and (c) no more than $35.0 million in any three-month period. Affiliates of Highland have already invested $10.0 million in Jernigan. The remainder of the investment will be funded by us or other Highland affiliates.
(2) The cash dividend will increase to 8.5% in July 2022. An additional 5% cash dividend is payable upon the occurrence of a change in control and other similar events. The PIK dividend will be equal to the lesser of (i) 25% of the incremental increase in book value plus the incremental increase in net asset value of any income producing real property and (ii) an amount that together with the cash dividends would equal a 14.00% internal rate of return.

Ashford at Feather Sound: Ashford at Feather Sound (f/k/a Bay Meadows) is a 276-unit property located within the master-planned country club community of Feather Sound in Clearwater, Florida. The property sits prominently at the entrance of this upscale, mixed-use community and directly across from St. Petersburg’s exclusive Carillon Park, a Class A office market. Ashford at Feather Sound offers a quiet, low density setting with ample green space and a beautiful lakeside setting. The property features an array of amenities and has limited deferred maintenance. Constructed in 1985, the property’s institutional ownership has invested over $2.28 million ($8,265 per unit) since 2010 in capital improvements such as the replacement of all roofs and skylights, resurfacing and resealing of the parking lot driveway, and exterior paint throughout the property. Community amenities include 24-hour lakeside fitness center, car care center, public area Wi-Fi, heated swimming pool and whirlpool spa, on-site storage units, business center, sun deck, tennis court, racquetball court, dog park, grilling area, and fishing dock. Interior features include maple cabinetry, black or stainless steel appliances, washer/dryer in all units, large walk-in closets, woodburning fireplace and sky light in select units, faux wood blinds, sunroom, and ceiling fan. The sponsor has budgeted approximately $3.45 million, or $12,500 per unit, for capital improvements. The sponsor’s business plan includes remodeling 50% of the units to include plank flooring, updated plumbing/lighting fixtures, granite or quartz counters, new cabinets or appliances where needed, backsplash, shower tile, 2” faux wood blinds where needed, and possibly some upgraded closets.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $1.7 million, $1.9 million and $1.0 million, respectively. As of June 30, 2017, the property was 94.2% occupied with a weighted average monthly effective rent per occupied unit of $1,121.

A third party national brokerage firm has provided the Company a valuation of the property at $38.0 million. As of June 30, 2017, the property has a $27.2 million first mortgage loan. The first mortgage loan bears interest at a floating rate of 1-month LIBOR plus 2.0% over a 35 month term maturing in May 2020.

NREF intends to make a $7.3 million mezzanine loan to Ashford at Feather Sound. The loan will pay interest at a rate of 8.25%, paid monthly, and a PIK return of 2.75%, which will compound monthly and be due at the time of a triggering event. NREF will be paid 1% when the loan is repaid.

 

85


Table of Contents

City Park Clearwater: City Park Clearwater (f/k/a Bay Park) is located in Clearwater, Florida, which is in the greater Tampa-St. Petersburg-Clearwater metropolitan area. The property was developed by Post Properties in 1990 and contains 228 one-, two- and three-bedroom units situated on 15.6 acres. There are nine three-story, open-air buildings on 15.6 acres, a 2,500-square-foot leasing center with a pool, and a lake at the center of the community. The leasing center contains office space, meeting areas, a movie theatre, and a small exercise facility that overlooks the pool. The site is heavily landscaped with bridges over the lake and there is a second wetlands area just south of the leasing center. Other amenities include a large putting green, lighted tennis courts and multiple dog parks. Units have 8-foot ceilings except the third floor units, which have vaulted ceilings. The units are individually metered for electric (residents pay) and there are individual systems for HVAC and hot water systems that were purchased in 2008 and are in good condition overall. In 2008, the property was sold to a condominium converter in a joint venture with an affiliate of the seller. The partnership invested approximately $2.5 million in capital improvements in anticipation of the condominium sales, giving City Park Clearwater the highest quality unit finish levels among its competitive set. Due to inopportune market timing, the condominium conversion failed and in 2010, the seller purchased the property from its affiliate. While the property, amenities and units are all well-maintained, it suffers from several weaknesses, which affords the sponsor the opportunity to increase rents to an appropriate level within its competitive set. The owner has budgeted approximately $2.04 million for capital improvements, or $8,962 per unit, to vastly improve its amenity package, and renovate approximately 50% of the units.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $1.6 million, $1.8 million and $0.9 million, respectively. As of June 30, 2017, the property was 91.2% occupied with a weighted average monthly effective rent per occupied unit of $1,224.

A third party national brokerage firm has provided the Company a valuation of the property at $37.0 million. As of June 30, 2017, the property has a $23.8 million first mortgage loan. The first mortgage loan bears interest at a floating rate of 1-month LIBOR plus 2.5% over a 56 month term maturing in February 2022.

NREF intends to make a $5.7 million mezzanine loan to City Park Clearwater. The loan will pay interest at a rate of 8.25%, paid monthly, and a PIK return of 2.75%, which will compound monthly and be due at the time of a triggering event. NREF will be paid 1% when the loan is repaid.

Floresta: Floresta is a 311-unit core plus quality Class A apartment community located in Jupiter, Florida. Located in the affluent community of Jupiter, the property offers some of the largest units in the market, many with direct access garages. Constructed of high quality concrete block and stucco with barrel tile roofs, Floresta has been well maintained and has attractive, mature landscaping. Community amenities include a clubhouse with Wi-Fi, heated resort-style swimming pool, 24-hour fitness center, tennis court with jogging track, basketball court, private lake with walking path, playground, BBQ/picnic area, valet trash, and attached or detached garages. Interior features include breakfast bar and pantry in the kitchen, garden tub, full size washer/dryer, ceramic tile flooring, crown molding, hurricane impact resistant windows, large walk-in closets, ceiling fans, microwaves, cable/internet ready, 9’ ceilings, recessed lighting and designer appliance packages. Select units include granite countertops, vaulted ceilings, and attached garages. The sponsor’s business plan focuses on bringing rents up to market as current in-place rents are presently approximately 10% behind the lowest competitor as further discussed in the following sections.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $3.0 million, $3.3 million and $1.4 million, respectively. As of June 30, 2017, the property was 90.7% occupied with a weighted average monthly effective rent per occupied unit of $1,705.

A third party national brokerage firm has provided the Company a valuation of the property at at $77.2 million. As of June 30, 2017, the property has a $52.0 million first mortgage loan. The first mortgage loan bears interest at a fixed rate of 3.45% over a 60 month term maturing in June 2022.

 

86


Table of Contents

NREF intends to make a $12.3 million mezzanine loan to Floresta. The loan will pay interest at a rate of 8.25%, paid monthly, and a PIK return of 2.75%, which will compound monthly and be due at the time of a triggering event. NREF will be paid 1% when the loan is repaid.

Jernigan Capital, Inc.: Jernigan is a publicly traded commercial real estate company incorporated in Maryland that provides capital to private developers, owners and operators of self-storage facilities. Its principal business objective is to deliver attractive, long-term risk-adjusted returns to its stockholders by investing primarily in newly-constructed self-storage facilities (“development property investments”). Jernigan generates returns on its development property investments through interest payments (typically at a fixed rate) on its invested capital together with a 49.9% interest in the positive cash flows from operations, sales and/or refinancings of the development property investments (collectively, the “Profit Interests”). As of June 30, 2017, Jernigan had 37 on-balance sheet investments, for an aggregate committed principal amount of $364.0 million, including 33 development property investments totaling approximately $337.5 million of aggregate committed principal amount, each of which provides Jernigan with a Profit Interest, one construction loan with approximately $17.7 million of aggregate committed principal amount and three operating property loans totaling approximately $8.8 million of aggregate committed principal amount.

We expect to make investments directly in Jernigan’s preferred stock by entering into a joinder agreement to the stock purchase agreement with Jernigan in connection with our investment in Jernigan. We expect to invest up to $35.0 million in this investment. The size of our investment will depend on the allocation policy of Highland and our Advisor, the size of this offering and the maintenance of our exemption from registration under the Investment Company Act. We expect our investment in Jernigan to increase or decrease on a pro rata basis in relation to the size of this offering. If there is a 10% increase or decrease in the size of this offering, we expect our investment in Jernigan to increase or decrease by $             million. The total investment in Jernigan under the Jernigan Stock Purchase Agreement may be for an amount up to $125.0 million at Jernigan’s option. At least $50.0 million must be invested in Jernigan before July 27, 2018, the date the stock purchase agreement terminates. Investments in Jernigan must be in amounts of (a) no less than $5.0 million, and if greater than $5.0 million, in multiples of $1.0 million (b) no more than $15.0 million in any given calendar month, and (c) no more than $35.0 million in any three-month period. Affiliates of Highland have already invested $10.0 million in Jernigan. The remainder of the investment will be funded by us or other Highland affiliates.

The preferred stock investment will have a current preferred return of 7%. The cash dividend will increase to 8.5% in July 2022 and the Company will be entitled to an additional 5% cash dividend upon the occurrence of a change in control and other similar events. Jernigan will pay a PIK dividend that is equal to the lesser of (i) 25% of the incremental increase in book value plus the incremental increase in net asset value of any income producing real property and (ii) an amount that together with the cash dividends would equal a 14% internal rate of return.

In addition to our rights to cash and PIK dividends, as a holder of Jernigan’s preferred stock, we will have the right to purchase a pro rata share of any qualified offering of Jernigan’s common stock.

Jernigan may redeem the preferred stock at Jernigan’s option (a) after five years from the effective date at a price equal to 105% of the liquidation value per share or (b) after six years from the effective date at a price equal to 100% of the liquidation value per share, plus the value of all accumulated and unpaid cash distributions and stock dividends in each case.

In the event of a change of control event (as defined in the articles supplementary) affecting Jernigan prior to the third anniversary of the effective date, Jernigan is required to redeem all of the preferred stock for a price equal to (a) the liquidation value, plus (b) accumulated and unpaid cash distributions and stock dividends, plus (c) a make-whole premium designed to provide us with a return on the redeemed shares equal to a 14.0% internal rate of return through the third anniversary of the effective date.

In the event of any liquidation, dissolution or winding up of Jernigan, we would be entitled to receive an amount equal to the greater of (i) the liquidation value, plus all accumulated but unpaid cash distributions and

 

87


Table of Contents

stock dividends thereon up to, but not including, the date of any liquidation, but excluding any cash premium and (ii) the amount that would be paid on such date in the event of a redemption following a change of control.

Jernigan is an example of our strategy to make alternative structured financing investments.

