Item 1. Business
Overview
Front Yard Residential (“we,” “our,” “us,” “Front Yard” or the “Company”) is an industry leader in providing quality, affordable rental homes to America’s families in a variety of suburban communities that have easy accessibility to metropolitan areas. Our tenants enjoy the space and comfort that is unique to single-family housing, at reasonable prices. Our mission is to provide our tenants with houses they are proud to call home.
We are a Maryland real estate investment trust (“REIT”), and we conduct substantially all of our activities through our wholly owned subsidiary, Front Yard Residential, L.P., and its subsidiaries (the “Operating Partnership”). We commenced operations in December 2012. We operate in a single segment focused on the acquisition and ownership of residential rental properties.
We are managed by Altisource Asset Management Corporation (“AAMC” or our “Manager”) pursuant to the asset management agreements described further below. AAMC provides us with dedicated personnel to administer our business and perform certain of our corporate governance functions. AAMC also provides portfolio management services in connection with our acquisition and management of single-family rental (“SFR”) properties and the management of our remaining real estate owned (“REO”) properties. On May 7, 2019, we amended and restated our asset management agreement with AAMC. For further details of our asset management agreements with AAMC, refer to Note 10, “Related-Party Transactions” of the consolidated financial statements.
On August 8, 2018, we acquired a property management firm and began the process of internalizing our property management function. During the first quarter of 2019, we completed the transfer of our externally managed homes to our internal property management platform. The internalization of property management provides us with an efficient, scalable property management platform that is designed to provide tenants with excellent service. As we continue to grow, this platform will to allow us to benefit from economies of scale that will enhance long-term stockholder value. Prior to this internalization, we relied exclusively on two external property management vendors to provide, among other things, leasing and lease management, operations, maintenance, repair and property management services in respect of certain of our SFR properties.
Since we commenced operations in 2012, we have financed our business through a combination of equity offerings, term loans, repurchase agreements, warehouse lines, seller financing arrangements and securitizations.
Merger Agreement
On February 17, 2020, Front Yard entered into an Agreement and Plan of Merger (the “Merger Agreement”) with BAF Holdings, LLC, a Delaware limited liability company (“Parent”), and BAF Sub, LLC, a Maryland limited liability company (“Merger Sub”), each affiliates of Amherst Single Family Residential Partners VI, LP (collectively, “Amherst”), providing for the acquisition of Front Yard by Parent.
The Merger Agreement provides that, among other things, upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the merger transaction (“Effective Time”), the Company will merge with and into Merger Sub (the “Merger”), with Merger Sub continuing as the surviving company and a wholly owned subsidiary of Parent.
Under the terms of the Merger Agreement, Front Yard shareholders will receive $12.50 in cash per share. The per share purchase price represents a premium of approximately 14.2% over the per share closing price of Front Yard’s common stock on May 20, 2019, the day prior to the public announcement of Front Yard’s decision to initiate a formal process to explore strategic alternatives.
The Front Yard Board of Directors has unanimously approved the merger agreement and intends to recommend that Front Yard shareholders vote in favor of it at a Special Meeting of Stockholders, to be scheduled as soon as practicable. The transaction is expected to close in the second quarter of 2020, subject to the approval of the holders of a majority of Front Yard’s outstanding shares and the satisfaction of customary closing conditions.
For further details of the Merger Agreement, refer to Note 17, “Subsequent Events” of the consolidated financial statements.
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Our Business Strategy
We are committed to being one of the top SFR REITs serving American families and their communities with a view to providing consistent and robust returns on equity and long-term growth for our investors. Our portfolio of SFR properties has grown substantially in recent years. The internalization of our property management function has provided us with additional opportunities to deliver an excellent tenant experience and manage our rental homes efficiently and in line with our key operating targets.
We believe there is a compelling opportunity in the SFR market and that we have implemented the right strategic plan to capitalize on the sustained growth in SFR demand. We target the moderately priced single-family home market to acquire rental properties, which, in our view, not only provide safe, comfortable homes for our residents, but also offer attractive yield opportunities.
We expect to hold SFR property assets over the long term with a focus on developing our brand. We also believe that, given the limited institutional penetration to date into the SFR marketplace, our ability to acquire and effectively manage assets with attractive yields in strategic markets provides us with a significant opportunity to establish ourselves as a leading SFR equity REIT.
From an operational standpoint, we have established an extensive renovation and property management infrastructure that provides us with geographic reach and a scalable property management structure that will allow us to grow in a cost-efficient manner.
Acquisition Strategy
Through our judicious use of cash, our strong financing relationships and the sale of non-core assets, we have capitalized on opportunities to buy large portfolios and smaller pools of stabilized rental homes and individual residential properties at attractive yields. We have been successful in our pursuit of this strategy to date, having increased our SFR portfolio to approximately 14,500 homes as of December 31, 2019 from approximately 3,000 at December 31, 2015. We may continue to opportunistically source, bid on and acquire SFR properties that meet our targeted metrics under our management in the future.
Scalable Internal Property Management Platform
Our efficient, scalable internal property management platform provides tenants with excellent service and allows us to benefit from economies of scale. We now have direct, internally managed control of leasing, renovation and turn management, vendor management, market analysis and other property management support functions, which will enhance our ability to control costs and generate long-term returns to our stockholders. As of December 31, 2019, we had 220 employees who serviced homes in 29 MSAs across 19 states, and we work directly with over 300 vendors providing services to our homes with capacity to process over 500 turns per month.
The transition to internal property management has also provided us with the opportunity to develop our brand and enhance the tenant experience. Our internal property manager has allowed us to develop a unified approach to renovation management, repair and maintenance, vendor contracting and material supply chain management in an effort to create a consistent look and feel for our SFR properties. Over time, we expect to develop a nationally recognized brand that is known for consistent quality at affordable prices.
This internal property management platform is driven by proprietary technology solutions that support the tenant experience and enhance operational efficiency and performance. In addition to in-house technicians, efficient back-office support evaluates and solicits the appropriate external vendors to perform required work, assigns the work to the vendor with the best possible combination of cost and delivery capabilities, provides uniform property management and inspection criteria and utilizes technology to review and assess properties. We believe this technology-driven property management infrastructure will result in increased long-term value for our stockholders.
Real Estate Portfolio Overview
We seek to acquire SFR properties with attractive return profiles. Our SFR portfolio was acquired through direct purchases of SFR and REO properties as well as through the resolution of non-performing mortgage loans we had previously acquired.
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We expect to continue to liquidate (i) certain rental properties that are non-strategic, underperforming or are in inefficient markets and (ii) the remaining REO properties that were acquired through mortgage loan resolution activities that do not meet our rental criteria in order to generate cash for reinvestment in other acquisitions, repurchases of common stock, the repayment of debt, dividend distributions or such other purposes as we may determine.
For details regarding our recent real estate acquisitions and dispositions, refer to Note 3, “Asset Acquisitions and Dispositions” to our consolidated financial statements.
The following table presents the status of our real estate assets as of the dates indicated:
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The following table sets forth a summary of our real estate portfolio as of December 31, 2019 ($ in thousands):
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The carrying value of an asset held for use is based on historical cost plus renovation costs, net of any accumulated depreciation and impairment. Assets held for sale are carried at the lower of the carrying amount or estimated fair value less costs to sell.
As of December 31, 2019, our highest concentrations of SFR properties were in four states (Florida, Georgia, Tennessee and Texas), which accounted for 9,867 SFR properties (67.8% of our SFR portfolio) with an aggregate carrying value of $1.3 billion (66.2% of the carrying value of our SFR portfolio), with the remainder of our SFR properties dispersed among 23 other states.
Our Strengths
We are committed to a business strategy that will enable us to efficiently manage and continue to grow our portfolio of affordable rental homes and become one of the largest nationwide SFR REITs. Our goal is to enhance long-term stockholder value through the execution of our business plan with a focus on our competitive strengths. Our strong competitive position is based on the following factors:
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Acquisition Strategy Enables us to Continue Building a Portfolio that Targets Attractive Yields to Stockholders. Through AAMC’s personnel and technical expertise, we have developed a disciplined market and asset selection approach and a valuation model that uses proprietary and market data to evaluate and project the performance of SFR assets. This valuation model has been built with multiple broad economic and geographic inputs as well as numerous property-level inputs to determine which properties will produce attractive yields and how much to pay for these properties to best achieve optimal results. These internally developed tools help us to evaluate the most attractive SFR portfolios available for purchase. We also leverage our property inspection, management and rental infrastructure and related data flows to identify and acquire attractive assets in the geographical locations into which we desire to grow. We intend to continue to focus on strategic geographical areas, develop regional experience to continually refine our acquisition strategy and achieve rental portfolio growth with properties marked by strong stabilized occupancy rates and optimal economic returns. We also believe that our focus on affordable housing provides us with a potential advantage, as we believe this is an underserved market segment that provides us with attractive yield and growth opportunities.
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Extensive Internal Property Management Infrastructure. With our internal property manager and the support of our growing nationwide vendor networks, we believe that we are well positioned to operate and manage SFR properties across the United States at an attractive cost structure. We have an excellent, experienced property management team
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with a successful track-record of internal property management operations that enables us to capitalize on additional opportunities to enhance our tenants’ experience and improve our operating efficiency for our entire portfolio. We believe that our internal property management infrastructure provides us with a cost-efficient, scalable platform that will be a key factor in our success as we continue to grow.
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Depth of Management Experience. We believe the experience and technical expertise of our management team is one of our key strengths. Our team has a broad and deep knowledge of the real estate market with decades of experience in real estate, mortgage trading, housing, financial services and asset management. Their experience in the real estate industry brings a wealth of understanding of the markets in which we operate and can help us build our portfolio in a manner that brings attractive potential returns to stockholders. Management and its supporting teams have expertise and extensive contacts that enable us to source SFR assets through access to auctions and sellers of SFR assets and obtain financing to optimize available leverage. We believe that AAMC’s asset evaluation process and the experience and judgment of its executive management team in identifying, assessing, valuing and acquiring new SFR assets will help us to appropriately value the portfolios at the time of purchase and operate them profitably as we continue to grow.
Our Investment Process
Our Manager continues to provide personnel and portfolio managers with substantial experience in the real estate market. Using extensive market connections and a disciplined market and asset selection approach incorporating advanced quantitative models, AAMC's capital markets group has demonstrated expertise in sourcing, analyzing and negotiating the purchase of both large and small portfolios of rented single-family properties. Through close collaboration by AAMC with our internal property management team, we are able to source and acquire properties that fit our investment strategy and integrate well with our property management infrastructure. This expertise and coordination has enabled us to strategically grow our SFR portfolio at December 31, 2019 to approximately 14,500 homes, the majority of which were stabilized rentals at the time of acquisition.
Our Financing Strategy
We intend to continue to finance our real estate investments with debt and equity, the proportions and character of which may vary based upon the particular characteristics of our portfolio and on market conditions. To the extent available at the relevant time, our financing sources may include bank credit facilities, term financing, warehouse lines of credit, securitization financing, seller financing arrangements, structured financing arrangements and repurchase agreements, among others. We may also seek to raise additional capital through public or private offerings of debt or equity securities, depending upon market conditions. For additional information on our financing arrangements, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”
Investment Committee and Investment Policy
Substantially all of our investment activities are conducted by AAMC on our behalf pursuant to the asset management agreement. Our principal objective is to generate attractive risk-adjusted returns for our stockholders over the long-term through dividends and capital appreciation.
Our Board of Directors has adopted a broad investment policy designed to facilitate the management of our capital and assets and the maintenance of an investment portfolio profile that meets our objectives. Our Board has appointed an Investment Committee consisting of our Chairman of the Board, two independent Board members, our Chief Executive Officer and our Chief Financial Officer. The Investment Committee's role is to act in accordance with the investment policy and guidelines approved by our Board of Directors for the investment of our capital. As part of an overall investment portfolio strategy, the investment policy provides that we can purchase or sell real estate assets, non-performing or sub-performing residential mortgage loans and residential mortgage-backed securities. We are also authorized to offer leases on acquired SFR properties. The investment policy may be modified by our Board of Directors without the approval of our stockholders.
The objective of the investment policy is to oversee our efforts to achieve a return on assets consistent with our business objectives and to maintain adequate liquidity to meet financial covenants and regular cash requirements.
The Investment Committee is authorized to approve the financing of our investment positions through bank credit facilities, seller financing arrangements, warehouse lines of credit, securitization financing, term financing, structured financing arrangements and repurchase agreements, among others, provided such agreements are negotiated with counterparties approved by the Investment Committee. We are also permitted to hedge our interest rate exposure on our financing activities through the use of interest rate swaps or caps, forwards, futures and options, subject to prior approval from the Investment Committee.
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Investment Committee Approval of Counterparties
The Investment Committee is authorized to consider and approve:
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the financial soundness of institutions with which we plan to transact business and make recommendations with respect thereto;
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our risk exposure limits with respect to the dollar amounts of total exposure with a given institution; and
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investment accounts and trading accounts to be opened with banks, broker-dealers and financial institutions.
Investment Committee Guidelines
The activities of our Investment Committee are subject to the following guidelines:
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No investment will be made that would cause us or any of our subsidiaries to fail to qualify as a REIT for U.S. federal income tax purposes;
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No investment will be made that would cause us to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”); and
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Until appropriate investments can be identified, we may invest available cash in interest-bearing and short-term investments that are consistent with (a) our intention to qualify as a REIT and (b) our exemption from registration as an investment company under the Investment Company Act.
Broad Investment Policy Risks
Our investment policy is very broad and provides our Investment Committee and AAMC with extensive latitude to determine the types of assets that are appropriate investments for us and to make individual investment decisions. In the future, AAMC may make investments with lower rates of return than those anticipated under current market conditions and/or may make investments with greater risks to achieve those anticipated returns. Our Board of Directors will periodically review our investment policy and our investment portfolio but will not typically review or approve each proposed investment by AAMC unless, for example, it falls outside our previously approved investment policy or constitutes a related party transaction.
In addition, in conducting its periodic reviews, our Board of Directors will rely primarily on information provided to it by AAMC, and the Board has delegated the oversight of certain investment decisions to the Investment Committee, which includes our Chairman of the Board of Directors. AAMC may use complex strategies, and transactions entered into by AAMC may be costly, difficult or impossible to unwind. Further, we may change our investment policy and targeted asset classes at any time without the consent of our stockholders, which could result in our making investments that are different in type from, and possibly riskier than, our current investments or the investments currently contemplated. Changes in our investment strategy, investment policy and targeted asset classes may increase our exposure to interest rate risk, counterparty risk, default risk and real estate market fluctuations, which could materially and adversely affect us.
Our Manager and the Asset Management Agreements
We are externally managed by AAMC, an asset management company that provides portfolio management and corporate governance services. Pursuant to the asset management agreement, amongst other duties, AAMC provides the following services to us: (1) performing and administering certain of our day-to-day operations; (2) implementing the investment criteria in our investment policy approved by our Board of Directors; (3) sourcing, analyzing and executing asset acquisitions, including the related financing activities; (4) overseeing the renovation, leasing and property management of our SFR properties; (5) analyzing and executing sales of certain rental properties; (6) performing asset management duties and (7) performing corporate governance and other management functions, including financial, accounting and tax management services.
AAMC provides us with a management team and support personnel who have substantial experience in the acquisition and management of residential properties. AAMC’s management also has significant corporate governance experience that enables it to manage our business and organizational structure efficiently. AAMC has agreed not to provide the same or substantially similar services without the prior written consent of our Board of Directors to any business or entity competing against us in (a) the acquisition or sale of SFR and/or REO properties, non-performing and re-performing mortgage loans or other similar assets, (b) the carrying on of an SFR business or (c) any other activity in which we engage. Notwithstanding the foregoing, AAMC may engage in any other business or render similar or different services to any businesses engaged in lending or insurance activities or any other activity other than those described above. Further, at any time following our determination and
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announcement that we will no longer engage in any of the above-described competitive activities, AAMC would be entitled to provide advisory or other services to businesses or entities in such competitive activities without our prior consent.
On March 31, 2015, we entered into an asset management agreement (the “Former AMA”), under which AAMC was our exclusive asset manager for an initial term of 15 years from April 1, 2015, with two potential five-year extensions. The Former AMA provided for a fee structure in which AAMC was entitled to a base management fee, an incentive management fee and a conversion fee for mortgage loans and REO properties that become rental properties for the first time during each quarter.
On May 7, 2019, we entered into an amended and restated asset management agreement (the “Amended AMA”), under which AAMC is our exclusive asset manager for an initial term of five years. The Amended AMA will renew automatically each year thereafter for an additional one-year term, subject in each case to certain termination provisions. The Amended AMA provides for a fee structure in which AAMC is entitled to a Base Management Fee and a potential Incentive Fee.
The management fees payable under the Amended AMA are subject to ongoing performance thresholds and an aggregate fee cap aimed to prevent such fees from increasing our general and administrative expenses above industry standards based on the size of our gross real estate asset base. The Amended AMA also provides us more flexibility in return for a termination fee to AAMC that we believe reflects industry norms.
For additional information regarding our asset management agreements with AAMC, refer to Note 10, “Related-Party Transactions” of the consolidated financial statements.
AAMC’s Management of the Operating Partnership
General
Substantially all of our assets are and will be held by, and substantially all of our operations are and will be conducted through, the Operating Partnership, either directly or through its subsidiaries or Delaware statutory trusts for its benefit. Front Yard Residential GP, LLC is the sole general partner of the Operating Partnership (the “General Partner”). We own 100% of the membership interests in the General Partner. We also own 100% of the limited partnership interests of the Operating Partnership. We do not intend to list any Operating Partnership interests on any exchange or any national market system. The provisions of the limited partnership agreement are described below.
The General Partner is managed by AAMC through our asset management agreement with AAMC. Except as otherwise expressly provided in the limited partnership agreement and subject to the rights of holders of any class or series of operating partnership interests, all management powers over the business and affairs of the Operating Partnership are exclusively vested in AAMC through its management of us and the General Partner, subject to the oversight of our Board of Directors. No limited partner, in its capacity as a limited partner, has any right to participate in or exercise control or management power over the Operating Partnership’s business and affairs other than through our Board of Directors’ oversight of AAMC’s executive officers who manage our business and that of the General Partner. With limited exceptions, the General Partner, through its management by AAMC, may execute, deliver and perform agreements and transactions on behalf of the Operating Partnership without the approval or consent of any limited partner.
Terms of the Limited Partnership Agreement
Capital Contributions, Profits and Losses and Distributions
Neither the General Partner nor the limited partner is required to make any additional capital contribution to the Operating Partnership, although we intend to contribute funds generally from equity offerings, repurchase facilities, securitization financings or other financing arrangements into the Operating Partnership in order to (a) make additional acquisitions of SFR properties, (b) pay property management fees and other expenses related to the management of our assets, (c) conduct the renovation, leasing and property management services for SFR properties and (d) provide funds for general corporate purposes.
The profits and losses of the Operating Partnership shall be allocated in proportion to the capital contributions of the partners of the Operating Partnership.
At the time or times determined by the General Partner, the General Partner may cause the Operating Partnership to distribute any cash held by it that is not reasonably necessary for the operation of the Operating Partnership. If the General Partner determines that cash will be distributed, the cash available for distribution will be distributed to us, as the sole limited partner of the Operating Partnership and sole contributor of all the funds in the Operating Partnership’s capital account.
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Restrictions on Transfer of Partnership Interests; Withdrawals
Any partner of the Operating Partnership may transfer all or any part of its interest in the Operating Partnership only with the consent of the General Partner. Because we are the only limited partner and control the General Partner, we do not expect to transfer our limited partnership interests for the foreseeable future.
No partner may withdraw from the Operating Partnership except pursuant to an amendment to the limited partnership agreement signed by all of the partners. The withdrawal of the limited partner, and admission of a new or substitute limited partner, as applicable, will be effective as of the date of any such amendment. Upon the withdrawal of any partner, the withdrawing partner shall, to the extent permitted by Delaware Revised Uniform Limited Partnership Act (“DRULPA”) be entitled to payment of the balance of its capital account and shall have no further right, interest or obligation of any kind whatsoever as a partner in the Operating Partnership. We do not intend to withdraw as a partner of the Operating Partnership for the foreseeable future.
Amendments; Admission of Additional Partners
Without our approval as the limited partner, the General Partner may amend, and may amend and restate, the limited partnership agreement. The General Partner may admit additional limited partners to the Operating Partnership. The admission of additional limited partners to the Operating Partnership may be accomplished by the amendment, or the amendment and restatement, of the limited partnership agreement without our consent, and, if required by DRULPA, the filing of an appropriate amendment of the Operating Partnership’s certificate of formation.
Policies with Respect to Certain Other Activities
We intend to raise additional funds through equity offerings, debt financings (including bank credit facilities, seller financing arrangements, warehouse lines of credit, securitization financing, term financing, structured financing arrangements and repurchase agreements), the retention of cash flow (subject to REIT distribution requirements) or a combination of these methods. In the event that our Board of Directors determines to raise additional equity capital, it has the authority, without stockholder approval, to issue additional common stock or preferred stock in any manner and on such terms and for such consideration as it deems appropriate, at any time, subject to compliance with New York Stock Exchange listing requirements.
In addition, we have borrowed and intend to continue to borrow money to finance or refinance the acquisition of SFR properties and for general corporate purposes. Our investment policy, the assets in our portfolio, the decision to use leverage and the appropriate level of leverage will be based on AAMC’s assessment of a variety of factors, including our historical and projected financial condition, liquidity, results of operations, financing covenants, the cash flow generation capability of assets, the availability of credit on favorable terms, our outlook for borrowing costs relative to the unlevered yields on our assets, maintenance of our REIT qualification, applicable law and other factors as AAMC and/or our Board of Directors may deem relevant from time to time. Our decision to use leverage will be at AAMC’s discretion and will not be subject to the approval of our stockholders. We are not restricted by our governing documents in the amount of leverage that we may use.