Latitude: Latitude is a 672-unit garden style multifamily community built in 1979 and located in Phoenix, Arizona. Property features include five different floor plans, including single story casitas and two-story garden style buildings. Community amenities include a clubhouse, fitness center, four swimming pools, two spas, two tennis courts, basketball courts, sand volleyball court, walking/ jogging path, dog parks, playground, park-like courtyards with barbecues and gazebos, and covered parking. Unit interiors include washer/dryer connections in 364 units. The property has undergone approximately $13.0 million of exterior capital improvements and renovations. The scope of work included extensive stucco work and balcony redesign, upgrades to the common areas, new fitness equipment, new soccer field, sand volleyball court, and basketball/sports courts, pool resurfacing, upgrading decks around pools, parking lot resurfacing, new flat roof system, replacement of approximately 50% of the AC units and 570 balconies, full exterior paint, landscaping, improvements to amenities, roof repairs, and other deferred maintenance. Interiors will be upgraded as units turn to include new flooring, appliances, fixtures, new cabinet doors and painted cabinet boxes.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $2.5 million, $2.9 million and $1.4 million, respectively. As of June 30, 2017, the property was 91.8% occupied with a weighted average monthly effective rent per occupied unit of $680.

A third party national brokerage firm has provided the Company a valuation of the property at $52.6 million and an estimated first mortgage of $38.8 million first mortgage loan. The estimated first mortgage loan will bear interest at a fixed rate of 4.31% over a 120 month term maturing in July 2027.

NREF intends to make a $6.0 million mezzanine loan to Latitude. The loan will pay interest at a rate of 8.5%, paid monthly, and a PIK return of 2%, which will compound monthly and be due at the time of a triggering event. NREF will be paid 1% when the loan is repaid.

Marbella: Marbella is a 783-unit garden style multifamily community built from 1978 to 1983 and located in Corpus Christi, Texas. The property, Corpus Christi’s largest apartment community, sits prominently along one of the town’s primary north-south arteries where drive-by traffic surpasses 24,000 cars daily. Marbella is conveniently located within walking distance to the nearest grocery-anchored retail center, as well as the local elementary, middle and high schools. Property features include 19 different floor plans spread across 66 low-density two-story garden style buildings on 31 acres. Community amenities include a clubhouse, two swimming pools, lighted tennis courts, basketball courts, picnic area, playground, dog park and 11 laundry rooms. The seller made significant capital investments during their ownership. Some of those improvements include stucco repair, exterior paint, repairing of gutters/downspouts, perimeter fence repairs, swimming pool resurfacing, various parking lot repairs, boiler replacements, and landscape improvements. Additionally, approximately 57 of the 72 roofs on property were replaced over the two years prior to sale. The sponsor’s business plan includes a renovation budget totaling $2 million with exterior improvements of $1.2 million including full exterior paint, landscaping, improvements to amenities, parking lot repairs, addition of patio fences and other deferred maintenance. Modest improvements will be made to 75% of the units.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $2.5 million, $2.7 million and $1.1 million, respectively. As of June 30, 2017, the property was 74.9% occupied with a weighted average monthly effective rent per occupied unit of $755.

A third party national brokerage firm has provided the Company a valuation of the property at $38.5 million. As of June 30, 2017, the property has a $19.3 million first mortgage loan and a supplemental second mortgage loan of $1.9 million. The first and second mortgage loans bear interest at a fixed rate of 4.12% over a 61 month term maturing in July 2022.

 

88


Table of Contents

NREF intends to make a $5.2 million mezzanine loan to Marbella. The loan will pay interest at a rate of 9%, paid monthly, and a PIK return of 4%, which will compound monthly and be due at the time of a triggering event. NREF will be paid 1% when the loan is repaid.

Riverside Villas: Riverside Villas is a 192-unit garden style multifamily community built in 2009 and located in Fort Worth, Texas. The property sits within close proximity to Alliance Town Center and Medical City Alliance, while this location feeds into the highly regarded Keller Independent School District. Riverside Villas features include seven different floor plans, including a select number of three-bedroom floorplans in seven three-story garden style buildings. Community amenities include a clubhouse, fitness center, business center, resort style swimming pool, outdoor grilling stations, valet trash service and covered parking. Unit interiors include 9’ ceilings, granite countertops, wood-style flooring, inviting terraces, double vanities, oval garden tubs and showers, and washer/dryer connections. The sponsor’s business plan includes a renovation budget totaling $1.3 million with exterior improvements of $0.5 million including full exterior paint and carpentry repairs, clubhouse and amenity improvements, the addition of a dog park and 38 new carports. Interiors will be upgraded as units turn to include new flooring, stainless steel appliances, updated fixtures, refinished cabinets, fresh paint and blinds.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $1.2 million, $1.3 million and $0.7 million, respectively. As of June 30, 2017, the property was 94.3% occupied with a weighted average monthly effective rent per occupied unit of $1,105.

A third party national brokerage firm has provided the Company a valuation of the property at $24.0 million. As of June 30, 2017, the property has a $11.1 million first mortgage loan. The first mortgage loan bears interest at a fixed rate of 4.05% over a 62 month term maturing in October 2022.

NREF intends to make a $2.0 million mezzanine loan to Riverside Villas. The loan will pay interest at a rate of 8.5%, paid monthly. NREF will be paid 1% when the loan is repaid.

Current Investments and Properties

The following is a summary of the investments we currently own that will be part of our Initial Portfolio following this offering:

 

Investment

     Property Type        Investment Type      Amount of
  Investment  
   Rate
Stone Oak    Multifamily    Preferred Equity    $5.25 million    8% + 3% PIK
Estates (1)    Multifamily    Property    $48.6 million    N/A

 

(1) We currently have a $26.9 million first mortgage on Estates.

Stone Oak: Stone Oak is located within the Stone Oak master planned community of San Antonio, Texas. The property was built in 2014 and is a 360-unit, garden-style Class A luxury apartment community with 11 different studio, one-, two-, and three-bedroom floor plans, totaling approximately 354,906 rentable square feet situated on 27.5 acres. Interior apartment features include fully equipped kitchens with stainless steel or black appliances, hardwood-style flooring, and ground level private entries. The property also offers select units, which feature updated ceiling fan and lighting kits, stainless steel appliances, granite countertops, and crown molding. Community amenities include a resort-style swimming pool, a state-of-the-art fitness center, dog spa, and a complimentary car wash area. The sponsor has budgeted and reserved approximately $0.58 million, or $1,615 per unit, for minor capital improvements, which include minor aesthetic improvements to unit interiors — adding tile backsplash, framed mirrors and upgraded fixtures, as well as several modest enhancements to community amenities.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $2.0 million, $2.2 million and $1.2 million, respectively. As of June 30, 2017, the property

 

89


Table of Contents

was approximately 91.7% leased with a weighted average monthly effective rent per occupied apartment unit of $1,095.

The Purchaser assumed a $34.0 million first mortgage loan originated by Fannie Mae, received a $5.3 million preferred equity investment from a wholly owned subsidiary of NREF and invested approximately $9.7 million of cash to fund the property acquisition. The first mortgage loan plus the preferred equity investment combine to make up approximately 80% of the total investment capitalization. The first mortgage loan bears interest at a fixed rate of 3.93% over a 120-month term maturing in December 2024. The $5.3 million preferred equity investment has an 8% current pay rate and a 3% accrual rate, which is compounded monthly and payable upon a triggering event.

Estates: Estates is located in Phoenix, Arizona. Pursuant to a contribution agreement among us, Highland and the OP, Highland transferred its 100% interest in Estates on Maryland Holdco, LLC (“Estates Holdco”) to us. Estates Holdco owns a 95% interest in the entity that owns Estates in fee simple. The remaining 5% interest in Estates is owned by affiliates of BH. The property was built in 2000 and is a 330-unit, garden-style Class A apartment complex situated on 11.66 acres. The property has 14 three-story garden style residential apartment buildings, which house a mixture of one-, two- and three-bedroom floor plans and a management/leasing office. There are 589 parking spaces; 202 surface spaces, 333 covered and 54 garages. Consistent with the multifamily property focus, the majority of the leases we enter into for the apartment units are for terms of typically one year or less. The property completed extensive exterior renovations in 2014 and 2015 and is currently undergoing a targeted exterior and interior renovation campaign. Recently completed capital improvements include LED lighting replacements, updated grilling areas, pool and landscape updates, parking lot repairs, amenity improvements, plumbing repairs, new paint and stucco, clubhouse/leasing renovation, updated signage and HVAC replacement. Common area amenities include two swimming pools with resort style sun decks, fitness center, outdoor barbeque and picnic areas, internet café with private lounge, business center and a multimedia theater. Unit interior amenities include island kitchen with white cabinetry, full size washer and dryer in all units, nine foot ceilings, garden tubs, private patio or balcony, ceiling fans, and units are alarm system ready. Upgraded hardware and lighting packages, repainted cabinet boxes, refaced cabinet doors, vinyl plank flooring, two-tone paint, granite countertops, stainless steel appliances, spa shower heads, brushed nickel ceilings fans, 8” sinks, 2” blinds, panel doors and updated thermostats were added to select units. Planned exterior and common area improvements include updating the clubhouse and leasing center, adding resort style pool furniture, updating the exterior lighting, and overhauling the landscape and drainage systems to improve curb appeal. Planned improvements to unit interiors include updating hardware and lighting fixtures, repainting cabinets, adding a two-tone paint scheme and replacing carpet with hardwood floors.

For the six months ended June 30, 2017, the property reported rental revenue, total revenue and total operating expenses of $1.8 million, $2.0 million and $0.8 million, respectively. As of June 30, 2017, the property was approximately 93.3% leased with a weighted average monthly effective rent per occupied apartment unit of $963.

We placed a first mortgage financing on the property, originated by Freddie Mac, with a principal amount of approximately $26.9 million, a floating interest rate at 1.9% over three-month LIBOR and a 60-month term. Contemporaneous to closing, a 3-year LIBOR cap was purchased, fixing the max note rate at 6%.

Market Opportunity

We believe there is a significant opportunity to originate structured investments in stabilized real estate assets that have short-term leases and a diversified tenant base such as multifamily, self-storage and hospitality properties. Third-party sponsors of these property types seek gap financing from time to time, which allows them to allocate capital more efficiently while earning a higher return. We have seen demand for gap financing increase as banks have reduced their commercial real estate refinancing due in large part to more onerous underwriting standards and stricter banking regulations.

 

90


Table of Contents

In particular, we believe multifamily assets currently represent an attractive opportunity for structured investments. With home ownership rates close to 64%, annual apartment rent increases have averaged in excess of 3.0% over the past 10 years with vacancy rates below 6%, which reflects strong demand coupled with limited new supply in most markets.

The multifamily loan market has approximately $1.2 trillion of debt outstanding as of March 31, 2017, with mortgage originations totaling $265 million in 2016. The financing market is heavily supported by Fannie Mae and Freddie Mac, which combined represented 42%, or $112 billion, of loan originations in 2016. We expect most of our multifamily investments will utilize a GSE first mortgage, which follow strict underwriting requirements. The GSEs experienced relatively low delinquency rates throughout the great recession and have been below 10 basis points since 2014.

 

LOGO

Primary Geographical Concentration

There has been explosive job growth in the Southeastern and Southwestern United States with MSAs such as Dallas/Fort Worth, Nashville, and Atlanta significantly outpacing the national average. Areas located in the Sunbelt present an opportunity in the three main sub-verticals that NREF plans on deploying capital (multifamily, self-storage, and hospitality). In addition, with the current population boom, there will be the necessity for an increased supply of infrastructure to meet the demands of these powered economies. As highlighted in the chart below, which is based on a recent report, Sunbelt states are projected for some of the largest overall increases in population through 2020. The red bars indicate markets where NREF intends to deploy capital based on its pipeline investments.