As of the date of this report, we do not intend to invest in the securities of other REITs, other entities engaged in real estate activities or securities of other issuers for the purpose of exercising control over such entities. We do not intend that our investments in securities will require us to register as an investment company under the Investment Company Act, and we would intend to divest such securities before any such registration would be required. We do not intend to underwrite securities of other issuers.
Our Board of Directors may change any of these policies without prior notice to, or the consent of, our stockholders.
REIT Qualification
We elected and qualified to be taxed as a REIT under Sections 856 through 859 of the Internal Revenue Code of 1986 (the “Code”) beginning with our taxable year ended December 31, 2013, and we currently expect to maintain this status for the foreseeable future. Our qualification as a REIT depends upon our ability to meet on a continuing basis, through actual investment and operating results, various complex 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 our common stock. We believe that we are organized in conformity with the requirements for qualification and taxation as a REIT under the Code, and that our manner of operation enables us to meet these requirements. As a REIT, we generally are not subject to U.S. federal income tax on the REIT taxable income we distribute to our stockholders.
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Even though we elected to be taxed as a REIT, we are subject to some U.S. federal, state and local taxes on our income or property. A portion of our business is expected to be conducted through, and a portion of our income is expected to be earned in, one or more taxable REIT subsidiaries (each a “TRS”). In general, a TRS may hold assets and engage in activities that the REIT cannot hold, may choose not to hold to maintain REIT compliance and/or cannot engage in directly. Additionally, a TRS may engage in any real estate or non-real estate related business. A TRS is subject to U.S. federal, state and local corporate income taxes. To maintain our REIT election, at the end of each quarter, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRS. If our TRS generates net income, our TRS can declare dividends to us, which will be included in our taxable income and necessitate a distribution to our stockholders. Conversely, if we retain earnings at the TRS level, no distribution is required, and we can increase stockholders’ equity of the consolidated entity.
Exemption from Investment Company Act
We rely on the exception from the Investment Company Act set forth in Section 3(c)(5)(C) of the Investment Company Act, which excludes from the definition of investment company “any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” The SEC Staff generally requires that, for the exception provided by Section 3(c)(5)(C) to be available, at least 55% of an entity’s assets be comprised of mortgages and other liens on and interests in real estate, also known as “qualifying interests,” and at least another 25% of the entity’s assets must be comprised of additional qualifying interests or real estate-type interests (with no more than 20% of the entity’s assets comprised of miscellaneous assets). Any significant acquisition by us of non-real estate assets without the acquisition of substantial real estate assets could cause us to meet the definitions of an “investment company.” If we are deemed to be an investment company, we may be required to register as an investment company if we are unable to dispose of the disqualifying assets, which could have a material adverse effect on us. See “Item 1A.
Item 1A. Risk Factors
The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. If any of the following risks actually occur, our business, operating results and financial condition could be materially adversely affected.
Risks Related to Our Business
We have a limited and evolving operating history. If we are unable to implement our business strategy as planned, we will be materially and adversely affected.
We commenced operations approximately seven years ago, and our business model is relatively untested and evolving. Businesses like ours that have a limited operating history present substantial business and financial risks and may suffer significant losses. As a result, we cannot predict our results of operations, financial condition and cash flows. We only began to generate residential rental revenue during 2013, and our historical financial results have been partially attributable to purchasing residential mortgage loans and other rental-related assets at a discount. As a result of the changes to our acquisition strategy and evolving market conditions, we have not completed any residential mortgage loan portfolio acquisitions since December 2014, and we do not anticipate further acquisitions of such loans. There can be no assurance, however, that the Company will be able to identify and successfully acquire portfolios of SFR properties or related assets on favorable terms or at all.
We have experienced significant growth in our rental portfolio and anticipate further growth, which may result in our inability to effectively manage our SFR portfolio, including, but not limited to, delays in renovations, suboptimal tenant underwriting and other operational inefficiencies that could reduce our profitability or damage our reputation. Generally, we expect that our SFR portfolio may grow at an uneven pace, if at all, as opportunities to acquire SFR portfolios on acceptable terms may be irregularly timed and may involve large or small portfolios of SFR properties. The timing and extent of our success in acquiring such assets cannot be predicted due to market conditions, limited financial resources or other constraints.
As a result of the foregoing developments, results from prior periods are not necessarily indicative of our results for any future period, and we may not have sufficient additional capital to implement our business model. There can be no assurance that our business will be profitable or that our profitability will be sustainable. The earnings potential of our business is unproven, and our limited and evolving operating history makes it difficult to evaluate our prospects. We may not be able to implement our business strategy as planned, which could materially and adversely affect us.
We are operating in an emerging industry, and the long-term viability of our investment strategy on an institutional scale is unproven.
Large-scale institutional investment in single-family residential homes for rent is a relatively recent phenomenon that has emerged out of the mortgage and housing crisis that began in late 2007. Prior to that time, SFR homes were generally not viewed as viable assets for investment on a large scale by institutional investors. Consequently, the long-term viability of the SFR property investment strategy on an institutional scale has not yet been proven. As a participant in this emerging industry, we are subject to the risk that SFR properties may not prove to be a viable long-term investment strategy on an institutional scale for a permanent capital vehicle. If it turns out that this investment strategy is not a viable one, we would be materially and adversely affected, and we may not be able to sustain the growth of our assets and results from operations that we seek.
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Our failure to raise equity capital and/or obtain adequate debt financing could adversely affect our ability to increase our rental portfolio, manage our existing assets and generate stockholder returns.
Our success has been, and may continue to be, largely dependent on our ability to use our remaining free capital, raise equity capital and/or obtain debt financing to increase the size of our rental portfolio, manage our existing assets and generate attractive stockholder returns. We require significant financial resources and rely on cost-effective leverage to maintain our obligations under our debt facilities and to continue to acquire portfolios of SFR properties. If we are unable to continue to raise equity capital, leverage our portfolio through financing facilities with optimal costs of debt or if our leverage ratios are too high, our current portfolio and cash from operations may become inadequate to meet our financial obligations.
We use leverage as a component of our financing strategy in an effort to increase our buying power and enhance our returns. We can provide no assurance that we will be able to timely access all funds available under our financing arrangements, refinance such financing arrangements or obtain other debt or equity financing on favorable terms or at all.
In any event, limited availability of credit may have an adverse effect on our ability to obtain financing on favorable terms, thereby increasing financing costs and/or requiring us to accept financing with increasing restrictions. Our long-term ability to grow through additional investments will be limited if we cannot obtain additional debt or equity financing.
We may not be able to successfully operate our business or generate sufficient operating cash flows to make or sustain distributions to our stockholders.
There can be no assurance that we will be able to successfully operate our business or generate sufficient cash to make distributions to our stockholders. Our ability to make or sustain distributions to our stockholders depends on many factors, including the following: the availability of attractive risk-adjusted investment opportunities that satisfy our investment strategy and our success in identifying and consummating such opportunities on favorable terms; the level and expected movement of home prices; the occupancy rates and rent levels of rental properties; the restoration, maintenance, marketing and other operating costs related to our SFR and REO properties; our relatively new internal property management platform and its ability to accommodate our growth; the level and volatility of interest rates; our ability to effectively manage a significant increase in the number of properties in our SFR portfolio; our ability to sell our remaining non-rental REO properties on favorable terms; the availability of short-term and long-term financing on favorable terms; conditions in the financial, real estate, housing and mortgage markets and the general economic conditions, as to which no assurance can be given. We cannot assure you that we will be able to make investments with attractive risk-adjusted returns or will not seek investments with greater risk to obtain the same level of returns or that the value of our investments in the future will not decline substantially. Existing and future government regulations may result in additional costs or delays, which could adversely affect the implementation of our investment strategy.
We have leveraged our investments and expect to continue to do so, which may materially and adversely affect our return on our investments and may reduce cash available for distribution to our stockholders.
To the extent available, we intend to continue to leverage our investments through borrowings, the level of which may vary based on the particular characteristics of our investment portfolio and on market conditions. Our financing agreements generally require us to comply with various financial covenants, including, without limitation, the following:
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reporting requirements to the agent or lender,
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minimum adjusted tangible net worth requirements,
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minimum net asset requirements,
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limitations on the indebtedness,
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minimum levels of liquidity, including specified levels of unrestricted cash,
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limitations on sales and dispositions of properties collateralizing certain of the loan agreements,
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various restrictions on the use of cash generated by the operations of properties, and
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a minimum fixed charge coverage ratio.
We expect any future financing arrangements will have similar provisions. In the event that we are unable to satisfy these requirements, we could be forced to sell additional investments at a loss, which could materially and adversely affect us.
Our financing agreements are complex and require a significant level of oversight by management. In part, this is due to the fact that our SFR properties and other assets that collateralize these facilities require specific activities to be performed at specific points in time in order to preserve value. Our inability to comply with the terms and conditions of these agreements could materially and adversely impact us. In addition, our outstanding financing agreements contain, and we expect any future
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financing agreements will contain, events of default, including payment defaults, substantial margin calls, breaches of financial and other covenants and/or certain representations and warranties, cross-defaults, servicer and property manager termination events, guarantor defaults, bankruptcy or insolvency proceedings and other events of default customary for these types of agreements. Because our financing agreements will typically contain cross-default provisions, a default that occurs under any one agreement could allow the lenders under our other agreements to also declare a default. Any losses we incur on our repurchase and other financing agreements could materially and adversely affect us.
We have utilized term financing arrangements, loan agreements, repurchase agreements, seller financing arrangements and securitization transactions to finance our portfolio and may in the future utilize other sources of borrowings, including bank credit facilities, warehouse lines of credit and structured financing arrangements, among others, each of which may have similar risks to other financing agreements, including, but not limited to, covenant compliance, events of default, acceleration and margin calls.
The percentage of leverage we employ, which could increase substantially in the future, varies depending on assets in our portfolios, our available capital, our ability to obtain and access financing arrangements with lenders and the lenders’ and rating agencies’ estimate of the stability of our investment portfolio’s cash flow. There can be no assurance that new sources of financing will be available to us in the future or that existing sources of financing will continue to be available to us. Our governing documents contain no limitation on the amount of debt we may incur. In general, the use of leverage amplifies our results, both positively and negatively. If we do not achieve our targeted results, our return on our investments and cash available for distribution to our stockholders may be reduced, and the cost of our financing could exceed the revenues we generate from our portfolio. Our debt service payments will reduce cash flow available for distribution to stockholders. We may not be able to meet our debt service obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to foreclosure or sale to satisfy the obligations.
We utilize non-recourse long-term financing structures, and such structures expose us to risks that could result in losses to us.
We currently utilize non-recourse long-term financing for certain of our investments and intend to continue to do so if, and to the extent, available. In such structures, our lenders typically have only a claim against the assets collateralizing the debt rather than a general claim against us as an entity, subject to certain exceptions. In addition, long-term financing structures may offer significantly less flexibility to refinance or terminate on cost-effective terms or at all and, as a result, could make it more difficult for us to capitalize on changes in market conditions, including the availability of less expensive debt. In the event we are unable to renew or refinance existing long-term facilities, we may increase our reliance on short-term facilities, which would likely be recourse to us as an entity.
We may also continue to finance our investments with relatively short-term facilities until a sufficient portfolio is accumulated. If we are unable to renew, refinance or obtain new long-term and/or short-term facilities, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price. In such an event, our overall results of operations and financial condition would be materially adversely impacted.
Our inability to make interest and/or principal payments on our single-family rental financing arrangements would have a material adverse effect on our results of operations and financial condition.
We have entered into various term financing loans to finance our portfolio of SFR properties. These loans (the “SFR Loans”) are each secured by the membership interests in the applicable subsidiary that owns the underlying properties (each, an “SFR Borrower”) and the properties and other assets held by such SFR Borrower. Upon the occurrence of a default of the payment of principal and/or interest on one or more of the SFR Loans, recourse may generally be had against the assets of the applicable SFR Borrower and the membership interests in such SFR Borrower. The primary security and source of payment for the SFR Loans is the cash flows generated by the properties and the other collateral described in the underlying loan agreements (the “SFR Loan Agreements”). Since revenues from the properties held by the relevant SFR Borrower generally serve as the primary source for monthly payments due on the corresponding SFR Loan, if revenue from the properties is reduced or if expenses incurred in the operation of the properties increase, the ability of such SFR Borrower to make payments with respect to such SFR Loan may be impaired. Similarly, the SFR Loan Agreements require the applicable SFR Borrower to make a balloon payment at the ultimate maturity date of the corresponding SFR Loan. The ability of the relevant SFR Borrower to sell and/or refinance the properties and to make the payment on the maturity date or the equity owner of the SFR Borrower (each a “SFR Equity Owner”), to sell and/or refinance its equity interest in such SFR Borrower to timely perform its guaranty obligations with respect to such maturity date payment, could be impaired by a decline in the value of the collateral properties. If an SFR Borrower is unable to make payments under the applicable SFR Loan or fails to make payment at maturity, the lender would be able to take possession/title to the membership interests of such SFR Borrower and the properties and other assets of
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such SFR Borrower to satisfy and discharge the corresponding SFR Loan obligations. In such an event, our overall results of operations and financial condition would be materially adversely affected.
Even though the SFR Loans are non-recourse to us and all of our subsidiaries other than the relevant SFR Equity Owner and SFR Borrower, we have agreed to limited bad act indemnification obligations to the lender for the payment of (i) certain losses arising out of certain bad or wrongful acts of the SFR Equity Owners and SFR Borrowers with respect to the SFR Loans and (ii) a portion of the principal amount of the SFR Loans and certain other obligations under the SFR Loan Agreements in the event we cause certain voluntary bankruptcy events of the applicable SFR Equity Owner or SFR Borrower. Any of such liabilities could have a material adverse effect on our results of operations and/or financial condition.
We utilize repurchase agreement financing structures, and such structures expose us to risks that could result in losses to us.
We have leveraged certain of our investments to date through our repurchase agreements. When we enter into any repurchase agreement, we may sell residential properties or securities to lenders (i.e., repurchase agreement counterparties) and receive cash from the lenders. The lenders are obligated to resell the same assets back to us at the end of the term of the transaction. Because the cash we receive from the lender when we initially sell the assets to the lender is less than the value of those assets, if the lender defaults on its obligation to resell the same assets back to us, we could incur a loss on the transaction. In addition, repurchase agreements generally allow the counterparties, to varying degrees, to determine a new market value of the collateral to reflect current market conditions or for other reasons. If such counterparty determines that the value of the collateral has decreased, it may initiate a margin call and require us to either post additional collateral to cover such decrease or repay a portion of the outstanding borrowing. Should this occur, in order to obtain cash to satisfy a margin call, we may be required to liquidate assets at a disadvantageous time, which could cause us to incur losses. In the event we are unable to satisfy a margin call, our counterparty may sell the collateral, which may result in significant losses to us.
We may be adversely affected by changes in LIBOR reporting practices, the method in which LIBOR is determined or the use of alternative reference rates.
Our variable rate debt and interest rate caps are currently indexed to the London Interbank Offered Rate (“LIBOR”). In July 2017, the United Kingdom regulator that regulates LIBOR announced its intention to phase out LIBOR rates by the end of 2021. It is impossible to predict the further effect of this announcement, any changes in the methods by which LIBOR is determined or other reforms to LIBOR that may be enacted. In April 2018, the Federal Reserve Bank of New York commenced publishing the Secured Overnight Financing Rate (“SOFR”), an alternative reference rate proposed by the Alternative Reference Rates Committee (“ARRC”), a group of major market participants convened by the U.S. Federal Reserve, with participation by SEC Staff and other regulators. SOFR is based on transactions in the more robust U.S. Treasury repurchase market and has been proposed as the alternative to LIBOR for use in derivatives and other financial contracts that currently rely on LIBOR as a reference rate. ARRC has proposed a paced market transition plan to SOFR from LIBOR, and organizations are currently working on industry-wide and company-specific transition plans as it relates to derivatives and cash markets exposed
to LIBOR. At this time, no consensus exists as to what rate or rates may become accepted alternatives to LIBOR, and it is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR, whether LIBOR rates will cease to be published or supported before or after 2021 or whether additional reforms to LIBOR may be enacted. Such developments and any other legal or regulatory changes in the method by which LIBOR is determined or the transition from LIBOR to a successor benchmark may result in, among other things, a sudden or prolonged increase or decrease in LIBOR, a delay in the publication of LIBOR and/or changes in the rules or methodologies of LIBOR, which may discourage market participants from continuing to administer or to participate in LIBOR’s determination and, in certain situations, could result in LIBOR no longer being determined and published. If a published U.S. dollar LIBOR rate is unavailable after 2021, the interest rates on our variable rate debt or strike rates on our interest rate caps that are indexed to LIBOR may be determined using various alternative methods, any of which may result in interest obligations that are more or less than or do not otherwise correlate over time with the payments that would have been made on such debt or received on such interest rate caps if U.S. dollar LIBOR was available in its current form. Further, the same costs and risks that may lead to the unavailability of U.S. dollar LIBOR may make one or more of the alternative methods impossible or impracticable to determine. Any of these proposals or consequences could have a material adverse effect on our financing costs, and, to the extent our interest rate cap arrangements cannot adequately protect against all such possibly adverse consequences, such proposals or consequences could adversely affect our financial condition, operating results and cash flows.
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Our failure to effectively perform property management functions or to effectively manage our portfolio and operations could materially and adversely affect us.
Prior to our acquisition of HavenBrook Partners, LLC (“HavenBrook” or our “internal property manager”), we had relied on third parties to provide property management services for the properties in our SFR portfolio. As a result, prior to August 8, 2018, we did not have direct experience operating our own property manager. If our internal property manager is unable to effectively perform property management services at the level and/or the cost that we expect or if we fail to allocate sufficient resources to meet our property management needs, it would adversely affect our performance. Through HavenBrook, we have direct responsibility for the management of the properties in our SFR portfolio, including, without limitation, renovations, maintenance and certain matters related to leasing, such as marketing and selection of tenants. In addition, we will be responsible for ensuring the compliance of HavenBrook with governmental laws, regulations and covenants that are applicable to our homes, our tenants and our prospective tenants, including, without limitation, permitting, licensing and zoning requirements and tenant relief laws, such as laws regulating evictions, rent control laws and other regulations that limit our ability to increase rental rates. We have limited experience operating our own property manager, and it is difficult to evaluate our potential future performance.
Our ability to perform the property management services will be affected by various factors, including, among other things, our ability to maintain sufficient personnel and retain key personnel and the number of our SFR properties that we manage. Increases in the number of properties we internally manage have required us to hire a large number of additional qualified personnel. No assurance can be made that we will continue to be successful in attracting and retaining skilled personnel or in integrating any new personnel into our organization.
Although we expect that the utilization of HavenBrook as an internal property manager will result in certain benefits, there can be no assurance regarding when or the extent to which we will be able to realize these benefits, which may be difficult, unpredictable and subject to delays. Our future success will depend, in part, upon our ability to successfully monitor our operations, costs, regulatory compliance and service quality and maintain other necessary internal controls. There can be no assurance that we will realize our expected operating efficiencies, cost savings, revenue enhancements or other benefits.
Our inability to effectively perform the property management services on the properties managed by us, through HavenBrook, or to effectively manage our portfolio and operations could materially adversely affect our business, financial results and share price.
We face intense competition for the employment of highly skilled managerial and operational personnel.
Our business plan may require that we employ additional highly skilled managerial and operational personnel, and our inability to recruit and retain qualified personnel in the future could have an adverse effect on our business and financial results. Competition for such skilled managerial and operational personnel is intense. As additional large real estate investors and property managers enter into and expand their scale within the single-family rental business, we expect to face increased challenges in hiring and retaining personnel, and there can be no assurance that we will be successful in attracting and retaining such skilled personnel. If we are unable to hire and retain qualified personnel as required, our growth and operating results could be adversely affected.
Our ability to meet our labor needs while controlling our labor costs is subject to numerous external factors, including unemployment levels, prevailing wage rates, changing demographics and changes in employment legislation. If we are unable to retain qualified personnel or our labor costs increase significantly, our business operations and our financial performance could be adversely impacted.
We may incur significant costs in renovating our properties or turning vacant properties, and we may underestimate the costs or amount of time necessary to complete restorations or unit turns.
While a substantial portion of the SFR properties we have acquired to date meet our rental specifications at the time of acquisition, properties frequently require additional renovations prior to renting. Before renting a property, a detailed assessment is performed, with an on-site review of the property, to identify the scope of renovation to be completed. Beyond customary repairs, we may undertake improvements designed to optimize the overall property appeal and increase the value of the property. Though we endeavor to conduct property inspections and due diligence prior to acquiring new SFR portfolios, we expect that nearly all of our rental properties will require some level of renovation immediately upon their acquisition or in the future following expiration of a lease or otherwise. We may acquire properties that we plan to extensively renovate and restore. In addition, in order to reposition properties in the rental market, we will be required to make ongoing capital improvements and may need to perform significant renovations and repairs from time to time. Consequently, we are exposed to the risks
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inherent in property renovation, including potential cost overruns, increases in labor and materials costs, delays by contractors in completing work, delays in the timing of receiving necessary work permits and certificates of occupancy and poor workmanship. If our assumptions regarding the cost or timing of renovations across our properties prove to be materially inaccurate, it may be more costly or take significantly more time than anticipated to develop and grow our SFR portfolio, which could materially and adversely affect us.
In addition, we anticipate a minimum level of effort will be required to prepare a newly vacant property to be made ready for occupancy by a new tenant, and we are exposed to risks of cost overruns, increases in costs of materials or labor, delays in the completion of work and other factors. If we are unable to perform unit turns efficiently or in a timely manner, we would experience decreased revenue, increased expenses or both.
The availability of portfolios of single-family residential properties for purchase on favorable terms may decline as market conditions change, our industry matures and/or additional purchasers for such portfolios emerge, and the prices for such portfolios may increase, any of which could materially and adversely affect us.