 

LOGO

 

91


Table of Contents

Generally, multifamily, storage, and select-service hospitality sectors are able to quickly adjust their rents in a raising interest rate or inflationary environment due to their short term leases and tenant diversification. They are less affected by the technology revolution that has been reshaping the supply/demand dynamics across other sectors of the real estate market. Because of the unpredictability of certain technology disrupters, our Advisor will focus on the aforementioned areas in real estate that are less prone to unknown external forces but rather rely on known demographic trends and historical precedence.

Large, Addressable Property Types with Compelling Market Fundamentals

 

    Multifamily: Mega-growth drivers such as demographics create demand for multifamily housing. According to a 2014 report by the U.S. Census Bureau, millennials are the largest segment of the overall population and have the highest propensity to rent. This age cohort also tends to marry later and live a more transient/mobile lifestyle, making homeownership a less likely choice. In addition, student loan debt has ballooned over the past decade, making it increasingly difficult to purchase a home. According to a recent report, six million households pay more than $250 per month on their student loans. Seniors, like millennials, are trending towards apartment living for reasons such as “empty nesters” downsizing and simplifying to alleviate the added stresses of homeownership. The demographic advantage described above, together with multifamily properties having one of the shortest lease terms, other than daily rates charged by hotels, provides the ability to continuously adjust rents to enhance revenue management and delivers an excellent opportunity for investing in the multifamily space.

 

LOGO

Source: United States Census Bureau

 

LOGO

 

92


Table of Contents

In addition, as shown in the chart below, the multifamily investment market is highly liquid, with transaction volume exceeding $150 billion in 2016.

 

LOGO

 

    Self-Storage: Self-storage assets are generally stable, low-risk, and reliable. The self-storage industry should be prepped for future growth due to decreasing homeownership rates, which have slipped to 62.9%, the lowest on record since 1965 according to a recent report. Approximately $5.4 billion in pre-recession self-storage commercial mortgage-backed securities will mature through 2017. As these securities mature, we believe that owners of the underlying properties will look to less restrictive debt alternatives for those refinancings. Further, many owners will look to recapitalize current assets and use proceeds to acquire/develop additional storage properties, creating a need for additional development capital.

 

    Select-Service and Extended-Stay Hospitality: Approximately $29.1 billion of U.S. hotel transaction volume was realized in 2016, and we would expect this trend to continue through 2017.

Representative Transaction History

Set forth below is a representative listing of past preferred equity transactions that our Advisor and its affiliates have originated. We are highlighting the 20 investments set forth below because we believe they are the most similar investments that our Advisor has made to the types of investments we will seek to make following the completion of this offering. The transaction sample is to help illustrate the investment profile we intend to underwrite and what returns our Advisor aims to achieve. We calculated the implied IRR based on the present value of forecasted cash flows that the investment was expected to produce, the purchase price paid for the investment and assuming a three year holding period. Past performance is not a guarantee of future results. Performance during time periods shown is limited and may not reflect the performance of these investments

 

93


Table of Contents

in different economic and market cycles. There can be no assurance that we will achieve comparable results to the investments discussed below.

 

Transaction

  Status     Initial
Date
    Investment
Amount
    Senior
Loan
To Cost
(%)
    Senior
Loan plus
Investment
to Cost

(%)
    Current
Pay
    PIK     Total
Rate
    Implied
IRR
 

Multifamily #1

    Repaid       Jun-14     $ 3,100,000       74     88     10.25     5.00     15.25     17.33

Multifamily #2

    Active       Jul-14       3,821,000       69     81     10.25     5.00     15.25     16.30

Multifamily #3

    Active       Aug-14       2,000,000       54     63     8.50     2.00     10.50     11.48

Multifamily #4

    Active       Oct-14       5,000,000       65     77     8.50     2.00     10.50     11.47

Multifamily #5

    Active       Jan-15       5,500,000       75     89     8.50     2.00     10.50     11.48

Multifamily #6

    Active       Feb-15       5,700,000       71     87     8.25     2.75     11.00     11.94

Multifamily #7

    Active       Mar-15       3,725,000       68     77     8.50     2.00     10.50     11.47

Multifamily #8

    Active       Mar-15       3,500,000       66     74     8.50     2.00     10.50     11.47

Multifamily #9

    Active       Mar-15       2,500,000       68     85     8.00     3.25     11.25     12.15

Multifamily #10

    Active       Apr-15       3,100,000       62     74     8.00     3.00     11.00     11.92

Multifamily #11

    Active       May-15       7,300,000       68     87     8.25     2.75     11.00     11.94

Multifamily #12

    Active       Jun-15       12,300,000       67     83     8.25     2.75     11.00     11.94

Multifamily #13

    Active       Aug-15       10,000,000       73     86     8.50     3.00     11.50     12.44

Multifamily #14

    Repaid       Oct-15       13,000,000       63     81     7.50     5.50     13.00     19.22

Multifamily #15

    Active       Nov-15       8,586,000       66     80     8.00     3.00     11.00     11.92

Multifamily #16

    Active       Jul-16       1,012,750       72     77     11.00     1.00     12.00     13.26

Multifamily #17

    Repaid       Dec-15       6,000,000       65     80     8.00     4.00     12.00     14.95

Multifamily #18

    Active       Aug-16       5,250,000       69     80     8.00     3.00     11.00     11.93

Multifamily #19

    Active       Dec-15       8,300,000       71     83     8.25     2.75     11.00     11.94

Hospitality

    Active       Nov-16       1,950,000       58     73     9.00     5.50     14.50     15.48
     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total/Weighted Average

      $ 111,644,750       67.77     81.90     8.33     3.25     11.58     13.29
     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Transaction history is representative of investments using similar strategy in affiliate accounts and as of December 31, 2016. Information is unaudited and furnished by our Advisor.

In addition to the representative preferred equity investments discussed above, our Advisor has realized returns on $108.9 million of other investments that our Advisor does not believe are representative of the types of investments that we intend to make. These real estate equity investments returned an average multiple on invested capital of 2.01x and a cumulative levered IRR of approximately 30.0%. The cumulative levered IRR on redeemed equity investments is the compound annual rate of return calculated by the Company based on the timing and amount of all equity contributions, distributions and net proceeds from sales of the properties.

Our Sponsor

Our Sponsor and its subsidiaries are primarily responsible for managing the real estate investment activities for Highland and its affiliates. Highland is an SEC-registered investment advisor which, together with its affiliates, had $13.7 billion in assets under management as of July 31, 2017, and employs more than 130 investment, accounting, finance, compliance, legal and human resource professionals. Highland’s diversified client base includes public pension plans, foundations, endowments, corporations, financial institutions, fund of funds, governments, and high net-worth individuals. Highland is one of the most experienced global alternative credit managers. The firm invests in various credit and equity strategies through hedge funds, long-only funds, separate accounts, CLOs, non-traded funds, publicly traded funds, closed-end funds, including an interval fund and a business development company, mutual funds and ETFs, and manages strategies such as distressed-for-control private equity, oil and gas, direct real estate, real estate credit and originated or structured real estate

 

94


Table of Contents

credit investments. Our senior management team will include James Dondero, Brian Mitts, Matt McGraner, Matthew Goetz and Scott Ellington. The members of our Sponsor’s real estate team, both during their tenure at Highland and in their previous roles before joining Highland, have a long history of investing in real estate and debt related to real estate properties. In addition, NexBank’s mortgage banking volume exceeded $5.0 billion in 2016, while also servicing $4.3 billion of 1-4 family residential loans for Fannie Mae, Freddie Mac, and Ginnie Mae, among others.

Tactical Relationship with Highland Capital Management, L.P.

Significant Shareholder Alignment — Investor as well as Advisor

Highland, our Advisor and its affiliates are committed to making a substantial investment in NREF. Concurrently with the closing of this offering, Highland and/or its affiliates will purchase in a separate private placement                 shares of our common stock representing an aggregate investment equal to $         million. Highland, our Advisor and its affiliates intend to beneficially own shares representing approximately 25% of our outstanding common stock, which they intend to accumulate over time. At the closing of this offering, taking into account the overallotment option, Highland, our Advisor and its affiliates expect to own approximately 10% of our outstanding common stock.

Highland, our Advisor and its affiliates firmly believe in taking proactive measures intended to align themselves with shareholders by holding substantial stakes in the investment vehicles they manage as well as implementing pro-investor programs further supporting its alignment and being a leading advocate for the investor base.

Leveraging Highland’s and NexBank’s Platforms

We will benefit from our Advisor’s affiliation with Highland and NexBank, which provide access to resources including research capabilities, an extensive relationship network, other proprietary information, and instant scalability. Given our Advisor’s access to these resources, our Advisor is able to research, source, and evaluate opportunities that competitors may not have the bandwidth nor opportunity to pursue.

We firmly believe Highland’s vast network of resources, and its and NexBank’s core competencies will benefit NREF in the following key areas:

 

    Highland’s Proven Processes: Highland’s time-tested investment process is rooted in its ability to identify mispricing through robust macro, top-down analysis as well as fundamental, bottoms-up analysis, proactive diligence, monitoring and very nimble trading capabilities. Highland’s investment team is comprised of industry focused research professionals with an average of approximately 11 years of investment experience. These professionals are responsible for reviewing existing investments, evaluating opportunities across issuer capital structures and monitoring trends within those industries. Highland maintains investment thesis and sell-discipline, and strives for active returns by avoidance. Finally, Highland’s active and focused portfolio management process is driven by its bold decision making and has been a key driver of creating active returns over time.

 

    Strategic Partnerships & Robust Third-Party Relationships: Over the years, Highland and its affiliates have forged mutually beneficial relationships and partnerships that have served to provide increased deal flow on attractive real estate with quality sponsors. Its robust relationships have also allowed for more creative financing solutions to better serve its clients and investors.

 

    Immediate Scalability: One of the benefits of being part of a $13.7 billion enterprise is the ability to provide immediate scalability to an investment vehicle. We expect instantaneous cost efficiencies and to achieve economies of scale upon the closing of this offering, which is reflected in NREF’s efficient fee structure by leveraging our first-class back-office groups.

 

95


Table of Contents
    First-Class Back-Office Support: Highland’s back-office was created to cover all functional areas for the on-going support and operations of the firm and its various products. The back-office consists of Accounting, Corporate, Human Resources, Valuation, Operations, Settlement, Trading, and Product Strategy. Each team has its own set of robust processes and policies to ensure consistency, accuracy, and reliability on respective functions. These groups cover and have expertise in a multitude of fund structures, including limited partnerships, separately managed accounts, publicly traded companies, mutual funds, ETFs, closed-end funds and private equity structures. They also have experience servicing various investor types such as large pension funds, high net worth individuals, public investors, and retail mutual fund investors.

 

    Expertise in Public Filings: Highland’s accounting group includes personnel with extensive experience with public SEC filings, and accounting and tax expertise in real estate accounting and accounting for loans, mortgages and other credit instruments. An affiliate of our Advisor externally manages a publicly traded REIT, NexPoint Residential Trust, Inc. (NYSE: NXRT); a publicly traded closed-end fund, NexPoint Credit Strategies Fund (NYSE: NHF); and a public, non-traded business development company, NexPoint Capital, Inc. All of these entities are public filers and have personnel dedicated to their accounting with extensive experience with financial statement reporting.

 

    In-House Legal Counsel: Highland utilizes a 14 person in-house Legal/Compliance team comprised of lawyers, paralegals, and compliance experts who have extensive experience in multiple facets of law.

 

    NexBank’s Infrastructure: NexBank will help source and execute investments, provide servicing infrastructure and asset management capabilities. Their credit/underwriting team is comprised of seven individuals, including John Holt, Matt Siekielski and Rhett Miller, with extensive experience in commercial real estate, commercial and industrial, residential real estate, municipal bond and asset based lending underwriting. Once a potential transaction is identified, the team gathers due diligence documents, third party reports, any additional research that is needed, and undergoes a site visit. An underwriting package is then prepared for a weekly investment committee meeting among NexPoint and NexBank representatives.

Financing Strategy

We intend to maintain normal operating leverage in the range of 25%-35% of our corporate enterprise value (excluding the leverage on Estates). We expect this leverage to be in the form of a credit facility, primarily utilized for the purposes of recycling capital when our investments are redeemed, paid off or retired, as applicable. Given that we expect loans and investments in stabilized multifamily assets to make up a majority of our portfolio, we believe this leverage target is prudent given that leverage typically exists at the asset level. By primarily utilizing (and in most cases, helping select) our borrowers’ property-level financing, we can more effectively manage credit risk. Finally, we believe that our leverage is appropriate to produce superior total returns to both equity and mortgage REITs, particularly at the later stages of the real estate cycle.

 

96


Table of Contents

Investment Process

Our Advisor takes great pride in its time-tested investment process developed by Highland and continues to refine the process in order to maintain a superior method of capital allocation and on-going investment monitoring. The primary objectives of the investment process are for it to be repeatable, dependable, and maximize shareholder value.

 

LOGO

Sourcing & Due Diligence:

 

    Identify & Leverage: Our Advisor begins with idea generation and honing in on investment types with key attributes it feels are attractive by combining a fundamental macro view paired with local knowledge of key geographical areas of interest. Our Advisor maintains a robust pipeline of deal flow created through strong relationships with institutions, brokers, and other investment professionals forged by our Advisor and its affiliates over the years. This allows our Advisor to be ultra-selective and only move forward with investments it believes to be best suited and aligned with NREF’s investment strategy. Our Advisor is able to harness the expertise and resources of Highland, allowing it to source opportunities that competitors may not have the bandwidth nor opportunity to pursue.

 

    Due Diligence: Our Advisor’s extensive due diligence process involves a rigorous three-pronged examination in the underwriting of the investment, a deep credit analysis of the sponsor, and lastly a physical inspection of the actual asset in a final attempt to investigate any potential issues not discovered or disclosed in the initial due diligence package.

 

    Assess: We will assess the overall feasibility of the sponsor’s business plan by stress testing various scenarios in an attempt to discover the durability and sustainability of cash flows.

 

    Acquire/Invest/Structure: The investment idea will then be presented to a member of management for approval, and then presented to the Investment Committee of our Advisor to examine the investment thesis, and finally decide if the overall investment fits within the parameters of the investment strategy and provides the appropriate risk/return profile for the Company.

Structuring & Enhancing Value:

 

    Differentiated: We are differentiated in our lending approach. We look at a wide variety of financing solutions to best meet the needs of borrowers to create symbiotic, long-lasting relationships.

 

97


Table of Contents
    Leverage: We intend to have a majority of our investment solutions crafted with protective rights to enhance value to shareholders. This allows for added downside protection in the event the borrower is unable to pay the interest or preferred return.

 

    Partner: We look to partner with top U.S. sponsors with strong balance sheets, thoughtful business plans, and stellar reputations.

Monitor & Exit:

 

    Monitor: Risk management and self-discipline are integrated through the investment process and a continual evaluation of risk factors and market fundamentals, and investment-level analysis is continuously conducted and scrutinized. Our Advisor and its affiliates have institutionalized best practices developed over 20 years of investing.

 

    Exit: Upon extensive evaluation of the portfolio, we will look to harvest gains or reposition the portfolio to optimize risk-adjusted returns.

Investment Guidelines

Upon completion of this offering, our board of directors will approve the following investment guidelines:

 

    No investment will be made that would cause us to fail qualify or maintain our qualification as a REIT under the Code;

 

    No investment will be made that would cause us or any of our subsidiaries to be required to be registered as an investment company under the Investment Company Act;

 

    Our Advisor will seek to invest our capital in our target assets;

 

    Prior to the deployment of our capital into our target assets, our Advisor may cause our capital to be invested in any short-term investments in money market funds, bank accounts, overnight repurchase agreements with primary Federal Reserve Bank dealers collateralized by direct U.S. government obligations and other instruments or investments determined by our Advisor to be of high quality; and

 

    No more than 25% of our Equity (as defined in our Advisory Agreement) may be invested in any individual investment without the approval of a majority of our independent directors (it being understood, however, that for purposes of the foregoing concentration limit, in the case of any investment that is comprised (whether through a structured investment vehicle or other arrangement) of securities, instruments or assets of multiple portfolio issuers, such investment will be deemed to be multiple investments in such underlying securities, instruments and assets and not the particular vehicle, product or other arrangement in which they are aggregated).

These investment guidelines may be amended, supplemented or waived pursuant to the approval of our board of directors (which must include a majority of our independent directors) from time to time, but without the approval of our stockholders.

 

98


Table of Contents

Our Structure

The following chart shows our ownership structure:

 

LOGO

Advisory Agreement

Pursuant to our Advisory Agreement, NexPoint Real Estate Advisors II, L.P. serves as our Advisor. On the closing of this offering, the Advisory Agreement will be amended and restated. Pursuant to the Advisory Agreement, subject to the overall supervision of our board of directors, our Advisor will manage our day-to-day operations, and provide investment management services to us. Under the revised terms of this agreement, our Advisor will, among other things:

 

    identify, evaluate and negotiate the structure of our investments (including performing due diligence);

 

    find, present and recommend investment opportunities consistent with our investment policies and objectives;

 

    structure the terms and conditions of our investments;

 

    review and analyze financial information for each underlying property of the overall portfolio; and

 

    close, monitor and administer our investments.

As consideration for the Advisor’s services, we will pay our Advisor an annual asset management fee of 1.5% of Equity, paid monthly, in cash.

“Equity” means (a) the sum of (1) total stockholders’ equity immediately prior to the closing of this offering, plus (2) the net proceeds received by NREF from all issuances of NREF’s common stock after the

 

99


Table of Contents

offering, plus (3) NREF’s cumulative Core Earnings (as defined below) from and after the offering to the end of the most recently completed calendar quarter, (b) less (1) any distributions to NREF’s common stockholders from and after the offering to the end of the most recently completed calendar quarter and (2) any amount that NREF has paid to repurchase NREF’s common stock from and after the offering to the end of the most recently completed calendar quarter. For the avoidance of doubt, Equity will include compensation expense relating to any restricted shares of common stock and any other shares of common stock underlying awards granted under one or more of NREF’s equity incentive plans as an adjustment to net income in the calculation of Core Earnings.

“Core Earnings” means the net income (loss) attributable to our common stockholders computed in accordance with GAAP, including realized gains and losses not otherwise included in net income (loss), and excluding (a) amortization of stock-based compensation, (b) depreciation and amortization, and (c) adjustments for noncontrolling interests. Net income (loss) attributable to common stockholders may also be adjusted for one-time events pursuant to changes in GAAP and certain material non-cash income or expense items, in each case after discussions between the Advisor and the independent directors of the board and approved by a majority of the independent directors of the board.

Additionally, incentive compensation will be payable to our executive officers and certain other employees of our Advisor or its affiliates pursuant to a long-term incentive plan approved by the shareholders featuring restricted stock units (“RSUs”), restricted stock, options, appreciation rights, and other equity-based compensation awards, which may be granted to management and employees under such terms and conditions as the compensation committee of our board may determine from time to time.

We will be required to pay directly or reimburse our Advisor for all of the documented “operating expenses” (all out-of-pocket expenses of our Advisor in performing services for us, including but not limited to the expenses incurred by our Advisor in connection with any provision by our Advisor of legal, accounting, financial and due diligence services performed by our Advisor that outside professionals or outside consultants would otherwise perform, compensation expenses under any long term incentive plan adopted by us and approved by our stockholders and our pro rata share of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of our Advisor required for our operations) and “offering expenses” (any and all expenses (other than underwriters’ discounts) paid or to be paid by us in connection with an offering of our securities, including, without limitation, our legal, accounting, printing, mailing and filing fees and other documented offering expenses) paid or incurred by our Advisor or its affiliates in connection with the services it provides to us pursuant to the Advisory Agreement. Reimbursement of operating expenses, plus the Annual Fee, may not exceed 2.5% of gross assets for any calendar year or portion thereof, provided, however, that this limitation will not apply to legal, accounting, financial, due diligence and other service fees incurred in connection with extraordinary litigation and mergers and acquisitions and other events outside the ordinary course of our business or any out-of-pocket acquisition or due diligence expenses incurred in connection with the acquisition or disposition of certain real estate assets. Reimbursements of offering expenses paid or to be paid to our Advisor in connection with this offering may not exceed $1.5 million.

Under the terms of the Advisory Agreement, our Advisor will indemnify and hold harmless us, our subsidiaries and the OP from all claims, liabilities, damages, losses, costs and expenses, including amounts paid in satisfaction of judgments, in compromises and settlements, as fines and penalties and legal or other costs and expenses of investigating or defending against any claim or alleged claim, of any nature whatsoever, known or unknown, liquidated or unliquidated, that are incurred by reason of our Advisor’s bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of its duties; provided, however, that our Advisor will not be held responsible for any action of our board of directors in following or declining to follow any written advice or written recommendation given by our Advisor. However, the aggregate maximum amount that our Advisor may be liable to us or the OP pursuant to the Advisory Agreement will, to the extent not prohibited by law, never exceed the amount of the management fees received by our Advisor under the Advisory Agreement prior to the date that the acts or omissions giving rise to a claim for indemnification or liability have

 

100


Table of Contents

occurred. In addition, our Advisor will not be liable for special, exemplary, punitive, indirect, or consequential loss, or damage of any kind whatsoever, including without limitation lost profits. The limitations described in the preceding two sentences will not apply, however, to the extent such damages are determined in a final binding non-appealable court or arbitration proceeding to result from the bad faith, fraud, willful misfeasance, intentional misconduct, gross negligence or reckless disregard of our Advisor’s duties.