In recent years, there has been an increase in supply of SFR property portfolios available for sale. Because we operate in an emerging industry, market conditions may be volatile, and the prices at which portfolios of SFR properties can be acquired may increase from time to time, or permanently, due to new market participants seeking such portfolios, a decrease in the supply of desirable portfolios or other adverse changes in the geographic areas that we may target from time to time. For these reasons, the supply of SFR properties that we may acquire may decline over time, which could materially and adversely affect us and our growth prospects.
Portfolios of properties that we have acquired or may acquire may include properties that do not fit our investment criteria, and divestiture of such properties may be costly or time consuming or both, which may adversely affect our operating results.
We have acquired, and expect to continue to acquire, portfolios of SFR properties, many of which are, or will be, subject to existing leases. To the extent the management and leasing of such properties has not been consistent with our property management and leasing standards, we may be subject to a variety of risks, including risks relating to the condition of the properties, the credit quality and employment stability of the tenants and compliance with applicable laws, among others. In addition, financial and other information provided to us regarding such portfolios during our due diligence may be inaccurate, and we may not be able to obtain relief under contractual remedies, if any. If we conclude that certain properties acquired as part of a portfolio do not fit our investment criteria, we may decide to sell such properties and may be required to renovate the properties prior to sale, to hold the properties for an extended marketing period and/or sell the property at an unfavorable price, any of which could materially and adversely affect us.
Competition in identifying and acquiring residential rental assets could adversely affect our ability to implement our business strategy, which could materially and adversely affect us.
We face competition from various sources for investment opportunities, including REITs, hedge funds, private equity funds, partnerships, developers and others. Some third-party competitors have substantially greater financial resources and access to capital than we do and may be able to accept more risk than we can. Competition from these companies may reduce the number of attractive investment opportunities available to us or increase the bargaining power of asset owners seeking to sell, which would increase the prices of assets. If such events occur, our ability to implement our business strategy could be adversely affected, which could materially and adversely affect us. Given the existing competition, complexity of the market and requisite time needed to make such investments, no assurance can be given that we will be successful in acquiring investments that generate attractive risk-adjusted returns. Furthermore, there is no assurance that such investments, once acquired, will perform as expected.
We may be materially and adversely affected by risks affecting the single-family rental properties in which our investments may be concentrated at any given time as well as from unfavorable changes in the related geographic regions.
Our assets are not subject to any geographic diversification requirements or concentration limitations, and, as a result, circumstances or events that impact a geographic region in which we have a significant concentration of properties, including a downturn in regional economic conditions or natural disasters, could materially and adversely affect us. Entities that sell residential rental portfolios may group the portfolios by location or other metrics that could result in a concentration of our portfolio by geography, SFR property characteristics and/or tenant demographics. Such concentration could increase the risk of loss to us if the particular concentration in our portfolio is subject to greater risks or undergoing adverse developments. In addition, adverse conditions in the areas where our properties or tenants are located (including business layoffs or downsizing,
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industry slowdowns, changing demographics, oversupply, reduced demand and other factors) may have an adverse effect on the value of our investments. A material decline in the demand for single-family housing or rentals in the areas where we own assets may materially and adversely affect us. Lack of diversification can increase the correlation of non-performance and foreclosure risks among our investments.
Short-term leases of residential property expose us more quickly to the effects of declining market rents.
We anticipate that a majority of our leases to tenants of SFR properties will be for a term of one year. As these leases permit the residents to leave at the end of the lease term without penalty, we anticipate our rental revenues will be affected by declines in market rents more quickly than if our leases were for longer terms. Short-term leases may result in high turnover, resulting in additional cost to renovate and maintain the property and lower occupancy levels. Because we have a limited operating history, our tenant turnover rate and related cost estimates may be less accurate than if we had more operating data upon which to base these estimates.
We may be unable to secure funds for property restoration or other capital improvements, which could limit our ability to attract, retain or replace tenants.
When we acquire or otherwise take title to single-family properties or when tenants fail to renew their leases or otherwise vacate their space, we will be required to expend funds for property restoration and leasing commissions in order to lease the property. If we have not established reserves or set aside sufficient funds for such expenditures, we may have to obtain financing from other sources, as to which no assurance can be given. We may also have future financing needs for other capital improvements to restore our properties. If we need to secure financing for capital improvements in the future but are unable to secure such financing on favorable terms or at all, we may be unable or unwilling to make capital improvements or may choose to defer such improvements. If this happens, our properties may suffer from a greater risk of obsolescence or decreased marketability, a decline in value or decreased cash flow as a result of fewer potential tenants being attracted to the property or existing tenants not renewing their leases. If we do not have access to sufficient funding in the future, we may not be able to make necessary capital improvements to our properties, and our properties’ ability to generate revenue may be significantly impaired.
Our revenue and expenses are not directly correlated, and, because a large percentage of our costs and expenses are fixed and some variable expenses may not decrease over time, we may not be able to adapt our cost structure to offset any declines in our revenue.
Many of the expenses associated with our business, such as acquisition costs, restoration and maintenance costs, HOA fees, personal and real property taxes, insurance, compensation and other general expenses are fixed and would not necessarily decrease proportionally with any decrease in revenue. Our assets also will likely require a significant amount of ongoing capital expenditure. Our expenses, including capital expenditures, will be affected by, among other things, any inflationary increases, and cost increases may exceed the rate of inflation in any given period. Certain expenses, such as HOA fees, taxes, insurance and maintenance costs are recurring in nature and may not decrease on a per-unit basis as our portfolio grows through additional property acquisitions. By contrast, our revenue is affected by many factors beyond our control, such as the availability and price of alternative rental housing and economic conditions in our markets. As a result, we may not be able to fully, or even partially, offset any increase in our expenses with a corresponding increase in our revenues. In addition, state and local regulations may require us to maintain our properties, even if the cost of maintenance is greater than the potential benefit.
Competition could limit our ability to lease single-family rental properties or increase or maintain rents.
Our SFR properties, when acquired, will compete with other housing alternatives to attract residents, including rental apartments, condominiums and other single-family homes available for rent as well as new and existing condominiums and single-family homes for sale. Our competitors’ properties may be of better quality, in a more desirable location or have leasing terms more favorable than we can provide. In addition, our ability to compete and generate favorable returns depends upon, among other factors, trends of the national and local economies, the financial condition and liquidity of current and prospective renters, availability and cost of capital, taxes and governmental regulations. Given significant competition, we cannot assure you that we will be successful in acquiring or managing SFR properties that generate favorable returns.
If rents in our markets do not increase sufficiently to keep pace with potential rising costs of operations, our operating results and cash available for distribution will decline.
The success of our business model will substantially depend on conditions in the SFR property market in our geographic markets. Our asset acquisitions are premised on assumptions about, among other things, occupancy and rent levels. If those
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assumptions prove to be inaccurate, our operating results and cash available for distribution will be lower than expected, potentially materially. Rental rates and occupancy levels have benefited in recent periods from macroeconomic trends affecting the U.S. economy and residential real estate and mortgage markets in particular, including a tightening of credit and increases in interest rates that has made it more difficult to finance a home purchase, combined with efforts by consumers generally to reduce their exposure to credit. A decrease in rental rates would have a material adverse effect on the performance of our SFR portfolio or could cause a default of our obligations under one or more financing agreements, and our business, results of operations and financial condition would therefore be materially harmed.
If the current trend favoring renting rather than homeownership reverses, the single-family rental market could decline.
The SFR market is currently significantly larger than in historical periods. We do not expect the favorable trends in the SFR market to continue indefinitely. Eventually, continued strengthening of the U.S. economy and job growth, together with the large supply of foreclosed SFR properties, the current availability of low residential mortgage rates and government sponsored programs promoting home ownership, may contribute to a stabilization or reversal of the current trend that favors renting rather than homeownership. In addition, we expect that as investors increasingly seek to capitalize on opportunities to purchase undervalued housing properties and convert them to productive uses, the supply of SFR properties will decrease and the competition for tenants will intensify. A softening of the rental property market in our markets would adversely affect our operating results and cash available for distribution, potentially materially.
Suboptimal tenant underwriting and defaults by our tenants may materially and adversely affect us.
Our success will depend, in large part, upon our ability to attract and retain qualified tenants for our properties. This will depend, in turn, upon our ability to screen applicants, identify good tenants and avoid tenants who may default. We will inevitably make mistakes in our selection of tenants, and we may rent to tenants whose default on our leases or failure to comply with the terms of the lease or HOA regulations could materially and adversely affect us. For example, tenants may default on payment of rent; make unreasonable and repeated demands for service or improvements; make unsupported or unjustified complaints to regulatory or political authorities; make use of our properties for illegal purposes; damage or make unauthorized structural changes to our properties that may not be fully covered by security deposits; refuse to leave the property when the lease is terminated; engage in domestic violence or similar disturbances; disturb nearby residents with noise, trash, odors or eyesores; fail to comply with HOA regulations; sub-let to less desirable individuals in violation of our leases or permit unauthorized persons to live with them. The process of evicting a defaulting tenant from a family residence can be adversarial, protracted and costly. Furthermore, some tenants facing eviction may damage or destroy the property. Damage to our properties may significantly delay re-leasing after eviction, necessitate expensive repairs, reduce the rental revenue generated by the property or impair its value. In addition, we will incur turnover costs associated with re-leasing the properties, such as marketing expenses and brokerage commissions, and will not collect revenue while the property is vacant. Although we will attempt to work with tenants to prevent such damage or destruction, there can be no assurance that we will be successful in all or most cases. Such tenants will not only cause us not to achieve our financial objectives for the properties in which they live, but may subject us to liability and may damage our reputation with our other tenants and in the communities where we do business.
A significant uninsured property or liability loss could have a material adverse effect on us.
We carry commercial general liability insurance and property insurance with respect to our SFR properties on terms we consider commercially reasonable. However, many of the policies covering casualty losses are subject to substantial deductibles and exclusions, and we will be self-insured up to the amount of the deductibles and exclusions. For example, we may not always be fully insured against losses arising from floods, windstorms, fires, earthquakes, acts of war or terrorism or civil unrest because they are either uninsurable or the cost of insurance makes it economically impractical. If an uninsured property loss or a property loss in excess of insured limits were to occur, we could lose our capital invested in a property or group of properties as well as the anticipated future revenues from affected SFR properties or groups of properties. Further, inflation, changes in building codes and ordinances, environmental considerations and other factors might also prevent us from using insurance proceeds to replace or renovate a property after it has been damaged or destroyed.
In the event that we incur a casualty loss that is not fully covered by insurance, the value of our assets will be reduced by the amount of any such uninsured loss, and we could experience a significant loss of capital invested and potential revenues in these properties and could potentially remain obligated under any recourse debt associated with the property. Further, if an uninsured liability to a third party were to occur, we would incur the cost of defense and settlement with or court ordered damages to that third party. A significant uninsured property or liability loss could adversely affect our financial condition, operating results, cash flows and ability to make distributions on our common stock.
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A significant number of our SFR properties and non-rental REO properties may be part of homeowners’ associations. We and our renters will be subject to the rules and regulations of such homeowners’ associations, which may be arbitrary or restrictive, and violations of such rules may subject us to additional fees and penalties and litigation, which may be costly.
A significant number of our properties may be subject to HOAs, which are private entities that regulate the activities of and levy assessments on properties in a residential subdivision. Some of the HOAs that will govern our properties may enact onerous or arbitrary rules that restrict our ability to renovate, market or lease our SFR properties or require us to renovate or maintain such properties at standards or costs that are in excess of our planned operating budgets. Such rules may include requirements for landscaping, limitations on signage promoting a property for lease or sale or the use of specific construction materials to be used in renovations. Some HOAs also impose limits on the number of property owners who may rent their homes, which, if met or exceeded, may cause us to incur additional costs to sell the affected property and opportunity costs of lost rental income. Furthermore, many HOAs impose restrictions on the conduct of occupants of homes and the use of common areas, and we may have renters who violate these HOA rules for which we may be liable as the property owner. Additionally, the boards of directors of the HOAs that will govern our properties may not make important disclosures or may block our access to HOA records, initiate litigation, restrict our ability to sell, impose assessments or arbitrarily change the HOA rules. We may be unaware of or unable to review or comply with certain HOA rules before acquiring a property, and any such excessively restrictive or arbitrary regulations may cause us to sell such property (if possible), prevent us from renting such property or otherwise reduce our cash flow from such property. Any of the above-described occurrences may materially and adversely affect us.
We rely on information supplied by prospective tenants in managing our business.
We rely on information supplied to us by prospective tenants in their rental applications as part of our due diligence process to make leasing decisions, and we cannot be certain that this information is accurate. In particular, we rely on information submitted by prospective tenants regarding household income, tenure at current job, number of children and size of household. Moreover, these applications are submitted to us at the time we evaluate a prospective tenant, and we do not require tenants to provide us with updated information during the terms of their leases, notwithstanding the fact that this information can, and frequently does, change over time. Even though this information is not updated, we will use it to evaluate the overall average credit characteristics of our portfolio over time. If tenant-supplied information is inaccurate or our tenants’ creditworthiness declines over time, we may make poor leasing decisions, and our portfolio may contain more credit risk than we believe.
Difficulties in selling REO properties and other non-core assets could limit our flexibility and/or harm our liquidity.
Federal tax laws may limit our ability to earn a gain on the sale of our properties if we are found to have held or acquired the properties with the intent to resell, and this limitation may adversely affect our willingness to sell REO properties under favorable conditions or if necessary for funding purposes. We typically contribute REO properties that will not meet our rental profile to our taxable REIT subsidiary in order to sell and generate gains or losses at the taxable REIT subsidiary upon such sales. In addition, our REO properties that we intend to sell may at times be difficult to dispose of quickly or at favorable prices. These potential difficulties in selling real estate in our markets may limit our ability to either sell properties that we deem unsuitable for rental or change or reduce the REO properties in our portfolio promptly in response to changes in economic or other conditions. Our failure to sell or delays in selling our REO properties could potentially cause a strain on our liquidity, and we may be forced to reduce prices and/or continue to hold such REO properties without leverage, which could materially and adversely affect our financial condition.
The growth of our SFR portfolio, at least in the short term, is expected to be partially dependent on our ability to sell non-core assets. If we are unable to sell these assets at optimal prices or on a timely basis, or if the market shifts, creating lower sales prices, our ability to utilize the equity embedded in these assets would be harmed, which would have a material adverse effect on our ability to convert the proceeds of such sales into buying power for the acquisition of SFR properties. Furthermore, a large portion of the sale proceeds of such non-core assets are utilized to purchase the assets off of our repurchase and loan facilities for which the assets are collateral. If a higher than expected portion of the sale consideration must be utilized to repurchase assets off of our facilities, our ability to purchase SFR properties may also be adversely affected, which would slow the growth of our rental portfolio.
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Our SFR and REO properties are not liquid assets, which could limit our ability to vary our portfolio or to realize the value at which such assets are carried if we are required to dispose of them.
Our SFR and REO properties are not liquid assets, which could limit our ability to vary our portfolio or to realize the value at which such assets are carried if we are required to dispose of them. Our inability to sell individual or portfolios of SFR and/or REO properties on acceptable terms and/or in accordance with our anticipated timing could materially and adversely affect our financial condition.
AAMC utilizes analytical models and data in connection with the valuation of our investments, and any incorrect, misleading or incomplete information used in connection therewith would subject us to potential risks.
AAMC relies heavily on models and data, including analytical models (both proprietary models developed by AAMC and those supplied by third parties) and information and data supplied by third parties. Models and data are used to value our assets or potential investments and also in connection with performing due diligence on our investments. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, we may be induced to buy certain investments at prices that are too high, to sell certain other investments at prices that are too low or to miss favorable opportunities altogether.
An unidentified material weakness in our internal control over financial reporting could, if not remediated, result in material misstatements in our financial statements.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as defined in Rule 13a-15(f) under the Exchange Act. If material weaknesses or significant deficiencies in our internal controls are discovered in the future, we could be required to restate our financial results or experience a decline in the price of our securities.
Our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving their objectives as specified above. Management does not expect, however, that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.
Changes in global economic and capital market conditions, including periods of generally deteriorating occupancy and real estate industry fundamentals, may materially and adversely affect us.
There are risks to the ownership of real estate and real estate related assets, including decreases in residential property values, changes in global, national, regional or local economic, demographic and real estate market conditions as well as other factors particular to the locations of our investments. A prolonged recession and a slow recovery could materially and adversely affect us as a result of, among other items, the following:
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joblessness or unemployment rates that adversely affect the local economy;
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an oversupply of or a reduced demand for SFR properties for rent;
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a decline in employment or lack of employment growth;
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the inability or unwillingness of residents to pay rent increases or fulfill their lease obligations;
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a decline in rental rate, which may be accentuated since we expect to generally have rent terms of one year;
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rent control or rent stabilization laws or other laws regulating housing that could prevent us from raising rents to offset increases in operating costs;
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changes in interest rates and availability and terms of debt financing; and
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economic conditions that could cause an increase in our operating expenses such as increases in property taxes, utilities and routine maintenance.
These conditions could also adversely impact the financial condition and liquidity of the renters that will occupy our real estate properties and, as a result, their ability to pay rent to us.
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Inflation or deflation may adversely affect our results of operations and cash flows.
Increased inflation could have an adverse impact on interest rates, property management expenses and general and administrative expenses as these costs could increase at a rate higher than our rental and other revenue. Conversely, deflation could lead to downward pressure on rents and other sources of income without an accompanying reduction in our expenses. Accordingly, inflation or deflation may adversely affect our results of operations and cash flows.
Changes in applicable laws or noncompliance with applicable law could materially and adversely affect us.
As an owner of real estate, we are required to comply with numerous federal, state and local laws and regulations, some of which may conflict with one another or be subject to limited judicial or regulatory interpretations. These laws and regulations may include zoning laws, building codes, landlord-tenant laws and other laws generally applicable to our business operations. Noncompliance with laws or regulations could expose us to liability.
Lower revenue growth or significant unanticipated expenditures may result from our need to comply with changes in (i) laws imposing remediation requirements and potential liability for environmental conditions existing on properties or the restrictions on discharges or other conditions, (ii) rent control or rent stabilization laws or other residential landlord-tenant laws or (iii) other governmental rules and regulations or enforcement policies affecting the rehabilitation, use and operation of our SFR properties, including changes to building codes and fire and life-safety codes.
Residential properties that are subject to foreclosure or short-sales are subject to risks of theft, vandalism or other damage that could impair their value.
When a residential property is subject to foreclosure, it is possible that the homeowner may cease to maintain the property adequately or that the property may be abandoned by the homeowner and become susceptible to theft or vandalism. Lack of maintenance, theft and vandalism can substantially impair the value of the property. To the extent we initiate foreclosure proceedings, some of our properties could be impaired.
Contingent or unknown liabilities associated with respect to our prior acquisitions of portfolios of properties could adversely affect our financial condition, cash flows and operating results.
Assets and entities that we have acquired in connection with prior SFR portfolio or operating entity acquisitions may be subject to unknown or contingent liabilities for which we may have limited or no recourse against the sellers. Unknown or contingent liabilities might include liabilities for or with respect to liens attached to properties; unpaid real estate tax, utilities or HOA charges for which a subsequent owner remains liable; clean-up or remediation of environmental conditions or code violations; claims of customers, vendors or other persons dealing with the acquired entities; or tax liabilities. Purchases of single-family properties in portfolio purchases typically involve limited representations or warranties with respect to the properties and may allow us limited or no recourse against the sellers. Such properties also often have unpaid tax, utility and HOA liabilities for which we may be obligated but fail to anticipate. As a result, the total amount of costs and expenses that we may incur with respect to liabilities associated with prior SFR property or entity acquisitions may exceed our expectations, which may adversely affect our operating results and financial condition. Additionally, such prior SFR property acquisitions may be subject to covenants, conditions or restrictions that restrict the use or ownership of such properties, including prohibitions on leasing. We may not have discovered such restrictions during the acquisition process, and such restrictions may adversely affect our ability to operate such properties as we intend.
The costs and amount of time necessary to secure possession and control of certain properties may exceed our assumptions, which would delay our receipt of revenue from, and return on, the property.
A majority of the SFR properties we have acquired have had an existing tenant at the time of acquisition. However, certain SFR and non-rental REO properties require us to secure possession. In certain circumstances, we may have to evict occupants who are in unlawful possession before we can secure possession and control of the property. The holdover occupants may be the former owners or tenants of a property, or they may be squatters or others who are illegally in possession. Securing control and possession from these occupants can be both costly and time consuming. If these costs and delays exceed our expectations, our financial performance may suffer because of the increased expenses incurred or the unexpected delays in turning the properties into revenue-producing rental properties.
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Eminent domain could lead to material losses on our investments.
It is possible that governmental authorities may exercise eminent domain to acquire land on which our properties are built in order to build roads or other infrastructure. Any such exercise of eminent domain would allow us to recover only the fair value of the affected properties, which we believe may be interpreted to be substantially less than the actual value of the property. Several cities are also exploring proposals to use eminent domain to acquire residential loans to assist borrowers to remain in their homes, potentially reducing the supply of single-family properties for sale in our markets. Any of these events can cause a material loss to us.
We are now exposed to labor and employment risks to which we have not historically been exposed.
Prior to the HB Acquisition, we had no employees of our own. With the completion of the HB Acquisition, we now have employees of our own managing the internal property management function. As an employer, we are now subject to those potential liabilities that are commonly faced by employers, such as workers’ disability and compensation claims, potential labor disputes and other employee-related liabilities and grievances. Further, we bear the costs of the establishment and maintenance of payroll management and health, retirement and similar benefit plans for our employees.
We are subject to the risks of securities laws liability and related civil litigation.