The Advisory Agreement has an initial term of three years, and is automatically renewed thereafter for a one-year term unless earlier terminated. We will have the right to terminate the Advisory Agreement on 30 days written notice for cause. The Advisory Agreement can be terminated by us or our Advisor without cause with six months’ written notice to the other party. Our Advisor may also terminate the agreement with 30 days written notice if the Company has materially breached the agreement and such breach has continued for 30 days. A termination fee will be payable to our Advisor upon termination of our Advisory Agreement for any reason other than a termination by the Company for cause. The termination fee will be equal to three times the average Annual Fee earned by our Advisor during the two-year period immediately preceding the most recently completed calendar quarter prior to the effective termination date; provided, however, if the Advisory Agreement is terminated prior to the two-year anniversary of the date of the Advisory Agreement, the asset management fee earned during such period will be annualized for purposes of calculating the average annual asset management fee.

See “Management Compensation.”

 

101


Table of Contents

MANAGEMENT

Board of Directors

We operate under the direction of our board of directors. Our board of directors is responsible for directing the management of our business and affairs. Our board of directors has retained our Advisor to manage our day-to-day operations and our portfolio of real estate assets, subject to the supervision of our board of directors.

Our directors must perform their duties in good faith and in a manner each director reasonably believes to be in our best interests. Further, our directors must act with such care as an ordinarily prudent person in a like position would use under similar circumstances. However, our directors are not required to devote all of their time to our business.

Each director will serve until the next annual meeting of stockholders and until his successor has been duly elected and qualified. At any meeting of stockholders, the presence in person or by proxy of stockholders entitled to cast a majority of all the votes entitled to be cast at such meeting on any matter constitutes a quorum. A plurality of all the votes cast at a meeting of stockholders duly called and at which a quorum is present is sufficient to elect a director.

Although our board of directors may increase or decrease the number of directors, a decrease may not have the effect of shortening the term of any incumbent director. Any director may resign at any time or may be removed only for cause, and then only by the stockholders upon the affirmative vote of at least a majority of all the votes entitled to be cast generally in the election of directors.

A vacancy created by an increase in the number of directors or the death, resignation, removal, adjudicated incompetence or other incapacity of a director may be filled only by a vote of a majority of the remaining directors, even if the remaining directors do not constitute a quorum, and any director elected to fill a vacancy will serve for the remainder of the full term of the directorship in which the vacancy occurred.

In addition to meetings of the various committees of our board of directors, which committees we describe below, we expect our directors to hold at least four regular board meetings each year.

Directors and Executive Officers

We expect our initial executive officers to be the same officers as our Advisor. Given their expertise and history with our Company, we also expect our directors to continue in their existing roles for the near term. The initial directors’ and executive officers’ respective positions and offices are as follows:

 

Name

   Age     

Position(s)

Brian Mitts

     46      Chief Financial Officer, Executive VP-Finance, Treasurer and Director

D. Kirk McAllaster, Jr.

     50      Independent Director

John M. Pons

     53      Independent Director

James Dondero

     54      President

Matthew McGraner

     33      Chief Investment Officer and Executive VP

Matthew Goetz

     31      VP-Investments and Asset Management

Scott Ellington

     46      General Counsel and Secretary

Brian Mitts: Mr. Mitts has served as our Chief Financial Officer, Executive Vice President-Finance and Treasurer since November 2014, a member of our board of directors since November 2013 and Chairman of the board of directors since June 2015. Mr. Mitts also is a member of the investment committee of our Advisor. Mr. Mitts joined Highland in February 2007 and currently also serves as the Chief Operations Officer for Highland Capital Management Fund Advisors L.P. and NexPoint Advisors, L.P., serves as director, the Chief Financial Officer, Executive Vice President, Treasurer and a member of the investment committee of NXRT,

 

102


Table of Contents

serves as Executive Vice President, Principal Financial Officer and Principal Accounting Officer of NHF, serves as Principal Financial Officer and Principal Accounting Officer of NexPoint Capital, serves as Executive Vice President, Principal Financial Officer and Principal Accounting Officer of NRESF, and serves as Executive Vice President of NexPoint Real Estate Advisors, L.P. Mr. Mitts is also the Chief Operating Officer of Highland Capital Funds Distributor, Inc. and the Financial and Operations Principal of NexBank Securities, Inc. Mr. Mitts works closely with the Highland real estate platform and is integral in marketing real estate products for Highland and its affiliates. Mr. Mitts received an MPA and a BBA from the University of Texas at Austin. Mr. Mitts is a licensed Certified Public Accountant.

We believe that Mr. Mitts’ experience as an executive officer of several Highland-sponsored entities, his work with the Highland real estate platform and his licensure as a Certified Public Accountant, qualify him to be one of our directors.

D. Kirk McAllaster, Jr.: Mr. McAllaster has served as our independent director and Chairman of the audit committee since June 2015. Since October 2015, Mr. McAllaster has served as President of Rincon Partners, LLC, a commercial real estate firm. Prior to Rincon Partners, LLC, Mr. McAllaster worked for Cole Capital, a full-service real estate operating company, from May 2003 — August 2014, and during the past five years he served as an executive officer and/or director for a number of entities affiliated with Cole Capital.

Mr. McAllaster has over 20 years of accounting and finance experience in public accounting and private industry. Mr. McAllaster received a B.S. from California State Polytechnic University — Pomona with a major in Accounting. He is a Certified Public Accountant licensed in the states of Arizona and Tennessee and is a member of the American Institute of CPAs and the Arizona Society of CPAs. Mr. McAllaster was selected to serve as a director due to his experience as an executive officer and director of a number of non-traded REITs, as well as his accounting firm experience and certification as a CPA.

John M. Pons: Mr. Pons has served as our independent director since June 2015. Since December 2014, Mr. Pons has served as managing principal and general counsel of Rincon Partners, LLC, a commercial real estate firm. Prior to Rincon Partners, LLC, Mr. Pons worked for Cole Capital, a full-service real estate operating company, from September 2003 — October 2014, and during the past five years he served as an executive officer and/or director for a number of entities affiliated with Cole Capital.

Mr. Pons was in private practice prior thereto. Before attending law school, Mr. Pons was a Captain in the United States Air Force where he served from 1988 until 1992. Mr. Pons received a B.S. degree in Mathematics from Colorado State University and a M.S. degree in Administration from Central Michigan University before earning his J.D. (Order of St. Ives) in 1995 at the University of Denver. Mr. Pons was selected to serve as a director due to his experience as an executive officer and director of a number of non-traded REITs.

James Dondero: Mr. Dondero has served as our President since February 2014. Mr. Dondero is also President and a member of the investment committee of our Advisor, the co-founder and President of Highland, founder and President of NexPoint Advisors, L.P., our Sponsor, Chairman of the board, Chief Executive Officer and member of the investment committee of NexPoint Residential Trust, Inc. (“NXRT”), President of NexPoint Capital, Inc. (“NexPoint Capital”), an affiliated publicly registered non-traded business development company, President of NexPoint Credit Strategies Fund, an affiliated registered closed-end investment company that has its shares listed on the New York Stock Exchange (“NHF”), President of NexPoint Real Estate Strategies Fund, a closed-end investment company that operates as an interval fund (“NRESF”), President of NexPoint Real Estate Advisors, L.P., an affiliate of our Advisor, director for Jernigan Capital, Inc., director for American Banknote Corporation, director for Metro-Goldwyn-Mayer, Chairman of the board of directors for Cornerstone Healthcare, Chairman of the board of directors for CCS Medical, and Chairman of NexBank, SSB, an affiliated bank. Mr. Dondero has over 30 years of experience investing in credit and equity markets and has helped pioneer credit asset classes. Highland and its affiliates managed $13.7 billion in assets as of May 31, 2017. Prior to founding Highland in 1993, Mr. Dondero served as Chief Investment Officer of Protective Life’s GIC subsidiary and

 

103


Table of Contents

helped grow the business from concept to over $2 billion between 1989 and 1993. His portfolio management experience includes mortgage-backed securities, investment grade corporates, leveraged bank loans, high-yield bonds, emerging market debt, real estate, derivatives, preferred stocks and common stocks. From 1985 to 1989, he managed approximately $1 billion in fixed income funds for American Express. Mr. Dondero received a BS in Commerce (Accounting and Finance) from the University of Virginia, and is a Certified Managerial Accountant and a Chartered Financial Analyst.

Matt McGraner: Mr. McGraner has served as our Chief Investment Officer and Executive Vice President since November 2014. Mr. McGraner is also a Managing Director at Highland, Chief Investment Officer and a member of the investment committee of NXRT, and a portfolio manager for NRESF. Mr. McGraner joined Highland in May 2013. With over nine years of real estate, private equity and legal experience, his primary responsibilities are to lead the strategic direction and operations of the real estate platform at Highland, as well as source and execute investments, manage risk and develop potential business opportunities, including fundraising, capital markets transactions and joint ventures. Mr. McGraner also is a licensed attorney and was formerly an associate at Jones Day from 2011 to 2013, with a practice primarily focused on private equity, real estate and mergers and acquisitions. Mr. McGraner has led the acquisition and financing of over $200 million of real estate investments and advised on $16.3 billion of mergers and acquisitions and private equity transactions. Since joining Highland, Mr. McGraner has led the acquisition and financing of over $2.4 billion of real estate investments. Mr. McGraner received a BS from Vanderbilt University and JD from Washington University School of Law.

Matthew Goetz: Mr. Goetz has served as our Vice President-Investments and Asset Management since November 2014. Mr. Goetz is also a Director at Highland, Director - Real Estate for NexPoint Advisors, L.P. and Senior Vice President-Investments and Asset Management for NXRT. With over nine years of real estate, private equity and equity trading experience, his primary responsibilities are to asset manage, source acquisitions, manage risk and develop potential business opportunities for Highland, including fundraising, private investments and joint ventures. Mr. Goetz has assisted in the acquisition and financing of over $4.8 billion in real estate. Before joining Highland in June 2014, Mr. Goetz was a Senior Financial Analyst in CBRE’s Debt and Structured Finance group from May 2011 to June 2014. Mr. Goetz received a BBA in Finance from St. Edward’s University.

Scott Ellington: Mr. Ellington has served as our General Counsel and Secretary since November 2014. Mr. Ellington also is a Partner and General Counsel at Highland. Prior to joining Highland in May 2007, Mr. Ellington was counsel to major U.S. financial institutions including Wells Fargo and Countrywide Financial. Mr. Ellington received his JD from Pepperdine University in California and his BA from the University of Texas in Dallas.

NexBank Executives

We also expect to utilize NexBank’s extensive infrastructure and experienced real estate credit and asset management teams led by John Holt, Matt Siekielski and Rhett Miller.