We may be subject to the risk of securities litigation and derivative actions from time to time as a result of being publicly traded. There can be no assurance that any settlement or liabilities in such lawsuits or claims against us would be covered or partially covered by our insurance policies, which could have a material adverse effect on our earnings in one or more periods. The range of possible resolutions in relation to any such lawsuits or claims could include determinations and judgments against us or settlements that could require substantial payments by us, including the costs of defending such suit, which could have a material adverse effect on our financial condition, results of operations and cash flows. An adverse resolution of any lawsuits or claims against us could have an adverse effect on our business, financial condition and/or operating results.
We likely will incur costs due to litigation, including but not limited to, class actions, tenant rights claims and consumer demands.
There are numerous tenants’ rights and consumer rights organizations throughout the country. As we grow in scale, we may attract attention from some of these organizations and become a target of legal demands or litigation. Many such consumer organizations have become more active and better funded in connection with mortgage foreclosure-related issues and displaced home ownership. Some of these organizations may shift their litigation, lobbying, fundraising and grass roots organizing activities to focus on landlord-tenant issues as more entities engage in the SFR property market. Additional actions that may be targeted at us include eviction proceedings and other landlord-tenant disputes, challenges to title and ownership rights (including actions brought by prior owners alleging wrongful foreclosure by their lender or servicer) and issues with local housing officials arising from the condition or maintenance of an SFR property. While we intend to conduct our rental business lawfully and in compliance with applicable landlord-tenant and consumer laws, such organizations might work in conjunction with trial and pro bono lawyers in one state or multiple states to attempt to bring claims against us on a class action basis for damages or injunctive relief. We cannot anticipate what form such legal actions might take or what remedies they may seek. Any of such claims may result in a finding of liability that may materially and adversely affect us.
Additionally, these organizations may lobby local county and municipal attorneys or state attorneys general to pursue enforcement or litigation against us or may lobby state and local legislatures to pass new laws and regulations to constrain our business operations. If they are successful in any such endeavors, they could directly limit and constrain our business operations and impose on us significant litigation expenses, including settlements to avoid continued litigation or judgments for damages or injunctions. Any of the above-described occurrences may materially and adversely affect us.
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Security breaches and other disruptions could compromise our information systems and expose us to liability, which would cause our business and reputation to suffer.
In the ordinary course of our business, we or our external service providers may acquire and store sensitive data on our network, such as our proprietary business information and personally identifiable information of our prospective and current tenants. The secure processing and maintenance of this information is critical to our business strategy. Despite our security measures, our information technology and infrastructure may be subject to attacks by hackers or breached due to employee error, malfeasance or other disruptions. Any such breach could compromise our networks, and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, regulatory penalties, disruption to our operations and the services we provide to customers or damage our reputation, which could materially and adversely affect us.
We may incur substantial costs due to environmental contamination or non-compliance.
Under various federal, state and local environmental and public health laws, regulations and ordinances, we may be required, regardless of knowledge or responsibility, to investigate and remediate the effects of hazardous or toxic substances or petroleum product releases at our SFR properties (including in some cases, asbestos-containing construction materials, lead-based paints, contaminants migrating from off-site sources and natural substances such as methane, mold and radon gas) and may be held liable under these laws or common law to a governmental entity or to third parties for property, personal injury or natural resources damages and for investigation and remediation costs incurred as a result of the contamination. These damages and costs may be substantial and may exceed any insurance coverage we may have for such events, which could materially and adversely affect us. The presence of such substances or the failure to properly remediate the contamination may adversely affect our ability to borrow against, sell or rent the affected property. In addition, some environmental laws create or allow a government agency to impose a lien on the contaminated site in favor of the government for damages and costs it incurs as a result of the contamination, which may also adversely affect our ability to borrow against, sell or rent the affected property.
Our properties will be subject to property and other taxes that may increase over time.
We will be responsible for property taxes for our SFR properties when acquired, which may increase as tax rates change and properties are reassessed by taxing authorities. If we fail to pay any such taxes, the applicable taxing authorities may place a lien on the property, and the property may be subject to a tax sale. Increases in property taxes would also adversely affect our yield from rental properties. Any such occurrence may materially and adversely affect us.
Our concentrations of credit risk could have a material adverse effect on us.
We maintain our cash and cash equivalent investments and our restricted cash at financial or other intermediary institutions. The combined account balances at each institution typically exceed FDIC insurance coverage of $250,000 per depositor and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. At December 31, 2019, substantially all of our cash and cash equivalent balances held at financial institutions exceeded FDIC insured limits. Any event that would cause the insolvency of a financial institution at which we hold a material portion of our cash and cash equivalents and restricted cash in excess of amounts subject to FDIC deposit insurance would have a material adverse effect on our financial condition and results of operations.
Our business could be negatively affected as a result of stockholder activism, which could cause us to incur significant expense, hinder execution of our business strategy and impact the trading value of our securities.
Activist stockholders may publicly advocate for certain governance and strategic changes at our company, and there is no assurance that any such efforts would not be successful or that we would not be subject to additional stockholder activity or demands in the future. Stockholder activism, including potential proxy contests, requires significant time and attention by management and the Board of Directors, potentially interfering with our ability to execute our strategic plan. Additionally, such stockholder activism could give rise to perceived uncertainties as to our future direction and adversely affect our relationships with key business partners. Also, we may be required to incur significant legal fees and other expenses related to activist stockholder matters. Any of these impacts could materially and adversely affect our business and operating results. Further, the market price of our common stock could be subject to significant fluctuation or otherwise be adversely affected by the events, risks and uncertainties described above.
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Risks Related to the Merger
The announcement and pendency of the Merger may have an adverse effect on the Company’s business, financial condition, operating results and cash flows.
Uncertainty about the effect of the proposed Merger on our employees, partners, customers, Manager and other third parties may disrupt our key business activities and may have a material adverse effect on our business, financial condition, operating results and cash flows. Current and prospective employees may experience uncertainty about their roles following the Merger, and this may have an effect on our corporate culture. There can be no assurance we will be able to attract and retain key talent, including senior leaders, to the same extent that we have previously been able to attract and retain employees. Any loss or distraction of such employees could have a material adverse effect on our business, financial condition and operating results. In addition, we have diverted, and will continue to divert, significant management and other internal resources towards the completion of the Merger and planning for integration, which could materially adversely affect our business, financial condition, operating results and cash flows. Parties with which we have business relationships may experience uncertainty as to the future of such relationships and may delay or defer certain business decisions, seek alternative relationships with third parties or seek to alter their present business relationships with us. Parties with whom we otherwise may have sought to establish business relationships may seek alternative relationships with third parties.
The failure to complete the Merger in a timely manner or at all could negatively impact the market price of our common stock as well as adversely affect our business, financial condition, operating results and cash flows.
Completion of the Merger is subject to several conditions beyond the Company’s control that may prevent, delay or otherwise adversely affect its completion in a material way. The Merger cannot be completed until the conditions to closing are satisfied or waived. We cannot guarantee that the closing conditions set forth in the Merger Agreement will be satisfied or, even if satisfied, that no event of termination will take place. In the event that the Merger is not completed for any reason, the holders of our common stock will not receive the Merger Consideration in connection with the proposed Merger. Instead, we will remain an independent public company, and the holders of our common stock will continue to own their shares of common stock.
If the Merger is not completed within the expected time frame or at all, we may be subject to a number of material risks. The price of our common stock may decline to the extent that current market prices reflect a market assumption that the Merger will be completed. We could be required to pay Parent termination fees of up to $24 million and, in addition, to reimburse Parent for certain expenses incurred by Parent in connection with the Merger Agreement up to a maximum of $8.2 million, if the Merger Agreement is terminated under specific circumstances described in the Merger Agreement. The failure to complete the Merger also may result in negative publicity and negatively affect our relationship with our stockholders, employees, customers and other business partners. We may also be required to devote significant time and resources to litigation related to any failure to complete the Merger or related to any enforcement proceeding commenced against us to perform our obligations under the Merger Agreement.
The Merger Agreement contains provisions that could discourage or deter a potential competing acquirer that might be willing to pay more to effect an alternative transaction with us.
Under the Merger Agreement, we are generally not permitted to solicit or discuss takeover proposals with third parties, subject to certain exceptions. The Merger Agreement provides that, during the period from the date of the Merger Agreement until the Effective Time, the Company is subject to certain restrictions on its ability to solicit alternative acquisition proposals from third parties, provide non-public information to third parties and engage in negotiations with third parties regarding alternative acquisition proposals, subject to customary exceptions.
We will incur substantial transaction fees and costs in connection with the Merger Agreement.
We have incurred and expect to continue to incur significant costs, expenses and fees for professional services and other transaction costs in connection with the Merger. A material portion of these expenses are payable by us whether or not the Merger is completed. Further, while we have assumed that a certain amount of transaction expenses will be incurred, factors beyond our control could affect the total amount or the timing of these expenses. Many of the expenses that will be incurred, by their nature, are difficult to estimate accurately. These expenses may exceed the costs historically borne by us. These costs could adversely affect our business, financial condition, operating results and cash flows.
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Risks Related to Our Management and Our Relationships
We could have conflicts with AAMC, and our Directors or management could have conflicts of interest due to their relationship with AAMC, any of which may be resolved in a manner adverse to us.
We have engaged, and expect to continue to engage, in a substantial amount of business with AAMC. Conflicts may arise between AAMC and us because of our ongoing agreement with AAMC and because of the nature of our respective businesses.
The majority of our executive officers are also executive officers of AAMC and have interests in our relationship with AAMC that may be different than the interests of our stockholders. As a result, they may have obligations to us and AAMC and could have conflicts of interest with respect to matters potentially or actually involving or affecting us and AAMC. In particular, these individuals have a direct interest in the financial success of AAMC that may encourage these individuals to support strategies in furtherance of the financial success of AAMC that could potentially adversely impact us.
We follow policies, procedures and practices to avoid potential conflicts with respect to our dealings with AAMC, including, where necessary, certain of our officers recusing themselves from discussions on, and approvals of, transactions with AAMC. We also manage potential conflicts of interest through oversight by independent members of our Board of Directors (all but one of our directors are independent directors), and we will seek to manage these potential conflicts through dispute resolution and other provisions of our agreements with AAMC. Although we continue to seek ways to lessen many of these conflicts of interest, there can be no assurance that such measures will be effective, that we will be able to resolve all conflicts with AAMC or that the resolution of any such conflicts will be no less favorable to us than if we were dealing with a third party that had none of the connections we have with AAMC.
Our Board of Directors has approved a very broad investment policy and guidelines for AAMC and will not review or approve each investment decision. We may change our investment policy and guidelines without stockholder consent, which may materially and adversely affect the market price of our common stock and our ability to make distributions to our stockholders.
AAMC is authorized to follow a very broad investment policy and, therefore, has great latitude in determining the types of assets that are proper investments for us as well as the individual investment decisions. Although our Investment Committee provides oversight of AAMC's investments made our behalf, AAMC may make investments with lower rates of return than those anticipated under current market conditions and/or may make investments with greater risks to achieve those anticipated returns. Our Board of Directors will periodically review our investment policy and our investment portfolio but will not typically review or approve each proposed investment by AAMC unless it falls outside the scope of our previously approved investment policy or constitutes a related party transaction. In addition, in conducting periodic reviews, our Board of Directors will rely primarily on information provided to it by AAMC. Furthermore, AAMC may use complex strategies, and transactions entered into by AAMC may be costly, difficult or impossible to unwind by the time they are reviewed by our Board of Directors. In addition, we may change our investment policy and targeted asset classes at any time without the consent of our stockholders, which could result in our making investments that are different in type from, and possibly riskier than, our current investments or the investments currently contemplated. Changes in our investment policy and targeted asset classes may increase our exposure to interest rate risk, counterparty risk, default risk and real estate market fluctuations, which could materially and adversely affect us.
We depend on AAMC as our Manager. We may not be able to retain our exclusive engagement of AAMC under certain circumstances, which could materially and adversely affect us. Termination of AAMC by us without cause could be costly, time consuming and potentially disruptive to our business.
Our success is dependent upon our relationships with and the performance of AAMC and its key personnel. Key personnel may leave AAMC, may become distracted by adverse financial or operational issues in connection with AAMC’s business and other activities or may fail to perform for any reason. In the event that the asset management agreement is terminated for any reason or AAMC is unable to retain its key personnel, it may also be difficult for us to secure a suitable replacement to AAMC on favorable terms or at all. The occurrence of any of the above described events could materially and adversely affect us.
The Amended AMA may only be terminated “for cause” in certain specified circumstances. If Front Yard were to terminate the Amended AMA without cause for any reason, AAMC would be entitled to 180 days' prior written notice and receipt of a termination fee payable to AAMC in an amount generally equal to three times the arithmetical mean of the aggregate fees actually paid or payable with respect to each of the three immediately preceding completed calendar years. If Front Yard were to determine to terminate AAMC without cause, such termination could be costly and time consuming and could materially adversely affect the Company’s business, financial condition, operating results and cash flows.
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Our Directors have the right to engage or invest in the same or similar businesses as ours.
Our Directors may have other investments and business activities in addition to their interest in, and responsibilities to, us. Under the provisions of our Charter and our bylaws (the “Bylaws”), our Directors have no duty to abstain from exercising the right to engage or invest in the same or similar businesses as ours or employ or otherwise engage any of the other Directors. If any of our Directors who are also directors, officers or employees of any other company acquires knowledge of a corporate opportunity or is offered a corporate opportunity outside of his capacity as one of our Directors, then our Bylaws provide that such Director will be permitted to pursue that corporate opportunity independently of us, so long as the Director has acted in good faith. Our Bylaws provide that, to the fullest extent permitted by law, such a Director will be deemed to have satisfied his fiduciary duties to us and will not be liable to us for pursuing such a corporate opportunity independently of us. This may create conflicts of interest between us and certain of our Directors and result in less than favorable treatment of us and our stockholders. As of this date, none of our Directors is directly involved as a director, officer or employee of a business that competes with us, but there can be no assurance that will remain unchanged in the future.
Risks Related to Our Qualification as a REIT
Failure to qualify as a REIT would materially and adversely affect us.
We made an election to be treated as a REIT for U.S. federal income tax purposes beginning with the year ended December 31, 2013. However, we cannot assure you that we will remain qualified as a REIT. Moreover, our qualification and taxation as a REIT will depend upon our ability to meet on a continuing basis, through actual operating results, certain qualification tests set forth in the federal income tax laws. Accordingly, no assurance can be given that our actual results of operations for any particular taxable year will satisfy such requirements. If we fail to qualify as a REIT in any taxable year, we will face serious tax consequences that will substantially reduce the funds available for distribution to our stockholders because:
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We would not be allowed a deduction for dividends paid to stockholders in computing our taxable income, thus becoming subject to federal income tax;
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We could be subject to increased state and local taxes; and
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Unless we are entitled to relief under certain federal income tax laws, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT. In addition, if we fail to qualify as a REIT, we will no longer be required to make distributions.
As a result of all these factors, our failure to qualify as a REIT could impair our ability to expand our business and raise capital, and it could materially and adversely affect us and the market price of our common stock.
Our tax position with respect to the accrual of interest and market discount income with respect to distressed mortgage loans that we previously owned involves risk.
Prior to our divestiture of our remaining mortgage loans in 2019, we did not accrue interest or market discount income on defaulted or delinquent loans when certain criteria were satisfied. The criteria generally related to whether those amounts were uncollectible or of doubtful collectability. If the Internal Revenue Service were to challenge this position successfully, we could be subject to entity level excise tax as a result of “deficiency dividends” that we would have been required to pay to our stockholders at the time of such an adjustment to our income in order to maintain our qualification as a REIT.
Compliance with REIT requirements may cause us to forego otherwise attractive opportunities, which may hinder or delay our ability to meet our investment objectives and reduce your overall return.
To qualify as a REIT, we are required at all times to satisfy certain tests relating to, among other things, the sources of our income, the nature and diversification of our assets, our financing, hedging and investment strategies, the ownership of our stock and amounts we distribute to our stockholders. Compliance with the REIT requirements may preclude us from certain financing or hedging strategies or cause us to forego otherwise attractive opportunities which may hinder or delay our ability to meet our investment objectives and reduce your overall return. For example, we may be required to pay distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution.
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Compliance with REIT requirements may force us to liquidate otherwise attractive investments, which could materially adversely affect us.
To qualify as a REIT, at the end of each calendar quarter, at least 75% of our assets must consist of qualified real estate assets, cash, cash items and government securities. In addition, no more than 20% of the value of our assets may be represented by securities of one or more taxable REIT subsidiaries. Except for securities that qualify for purposes of the 75% asset test above and investments in our qualified REIT subsidiaries and our taxable REIT subsidiaries, our investment in the value of any one issuer’s securities may not exceed 5% of the value of our total assets, and we may not own more than 10% of the total vote or value of the outstanding securities of any one issuer, except, in the case of the 10% value test, certain “straight debt” securities. In order to satisfy these requirements, we may be forced to liquidate otherwise attractive investments, potentially at a loss, which could materially and adversely affect us.
Failure to make required distributions would subject us to federal corporate income tax.
We intend to continue to operate in a manner so as to qualify as a REIT for federal income tax purposes. In order to qualify as a REIT, we generally are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, each year to our stockholders. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under the Code.
The IRS may deem the gains from sales of our properties to be subject to a 100% prohibited transaction tax.
From time to time, we may be forced to sell properties that do not meet our investment objectives or we may need to sell properties or other assets either because they do not meet our rental portfolio objectives or to satisfy our REIT distribution requirements. In general, to prevent even the appearance of acting as a “dealer,” REITs do not sell residential assets out of the REIT itself. Rather, taxable REIT subsidiaries are utilized for that purpose. Were we to purchase real estate assets with a view toward re-selling them, we could be considered a “dealer” of real estate, which could cause us to fail to meet our REIT requirements or such sales could be considered “prohibited transactions.” Because we have historically purchased large portfolios of mortgage loans with a view toward converting them into rental homes, there may be assets that we have purchased as part of all-or none portfolios that are not acceptable for our portfolio and necessary to sell. Typically, we contribute REO properties that we determine will not meet our rental portfolio criteria to our taxable REIT subsidiary to prevent the sales from being deemed prohibited transactions. The IRS may deem one or more sales of our properties to be “prohibited transactions.” If the IRS takes the position that we have engaged in a “prohibited transaction” (i.e., if we sell a property held by us primarily for sale in the ordinary course of our trade or business), then any gain we recognize from such sale would not disqualify us as a REIT, but such gains would be subject to a 100% tax. The Code sets forth a safe harbor for REITs that wish to sell property without risking the imposition of the 100% tax; however, there is no assurance that we will be able to qualify for the safe harbor. We do not intend to hold property for sale in the ordinary course of business; however, there is no assurance that our position will not be challenged by the IRS, especially if we make frequent sales or sales of property in which we have short holding periods.
In the future, we could be required to sell assets, borrow funds or raise equity capital to fund our distributions or to make a portion of our distributions in the form of a taxable stock distribution.
Our Board of Directors has the sole discretion to determine the timing, form and amount of any distributions to our stockholders, and the amount of such distributions may be limited. In the future, we could be required to sell assets, borrow funds or raise equity capital to fund our distributions or to make a portion of our distributions in the form of a taxable stock distribution. Our Board of Directors will make determinations regarding distributions based upon various factors, including our historical and projected financial condition and requirements, liquidity and results of operations, financing covenants, maintenance of our REIT qualification, applicable law and other factors, as our Board of Directors may deem relevant from time to time. To the extent that we are required to sell assets in adverse market conditions or borrow funds at unfavorable rates, we could be materially and adversely affected. To the extent we may have to raise equity capital, we may be unable to do so at attractive prices, on a timely basis or at all, which could adversely affect our ability to make distributions to our stockholders.
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Even if we qualify as a REIT, we may be subject to tax liabilities that could materially and adversely affect us.
Even if we qualify for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure and state or local income, property and transfer taxes. In addition, we could, in certain circumstances, be required to pay an excise tax or penalty tax (which could be significant in amount) in order to utilize one or more of the relief provisions under the Code to maintain our qualification as a REIT. In order to meet the REIT qualification requirements or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from sales of “dealer property,” we may also move or hold some of our assets or conduct activities through a TRS. In addition, if we lend money to a TRS, the TRS may be unable to deduct all or a portion of the interest paid to us, which could result in an even higher corporate level tax liability. Any of these taxes would decrease cash available for distribution to our stockholders.
Furthermore, the Code imposes a 100% tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s length basis. We will structure our transaction with any of our TRS entities on terms that we believe are arm’s length to avoid incurring the 100% excise tax described above. There can be no assurances, however, that we will be able to avoid application of the 100% tax. Any such additional tax liabilities would have an adverse effect on us.
Ordinary dividends payable by REITs are generally taxed at U.S. federal income tax rates, higher than tax rates applicable to dividends from Subchapter C corporations.
The maximum U.S. federal income tax rate for “qualifying dividends” payable by Subchapter C U.S. corporations to individual U.S. stockholders is 23.8%, including the 3.8% Medicare tax. Subject to a number of limitations, individuals receiving ordinary dividends payable by REITs will be eligible for up to a 20% deduction. For those individuals qualifying for the full 20% deduction, the maximum tax rate on such dividends will be 33.4%, including the 3.8% Medicare tax.
We may be subject to legislative or regulatory tax changes that could materially and adversely affect us.
At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective, and any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be materially and adversely affected by any such change in or any new, federal income tax law, regulation or administrative interpretation.
Risks Related to Our Organization and Structure
Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in your best interests.
Under Maryland law, generally, a director will not be liable if he or she performs his or her duties in good faith, in a manner he or she reasonably believes to be in the best interests of the corporation and with the care that an ordinarily prudent person in a like position would use under similar circumstances. In addition, our Charter limits the liability of our directors and officers to us and our stockholders for money damages, except for liability resulting from:
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Actual receipt of an improper benefit or profit in money, property or services; or
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Active and deliberate dishonesty that is established by a final judgment and is material to the cause of action.
Our Charter and Bylaws provide for indemnification of our directors and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our Bylaws require us to indemnify each director and officer, to the maximum extent permitted by Maryland law, 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 to us. In addition, we may be obligated to advance the defense costs incurred by our directors and officers. As a result, we and our stockholders may have more limited rights against our directors and officers than might otherwise exist absent the current provisions in our Charter and Bylaws or that might exist with other companies.
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Our Charter may limit or otherwise discourage a takeover or business combination that could otherwise benefit our stockholders.
Our Charter, with certain exceptions, authorizes our Board of Directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. Unless exempted by our Board of Directors, no person may own more than 9.8% in value or number of shares, whichever is more restrictive, of our outstanding shares of common or capital stock. A person that did not acquire more than 9.8% of our outstanding shares of common or capital stock may become subject to our Charter restrictions if repurchases by us cause such person’s holdings to exceed 9.8% of our outstanding shares of common or capital stock. Any attempt to own or transfer shares of our common stock in excess of the ownership limit without the consent of our Board of Directors will be void or will result in those shares being transferred to a charitable trust, and the person who acquired such excess shares will not be entitled to any distributions thereon or to vote those excess shares. Our 9.8% ownership limitation may 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 for our stockholders.
Our Board of Directors may also, without stockholder approval, amend our Charter to increase or decrease the aggregate number of our shares or the number of shares of any class or series that we have the authority to issue and to classify or reclassify any unissued shares of our common or preferred stock, and set the preferences, rights and other terms of the classified or reclassified shares. As a result, our Board of Directors may authorize the issuance of additional shares or establish a series of common or preferred stock that may have the effect of delaying or preventing a change in control, including transactions at a premium over the market price of our shares, even if stockholders believe that a change in control is in their interest. These provisions, along with the restrictions on ownership and transfer contained in our Charter and certain provisions of Maryland law described below, could discourage unsolicited acquisition proposals or make it more difficult for a third party to gain control of us, which could adversely affect the market price of our common stock.
Certain provisions of Maryland law could inhibit changes in control, preventing our stockholders from realizing a potential premium over the market price of our stock in a proposed acquisition.
Certain provisions of the Maryland General Corporate Law (“MGCL”) may have the effect of deterring a third party from making a proposal to acquire us or impeding a change in control under circumstances that otherwise could provide the holders of our common stock with the opportunity to realize a premium over the then-prevailing market price of our common stock. Subject to limitations, the “business combination” provisions of the MGCL that prohibit certain business combinations (including a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities) between us and an “interested stockholder” or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder. An “interested stockholder” is defined generally as any person who beneficially owns 10% or more of our outstanding voting stock or an affiliate or associate of ours who was the beneficial owner of 10% or more of our then outstanding voting stock within the last two years. After the five-year prohibition, any business combination between us and an interested stockholder generally must be recommended by our Board of Directors and approved by the affirmative vote of at least (1) 80% of the votes entitled to be cast by holders of outstanding shares of our voting stock and (2) two-thirds of the votes entitled to be cast by holders of voting stock of the corporation (excluding the shares held by the interested stockholder or its affiliate the business combination is to be effected). These super-majority vote requirements do not apply if our common stockholders receive a minimum price, as described under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares. These provisions of the MGCL do not apply, however, to business combinations that are approved or exempted by a Board of Directors prior to the time that the interested stockholder becomes an interested stockholder. Pursuant to the statute, our Board of Directors has by resolution exempted business combinations between us and any other person. There is no assurance that our Board of Directors will not supersede this resolution in the future.
The “control share” provisions of the MGCL provide that “control shares” (generally defined as shares that, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) of a Maryland corporation acquired in a “control share acquisition” (defined as the acquisition of ownership or control of “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 the votes entitled to be cast on the matter (excluding the control shares in question).
Our Bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of shares of our stock. There can be no assurance that this provision will not be amended or eliminated at any time in the future. The “unsolicited takeover” provisions of the MGCL permit our Board of Directors, without stockholder approval, to implement certain provisions if we have a class of equity securities registered under the Exchange Act and at least three independent directors (which we have). These provisions may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring or preventing a change in control of us under the circumstances that otherwise could provide the
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holders of shares of common stock with the opportunity to realize a premium over the then current market price. Our Charter contains a provision whereby we have elected to be subject to the provisions of Title 3, Subtitle 8 of the MGCL allowing vacancies on our Board of Directors to be filled only by the affirmative vote of the remaining directors in office.
We could be materially and adversely affected if we are deemed to be an investment company under the Investment Company Act.
We rely on the exception from the Investment Company Act set forth in Section 3(c)(5)(C) of the Investment Company Act, which excludes from the definition of investment company “any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” The SEC Staff generally requires that, for the exception provided by Section 3(c)(5)(C) to be available, at least 55% of an entity’s assets be comprised of mortgages and other liens on and interests in real estate, also known as “qualifying interests,” and at least another 25% of the entity’s assets must be comprised of additional qualifying interests or real estate-type interests (with no more than 20% of the entity’s assets comprised of miscellaneous assets). Any significant acquisition by us of non-real estate assets without the acquisition of substantial real estate assets could cause us to meet the definitions of an “investment company.” If we are deemed to be an investment company, we may be required to register as an investment company if we are unable to dispose of the disqualifying assets, which could have a material adverse effect on us.
Registration under the Investment Company Act would require us to comply with a variety of substantive requirements that impose, among other things:
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limitations on capital structure;
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restrictions on specified investments;
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restrictions on leverage or senior securities;
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restrictions on unsecured borrowings;
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prohibitions on transactions with affiliates; and
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compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly increase our operating expenses.
If we were required to register as an investment company but failed to do so, we could be prohibited from engaging in our business, and criminal and civil actions could be brought against us. Registration with the SEC as an investment company would be costly, would subject us to a host of complex regulations and would divert attention from the conduct of our business, which could materially and adversely affect us. In addition, if we purchase or sell any real estate assets to avoid becoming an investment company under the Investment Company Act, our net asset value, the amount of funds available for investment and our ability to pay distributions to our stockholders could be materially adversely affected.
Risks Related to Our Common Stock
Refer to the “Risks Related to the Merger” section above for a discussion of risks related to our common stock that could arise as a result of the Merger.
The market price and trading volume of our common stock may be volatile and may be affected by market conditions beyond our control.
The price at which our common stock trades has fluctuated, and may continue to fluctuate, significantly. The market price of our common stock may fluctuate in response to many things, including but not limited to:
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variations in our actual or anticipated results of operations, liquidity or financial condition;
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the announcement of material transactions or the failure to consummate such transactions;
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changes in, or the failure to meet, our financial estimates or those of securities analysts;
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the amount and timing of any cash distributions;
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actions or announcements by our competitors;
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failure of HavenBrook to provide effective and cost efficient property management services;
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actual or anticipated accounting problems;
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adverse market reaction to any increased indebtedness we incur in the future;
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regulatory actions;
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changes in the market outlook for the real estate, mortgage or housing markets;
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technology changes in our business;
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changes in interest rates that lead purchasers of our common stock to demand a higher yield;
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future equity issuances by us, share resales by our stockholders or the perception that such issuances or resales may occur;
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actions by our stockholders;
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changes to our investment strategy;
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speculation in the press or investment community;
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general market, economic and political conditions, including an economic slowdown or dislocation in the global credit markets;
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failure to maintain the listing of our common stock on the New York Stock Exchange;
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failure to qualify or maintain our qualification as a REIT;
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failure to maintain our exemption from registration under the Investment Company Act;
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changes in accounting principles;
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passage of legislation or other regulatory developments that adversely affect us or our industry; and
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departure of AAMC’s, and therefore our, key personnel.
The market prices of securities of public REITs have experienced fluctuations that often have been unrelated or disproportionate to the operating results or net asset values of these companies. These market fluctuations could result in extreme volatility in the market price of our common stock.
Furthermore, our small size and different investment characteristics may not continue to appeal to our investor base, and they may seek to dispose of large amounts of our common stock. There is no assurance that there will be sufficient buying interest to offset those sales, and, accordingly, the market price of our common stock could be depressed and/or experience periods of high volatility.
The availability and timing of cash distributions is uncertain.
We are generally required to distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, each year in order for us to qualify as a REIT under the Code. We currently intend to satisfy this distribution requirement through quarterly cash distributions of all or substantially all of our REIT taxable income each year, subject to certain adjustments. We have not established a minimum distribution payment level, and our ability to make distributions may be adversely affected by a number of factors, including the risk factors described in this Annual Report.
Our Board of Directors, in its sole discretion, will determine the amount and timing of any distributions. In making such determinations, our Board of Directors will consider all relevant factors, including, without limitation, the amount of cash available for distribution, capital expenditures and general operational requirements. Our Board of Directors will also consider our historical and projected financial condition, liquidity and results of operations, any financing covenants, maintenance of our REIT qualification, applicable law and such other factors as our Board of Directors may deem relevant from time to time. We intend over time to make regular quarterly distributions to holders of our common stock. However, we bear all expenses incurred by our operations, and the funds generated by our operations, after deducting these expenses, may not be sufficient to cover desired levels of distributions to our stockholders. In addition, our Board of Directors, in its discretion, may retain any portion of such cash in excess of our REIT taxable income for working capital. We cannot assure you how long it may take to generate sufficient available cash flow to fund distributions, nor can we assure you that sufficient cash will be available to make distributions to you. With a limited and evolving operating history, we cannot predict the amount of distributions you may receive, and we may be unable to make, maintain or increase distributions over time. There are many factors that can affect the availability and timing of cash distributions to stockholders. Because we may receive rents and income from our properties at various times during our fiscal year, distributions paid may not reflect our income earned in that particular distribution period. The amount of cash available for distribution will be affected by many factors, including, without limitation, the amount of time it takes for us to deploy the net proceeds from equity raises or financing arrangements into our target assets, the amount of income we will earn from those investments, the amount of our operating expenses and many other variables. Actual cash available for distribution may vary substantially from our expectations.
While we intend to fund the payment of quarterly distributions to our stockholders entirely from distributable cash flows, in the future we could be required to sell assets, borrow funds or raise equity to make distributions to our stockholders, which, if not available on favorable terms, or at all, may require us to eliminate or otherwise reduce such distributions or to make a portion of such distributions in the form of a taxable stock distribution. In the event we are unable to consistently fund future quarterly distributions to our stockholders entirely from distributable cash flows, the market price of our common stock may be negatively impacted.
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The incurrence or issuance of debt, which ranks senior to our common stock upon our liquidation, and future issuances of equity or equity-related securities, which would dilute the holdings of our existing common stockholders and may be senior to our common stock for the purposes of making distributions, periodically or upon liquidation, may negatively affect the market price of our common stock.
We have incurred debt and may in the future incur or issue additional debt or issue equity or equity-related securities. Upon our liquidation, lenders and holders of our debt will receive a distribution of our available assets before common stockholders. Any future incurrence or issuance of debt will increase our interest cost and could adversely affect our results of operations and cash flows. We are not required to offer any additional equity securities to existing common stockholders on a preemptive basis. Therefore, additional issuances of common stock, directly or through convertible or exchangeable securities (including limited partnership interests in our operating partnership), 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 our common stock. Our preferred stock, if issued, 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. Because our decision to incur or issue debt or issue equity or equity-related securities in the future will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, nature or success of our future capital raising efforts. Thus, common stockholders bear the risk that our future incurrence or issuance of debt or issuance of equity or equity-related securities will adversely affect the market price of our common stock.
An increase in market interest rates may have an adverse effect on the market price of our common stock and our ability to make distributions to our stockholders.
One of the factors that investors may consider in deciding whether to buy or sell shares of our common stock is our distribution rate as a percentage of our share price, relative to market interest rates. If market interest rates increase, prospective investors may demand a higher distribution rate on shares of our common stock or seek alternative investments paying higher distributions or interest. As a result, interest rate fluctuations and capital market conditions can adversely affect the market price of our common stock. For instance, if interest rates rise without an increase in our distribution rate, the market price of shares of our common stock could decrease because potential investors may require a higher distribution yield on shares of our common stock as market rates on our interest-bearing instruments such as bonds rise. In addition, to the extent we have variable rate debt, rising interest rates would result in increased interest expense on our variable rate debt, thereby adversely affecting our results of operations and cash flows and our ability to make distributions to our stockholders.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties
Our principal executive offices are the offices of our Manager, which is an office space of approximately 5,000 square feet located at 5100 Tamarind Reef, Christiansted, St. Croix, United States Virgin Islands 00820. We also lease office space located in Alabama, Florida, Georgia, Indiana, Minnesota, Missouri, Tennessee and Texas to support our property management functions. For more information, please see Note 7, “Leases” to our consolidated financial statements contained in this Annual Report on Form 10-K.
For information concerning our real estate assets, see “Item 1. Business.”
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Item 3.
Item 3. Legal Proceedings
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. Set forth below is a summary of legal proceedings to which we are a party as of December 31, 2019:
Martin v. Altisource Residential Corporation et al.
On March 27, 2015, a putative shareholder class action complaint was filed in the United States District Court of the Virgin Islands by a purported shareholder of the Company under the caption Martin v. Altisource Residential Corporation, et al., 15-cv-00024. The action names as Defendants the Company, our former Chairman, William C. Erbey, and certain officers and a former officer of the Company and alleges that the Defendants violated federal securities laws by, among other things, making materially false statements and/or failing to disclose material information to the Company's shareholders regarding the Company's relationship and transactions with Ocwen Financial Corporation (“Ocwen”), Altisource Portfolio Solutions S.A., and other third-party entities. These alleged misstatements and omissions include allegations that the Defendants failed to adequately disclose the Company's reliance on Ocwen and the risks relating to its relationship with Ocwen, including that Ocwen was not properly servicing and selling loans, that Ocwen was under investigation by regulators for violating state and federal laws regarding servicing of loans and Ocwen’s lack of proper internal controls. The action seeks, among other things, an award of monetary damages to the putative class in an unspecified amount and an award of attorney’s and other fees and expenses.
In May 2015, two of our purported shareholders filed competing motions with the court to be appointed Lead Plaintiff and for selection of lead counsel in the action. On October 7, 2015, the court entered an order granting the motion of Lei Shi to be Lead Plaintiff and denying the other motion to be Lead Plaintiff.
On January 23, 2016, the Lead Plaintiff filed an amended complaint.
On March 22, 2016, Defendants filed a motion to dismiss all claims in the action. The Plaintiff filed opposition papers on May 20, 2016, and the Defendants filed a reply brief in support of the motion to dismiss the amended complaint on July 11, 2016.
On November 14, 2016, the Martin case was reassigned to Judge Anne E. Thompson of the United States District Court of New Jersey. In a hearing on December 19, 2016, the parties made oral arguments on the motion to dismiss, and on March 16, 2017 the Court issued an order that the motion to dismiss had been denied. On April 17, 2017, the Defendants filed a motion for reconsideration of the Court’s decision to deny the motion to dismiss. On April 21, 2017, the Defendants filed their answer and affirmative defenses. Plaintiff filed an opposition to Defendants’ motion for reconsideration on May 8, 2017. On May 30, 2017, the Court issued an order that the motion for reconsideration had been denied. Shortly thereafter, discovery commenced.
On October 10, 2018, the Lead Plaintiff filed a second amended complaint, which added a second Lead Plaintiff to the case. The allegations and causes of action asserted by the Plaintiffs were virtually identical to the prior complaint, except that they added what the Plaintiffs claimed was additional detail in support of their allegations.
On December 7, 2018, the Defendants moved to dismiss the second amended complaint in its entirety. Plaintiffs filed their opposition to the motion on December 31, 2018, and Defendants filed their reply brief on January 24, 2019. On February 21, 2019, Judge Thompson issued an order that granted Defendants’ motion and dismissed the second amended complaint in its entirety.
On February 26, 2019, the Court granted Plaintiffs’ request for leave to file a Third Amended Complaint within 14 days. On March 12, 2019, Plaintiffs filed their Third Amended Complaint, and on April 12, 2019, Defendants moved to dismiss the Third Amended Complaint in its entirety. Plaintiffs filed their opposition to the motion to dismiss on May 13, 2019, and Defendants filed their reply in support of the motion on May 31, 2019. On June 12, 2019, Judge Thompson issued an Order granting in part and denying in part Defendants’ motion to dismiss the Third Amended Complaint. Specifically, Judge Thompson granted Defendants’ motion to dismiss any alleged misrepresentation made after each Plaintiff’s final purchase of securities. Judge Thompson denied Defendants’ motion to dismiss on the remaining grounds.
On June 26, 2019, Defendants filed a motion to certify interlocutory appeal to the Third Circuit of Judge Thompson’s Order granting in part and denying in part Defendants’ motion to dismiss the Third Amended Complaint. Plaintiffs filed their opposition to the motion on July 10, 2019 and Defendants’ reply in support of the motion was filed on July 24, 2019.
On August 6, 2019, Judge Thompson denied Defendants’ motion to certify interlocutory appeal.
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Separately, on July 5, 2019, Judge Thompson accepted the case schedule proposed by the parties, and discovery resumed. The deadline for the completion of fact discovery was November 8, 2019, the deadline for the completion of expert discovery was January 30, 2020, and the deadline to submit dispositive motions was February 27, 2020.
On October 8, 2019, based on input from a mediator, we entered into a stipulation and agreement of settlement with Plaintiffs to settle the litigation for $15.5 million in exchange for, among various other terms, a full release of claims by Plaintiffs on behalf of the purported class of shareholders. On the same date, Plaintiffs filed their unopposed motion for preliminary approval of the settlement and ancillary documents, which included the stipulation and agreement of settlement. On October 17, 2019, the court issued an order granting preliminary approval of the settlement, approving the form and manner of notice and setting a hearing date for final approval of the settlement for January 30, 2020. The approval hearing was rescheduled to and occurred on February 5, 2020. Following the hearing, on February 13, 2020, Judge Thompson entered a final order and judgment approving the settlement and an order awarding attorneys’ fees and expenses. The settlement amount was paid in two installments: (i) a payment of $10.0 million on November 28, 2019; and (ii) a payment of $5.5 million on January 28, 2020. Proceeds from the directors' and officers' insurance policies funded $5.5 million of the settlement. We have included the settlement amount, net of insurance coverage, as a component of other expense within the consolidated statement of operations for the year ended December 31, 2019.
Item 4.
Item 4. Mine safety disclosures
Not applicable.
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Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock has been listed on the New York Stock Exchange under the symbol “RESI” since December 13, 2012. The following table sets forth the high and low close-of-day sales prices for our common stock as reported by the New York Stock Exchange and dividends declared per share for the periods indicated:
The number of holders of record of our common stock as of February 21, 2020 was 49. The number of beneficial stockholders is substantially greater than the number of holders as a large portion of our stock is held through brokerage firms. Information regarding securities authorized for issuance under equity compensation plans is set forth in Note 11, “Share-based Payments” to the consolidated financial statements.
The information under the heading “Equity Compensation Plan Information” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders to be filed with the SEC not later than 120 days after December 31, 2019 is incorporated herein by reference. To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
During the fiscal year ended December 31, 2019, no equity securities were sold by us that were not registered under the Securities Act of 1933, as amended.
Dividends
We will pay dividends at the sole and absolute discretion of our Board of Directors in the light of conditions then existing, including our earnings, taxable income, financial condition, liquidity, capital requirements, the availability of capital, applicable REIT and legal restrictions, general overall economic conditions and other factors.
In order to qualify as a REIT, we are required to distribute an amount at least equal to the sum of 90% of our REIT taxable income (computed without regard to our deduction for dividends paid and our net capital gains) and 90% of the net income after tax, if any, from foreclosure property, less the sum of specified items of non-cash income that exceeds a percentage of our income.
During 2019, cash dividends paid on common stock totaled $0.60 per share, or an aggregate of $32.2 million, which includes a dividend of $0.15 per share, or an aggregate of $8.0 million, we declared in December 2018 and paid in January 2019. After these distributions, the aggregate minimum distribution to stockholders required to maintain our REIT status has been met for 2019. All of these dividends were classified as return of capital for tax purposes.
During 2018, cash dividends paid on common stock totaled $0.60 per share, or an aggregate of $32.1 million, which included a dividend of $0.15 per share, or an aggregate of $8.0 million, we declared in December 2017 and paid in January 2018, but excludes the dividend we declared in December 2018 that was paid in January 2019. All of these dividends were classified as return of capital for tax purposes.
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Issuer Purchases of Equity Securities
During August 2015, our Board of Directors authorized a stock repurchase plan of up to $100.0 million of common stock. At December 31, 2019, we have remaining approximately $48.5 million authorized by our Board of Directors for share repurchases. No repurchases of common stock were made during the year ended December 31, 2019. At December 31, 2019, we had repurchased an aggregate total of 3,961,262 shares of common stock since the repurchase plan was authorized in August 2015.
No repurchase plan has expired during the year ended December 31, 2019.
Pursuant to our equity incentive plans, we may reacquire shares of common stock tendered to satisfy the tax withholding on equity awards. During the year ended December 31, 2019, 75,708 shares were reacquired at a weighted average per share price of $11.70 pursuant to our equity incentive plans.
Performance Graph
The following stock price performance graph compares the performance of our common stock to the S&P 500, the Russell 2000 and the FTSE NAREIT All Equity REITs indices. The stock price performance graph assumes an investment of $100 in our common stock and each of the indices on December 31, 2014 and further assumes the reinvestment of all dividends. Stock price performance is not necessarily indicative of future results.
The performance graph above is being furnished as part of this Annual Report solely in accordance with the requirement under Rule 14a-3(b)(9) to furnish the Company’s stockholders with such information and, therefore, is not deemed to be filed, or incorporated by reference in any filing, by the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934.