John Holt: Mr. Holt is a Director of NexBank and Chairman of the Board of NexBank SSB and serves as the President and CEO of both NexBank and NexBank SSB. In his capacity, he establishes and executes the strategy of NexBank and oversees NexBank’s financial and operational performance. Since Mr. Holt’s arrival in 2011, NexBank has grown to one of the largest banks headquartered and operating in Dallas, Texas, with assets of $5.3 billion. Under his leadership and direction, the bank has achieved strong growth and performance and expanded its commercial banking, mortgage banking and institutional services to meet the goals of its clients, which include institutional clients, financial institutions, large corporations, real estate investors, middle-market companies and small businesses. Mr. Holt serves on the Board of Directors of the Texas Bankers Association (TBA) with additional responsibilities as Chairman of the TBA’s Community Bankers Council and member of the Audit and Finance Committee, Executive Committee and Investment Committee. Mr. Holt is a graduate of

 

104


Table of Contents

Southern Methodist University’s Southwestern Graduate School of Banking and he earned his BBA from the University of Texas at Arlington.

Matt Siekielski: Mr. Siekielski is the Executive Vice President and Chief Operating Officer of NexBank and NexBank SSB. His primary responsibility is the growth and management of NexBank SSB’s primary operating businesses, including commercial banking, mortgage banking, deposit operations and treasury management. Through these business lines, NexBank focuses on providing tailored lending and depository products to institutional clients nationally. Mr. Siekielski is actively involved in the community and currently serves on the board of Impact Dallas Capital, a not-for-profit organization created to drive investment in Southern Dallas and produce positive, sustainable economic, social and environmental benefits for Southern Dallas residents. He also serves on the board of the Real Estate Council Community Fund, a community development financial institution that provides access to capital for real estate projects in low-income areas of Dallas County. Mr. Siekielski holds an MBA in Accounting and MS in Real Estate from the University of Texas at Arlington, and received his BA in Business Administration from Southwestern University in Georgetown, Texas.

Rhett Miller: Mr. Miller serves as Senior Vice President and Chief Credit Officer of NexBank and NexBank SSB. His career spans over 35 years with a primary focus in credit and risk management, corporate finance, and commercial real estate acquisition and development. He is responsible for leading and managing all credit-related activities within NexBank SSB, including underwriting, credit approval, loan administration and loan policies. Mr. Miller has held a number of executive and strategic planning roles during his career and has years of experience in business development and the management of special assets. Most recently, he held the role of Senior Vice President and Manager of Special Assets with Southwest Securities, FSB. Prior to this, he was a Principal at MMA Realty Capital. Mr. Miller holds an MBA from the University of Dallas and a BS in Finance from Florida State University.

Compensation of Our Executive Officers

Our executive officers do not receive compensation from us for services rendered to us. Our executive officers are employees of Highland Capital Management and its affiliates and are compensated by these entities, in part, for their services to us. See “Management Compensation” below for a discussion of the fees paid to and services provided by our Advisor and its affiliates.

Compensation of Our Directors

On June 4, 2015, our board of directors adopted a director compensation policy, in which all independent directors will participate. The director compensation policy is as follows:

 

    Each independent director will receive an annual director’s fee payable in cash equal to $40,000;

 

    The chair of the Audit Committee will receive an additional annual fee payable in cash equal to $7,500;

 

    The chair of the Nominating and Corporate Governance Committee, if any, will receive an additional annual fee payable in cash equal to $7,500;

 

    Each independent director will receive $1,500 for attending each board and committee meeting in person. The chair of the Audit Committee will receive $1,500 for attending each board and committee meeting by telephone, and the other independent directors will receive $750 for attending each board and committee meeting by telephone. In the event there are multiple meetings of the board and one or more committees in a single day, the fees paid to an individual independent director would be limited to $2,000 per day; and

 

   

Each independent director will receive a grant of 3,000 restricted shares of our common stock that will vest in equal amounts annually over a four-year period. An additional 3,000 restricted shares of our

 

105


Table of Contents
 

common stock will be granted upon each reelection as an independent director. Upon completion of this offering, we anticipate that future equity awards will be granted to our independent directors under our 2017 LTIP (as defined below).

We will also reimburse each of our directors for his or her travel expenses incurred in connection with his or her attendance at meetings of our board and committee meetings.

NexPoint Real Estate Finance, Inc. 2017 Long Term Incentive Plan

Prior to this offering, our board of directors will adopt and our shareholders will approve the NexPoint Real Estate Finance, Inc. 2017 Long Term Incentive Plan (the “2017 LTIP”). The description of the 2017 LTIP set forth below is a summary of the material features of the 2017 LTIP. This summary does not purport to be a complete description of all provisions of the 2017 LTIP. As a result, the following description is qualified in its entirety by reference to the 2017 LTIP, which is filed as an exhibit to the registration statement of which this prospectus forms a part.

Administration of the 2017 LTIP and Eligibility

The 2017 LTIP will generally be administered by the compensation committee, or any other committee of the board designated by the board to administer the 2017 LTIP. The compensation committee may from time to time delegate all or any part of its authority under the 2017 LTIP to any subcommittee thereof. Any interpretation, construction and determination by the compensation committee of any provision of the 2017 LTIP, or of any agreement, notification or document evidencing the grant of awards under the 2017 LTIP, will be final and conclusive. To the maximum extent permitted by applicable law, the compensation committee may delegate to one or more of its members or to one or more officers, or to one or more agents or advisors of the Company, such administrative duties or powers as it deems advisable. In addition, the compensation committee may by resolution, subject to certain restrictions set forth in the 2017 LTIP, authorize one or more officers of the Company to (a) designate employees to be recipients of awards under the 2017 LTIP, and (b) determine the size of such awards. However, the compensation committee may not delegate such responsibilities to officers for awards granted to certain employees who are subject to the reporting requirements of Section 16 of the Exchange Act or subject to Section 162(m) of the Code.

Any person who is selected by the compensation committee to receive awards under the 2017 LTIP and who is at that time an officer, service provider or other key employee of the Company or any of its affiliates or subsidiaries (including a person who has agreed to commence serving in such capacity within 90 days of the date of grant) or director is eligible to participate in the 2017 LTIP. In addition, certain persons who provide services to the Company or any of its affiliates or subsidiaries that are equivalent to those typically provided by an employee, including employees of our Advisor may also be selected to participate in the 2017 LTIP. At the consummation of this offering, there will be approximately five employees of our Advisor and                      independent directors expected to participate in the 2017 LTIP.

Stock Options

The 2017 LTIP authorizes the grant of incentive stock options and options that do not qualify as incentive stock options, except that incentive stock options will be granted only to eligible participants who meet the definition of “employees” under Section 3401(c) of the Code. The exercise price of each option cannot be less than the market value per share of our common stock on the date on which the option is granted. The term of an option cannot exceed ten years from the date of grant (or five years in the case of an incentive stock option granted to a ten percent stockholder).

Appreciation Rights

The 2017 LTIP authorizes the grant of appreciation rights. An appreciation right provides the recipient with the right to receive, upon exercise of the appreciation right, shares of our common stock, cash, or a combination

 

106


Table of Contents

of the two, as specified in the award agreement. The amount that the recipient will receive upon exercise of the appreciation right generally will equal the excess of the market value per share of our common stock on the date when the appreciation right is exercised over the base price provided for in the related stock appreciation right. Appreciation rights will become exercisable in accordance with terms determined by our compensation committee. Appreciation rights may be granted in tandem with an option grant or as independent grants. The term of an appreciation right cannot exceed, in the case of a tandem appreciation right, the expiration, cancellation, forfeiture or other termination of the related option and, in the case of a free-standing appreciation right, ten years from the date of grant.

Restricted Stock and RSUs

The 2017 LTIP also provides for the grant of restricted stock and RSUs. Our compensation committee will determine the number of shares of common stock subject to a restricted stock or RSU award and the restriction period, performance period (if any), the performance measures (if any) and the other terms applicable to a stock award under the 2017 LTIP. A RSU confers on the participant the right to receive common stock, cash or a combination thereof. The holders of awards of restricted stock will be entitled to receive dividends, and unless otherwise set forth in the applicable award agreement, the holders of awards of RSUs will not be entitled to receive dividend equivalents.

Performance Awards

The 2017 LTIP also authorizes the grant of performance awards in the form of performance shares, performance units or cash incentive awards. Performance awards represent the participant’s right to receive an amount of cash, shares of our common stock, or a combination of both, contingent upon the attainment of specified performance measures within a specified period. Our compensation committee will determine the applicable performance period, the performance goals and such other conditions that apply to the performance award.

Other Stock-Based Awards

Our compensation committee may grant other forms of awards that are denominated in or payable in, valued in whole or in part by reference to, or otherwise based on or related to, shares of our common stock or factors that may influence the value of shares of our common stock.

Share Authorization

Subject to adjustment as described in the 2017 LTIP, the number of shares of our common stock available under the 2017 LTIP for awards shall be, in the aggregate,                 shares of our common stock plus any shares of our common stock that become available under the 2017 LTIP as a result of forfeiture, cancellation, expiration, or cash settlement of awards.

Our compensation committee will make or provide for such adjustments in the numbers of shares of our common stock covered by outstanding awards under the 2017 LTIP as the committee, in its sole discretion, exercised in good faith, determines is equitably required to prevent dilution or enlargement of the rights of participants that otherwise would result from (a) any stock dividend, stock split, combination of shares, recapitalization or other change in the capital structure of the Company, (b) any merger, consolidation, spin-off, split-off, spin-out, split-up, reorganization, partial or complete liquidation or other distribution of assets, issuance of rights or warrants to purchase securities, or (c) any other corporate transaction or event having an effect similar to any of the foregoing. Moreover, in the event of any such transaction or event or in the event of a change in control, the compensation committee will provide in substitution for any or all outstanding awards under the 2017 LTIP such alternative consideration (including cash), if any, as it, in good faith, may determine to be equitable in the circumstances. Subject to certain limitations, the compensation committee will also make or

 

107


Table of Contents

provide for such adjustments in the numbers of authorized shares under the 2017 LTIP as the committee in its sole discretion, exercised in good faith, determines is appropriate to reflect any transaction or event described above.

Termination; Amendment

No grant will be made under the 2017 LTIP after the tenth anniversary of the 2017 LTIP’s effective date, but all grants made on or prior to such date will continue in effect thereafter subject to the terms thereof and of the 2017 LTIP. The board of directors may at any time and from time to time amend the 2017 LTIP in whole or in part; provided, however, that if an amendment to the 2017 LTIP (i) would materially increase the benefits accruing to participants under the 2017 LTIP, (ii) would materially increase the number of securities which may be issued under the 2017 LTIP, (iii) would materially modify the requirements for participation in the 2017 LTIP, or (iv) must otherwise be approved by our stockholders in order to comply with applicable law or the rules of the NYSE or other principal national securities exchange upon which shares of our common stock are traded or quoted, then such amendment will be subject to shareholder approval and will not be effective unless and until such approval has been obtained.

We previously adopted a restricted share plan. In connection with the adoption of the 2017 LTIP, we will terminate the restricted share plan. Any awards under the restricted share plan outstanding at the time of termination will continue to remain outstanding.

Director Independence

The board of directors will review the materiality of any relationship that each of our directors has with us, either directly or indirectly. The board of directors has determined that each of Mr. McAllaster and Mr. Pons is independent as defined by the NYSE rules.