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Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial data as derived from our audited consolidated financial statements ($ in thousands, except per share data). The historical results presented below may not be indicative of our future performance. The data should be read in conjunction with our consolidated financial statements and notes thereto, included elsewhere in this report, and “Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Our Company
We are an industry leader in providing quality, affordable rental homes to America’s families in a variety of suburban communities that have easy accessibility to metropolitan areas. Our tenants enjoy the space and comfort that is unique to single-family housing, at reasonable prices. Our mission is to provide our tenants with houses they are proud to call home.
We are a Maryland REIT, and we conduct substantially all of our activities through our Operating Partnership and its subsidiaries. We conduct an SFR business with an efficient and effective property management structure in order to pursue our objective of becoming one of the top single-family equity REITs serving American families and their communities.
Our strategy is to build long-term stockholder value through the efficient management and continued growth of our portfolio of SFR homes, which we target to operate at an attractive yield. We believe there is a compelling opportunity in the SFR market and that we have implemented the right strategic plan to capitalize on the sustained growth in SFR demand. We target the moderately priced single-family home market that, in our view, offers attractive yield opportunities and one of the best-available avenues for growth.
In order to achieve this goal, we are focused on (i) maximizing the scale and operating efficiencies of our internal property management platform; (ii) identifying and acquiring high-yielding SFR properties; (iii) selling certain non-core assets to generate cash that we may reinvest in acquiring additional SFR properties and (iv) when deemed necessary or advisable, extending the duration of our financing arrangements to better match the long-term nature of our rental portfolio and, at times, reducing our exposure to floating interest rate fluctuations.
We are managed by AAMC, on which we rely to provide us with dedicated personnel to administer our business and perform certain of our corporate governance functions. AAMC also provides portfolio management services in connection with our acquisition and management of SFR properties and the ongoing disposition and management of our remaining REO properties. For additional information regarding our asset management agreements with AAMC, refer to Note 10, “Related-Party Transactions” of the consolidated financial statements.
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Management Overview
We made substantial progress during the 2019 fiscal year towards our strategic objectives and building stockholder value, including the formation of a committee comprised of independent directors (the “Review Committee”) to explore strategic alternatives, the renegotiation of the asset management agreement with AAMC, the completion of the internalization of our property management and the continued disposition of non-core assets.
Strategic Review Update
The Review Committee, in conjunction with its independent financial advisor, has now completed its review of the strategic alternatives available to Front Yard. On February 17, 2020, Front Yard entered into an Agreement and Plan of Merger (the “Merger Agreement”) with BAF Holdings, LLC, a Delaware limited liability company (“Parent”), and BAF Sub, LLC, a Maryland limited liability company (“Merger Sub”), each affiliates of Amherst Single Family Residential Partners VI, LP (collectively, “Amherst”), providing for the acquisition of the Company by Parent. The Front Yard Board of Directors has unanimously approved the merger agreement and intends to recommend that Front Yard shareholders vote in favor of it at a Special Meeting of Stockholders, to be scheduled as soon as practicable. The transaction is expected to close in the second quarter of 2020, subject to the approval of the holders of a majority of Front Yard’s outstanding shares and the satisfaction of customary closing conditions.
Under the terms of the Merger Agreement, Front Yard shareholders will receive $12.50 in cash per share. The per share purchase price represents a premium of approximately 14.2% over the per share closing price of Front Yard’s common stock on May 20, 2019, the day prior to the public announcement of Front Yard’s decision to initiate a formal process to explore strategic alternatives. We believe that the merger is in the best interests of our stockholders, employees and residents.
For further details of the Merger Agreement, refer to Note 17, “Subsequent Events” of the consolidated financial statements.
Amended Asset Management Agreement with AAMC
On May 7, 2019, we amended and restated our asset management agreement with AAMC. We believe the Amended AMA provides an improved fee structure that further aligns interests between Front Yard and AAMC. The management fees payable under the Amended AMA are subject to ongoing performance thresholds and an aggregate fee cap aimed to prevent such fees from increasing our general and administrative expenses above industry standards based on the size of our gross real estate asset base. The Amended AMA also provides us more flexibility in return for a termination fee to AAMC that we believe reflects industry norms. For further details of the Amended AMA, refer to Note 10, “Related-Party Transactions” of the consolidated financial statements.
Full Internalization of Property Management
During the first quarter of 2019, the internalization of our property management function was completed with more than 14,000 of our rental properties managed on our internal platform. We now have direct control of leasing, renovation and turn management, vendor management, market analysis and other property management support functions, which has enhanced our ability to control costs and generate long-term returns to our stockholders. The transition to internal property management has also provided us with the opportunity to continue developing our brand and enhancing our residents' experience. Over time, we expect to develop a nationally recognized brand that is known for consistent quality at affordable prices. We believe that with the completion of the internalization, we are well positioned to continue improving upon our operating efficiencies as we refine our internal property management platform and grow our rental portfolio.
Continued Liquidation of Non-Core Assets
We continued to liquidate our remaining non-core assets, including the full divestiture of our remaining mortgage loans in the fourth quarter of 2019. In addition, as of December 31, 2019, our real estate portfolio included only 22 non-rental REO properties. We continually evaluate the performance of our SFR portfolio and market certain rental properties for sale that do not meet our strategic objectives, and we have identified 181 former rental properties for sale as of December 31, 2019. These property sales allow us to improve our operating efficiency and recycle capital that may be used to purchase pools of stabilized rental homes at attractive yields, to repurchase common stock, to pay down debt or to utilize the proceeds for such other purposes as we determine will best serve our stockholders.
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Optimization of Financing in 2019
We have continued our efforts to optimize our financing structure during 2019. On April 5, 2019 we amended our loan agreement (the “Nomura Loan Agreement”) with Nomura Corporate Funding Americas, LLC (“Nomura”) to, among other things, reduce the interest rate spread over one-month LIBOR from 3.00% to 2.30%, improve certain advance rates and modify the facility's fee structure, resulting in a net reduction of fees to us. In addition, on April 26, 2019, we amended our repurchase agreement (the “CS Repurchase Agreement”) with Credit Suisse AG (“CS”) to reduce the interest rate spread over one-month LIBOR from 3.00% to 2.30% for funding under the facility secured by rental properties and reduce the fee structure of the facility. These enhancements to our short-term facilities will result in interest savings while also providing us with additional flexibility in deploying our capital.
We believe the foregoing developments are critical to our strategy of building long-term stockholder value through the creation and efficient management of a large portfolio of internally managed SFR homes that we target operating at an attractive yield.
Observations on Current Market Opportunities
We believe there is a compelling opportunity in the SFR market and that we have implemented the right strategic plan to capitalize on the sustained growth in SFR demand. We target the moderately priced single-family home market to acquire rental properties, which, in our view, not only provide a safe, comfortable SFR rental opportunity for our residents, but also offer attractive yield opportunities driven by demand from renters for quality.
We believe that our focus on affordable housing provides us with a potential advantage, as we believe this is an underserved market segment that provides us with attractive yield and growth opportunities. In our view, the macroeconomic environment is creating favorable tailwinds for our business. Economic indicators suggest that affordable single-family housing is in short supply, home building is not keeping up with demand and mortgage lending for credit-challenged families remains constrained. We provide an important alternative: affordable rental properties that our residents are proud to call home. By targeting moderately priced, single-family homes, we believe that we can optimize the yield on our investments and capitalize on the sustained growth in affordable single-family rental demand.
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Portfolio Overview
Real Estate Assets
The following table presents the number of real estate assets by status as of the dates indicated:
We define a property as stabilized once it has been renovated and then initially leased or available for rent for a period greater than 90 days. All other homes are considered non-stabilized. Homes are considered stabilized even after subsequent resident turnover. However, homes may be removed from the stabilized home portfolio and placed in the non-stabilized home portfolio due to renovation during the home lifecycle or because they are identified for sale. At December 31, 2019, 95.0% of our stabilized properties were leased.
Real Estate Acquisitions and Dispositions
The following table summarizes changes in our real estate assets for the periods indicated:
_____________
(1)
Subsequent to the foreclosure sale, we may be notified that the foreclosure sale was invalidated for certain reasons.
For additional details regarding our real estate acquisitions and dispositions, refer to Note 3, “Asset Acquisitions and Dispositions” to our consolidated financial statements.
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Mortgage Loans
As of December 31, 2019, we held no mortgage loans. As of December 31, 2018, we owned 74 remaining mortgage loans with an aggregate UPB of approximately $21.2 million, an aggregate market value of underlying properties of approximately $26.0 million and a carrying value of $8.1 million.
The following table summarizes changes in our mortgage loans for the periods indicated:
_____________
(1)
We generally liquidated our mortgage loan assets through sales to third party purchasers, short sales, refinancing or foreclosure sales.
(2)
Subsequent to the foreclosure sale, we may be notified that the foreclosure sale was invalidated for certain reasons.
For additional details regarding our mortgage loan resolutions and dispositions, refer to Note 3, “Asset Acquisitions and Dispositions” to our consolidated financial statements.
Metrics Affecting Our Consolidated Results
Revenues
Effective January 1, 2018, our revenues primarily consist of rental revenues. Minimum contractual rents from leases are recognized on a straight-line basis over the terms of the leases in residential rental revenues. Therefore, actual amounts billed in accordance with the lease during any given period may be higher or lower than the amount of rental revenue recognized for the period. We believe the key variables that will affect our rental revenues over the long term will be the size of our SFR portfolio, average occupancy levels and rental rates. The majority of our leases are for a term of one year. As these leases permit the residents to leave at the end of the lease term without penalty, we anticipate our rental revenues will be affected by declines in market rents more quickly than if our leases were for longer terms. Short-term leases may result in high turnover, which involves expenses such as additional renovation costs and leasing expenses or reduced rental revenues. Our rental properties had an average annual rental rate of $15,648 per home for the 13,711 stabilized properties that were leased at December 31, 2019.
Prior to January 1, 2018, our revenues also included gains and losses on real estate and mortgage loans, which consisted of (i) changes in the unrealized gain or loss on mortgage loans, (ii) net realized gains or losses on sales and resolutions of mortgage loans and (iii) net realized gains or losses on sales of real estate.
i.
Change in unrealized gain or loss on mortgage loans. Upon conversion of loans to REO, we marked the properties to the most recent market value. The difference between the carrying value of the asset at the time of conversion and the most recent market value, based on broker price opinions (“BPOs”), was recorded in our statement of operations as change in unrealized gain on mortgage loans. In addition, change in unrealized gain on mortgage loans included the adjustment of the carrying value of our mortgage loans to estimated fair value at each reporting date, which may have been based on (i) market information, to the extent available and as adjusted for factors specific to individual mortgage loans, or (ii) as determined by AAMC's proprietary discounted cash flow model. Lastly, upon the liquidation of a mortgage loan or REO property, we reclassify previously accumulated unrealized gains to realized gains.
ii.
Net realized gain or loss on mortgage loans. We recognized net realized gains or losses, including the reclassification of previously accumulated net unrealized gains, upon the liquidation of a loan, which may have consisted of short sale, third party sale of the underlying property, refinancing or full debt pay-off of the loan.
iii.
Net realized gain or loss on sales of real estate. REO properties that do not meet our investment criteria and certain former rental properties are sold out of our taxable REIT subsidiary. The realized gain or loss recognized in the fi
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nancial statements reflects the net amount of realized and unrealized gains on such properties from the time of acquisition to sale completion.
Effective January 1, 2018, we present these three components as a single line outside of revenues in the consolidated statement of operations. In accordance with the SEC’s elimination of Rule 3-15(a) of Regulation S-X as part of Release No. 33-10532; 34-83875; IC-33203, which had required REITs to present gains and losses on sales of properties outside of continuing operations in the income statement, we classify net gain (loss) on real estate and mortgage loans as a component of operating loss.
We continue to sell non-rental REO properties that do not meet our rental investment criteria and certain former rental properties to generate additional cash for reinvestment in other SFR acquisitions. The real estate market and home prices will determine proceeds from any sale of real estate. Future real estate values are subject to influences beyond our control.
Our investment strategy is to develop a portfolio of SFR properties in the United States that provides attractive risk-adjusted returns on invested capital. In determining which properties we retain for our rental portfolio, we consider various objective and subjective factors, including but not limited to gross and net rental yields, property values, renovation costs, location in relation to our coverage area, property type, HOA covenants, potential future appreciation and neighborhood amenities.
Expenses
Our expenses primarily consist of the following:
i.
Residential property operating expenses. Residential property operating expenses are expenses associated with our ownership and operation of residential properties, including costs such as expenses towards repairs, turnover costs, utility expenses on vacant properties, property taxes, insurance, HOA dues and personnel costs for repair and maintenance employees.
ii.
Property management expenses. Property management expenses include personnel costs of property management employees and other costs incurred in the oversight and management of our portfolio of homes. In addition, prior to our internalization of the property management function, property management expenses includes fees paid to external property managers.
iii.
Depreciation and amortization. Depreciation and amortization is a non-cash expense associated with the ownership of real estate and generally remains consistent over the life of an asset since we depreciate our properties on a straight-line basis. Depreciation and amortization also includes the amortization of our in-place lease intangible assets and lease commissions, which generally are amortized for periods of one year or less. The level of amortization of in-place lease intangible assets will vary depending upon our acquisition activity.
iv.
Acquisition and integration costs. Acquisition and integration costs include expenses associated with acquisitions as well as duplicative or non-recurring costs associated with the internalization of our property management function. We expect the majority of our asset acquisitions will not meet the definition of a business; therefore, we expect that the majority of acquisition costs will be capitalized into the cost basis of such assets.
v.
Impairment. Impairment represents the amount by which we estimate the carrying amount of a property will not be recoverable.
vi.
Mortgage loan servicing costs. Mortgage loan servicing costs are primarily for servicing fees, foreclosure fees and advances of residential property insurance. With the divestiture of our last remaining mortgage loans during 2019, we do not expect to incur mortgage servicing costs in subsequent periods.
vii.
Interest expense. Interest expense consists of the costs to borrow money in connection with our debt financing of our portfolios.
i.
Share-based compensation. Share-based compensation is a non-cash expense related to the restricted stock units and stock options issued pursuant to our authorized share-based compensation plans.
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viii.
General and administrative. General and administrative expenses consist of the costs related to the general operation and overall administration of our business, including compensation and benefits of certain employees. In addition, general administrative expenses include expense reimbursements to AAMC, which include the compensation and benefits of the General Counsel dedicated to us and certain operating expenses incurred by AAMC on our behalf.
ix.
Management fees to AAMC. Under the Amended AMA, our management fees to AAMC include a quarterly Base Management Fee and a potential annual Incentive Fee, each of which are dependent upon our performance and are subject to potential downward adjustments and an aggregate fee cap. The quarterly Base Management Fee under the Amended AMA is subject to a minimum of $3,584,000. Under the Former AMA, our management fees to AAMC included a base management fee and a conversion fee. The base management fee was calculated as a percentage of our average invested capital, and the conversion fee was based on the number and value of mortgage loans and/or REO properties that Front Yard converted to rental properties for the first time in each period. For additional information regarding our management fees to AAMC, refer to Note 10, “Related-Party Transactions” of the consolidated financial statements.
Other Factors Affecting Our Consolidated Results
We expect our results of operations will be affected by various factors, many of which are beyond our control, including the following:
Portfolio Size
The size of our SFR portfolio will impact our operating results. Generally, as the size of our investment portfolio grows, the amount of revenue we expect to generate will increase. A growing investment portfolio, however, will drive increased expenses, including possibly higher property management fees, property operating expenses and, depending on our performance, fees payable to AAMC. We may also incur additional interest expense if we incur additional debt to finance the purchase of assets.
The growth of our SFR portfolio will depend on our ability to identify and acquire SFR properties and other single-family residential assets. Generally, we expect that our SFR portfolio may grow at an uneven pace, as opportunities to acquire SFR properties may be irregularly timed and may involve portfolios of varying sizes. The timing and extent of our success in acquiring such assets cannot be predicted. In addition, as we continue to identify rental properties for sale in order to optimize our operating results, we may experience a decrease in our SFR portfolio if we are not able to successfully identify and acquire replacement SFR properties.
Financing
Our ability to grow our business is dependent on the availability of adequate financing, including additional equity financing, debt financing or a combination thereof, in order to meet our objectives. We intend to leverage our investments with debt, the level of which may vary based upon the particular characteristics of our portfolio and on market conditions. To the extent available at the relevant time, our financing sources may include term loan facilities, warehouse lines of credit, securitization financing, structured financing arrangements, seller financing loan arrangements, repurchase agreements and bank credit facilities, among others. We may also seek to raise additional capital through public or private offerings of debt or equity securities, depending upon market conditions.
To qualify as a REIT under the Internal Revenue Code, we will need to distribute at least 90% of our taxable income each year to our stockholders. This distribution requirement limits our ability to retain earnings and thereby replenish or increase capital to support our activities.
Liquidation of Non-Core Assets
We continuously monitor the performance of our assets and expect to liquidate certain assets that no longer meet our investment criteria, including certain rental properties in sub-scale markets or that do not generate attractive returns and REO properties that do not meet our investment criteria. We generally sell real estate assets on an individual basis. We believe these non-core asset sales will allow us to improve our operating efficiency and recycle capital that may be used to purchase pools of stabilized rental homes at attractive yields, repurchase common stock, pay down debt or to utilize the proceeds for such other purposes as we determine will best serve our stockholders.
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Results of Operations
The following discussion compares our results of operations for the years ended December 31, 2019 and 2018. Our results of operations for the periods presented are not indicative of our expected results in future periods.
For discussion that compares our results of operations for the years ended December 31, 2018 and 2017, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations” included within our Annual Report on Form 10-K for the year ended December 31, 2018 filed with the SEC on February 27, 2019.
Year Ended December 31, 2019 Compared to Year Ended December 31, 2018
Rental revenues
Rental revenues increased to $207.0 million for the year ended December 31, 2019 compared to $183.0 million for the year ended December 31, 2018, primarily due to an increase in the average number of rented properties during 2019. The average number of leased properties increased to 13,608 homes for the year ended December 31, 2019 from 12,022 homes for the year ended December 31, 2018.
Our rental revenues depend primarily on the number of SFR properties in our portfolio as well as changes in the occupancy levels and rental rates for our residential rental properties. We expect to generate increasing rental revenues from increases in rents on existing properties upon the re-lease of properties or renewal of existing leases. Because our lease terms generally are expected to be one year, our occupancy levels and rental rates will be highly dependent on localized residential rental markets and our renters’ desire to remain in our properties. In addition, we continuously evaluate opportunities to grow our rental portfolio, which would increase our rental revenues.
Residential property operating expenses
We incurred $77.8 million compared to $64.0 million of residential property operating expenses for the year ended December 31, 2019 and 2018, respectively. This increase was primarily due to an increased total number of properties in our real estate portfolio and increased property tax assessments, partially offset by (i) our having fewer non-rental REO properties and (ii) a higher proportion of properties being leased properties, which are generally less costly to operate because the tenant is responsible for certain ongoing expenses. During the year ended December 31, 2019, our average count of properties in our rental portfolio increased to 14,482 properties compared to 12,989 properties during the year ended December 31, 2018.
Our residential property operating expenses for occupied rental properties depends primarily on repair and maintenance expenditures, turnover costs, utility expenses on vacant properties, property taxes, insurance, and HOA dues. Our residential property operating expenses for non-rental REO properties and vacant rental properties also includes utilities, property preservation and repairs and maintenance. With the internalization of our property management function, our residential property operating expenses will be dependent on our ability to control costs and perform unit turns and secure new tenants in a timely manner. Further, in periods when we are successful in growing our portfolio, we generally expect to incur increasing residential property operating expenses beginning in such periods.
Property management expenses
Property management expenses were $15.4 million compared to $13.2 million for the years ended December 31, 2019 and 2018, respectively. This increase is primarily due to our acquisition of 3,236 homes in August 2018 as well as growth in our property management operations to manage the increased number of internally managed homes.
Depreciation and amortization
We incurred $82.2 million of depreciation and amortization for the year ended December 31, 2019 compared to $81.0 million for the year ended December 31, 2018. This increase is due primarily to the growth in our rental portfolio, partially offset by reduced amortization of lease-in-place intangible assets during 2019. During the year ended December 31, 2019, our average count of properties in our rental portfolio increased to 14,482 properties compared to 12,989 properties during the year ended December 31, 2018. Depreciation and amortization are non-cash expenditures that generally are not expected to be indicative of the market value or condition of our residential rental properties.
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Depreciation and amortization includes amortization of lease-in-place intangible assets associated with our real estate acquisitions. We recognized $3.0 million of lease-in-place intangible asset amortization for the year ended December 31, 2019 compared to $9.9 million for the year ended December 31, 2018.
Acquisition and integration costs
Acquisition and integration costs decreased to $3.1 million for year ended December 31, 2019 from $33.6 million for the year ended December 31, 2018. This decrease was primarily driven by the non-recurrence of expenses associated with the acquisition of our internal property manager, including termination and transition fees associated with amendment of the property management service agreements with our former external property managers.
Impairment
We recognized $4.5 million of valuation impairment on our real estate assets for the year ended December 31, 2019 compared to $12.7 million for the year ended December 31, 2018. The majority of the impairments we realize relates to our real estate assets held for sale, and we expect to recognize lower impairments in future periods as our portfolio of non-rental assets declines.
Mortgage loan servicing costs
We incurred $0.9 million of mortgage loan servicing costs for the year ended December 31, 2019 compared to $1.5 million for the year ended December 31, 2018. This reduction of servicing costs was primarily due to a reduction in the number of loans requiring servicing following the liquidation of the last of our remaining mortgage loans during 2019.
Interest expense
Interest expense relates to borrowings under our debt facilities and includes amortization of deferred debt issuance costs and mark-to-market adjustments of our interest rate caps. Interest expense increased to $84.1 million for the year ended December 31, 2019 from $77.0 million for the year ended December 31, 2018. This increase was driven primarily by increased average outstanding debt balances during 2019, partially offset by a decrease in our average borrowing rate. This increase also includes non-cash interest expense related to our interest rate cap derivatives, which increased to $5.0 million for the year ended December 31, 2019 from $1.3 million for the year ended December 31, 2018 due to our entry into three interest rate caps during the fourth quarter of 2018.
Certain of the interest rates under certain of our repurchase and loan agreements are subject to change based on changes in the relevant index. We also expect our interest expense to increase as our debt increases to fund and/or leverage our ownership of existing and future portfolios we may acquire.
Share-based compensation
Share-based compensation expense increased to $5.9 million for the year ended December 31, 2019 compared to $3.0 million for the year ended December 31, 2018. This increase is primarily due to additional grants of restricted stock units to certain of our employees and employees of AAMC, partially offset by the vesting of prior grants of restricted stock units.
Prior to the second quarter of 2018, our share-based compensation awarded to employees of AAMC fluctuated with changes in the market value of our common stock, among other factors. In the second quarter of 2018, the Financial Accounting Standards Board issued Accounting Standards Update 2018-07: Compensation - Stock Compensation (Topic 718), which we adopted on April 1, 2018. This adoption resulted in (i) the fair value of share-based compensation awards granted to management of AAMC prior to April 1, 2018 being fixed at the transition date fair value and (ii) the fair value of awards granted subsequent to April 1, 2018 to be measured at the grant date fair value, thus eliminating periodic fluctuations of share-based compensation expense that previously arose from changes in our common stock price.
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General and administrative expenses
General and administrative expenses were $25.8 million and $13.8 million for the years ended December 31, 2019 and 2018, respectively. This increase is primarily driven by increased legal and professional costs primarily arising from the contested proxy related to our 2019 Annual Meeting of Stockholders, the renegotiation of the AMA, legal costs related to the settlement of our last outstanding stockholder action, as well as certain incremental support costs associated with growth in the property management function that we internalized on August 8, 2018.
Management fees
We incurred base management fees of $14.3 million for the year ended December 31, 2019 compared to $14.6 million for the year ended December 31, 2018. The decrease in base management fees is primarily driven by (i) reductions in our average invested capital (as defined in the Former AMA) during the first four months of 2019 and (ii) the Minimum Base Fee of $3.6 million per quarter becoming applicable beginning in May 2019.
We incurred conversion fees to AAMC of $29,000 for the year ended December 31, 2019 compared to $0.2 million for the year ended December 31, 2018. Prior to our entry into the Amended AMA, conversion fees fluctuated dependent upon the number and fair market value of properties converted to rented properties for the first time during the quarter.
Due to our entry into the Amended AMA, we expect that the management fees may increase over time but at a lower rate as we grow SFR properties in our portfolio, and we will no longer pay conversion fees to AAMC.
Net gain (loss) on real estate and mortgage loans
The following table presents the components of net gain (loss) on real estate and mortgage loans during the periods indicated ($ in thousands):
_____________
(1)
The year ended December 31, 2019 includes downward purchase price adjustments on prior loan sales of $3.5 million.
As we have fully divested our portfolio of mortgage loans during 2019, we do not expect to recognize future gains or losses on mortgage loans. In addition, as our portfolio of non-rental REO properties declines, the amount of gains or losses on real estate that we recognize in future periods will be dependent upon the number and value of rental assets we identify for sale.
Liquidity and Capital Resources
As of December 31, 2019, we had cash and cash equivalents of $43.7 million compared to $44.2 million as of December 31, 2018. Our liquidity reflects our ability to meet our current obligations (including our operating expenses and, when applicable, retirement of, and margin calls relating to, our financing arrangements) and to make distributions to our stockholders. We are required to distribute at least 90% of our taxable income each year to our stockholders to qualify as a REIT under the Code. This distribution requirement limits our ability to retain earnings and thereby replenish or increase capital to support our activities.
We were initially funded with $100.0 million on December 21, 2012. Since our inception, our primary sources of liquidity have been proceeds from equity offerings, borrowings under our repurchase and loan agreements and securitization financings, cash generated from non-core asset liquidations and cash generated from our rental portfolio. We expect our existing business
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strategy will continue to require debt and/or equity financing. We continue to explore a variety of financing sources to support our growth, including, but not limited to, debt financing through bank warehouse lines of credit, additional and/or amended repurchase agreements, term financing, seller financing arrangements, securitization transactions and additional debt or equity offerings. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or that such efforts will be successful. If we are unable to renew, replace or expand our sources of financing, our business, financial condition, liquidity and results of operations may be materially and adversely affected.
Based on our current borrowing capacity, leverage ratio, and anticipated additional debt financing transactions, we believe that these sources of liquidity will be sufficient to enable us to meet anticipated short-term (one year) liquidity requirements, including paying expenses on our SFR portfolio, paying fees to AAMC under the Amended AMA and general corporate expenses.
Repurchase and Loan Agreements
The following table sets forth data with respect to our repurchase and loan agreements as of December 31, 2019 and 2018 ($ in thousands):
_____________
(1)
On February 13, 2020, we extended the maturity date to May 15, 2020.
(2)
Represents current maturity date as of the reporting date. We have the option to extend the maturity date for up to three successive one-year extensions, the first of which we exercised on November 9, 2019.
(3)
The interest rate is capped at 4.40% under an interest rate cap derivative.
(4)
The interest rate is capped at 4.30% under an interest rate cap derivative.
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For a discussion of additional details regarding the above repurchase and loan agreements, see Note 8, “Borrowings” to our consolidated financial statements.
Compliance with Covenants
Our repurchase and loan agreements require us and certain of our subsidiaries to maintain various financial and other covenants customary to these types of indebtedness. The covenants of each facility may include, without limitation, the following:
•
reporting requirements to the agent or lender,
•
minimum adjusted tangible net worth requirements,
•
minimum net asset requirements,
•
limitations on the indebtedness,
•
minimum levels of liquidity, including specified levels of unrestricted cash,
•
limitations on sales and dispositions of properties collateralizing certain of the loan agreements,
•
various restrictions on the use of cash generated by the operations of properties, and
•
a minimum fixed charge coverage ratio.
We are currently in compliance with the covenants and other requirements with respect to the repurchase and loan agreements.
Counterparty Risk
We monitor our lending partners’ ability to perform under the repurchase and loan agreements, including the obligation of lenders under repurchase agreements to resell the same assets back to us at the end of the term of the transaction, and have concluded there is currently no reason to doubt that they will continue to perform under the repurchase and loan agreements as contractually obligated.
Advance Rates
As amended, the CS Repurchase Agreement and the Nomura Loan Agreement provide for the lender to finance our portfolio at advance rates. Advance rates for our SFR and REO properties currently range from 55% to 78% of the discounted value of the underlying asset as described below. Our overall advance rate under the CS Repurchase Agreement and the Nomura Loan Agreement was 65.9% of estimated fair value at December 31, 2019 compared to 56.8% as of December 31, 2018. The advance rate of the CS and Nomura agreements will vary from period to period dependent upon the value of assets that serve as collateral thereunder. The advance rate on each of the HOME II Loan Agreement, HOME III Loan Agreement and the HOME IV Loan Agreements was 75% of the aggregate purchase price at acquisition. The advance rate on the Term Loan Agreement, the FYR SFR Loan Agreement and the MS Loan Agreement was 72%, 68.5% and 70% of the BPO value of the underlying properties at the time of funding, respectively. We do not collateralize any of our repurchase facilities with cash.
The lender determines the discounted asset value by applying a “haircut,” which is the percentage discount that a lender applies to the market value of an asset serving as collateral for a borrowing under a repurchase or loan agreement for the purpose of determining whether such borrowing is adequately collateralized. Under these agreements, the haircut currently ranges from 0% to 15%, depending on the class of asset serving as collateral. We believe these are typical market terms that are designed to provide protection for the lender to collateralize its advances to us in the event the collateral declines in value. The weighted average contractual haircut applicable to the assets that serve as collateral for the CS Repurchase Agreement and the Nomura Loan Agreement decreased to 8.0% of the estimated fair value (based on BPOs) of such assets at December 31, 2019 from 11.1% at December 31, 2018. The haircut applied will vary from period to period dependent upon the assets that serve as collateral under the CS and Nomura agreements. Under these agreements, if the carrying value of the collateral declines beyond certain limits, we would have to either (a) provide additional collateral or (b) repurchase certain assets under the agreement to maintain the applicable advance rate.
The decrease in amounts outstanding under our repurchase and loan agreements from December 31, 2018 to December 31, 2019 is primarily due to reductions of our repurchase and loan agreements upon the liquidation of REO properties and the divestiture of our last remaining mortgage loans.
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The following table sets forth data with respect to our repurchase and loan agreements as of and for the years ended as indicated ($ in thousands):
Cash Flows
We report and analyze our cash flows based on operating activities, investing activities and financing activities. The following table summarizes our cash flows for the periods indicated ($ in thousands):
Net cash used in operating activities for the years ended December 31, 2019, 2018 and 2017 consisted primarily of residential property operating expenses, property management expenses, mortgage loan servicing costs (including servicing fees, foreclosure fees and advances of residential property insurance on delinquent loans), interest expense, professional fees and management fees to AAMC, partially offset by rent payments received from tenants and net changes in operating assets and liabilities.
Net cash provided by investing activities for the year ended December 31, 2019 consisted primarily of proceeds from real estate and mortgage loan dispositions, partially offset by investments in real estate and renovations of rental properties. Net cash used in investing activities for the year ended December 31, 2018 consisted primarily of cash used in the acquisition of our internal property manager and the 3,236 homes it managed as well as investments in renovations of rental properties, partially offset by proceeds from mortgage loan and real estate dispositions. Net cash provided by investing activities for the year ended December 31, 2017 consisted primarily of proceeds from mortgage loan and real estate dispositions, partly offset by investments in real estate and renovations of rental properties.
Net cash used in financing activities for the year ended December 31, 2019 consisted primarily of net repayments of repurchase and loan agreements and payment of dividends. Net cash provided by financing activities for the year ended December 31, 2018 consisted primarily of net proceeds of repurchase and loan agreements associated with the acquisition of our internal property manager, partially offset by payment of dividends and purchases of interest rate cap derivatives. Net cash used in financing activities for the year ended December 31, 2017 consisted primarily of net repayments of repurchase and loan agreements (excluding the proceeds of seller financing arrangements), repayments of the notes issued a securitization trust, payment of dividends and repurchases of common stock.
Off-balance Sheet Arrangements
We had no off-balance sheet arrangements as of December 31, 2019 or 2018.
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Contractual Obligations
The following table summarizes (i) the minimum amount contractual due under the Amended AMA, (ii) the future lease payments under our operating and finance leases and (iii) our known contractual obligations based on the current principal outstanding and contractual terms of the debt obligations (based on current interest rates) at December 31, 2019 ($ in thousands):
_____________
(1)
Represents the Minimum Base Fee during the initial term of the Amended AMA.
(2)
Maturities include applicable extensions.
(3)
Assumes interest rates as of December 31, 2019 remain in effect for the remaining term of the borrowings. Actual payments could vary.
We enter into certain contracts that contain a variety of indemnification obligations. The maximum potential future payment amount we could be required to pay under these indemnification obligations is unlimited. We have not incurred any costs to defend lawsuits or settle claims related to these indemnification obligations. As a result, the estimated fair value of these agreements is minimal. Accordingly, we recorded no liabilities for these agreements as of December 31, 2019 or 2018.
Recent Accounting Pronouncements
See Note 1, “Organization and basis of presentation - Recently issued accounting standards” to our consolidated financial statements.
Critical Accounting Judgments
Accounting standards require information in financial statements about the risks and uncertainties inherent in significant estimates, and the application of generally accepted accounting principles involves the exercise of varying degrees of judgment. Certain amounts included in or affecting our financial statements and related disclosures must be estimated requiring us to make certain assumptions with respect to values or conditions that cannot be known with certainty at the time our consolidated financial statements are prepared. These estimates and assumptions affect the amounts we report for our assets and liabilities and our revenues and expenses during the reporting period and our disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Actual results may differ significantly from our estimates and any effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known.
We consider our critical accounting judgments to be those used in the determination of the reported amounts and disclosure related to the following:
Income taxes
We elected REIT status upon the filing of our 2013 income tax return. We believe that we have complied with the provisions of the federal income tax code applicable to REITs for each financial year commencing in the year ended December 31, 2013. As a REIT, we believe that we will not be subject to federal income tax on the portion of our REIT taxable income that was distributed to our stockholders for such years, nor do we expect to be taxed on future distributions of REIT taxable income as long as certain asset, income and share ownership tests continue to be met. If after electing to be taxed as a REIT, we subsequently fail to qualify as a REIT in any taxable year, we generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost.
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Our taxable REIT subsidiaries (each a “TRS”) are utilized to enter into transactions that do not qualify as REIT activities and are subject to federal and state income taxes. Income taxes are provided for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted rates expected to apply to taxable income in the years in which management expects those temporary differences to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period in which the change occurs. Subject to our judgment, we reduce a deferred tax asset by a valuation allowance if it is “more likely than not” that some or all of the deferred tax asset will not be realized. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Judgment may be required in evaluating tax positions, and we recognize tax benefits only if it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authority.
Leases
Front Yard as Lessor
Our primary business is to lease single-family homes to families throughout the United States. Our leases to tenants generally have a term of one year with potential extensions, including month-to-month leases after the initial term. These leases are classified as operating leases. Rental revenues, net of any concessions and uncollectible amounts, consist primarily of rents collected under lease agreements related to our single-family residential properties.
Upon adoption of Accounting Standards Update 2016-02, Leases (Topic 842) (“ASC 842”), we elected the practical expedient not to separate the lease and non-lease components of the operating leases with our residents. Our lease components consist primarily of rental income and pet rent. Non-lease components consist of variable lease payments, including resident reimbursements and various other fees, including late fees and lease termination fees, among others. The lease component is the predominant component in these arrangements, and as such, we recognize rental revenues and other property income in accordance with ASC 842 for the year ended December 31, 2019, and in accordance with previous GAAP for years prior to this adoption.
Real estate assets
Our real estate assets consist of (i) residential properties held as rental units, (ii) residential properties that we acquired through the conversion of mortgage loans to REO that have not yet been placed in service as a rental or that do not meet the criteria to be classified as held for sale and (iii) residential properties that are held for sale.
Rental residential properties
We record rental residential properties at historical cost less accumulated depreciation. The cost basis of residential rental properties is depreciated using the straight-line method over an estimated useful life of three to 27.5 years based on the nature of the components.
Certain of our rental residential properties may require renovation before being placed in service. Interest and other carrying costs incurred during the renovation period are capitalized until the property is ready for its intended use. Expenditures for ordinary maintenance and repairs are charged to expense as incurred.
Purchases of residential properties are evaluated to determine whether they meet the definition of an asset acquisition or of a business combination under U.S. GAAP. For asset acquisitions, we capitalize the pre-acquisition costs to the extent such costs would have been capitalized had we owned the asset when the cost was incurred and capitalize closing and other direct acquisition costs. We then allocate the total cost of the property, including the acquisition costs, between land; building; site improvements; furniture, fixtures and equipment and any identified intangible assets and liabilities (including in-place leases). For acquisitions that meet the definition of a business combination, we expense the acquisition costs in the period in which the costs were incurred and allocate the cost of the property among land; building; site improvements; furniture, fixtures and equipment and any identified intangible assets and liabilities.
In-place lease intangibles are recorded at the estimated fair value, which is the estimated costs that would have been incurred to lease the property, and are amortized on a straight-line basis over the remaining life of the related lease or, in the case of acquisitions of real estate pools, over the weighted average remaining life of the related pool of leases.
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Real estate owned
Real estate owned includes properties that we identified for disposal that do not yet meet the criteria to be classified as held for sale, including (i) vacant rental properties that are non-strategic, underperforming or are in inefficient markets that are identified for future disposal and (ii) the remaining properties acquired through foreclosure of our previous mortgage loans that do not meet our rental profile. Once a property is ready to be marketed, we reclassify the asset to real estate assets held for sale.
Upon the acquisition of real estate through the completion of foreclosure, we recorded the assets at fair value as of the acquisition date as a component of real estate owned based on information obtained from a BPO, a full appraisal or the price given in a current contract of sale of the property.
For those REO properties that met our rental profile, we reclassified the property to rental residential property and allocated the carrying value between land and rental residential properties in our consolidated balance sheet once the property was placed in rental service.
Real estate assets held for sale
Residential properties are classified as real estate assets held for sale when sale of the assets has been formally approved, the sale is expected to occur in the next twelve months and the property has been listed for sale. We record residential properties held for sale at the lower of the accumulated costs, net of depreciation, or estimated fair value less costs to sell. The fair value of real estate assets held for sale is determined as the lesser of the BPO or the expected selling price (which we consider to be Level 3 inputs). The expected selling price may be based on the current listing price of the property.
Real estate impairment
We perform an impairment analysis of our real estate assets if events or changes in circumstances indicate that the carrying value may be impaired, such as prolonged vacancy, identification of materially adverse legal or environmental factors, changes in expected ownership period or manner of use, significant deterioration in physical condition or indications that the market value of a property has declined to an amount less than the carrying amount.
For our SFR portfolio, we perform a quantitative analysis to determine if any of these indicators of impairment exist, which may require a cash flow analysis on a property-level basis. For our real estate assets held for sale and properties identified for future disposition, we perform a cash flow analysis at the property level. These analyses are based on a number of assumptions that are subject to economic and market uncertainties, including, among others, demand for rental properties, competition for customers, changes in market rental rates, the estimated fair value of the property (based on BPOs), costs to operate each property and expected ownership periods.
If the carrying amount of a property exceeds the sum of its undiscounted future operating and residual cash flows, an impairment loss is recorded for the excess of the carrying amount over the estimated fair value (in the case of rental residential properties and real estate owned) or the estimated fair value less costs to sell (in the case of real estate assets held for sale).
For rental residential properties and real estate owned, we are not able to recover any previously recognized impairments should the estimated fair value subsequently improve. For real estate assets held for sale, we are able to recover impairments to the extent previously recognized in the event that the estimated fair value of impaired properties held for sale subsequently improves.
We generally estimate the fair value of real estate assets by using BPOs, and, for real estate assets held for sale, we also consider the expected selling price, which may be based on the current listing price of the property. In some instances, appraisal information may be available and is used in addition to BPOs. We engage third party vendors to obtain and evaluate BPOs prepared by other third party brokers for our ultimate use. BPOs are subject to judgments of a particular broker formed by visiting a property, assessing general home values in an area, reviewing comparable listings and reviewing comparable completed sales. These judgments may vary among brokers and may fluctuate over time based on housing market activities and the influx of additional comparable listings and sales. Our results could be materially and adversely affected if the judgments used by brokers in providing BPOs prove to be incorrect or inaccurate.
We have established validation procedures to confirm the values we receive from third party vendors are consistent with our observations of market values. These validation procedures include establishing thresholds to identify changes in value that require further analysis. Our current policies require that we update the fair value estimate of each held-for-sale property at least
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every six months by obtaining a new BPO, and we obtain new BPOs for a portion of our held-for-use properties each year. These BPOs are subject to the review processes of our third party vendors. In addition, we generally perform further analysis when the value of the property per the new BPO varies from the old BPO by 25% or $75,000 per property. If a newly obtained BPO varies from the old BPO by this established threshold, we perform additional procedures to ensure the BPO accurately reflects the current fair value of the property. These procedures include engaging additional third party vendors to compare the old BPOs to the new BPOs and to assist us in evaluating the appropriateness of comparable properties and property-specific characteristics used in the valuation process. As part of this evaluation, our third party vendors often discuss the differing BPOs with the providing brokers to ensure that proper comparable properties have been identified. These third party vendors also compare the BPOs to past appraisals, if any, of the property to ensure the BPOs are in line with those appraisals. Following the consideration and reconciliation of the BPOs, the third party provider may provide us with a new property value reflecting the analysis they performed or confirm the BPO value we received, in which case we use the new property value or the validated BPO, respectively, for our fair value estimate of the property.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. The primary market risks that we are currently exposed to are real estate risk and interest rate risk. A substantial portion of our investments are, and we expect will continue to be, comprised of SFR properties. The primary driver of the value of this asset class is the fair value of the underlying real estate.
Real Estate Risk
Residential property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to: national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions (such as an oversupply of housing); construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. Although decreases in property values may allow us to acquire additional homes with more attractive yields, such decreases could lead to increased unit turnover as more tenants may choose to purchase their own home or difficulties in refinancing, including our ability to finance existing collateral at the same level of funding or at the existing rate.
Interest Rate Risk
We will be exposed to interest rate risk from our debt financing activities. Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in interest rates may affect our financing interest rate expense.
We have undertaken and may continue to undertake risk mitigation activities with respect to our debt financing interest rate obligations. A portion of our debt financing is, and will likely continue to be, based on a floating rate of interest calculated on a fixed spread over the relevant index, as determined by the particular financing arrangement. A significantly rising interest rate environment could have an adverse effect on the cost of such financing. To mitigate this risk, we have used, and may continue to use, derivative financial instruments such as interest rate caps in an effort to reduce the variability of earnings caused by changes in the interest rates we pay on our debt.
These derivative transactions have been and will continue to be entered into solely for risk management purposes, not for investment purposes. When undertaken, these derivative instruments likely will expose us to certain risks such as price and interest rate fluctuations, timing risk, volatility risk, credit risk, counterparty risk and changes in the liquidity of markets. Therefore, although we expect to transact in these derivative instruments purely for risk management, they may not adequately protect us from fluctuations in our financing interest rate obligations.
We have entered into multiple interest rate caps in order to manage the economic risk of increases in the floating rate portion of our variable rate debt. We will be reimbursed by the counterparties of the interest rate caps to the extent that the one-month LIBOR exceeds the applicable strike rate based on the scheduled notional amount. We are also exposed to counterparty risk should any of the counterparties fail to meet their obligations under the terms of the agreement.