Corporate Governance Profile

We have structured our corporate governance in a manner we believe aligns our interests with those of our stockholders. Notable features of our corporate governance structure include the following:

 

    the board of directors is not staggered, meaning that each of our directors is subject to re-election annually;

 

    at least one of our directors qualifies as an “audit committee financial expert” as defined by the SEC; and

 

    we have opted out of the business combination provisions and the control share acquisition provisions of the MGCL.

Board Committees

The board of directors has three standing committees: an audit committee, a compensation committee and a nominating and corporate governance committee. The principal functions of each committee are briefly described below. Additionally, the board of directors may from time to time establish certain other committees to facilitate the management of our Company.

Audit Committee

Our audit committee consists of Mr. McAllaster and Mr. Pons, with Mr. McAllaster serving as chair of the committee. The board of directors has determined that Mr. McAllaster qualifies as an “audit committee financial expert” as that term is defined by the applicable SEC regulations and NYSE corporate governance listing

 

108


Table of Contents

standards. The board of directors has also determined that each of Mr. McAllaster and Mr. Pons is “financially literate” as that term is defined by the NYSE corporate governance listing standards and is independent as defined by NYSE rules and SEC requirements relating to the independence of audit committee members. Pursuant to the NYSE’s phase-in rules for newly listed companies, we have one year from the date on which we are first listed on the NYSE to have our audit committee be comprised of three independent members. We intend to identify one additional independent director to serve on the audit committee within the applicable time period. Our audit committee charter details the principal functions of the audit committee, including oversight related to:

 

    our accounting and financial reporting processes;

 

    the integrity of our consolidated financial statements;

 

    our systems of disclosure controls and procedures and internal control over financial reporting;

 

    our compliance with financial, legal and regulatory requirements;

 

    the performance of our internal audit function; and

 

    our overall risk assessment and management.

The audit committee will also be responsible for engaging an independent registered public accounting firm, reviewing with the independent registered public accounting firm the plans and results of the audit engagement, approving professional services provided by the independent registered public accounting firm, including all audit and non-audit services, reviewing the independence of the independent registered public accounting firm, considering the range of audit and non-audit fees and reviewing the adequacy of our internal accounting controls. The audit committee also will prepare the audit committee report required by SEC regulations to be included in our annual proxy statement. A copy of the audit committee charter will be available under the Investors section of the Company’s website at www.nref.com.

Compensation Committee

Our compensation committee consists of Mr. McAllaster and Mr. Pons, with Mr. Pons serving as chair of the committee. The board of directors has determined that each of Mr. McAllaster and Mr. Pons is independent as defined by NYSE rules and SEC requirements relating to the independence of compensation committee members. Our compensation committee charter details the principal functions of the compensation committee, including:

 

    reviewing our compensation policies and plans;

 

    implementing and administering a long-term incentive plan;

 

    assisting management in complying with our proxy statement and annual report disclosure requirements;

 

    producing a report on compensation to be included in our annual proxy statement; and

 

    reviewing, evaluating and recommending changes, if appropriate, to the remuneration for directors.

The compensation committee will have the sole authority to retain and terminate compensation consultants to assist in the evaluation of our compensation and the sole authority to approve the fees and other retention terms of such compensation consultants. The committee will also be able to retain independent counsel and other independent advisors to assist it in carrying out its responsibilities. A copy of the compensation committee charter will be available under the Investors section of the Company’s website at www.nref.com.

Nominating and Corporate Governance Committee

Our nominating and corporate governance committee consists of Mr. McAllaster and Mr. Pons, with Mr. Pons serving as chair of the committee. The board of directors has determined that each of Mr. McAllaster

 

109


Table of Contents

and Mr. Pons is independent as defined by NYSE rules. Our nominating and corporate governance committee charter details the principal functions of the nominating and corporate governance committee, including:

 

    identifying and recommending to the full board of directors qualified candidates for election as directors and recommending nominees for election as directors at the annual meeting of stockholders;

 

    developing and recommending to the board of directors corporate governance guidelines and implementing and monitoring such guidelines;

 

    reviewing and making recommendations on matters involving the general operation of the board of directors, including board size and composition, and committee composition and structure;

 

    recommending to the board of directors nominees for each committee of the board of directors;

 

    annually facilitating the assessment of the board of directors’ performance, as required by applicable law, regulations and the NYSE corporate governance listing standards; and

 

    annually reviewing and making recommendations to the board of directors regarding revisions to the corporate governance guidelines and the code of business conduct and ethics.

The nominating and corporate governance committee will have the sole authority to retain and terminate any search firm to assist in the identification of director candidates and the sole authority to set the fees and other retention terms of such search firms. The committee will also be able to retain independent counsel and other independent advisors to assist it in carrying out its responsibilities. A copy of the nominating and corporate governance committee charter will be available under the Investors section of the Company’s website at www.nref.com.

Other Committees

The board of directors may establish other committees as it deems necessary or appropriate from time to time.

Corporate Governance Guidelines and Code of Business Conduct and Ethics

The board of directors has adopted corporate governance guidelines that describe the principles under which the board of directors will operate and has established a code of business conduct and ethics that applies to our directors and executive officers, who are employees of our Advisor. Among other matters, our code of business conduct and ethics is designed to deter wrongdoing and to promote:

 

    honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;

 

    full, fair, accurate, timely and understandable disclosure in our SEC reports and other public communications;

 

    compliance with laws, rules and regulations;

 

    prompt internal reporting of violations of the code to appropriate persons identified in the code; and

 

    accountability for adherence to the code of business conduct and ethics.

Copies of our corporate governance guidelines and code of business conduct and ethics will be available under the Investors section of the Company’s website at www.nref.com.

Compensation Committee Interlocks and Insider Participation

None of our executive officers has served as a member of the board of directors or compensation committee of any related entity that has one or more executive officers serving on our board of directors or compensation committee.

 

110


Table of Contents

Board Leadership Structure and Board’s Role in Risk Oversight

Our Chairman is also an executive officer of the Company. The board of directors believes that combining these positions is the most effective leadership structure for the Company at this time. As the Chief Financial Officer, Mr. Mitts is involved in the day-to-day operations and is familiar with the opportunities and challenges that the Company faces at any given time. With this insight, he is able to assist the board of directors in setting strategic priorities, lead the discussion of business and strategic issues and translate board of directors recommendations into Company operations and policies.

The board of directors has appointed Mr. McAllaster as its lead independent director. His key responsibilities in this role include:

 

    developing agendas for, and presiding over, the executive sessions of the non-management or independent directors;

 

    reporting the results of the executive sessions to the Chairman (provided, that each director will also be afforded direct and complete access to the Chairman at any such time such director deems necessary or appropriate);

 

    presiding at all meetings of the board of directors at which the Chairman is not present;

 

    approving information sent to the board of directors;

 

    approving agendas for meetings of the board of directors;

 

    approving board meeting schedules to ensure that there is sufficient time for discussion of all agenda items;

 

    calling meetings of the independent directors; and

 

    if requested by major shareholders, ensuring that he is available for consultation and direct communication.

Risk is inherent with every business, and we face a number of risks as outlined in the “Risk Factors” section of this prospectus. Management is responsible for the day-to-day management of risks we face, while the board of directors, as a whole and through our audit committee, is responsible for overseeing our management and operations, including overseeing its risk assessment and risk management functions. The board of directors will delegate responsibility for reviewing our policies with respect to risk assessment and risk management to our audit committee through its charter. The board of directors has determined that this oversight responsibility can be most efficiently performed by our audit committee as part of its overall responsibility for providing independent, objective oversight with respect to our accounting and financial reporting functions, internal and external audit functions and systems of internal controls over financial reporting and legal, ethical and regulatory compliance. Our audit committee will regularly report to the board of directors with respect to its oversight of these areas.

Communications with the Board

Any stockholder or other interested party who wishes to communicate directly with the board of directors or any of its members may do so by writing to: Board of Directors, c/o NexPoint Real Estate Finance, Inc., 300 Crescent Court, Suite 700, Dallas, Texas 75201, Attn: Corporate Secretary. The mailing envelope should clearly indicate whether the communication is intended for the board of directors as a group, the non-employee directors or a specific director.

Limited Liability and Indemnification of Directors, Officers and Other Agents

We are permitted to limit the liability of our directors and officers to us and our stockholders for monetary damages and to indemnify and advance expenses to our directors, officers and other agents, to the extent permitted by Maryland law and our charter.

 

111


Table of Contents

Maryland law permits us to include in our charter a provision eliminating the liability of our directors and officers to our stockholders and us for money damages, except for liability resulting from (i) actual receipt of an improper benefit or profit in money, property or services or (ii) active and deliberate dishonesty established by a final judgment and that is material to the cause of action.

Maryland law requires us (unless our charter provides otherwise, which our charter does not) to indemnify a director or officer who has been successful in the defense of any proceeding to which he or she is made or threatened to be made a party by reason of his or her service in that capacity. Maryland law allows directors and officers to be indemnified against judgments, penalties, fines, settlements and reasonable expenses actually incurred in a proceeding unless the following can be established:

 

    an act or omission of the director or officer was material to the cause of action adjudicated in the proceeding and was committed in bad faith or was the result of active and deliberate dishonesty;

 

    the director or officer actually received an improper personal benefit in money, property or services; or

 

    with respect to any criminal proceeding, the director or officer had reasonable cause to believe his or her act or omission was unlawful.

A court may order indemnification if it determines that the director or officer is fairly and reasonably entitled to indemnification, even though the director or officer did not meet the prescribed standard of conduct or was adjudged liable on the basis that personal benefit was improperly received. However, indemnification for an adverse judgment in a suit by the corporation or in its right, or for a judgment of liability on the basis that personal benefit was improperly received, is limited to expenses. Maryland law permits a corporation to advance reasonable expenses to a director or officer upon receipt of a written affirmation by the director or officer of his or her good faith belief that he or she has met the standard of conduct necessary for indemnification and a written undertaking by him or her or on his or her behalf to repay the amount paid or reimbursed if it is ultimately determined that the standard of conduct was not met.

Subject to the limitations contained in Maryland law, our charter limits directors’ and officers’ liability to us and our stockholders for monetary damages, requires us to indemnify and pay or reimburse reasonable expenses in advance of final disposition of a proceeding to our directors and our officers and permits us to provide such indemnification and advance of expenses to our employees and agents. This provision neither reduces the exposure of directors and officers to liability under federal or state securities laws, nor does it limit the stockholders’ ability to obtain injunctive relief or other equitable remedies for a violation of a director’s or an officer’s duties to us, although the equitable remedies may not be an effective remedy in some circumstances.

The SEC and some state securities commissions take the position that indemnification against liabilities arising under the Securities Act of 1933 is against public policy and unenforceable.

We will also purchase and maintain insurance on behalf of all of our directors and executive officers against liability asserted against or incurred by them in their official capacities with us, whether or not we are required or have the power to indemnify them against the same liability.

Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers or persons controlling NREF pursuant to the foregoing provisions, NREF has been advised that in the opinion of the staff of the SEC, such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.

Our Advisor

Our Advisor is NexPoint Real Estate Advisors II, L.P. and its address is 300 Crescent Court, Suite 700, Dallas, Texas 75201. Our Advisor has contractual responsibilities to us and our stockholders.

 

112


Table of Contents

Our Advisor will apply to the SEC to register as an investment adviser under the Advisers Act. There can be no assurance that the application will be granted. If our Advisor’s application to register as an investment adviser becomes effective, additional information regarding our Advisor will be available on our Advisor’s Form ADV which will be available on the SEC’s website at www.adviserinfo.sec.gov. Registration as an investment adviser does not imply a certain level of skill or training.

Advisory Agreement

Subject to the overall supervision of our board of directors, our Advisor will manage the day-to-day operations of, and provide investment management services to, us. Under the terms of the Advisory Agreement, our Advisor will, among other things:

 

    identify, evaluate and negotiate the structure of our investments (including performing due diligence);

 

    find, present and recommend investment opportunities consistent with our investment policies and objectives;

 

    structure the terms and conditions of our investments;

 

    review and analyze financial information for each underlying property of the overall portfolio; and

 

    close, monitor and administer our investments.

Our Advisor’s services under the Advisory Agreement are not exclusive, and it is free to furnish similar services to other entities so long as its services to us are not impaired. We will pay our Advisor fees and reimburse it for certain expenses incurred on our behalf. We will not pay our Advisor and its affiliates any fees associated with arranging for financing and refinancing of properties, or a debt financing fee, but we will pay unaffiliated third parties a debt financing fee, if applicable. For a detailed description of the fees and expense reimbursements payable to our Advisor, see the section in this prospectus entitled “Management Compensation.”

Related Party Transactions

See Note 10, Related Party Transactions, to our audited consolidated financial statements included in this prospectus for a complete description of the related party transactions.

Concurrent Private Placement

Concurrently with the closing of this offering, Highland and/or its affiliates will purchase in a separate private placement                 shares of our common stock representing an aggregate investment equal to $         million. Highland and/or its affiliates will pay the same price for shares in the private placement as investors who purchase shares in this offering.

Our Advisory Agreement

We are externally managed by our Advisor pursuant to our Advisory Agreement. Our Advisor is an affiliate of Highland. For a summary of the terms of Advisory Agreement and fees to be paid to our Advisor, see “— Advisory Agreement” and “Management Compensation.” For the years ended December 31, 2016, 2015 and 2014 and the six months ended June 30, 2017, we paid asset management fees to our Advisor of $273,000, $0, $0 and $173,000, respectively, under our previous advisory agreement.

Acquisitions

During the year ended December 31, 2016, we acquired three real estate assets, two of which were acquired from related parties.

 

113


Table of Contents

On April 7, 2016, we entered into the Contribution Agreement with Highland and the OP. Pursuant to the Contribution Agreement, Highland transferred its 100% interest in Estates Holdco to us. Highland was the sole Member and Manager of Estates Holdco. Estates Holdco owns a 95% interest in Estates. The remaining 5% interest in Estates is owned by affiliates of BH.

As further discussed in Note 2 to our audited consolidated financial statements included in this prospectus, the acquisition of Estates by us was deemed to be made on the Original Acquisition Date. In connection with the acquisition of Estates, we incurred acquisition fees payable to our Advisor of approximately $0.4 million (see “Acquisition Fee” below), pursuant to the previous advisory agreement, which are deemed to have been incurred on the Original Acquisition Date. Our independent directors unanimously approved the acquisition of Estates and the incurrence of acquisition fees payable to our Advisor.

On April 7, 2016, we, through the OP, acquired a 16% preferred equity interest in Bell Midtown by purchasing the 100% interest in Nashville RE Holdings, LLC for $6.0 million pursuant to a purchase and sale agreement from an entity that is owned by affiliates of, and managed by, Highland. On December 23, 2016, our preferred equity interest in Bell Midtown was redeemed in full by the entity that owned Bell Midtown (see Note 4 to the consolidated financial statements). We did not incur any acquisition or disposition fees payable to our Advisor in connection with this investment or its redemption.

Affiliated Dealer Manager

The dealer manager for our Continuous Offering was an affiliate of Highland. The dealer manager received fees, distributions and other compensation for services related to our Continuous Offering and the investment and management of our assets. We paid the dealer manager selling commissions of up to 7% of gross offering proceeds from the sale of Class A shares and up to 3% of gross offering proceeds from the sale of Class T shares. We paid the Dealer Manager a dealer manager fee of up to 1% of gross offering proceeds from the sale of Class A shares and Class T shares.

For the years ended December 31, 2016, 2015 and 2014 and for the six months ended June 30, 2017, we paid our dealer manager $5,000, $0, $0 and $0, respectively, under our dealer manager agreement.

On September 14, 2016, the Company entered into an agreement with our Advisor and the dealer manager whereby our Advisor will pay a portion of the selling commissions payable to the dealer manager in connection with the sale of Class A shares in the Continuous Offering subject to certain volume discounts. For purchases by an investor of $1,000,001 up to $2,000,000, our Advisor would pay a 0.5% selling commission to the dealer manager. For purchases by an investor of $2,000,001 up to $5,000,000, our Advisor would pay a 1% selling commission to the dealer manager. For purchases by an investor of $5,000,001 up to $10,000,000, our Advisor would pay the full amount of the selling commissions payable to the dealer manager, or 2%. For purchases by an investor of $10,000,001 or more, our Advisor would pay the full amount of the selling commissions payable to the dealer manager, after taking into account the volume discount, or 1%, and our Advisor would pay an additional 1% of the total purchase price to the investor, which would be used to purchase additional Class A shares offered in the Continuous Offering at a purchase price of $9.10 per share, which reflects that no selling commissions or dealer manager fees are charged on such additional Class A shares offered in the Continuous Offering. No commissions will be payable to our affiliated dealer manager in connection with the sale of shares of common stock in this offering. See “Underwriting” for more discussion on underwriting commissions to be paid in connection with this offering.

For the years ended December 31, 2016, 2015 and 2014 and for the six months ended June 30, 2017, our Advisor incurred approximately $3,000, $0, $0 and $21,000, respectively, of selling commissions payable to the dealer manager in connection with the sale of our Class A shares.

On July 21, 2017, the Company filed a post-effective amendment to its registration statement relating to the Continuous Offering to terminate the Continuous Offering and deregister all of the unsold shares. The post-effective amendment was declared effective by the SEC on July 26, 2017.

 

114


Table of Contents

Formation Transactions

In connection with our incorporation, we sold an aggregate of approximately 22,222 shares of our common stock to our Advisor for an aggregate purchase price of $200,000, or $9.00 per share, reflecting the fact that selling commissions and dealer manager fees in effect at the time of the purchase were not paid in connection with the sale. These shares were subsequently renamed as shares of Class A common stock.

Registration Rights

Upon the completion of this offering and the concurrent private placement, we will enter into a registration rights agreement with our Advisor with respect to (i) all shares of our common stock owned by our Advisor and affiliates of our Advisor, including Highland and its affiliates and (ii) shares of our common stock at any time beneficially owned by our Advisor which are issuable or issued as compensation for our Advisor’s services under the Advisory Agreement and any additional shares of our common stock issued as a dividend, distribution or exchange for, or in respect of such shares. Pursuant to the registration rights agreement, if we propose to file a registration statement (or a prospectus supplement pursuant to a then-existing shelf registration statement) under the Securities Act with respect to a proposed underwritten equity offering by us for our own account or for the account of any of our respective securityholders of any class of security other than a registration statement on Form S-4 or S-8 (or any substitute form that may be adopted by the SEC) filed in connection with an exchange offer or offering of securities solely to our existing securityholders, then we will give written notice of such proposed filing to the holders of registrable securities and such notice will offer such holders the opportunity to register such number of shares of registrable securities as each such holder may request. We will use commercially reasonable efforts to cause the managing underwriter or underwriters of a proposed underwritten offering to permit the registrable securities requested to be included in such a registration to be included on the same terms and conditions as any similar securities included therein.

In addition, commencing on or after the date that is one year after the date of the Advisory Agreement, holders of registrable securities may make a written request for registration under the Securities Act of all or part of their registrable securities (a “demand registration”). However, we will not be obligated to effect more than one such registration in any 12-month period and not more than two such registrations during the term of the Advisory Agreement. If the Advisory Agreement is extended, the holders will be entitled to one additional demand registration per year that the Advisory Agreement is extended. Holders making such written request must propose the sale of at least 100,000 shares of registrable securities (as adjusted for stock splits or recapitalizations) or such lesser number of registrable securities if such lesser number is all of the registrable securities owned by the holders. Any such request must specify the number of shares of registrable securities proposed to be sold and will also specify the intended method of disposition. Within ten days after receipt of such request, we will give written notice of such registration request to all other holders of registrable securities and include in such registration all such registrable securities with respect to which we have received written requests for inclusion therein within ten business days after the receipt by the applicable holder of our notice.

Notwithstanding the foregoing, any registration will be subject to cutback provisions, and we will be permitted to suspend the registration or sale of registrable securities in certain situations.

Policies and Procedures for Transactions with Related Persons

In connection with this offering, the board of directors will adopt a related party transaction policy for the review, approval or ratification of any related party transaction. This policy provides that all related party transactions other than those for an aggregate amount of $120,000 or less and on terms comparable to those that could reasonably be expected to be obtained in arm’s length dealings with an unrelated third party, must be reviewed and approved by the disinterested members of the Audit Committee. The term “related party transaction” refers to any transaction, arrangement or relationship (including charitable contributions and including any series of similar transactions, arrangements or relationships) with the Company in which any Related Party (as defined below) has a direct or indirect material interest, other than: (a) transactions available to

 

115


Table of Contents

employees generally; (b) transactions involving less than $50,000 when aggregated with all related or similar transactions, except if receipt of any amount would result in a director no longer being considered independent under NYSE rules or would disqualify a director from serving as a member of a committee of the Board; (c) transactions involving compensation or indemnification of executive officers and directors duly authorized by the Board or an authorized Board committee; (d) transactions involving reimbursement for routine expenses in accordance with Company policy; and (e) purchases of any products on terms generally available to third parties.

 

    For the purposes of this policy, “Related Parties” include:

 

    directors (and nominees for director) and executive officers of the Company;

 

    immediate family members of such directors, nominees for director and executive officers, including an individual’s spouse, parents, step-parents, children, step-children, siblings, mothers- and fathers-in law, sons- and daughters-in law, brothers- and sisters-in law and other persons (except tenants or employees) who share such individual’s household;

 

    our Advisor;

 

    a stockholder owning in excess of five percent of the Company’s voting securities or an immediate family member of such a stockholder; or

 

    an entity which is owned or controlled by any of the above persons.

The Company may do business with NexBank and NexTitle in the ordinary course of its business. NexBank and NexTitle will be considered related parties under this policy. Upon adoption of the related party transaction policy, the Audit Committee will review and approve these transactions in accordance with the policy.

 

116