We currently borrow funds on our repurchase and loan facilities at variable rates. At December 31, 2019, we had $142.7 million of variable rate debt outstanding that was not protected by interest rate hedge contracts and $677.4 million that was protected by interest rate caps. The estimated aggregate fair market value of this variable rate debt was $816.4 million. If the weighted
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average interest rate on this variable rate debt had been 100 basis points higher or lower, the annual interest expense would increase by $5.1 million or decrease by $8.2 million, respectively.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
See our consolidated financial statements starting on page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We carried out an evaluation required by the Exchange Act, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Exchange Act, as of December 31, 2019. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of December 31, 2019, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Management has assessed the effectiveness of our internal control over financial reporting as of December 31, 2019 based on criteria established in Internal Control-Integrated Framework issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission. As a result of this assessment, management concluded that, as of December 31, 2019, our internal control over financial reporting was effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that 1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer; 2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and 3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer's assets that could have a material effect on the financial statements.
The effectiveness of our internal control over financial reporting as of December 31, 2019 has been audited by Ernst & Young LLP, an independent registered certified public accounting firm, as stated in their report that appears herein.
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Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors of Front Yard Residential Corporation
Opinion on Internal Control over Financial Reporting
We have audited Front Yard Residential Corporation’s (formerly known as Altisource Residential Corporation) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Front Yard Residential Corporation (the Company) management maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of Front Yard Residential Corporation as of December 31, 2019 and 2018, and the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the three years then ended in the period ended December 31, 2019, and the related notes and financial schedules listed in the index at Item 15(a) and our report dated February 28, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Ernst & Young LLP
Atlanta, Georgia
February 28, 2020
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Changes in Internal Control over Financial Reporting
There have been no changes in the Company's internal control over financial reporting during the fiscal quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
Limitations on Controls
Our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving their objectives as specified above. Management does not expect, however, that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.
Item 9B.
Item 9B. Other Information
None.
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Part III
We may file a definitive Proxy Statement for our 2020 Annual Meeting of Stockholders ( the “2020 Proxy Statement”) with the Securities and Exchange Commission, pursuant to Regulation 14A, not later than 120 days after December 31, 2019. Accordingly, certain information required by Part III has been omitted under General Instruction G(3) to Form 10-K. Only those sections of the 2020 Proxy Statement that specifically address the items set forth herein are incorporated by reference.
To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by Item 10 is hereby incorporated by reference from our 2020 Proxy Statement under the captions “Election of Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Code of Ethics.” To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 is hereby incorporated by reference from our 2020 Proxy Statement under the captions “Executive Compensation” and “Director Compensation.” To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 is hereby incorporated by reference from our 2020 Proxy Statement under the caption “Security Ownership of Certain Beneficial Owners and Management.” To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 is hereby incorporated by reference from our 2020 Proxy Statement under the captions “Transactions with Related Persons” and “Information Regarding the Board of Directors and Corporate Governance.” To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 is hereby incorporated by reference from our 2020 Proxy Statement under the captions “Independent Registered Public Accounting Firm Fees” and “Pre-Approval Policy and Procedures.” To the extent that we do not file the 2020 Proxy Statement prior to the end of the 120-day period following December 31, 2019, we will amend this Annual Report on Form 10-K to provide the required information.
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Part IV
Item 15.
Item 15. Exhibits
Exhibits
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__________
* Filed herewith.
† Denotes management contract or compensatory arrangement.
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Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Power of Attorney
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints George G. Ellison and Robin N. Lowe and each of them severally, his or her true and lawful attorney-in-fact with power of substitution and resubstitution to sign in his or her name, place and stead, in any and all capacities, to do any and all things and execute any and all instruments that such attorney may deem necessary or advisable under the Securities Exchange Act of 1934, as amended, and any rules, regulations and requirements of the Securities and Exchange Commission in connection with the Annual Report on Form 10-K and any and all amendments hereto, as fully for all intents and purposes as he or she might or could do in person, and hereby ratifies and confirms all said attorneys-in-fact and agents, each acting alone, and his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated:
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Index to Consolidated Financial Statements
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Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors of Front Yard Residential Corporation
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Front Yard Residential Corporation (formerly known as Altisource Residential Corporation) (the Company) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive loss, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedules listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Front Yard Residential Corporation at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 28, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Ernst & Young LLP
We have served as the Company‘s auditor since 2017.
Atlanta, Georgia
February 28, 2020
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Front Yard Residential Corporation
Consolidated Balance Sheets
(In thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
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Front Yard Residential Corporation
Consolidated Statements of Operations
(In thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
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Front Yard Residential Corporation
Consolidated Statements of Comprehensive Loss
(In thousands)
See accompanying notes to consolidated financial statements.
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Front Yard Residential Corporation
Consolidated Statements of Stockholders' Equity
(In thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
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Front Yard Residential Corporation
Consolidated Statements of Cash Flows
(In thousands)
See accompanying notes to consolidated financial statements.
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See accompanying notes to consolidated financial statements.
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Front Yard Residential Corporation
Notes to Consolidated Financial Statements
December 31, 2019
1. Organization and Basis of Presentation
Front Yard Residential Corporation, (“we,” “our,” “us,” or the “Company”), is a Maryland real estate investment trust (“REIT”) focused on acquiring, owning and managing single-family rental (“SFR”) properties throughout the United States. We conduct substantially all of our activities through our wholly owned subsidiary, Front Yard Residential, L.P., and its subsidiaries. On December 21, 2012, we became a stand-alone publicly traded company with an initial capital contribution of $100 million.
We employ a diversified SFR property acquisition strategy that includes acquiring large portfolios and smaller pools of SFR properties from a variety of market participants. As of December 31, 2019, our portfolio consisted of 14,748 homes.
On August 8, 2018, we acquired a property management firm and commenced the internalization of our property management function. During the first quarter of 2019, we completed the transition of property management for our SFR properties that were previously externally managed to our internal property management platform. We anticipate that all SFR properties acquired in the future will also be managed internally.
We are managed by Altisource Asset Management Corporation (“AAMC” or our “Manager”). AAMC provides us with dedicated personnel to administer certain aspects of our business and perform certain of our corporate governance functions. AAMC also provides oversight of our acquisition and management of SFR properties and the ongoing management of our remaining real estate owned (“REO”) properties. See Note 10 for a description of this related-party relationship.
Prior to the acquisition of our internal property manager, we contracted with third-party service providers to provide, among other things, leasing and lease management, operations, maintenance, repair and property management in respect of certain of our REO and SFR properties until such properties were transitioned onto our internal property management platform or sold. In addition, we contracted with a mortgage servicer to provide servicing for the mortgage loans we previously owned.
On February 17, 2020, Front Yard entered into an Agreement and Plan of Merger (the “Merger Agreement”) with BAF Holdings, LLC, a Delaware limited liability company (“Parent”), and BAF Sub, LLC, a Maryland limited liability company (“Merger Sub”), each affiliates of Amherst Single Family Residential Partners VI, LP (collectively, “Amherst”), providing for the acquisition of the Company by Parent. The Front Yard Board of Directors has unanimously approved the merger agreement and intends to recommend that Front Yard shareholders vote in favor of it at a Special Meeting of Stockholders, to be scheduled as soon as practicable. The transaction is expected to close in the second quarter of 2020, subject to the approval of the holders of a majority of Front Yard’s outstanding shares and the satisfaction of customary closing conditions.
Under the terms of the Merger Agreement, Front Yard shareholders will receive $12.50 in cash per share. For further details of the Merger Agreement, refer to Note 17, “Subsequent Events” of the consolidated financial statements.
Basis of presentation and use of estimates
The accompanying audited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). All wholly owned subsidiaries and variable interest entities (“VIEs”) of which we are the primary beneficiary are included, and all intercompany accounts and transactions have been eliminated. For more information on our consolidation policy, see Note 2.
Use of estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates.
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Recently issued accounting standards
Adoption of recent accounting standards
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842) (“ASC 842”). ASC 842 requires that lessees recognize assets and liabilities for leases with lease terms greater than twelve months in the statement of financial position and also requires improved disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows arising from leases. Accounting by lessors is substantially unchanged from prior practice as lessors will continue to recognize lease revenue on a straight-line basis. The FASB has also issued multiple ASUs amending certain aspects of Topic 842. ASC 842, as amended, also provides for certain practical expedients related to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset. ASC 842 is effective for fiscal years beginning after December 15, 2018, including interim reporting periods within those fiscal years. We have applied the amendments in ASU 2016-02 on a modified retrospective transition basis as of January 1, 2019, the effective date of the standard. We elected the “package of practical expedients,” which permits us not to reassess our prior conclusions about lease identification, lease classification and initial direct costs under the new standard. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The new standard also provides practical expedients for an entity's ongoing accounting. We elected the short-term lease exemption for all leases for which we are lessee that qualify; as a result, we will not recognize right-of-use assets or lease liabilities for qualifying leases. We also elected the practical expedient to not separate lease and non-lease components. Effective January 1, 2019, we recognized aggregate right-of-use lease assets as a component of prepaid expenses and other assets and lease liabilities as a component of accounts payable and accrued expenses, resulting in a nominal aggregate transition adjustment to retained earnings. For more information on our leasing activity, see Note 7.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. ASU 2017-04 simplifies the accounting for goodwill impairment by removing step two of the goodwill impairment test, which had involved determining the fair value of individual assets and liabilities of a reporting unit to measure goodwill. Instead, goodwill impairment will be determined as the excess of a reporting unit’s carrying value over its fair value, not to exceed the carrying amount of goodwill. ASU 2017-04 is effective for annual reporting periods beginning after December 15, 2019 and early adoption is permitted. We adopted ASU 2017-04 effective June 30, 2019. Though it changed our goodwill impairment testing process, the adoption of ASU 2017-04 did not have a material impact on our consolidated financial statements.
Recently issued accounting standards not yet adopted
In December 2019, the FASB issued ASU 2019-12, Income Taxes - Simplifying the Accounting for Income Taxes (Topic 740), which is intended to simplify various aspects related to accounting for income taxes. ASU 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. ASU 2019-12 is effective for fiscal years beginning after December 15, 2021. While are currently evaluating the impact of the adoption of this standard, we do not expect the adoption of this standard to have a material impact on our consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments, which amends the guidance on measuring credit losses on financial assets held at amortized cost. The amendment is intended to address the issue that the previous “incurred loss” methodology was restrictive for an entity's ability to record credit losses based on not yet meeting the “probable” threshold. The new language will require these assets to be valued at amortized cost presented at the net amount expected to be collected with a valuation provision. This ASU is effective for fiscal years beginning after December 15, 2019. The amendments in ASU 2016-13 should be applied on a modified retrospective transition basis. We expect to adopt this standard on January 1, 2020. We do not expect the adoption of this standard to have a material impact on our consolidated financial statements because the standard, as amended, excludes receivables arising from operating leases, which represent the majority of our receivables.
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2. Summary of Significant Accounting Policies
Cash, cash equivalents and restricted cash
We consider highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents.
Restricted cash represents cash deposits that are legally restricted or held by third parties on our behalf, such as security deposits from tenants and reserves for debt service established pursuant to certain of our repurchase and loan agreements.
Certain account balances exceed FDIC insurance coverage and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. To mitigate this risk, we maintain our cash and cash equivalents at large national or international banking institutions.
The following table provides a reconciliation of cash, cash equivalents and restricted cash reported on the consolidated balance sheets to the consolidated statements of cash flows:
Consolidations
The consolidated financial statements include the accounts of the Company and its consolidated subsidiaries, which are comprised of voting interest entities in which we are determined to have a controlling financial interest, which consists entirely of our wholly owned subsidiaries. We also consider VIEs for consolidation where we are the primary beneficiary. We had no VIEs or potential VIEs as of December 31, 2019 or 2018. Our former securitization trusts were determined to be VIEs and were consolidated in our financial statements prior to their termination, the last of which terminated in the second quarter of 2017.
Derivative financial instruments
We borrow funds at a combination of fixed and variable rates. Borrowings under certain of our repurchase and loan agreements bear interest at variable rates. Our interest rate risk management objectives are to limit the impact of changes in interest rates on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time, we may enter into interest rate hedge contracts such as caps or swaps in order to mitigate our interest rate risk with respect to our various debt instruments. We do not hold or issue these derivative contracts for trading or speculative purposes. See Note 12 for further information on our derivative positions.
We account for terminated derivative instruments by recognizing the related accumulated comprehensive income or loss balance in current earnings, unless the hedged forecasted transaction continues as originally planned, in which case we continue to amortize the accumulated comprehensive income or loss into earnings over the originally designated hedge period.
Earnings per share
Basic earnings per share is computed by dividing net income or loss by the weighted average common stock outstanding during the period. Diluted earnings per share is computed by dividing net income or loss by the weighted average common stock outstanding for the period plus the dilutive effect of stock options and restricted stock outstanding using the treasury stock method.
Fees under the asset management agreement
In accordance with the asset management agreement, we compensate AAMC, a related party, on a quarterly basis for its efforts in the management of our business. We recognize these fees in the fiscal quarter in which they are incurred by us and earned by AAMC. Refer to Note 10 for details of the fee structure under the asset management agreement.
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Fair value of financial instruments
We designate fair value measurements into three levels based on the lowest level of substantive input used to make the fair value measurement. Those levels are as follows:
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Level 1 - Quoted prices in active markets for identical assets or liabilities.
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Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities.
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Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Goodwill
Goodwill represents the excess of the amount paid over the fair value of the identifiable tangible and intangible assets that were acquired in connection with the acquisition of our internal property manager and the corresponding internalization of property management beginning in August 2018. Goodwill has an indefinite life and is therefore not amortized. We test goodwill for impairment on an annual basis, or more frequently if circumstances indicate that the carrying value of goodwill exceeds its fair value.
Income taxes
We elected REIT status upon the filing of our 2013 income tax return. We believe that we have complied with the provisions of the federal income tax code applicable to REITs for each financial year commencing in the year ended December 31, 2013. As a REIT, we believe that we will not be subject to federal income tax on the portion of our REIT taxable income that was distributed to our stockholders for such years, nor do we expect to be taxed on future distributions of REIT taxable income as long as certain asset, income and share ownership tests continue to be met. If after electing to be taxed as a REIT, we subsequently fail to qualify as a REIT in any taxable year, we generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost.
Our taxable REIT subsidiaries (each a “TRS”) are utilized to enter into transactions that do not qualify as REIT activities and are subject to federal and state income taxes. Income taxes are provided for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted rates expected to apply to taxable income in the years in which management expects those temporary differences to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period in which the change occurs. Subject to our judgment, we reduce a deferred tax asset by a valuation allowance if it is “more likely than not” that some or all of the deferred tax asset will not be realized. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Judgment may be required in evaluating tax positions, and we recognize tax benefits only if it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authority.
Leases
Front Yard as Lessor
Our primary business is to lease single-family homes to families throughout the United States. Our leases to tenants generally have a term of one year with potential extensions, including month-to-month leases after the initial term. These leases are classified as operating leases. Rental revenues, net of any concessions and uncollectible amounts, consist primarily of rents collected under lease agreements related to our single-family residential properties.
We adopted the provisions of ASC 842 effective January 1, 2019. Accounting for leases by lessors is substantially unchanged from the prior lease guidance under ASC 840; however, ASC 842 fundamentally changed the definition of a lease. Upon adoption of ASC 842, we elected the practical expedient not to separate the lease and non-lease components of the operating leases with our residents. Our lease components consist primarily of rental income and pet rent. Non-lease components consist of variable lease payments, including resident reimbursements and various other fees, including late fees and lease termination fees, among others. The lease component is the predominant component in these arrangements, and as such, we recognize rental
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revenues and other property income in accordance with ASC 842 for the year ended December 31, 2019, and in accordance with previous GAAP for years prior to this adoption.
Front Yard as Lessee
We lease office space under various operating leases. Prior to our adoption of ASC 842, our operating leases were not recognized in our consolidated balance sheets. Effective with our adoption of ASC 842, we now recognize right-of-use assets and lease liabilities related to our operating leases, except for short-term operating leases.
Our office leases are generally for terms of one to five years and typically include renewal options, which we consider in determining our lease right-of-use assets and lease liabilities to the extent that a renewal option is reasonably certain of being exercised. We do not record lease right-of-use assets or lease liabilities for leases with an initial maturity of one year or less. Along with rents, we are generally required to pay common area maintenance, property taxes and insurance, each of which vary from period to period and are therefore expensed as incurred.
We lease a fleet of vehicles under finance leases. Our accounting for finance leases remains substantially unchanged with the adoption of ASC 842. Each vehicle lease has an initial term of 36 months with the option to renew on a month-to-month basis. In determining our lease right-of-use assets and lease liabilities, we include such future month-to-month extensions based on our historical average period of use for our vehicles. We have elected to combine the lease and non-lease components, which relate primarily to maintenance services.
We include lease right-of-use assets as a component of prepaid assets and other expenses, and we include lease liabilities as a component of accounts payable and accrued liabilities.
Mortgage loans, at fair value
At December 31, 2019, we no longer held any mortgage loans. We liquidated our portfolio through a variety of resolution activities, including short sales, foreclosure sales to third party purchasers, REO conversions, full debt pay-offs of the mortgage loan by the borrower, negotiated settlements and loan portfolio sales.
We initially recorded our mortgage loans at fair value, which generally equaled the purchase price we paid for the loans on the acquisition date. Mortgage loans were subsequently accounted for at fair value under the fair value option election with unrealized gains and losses recorded in current period earnings. Such changes in fair value occurred as a result of servicing efforts, restructuring, changes in the condition of the underlying collateral or other factors. We concluded that mortgage loans accounted for at fair value timely reflected the results of our investment performance.
We determined the purchase price for mortgage loans at the time of acquisition by using a discounted cash flow valuation model and considering alternate loan resolution probabilities, including modification, liquidation or conversion to rental property. Observable inputs to the model included interest rates, loan amounts, status of payments and property types. Unobservable inputs to the model included discount rates, forecast of future home prices, alternate loan resolution probabilities, resolution timelines and the value of underlying properties. AAMC’s capital markets group determined the fair value of mortgage loans monthly and developed procedures and controls governing the valuation process relating to these assets.
The carrying value of each loan was adjusted in each reporting period to the estimated fair value, which may have been based on (i) market information, to the extent available and as adjusted for factors specific to individual mortgage loans, or (ii) as determined by AAMC's proprietary discounted cash flow model. Under this model, as a loan approached resolution (i.e., modification or conversion to real estate owned), the resolution timeline for that loan decreased and costs embedded for loan servicing, foreclosure costs and property insurance were incurred and removed from future expenses. The shorter resolution timelines and reduced future expenses each increased the fair value of the loan. The change in the value of the loan was recognized in our consolidated statements of operations as a component of change in unrealized gain on mortgage loans, which was included in net realized gain (loss) on real estate and mortgage loans beginning in 2018 as described below.
We also recognized unrealized gains and losses in each reporting period when our mortgage loans are transferred to real estate owned. The transfer to real estate owned occurred when we obtained title to the property through completion of the foreclosure process. The fair value of these assets at the time of transfer to real estate owned was estimated using broker price opinions (“BPOs”).
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Net gain (loss) on real estate and mortgage loans
Net gain (loss) on real estate and mortgage loans consists of three components: change in unrealized gains on mortgage loans, net realized gains on mortgage loans and net realized gains on sales of real estate. Prior to 2018, we reported these components separately in the consolidated statements of operations within revenues. With our adoption of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) effective January 1, 2018, we present these three components as a single line outside of revenues in the consolidated statement of operations as our mortgage loan and related REO activities were no longer a core part of our operations at that time due to our continued disposition of these asset classes. In accordance with the Securities and Exchange Commission's elimination of Rule 3-15(a) of Regulation S-X as part of Release No. 33-10532; 34-83875; IC-33203, which had required REITs to present gains and losses on sales of properties outside of continuing operations in the income statement, we classify net gain (loss) on real estate and mortgage loans as a component of operating loss.
Change in unrealized gains or losses on mortgage loans
We recognized changes in unrealized gains or losses on mortgage loans from three sources: conversions of mortgage loans to REO, changes in the fair value of mortgage loans and reclassifications of accumulated unrealized gains or losses to realized upon the sale of mortgage loans or REO.
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Upon conversion of loans to REO, we marked the properties to the most recent market value. The difference between the carrying value of the asset at the time of conversion and the most recent market value, based on BPOs, was recorded in our statement of operations as change in unrealized gain on mortgage loans.
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The carrying value of each loan was adjusted in each reporting period to the estimated fair value, which may have been based on (i) market information, to the extent available and as adjusted for factors specific to individual mortgage loans, or (ii) as determined by AAMC's proprietary discounted cash flow model.
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Upon the liquidation of a mortgage loan or REO property, we reclassify previously accumulated unrealized gains or losses to realized gains or losses.
Net realized gain or loss on mortgage loans
We recorded net realized gains or losses, including the reclassification of previously accumulated net unrealized gains, upon the liquidation of a loan. We collected proceeds of loan liquidations in cash and, thereafter, had no continuing involvement with the asset.
Net realized gain or loss on sale of real estate
Certain former rental properties identified and REO properties that do not meet our investment criteria are sold out of our TRS. The realized gain or loss recognized in the financial statements, including the reclassification of previously accumulated net unrealized gains, reflects the net amount of realized and unrealized gains on sold properties from the time of acquisition to sale completion. We sell real estate generally for cash at the time of closing and have no continuing involvement thereafter.
Real estate assets
Our real estate assets consist of (i) residential properties held as rental units, (ii) residential properties that we acquired through the conversion of mortgage loans to REO that have not yet been placed in service as a rental or that do not meet the criteria to be classified as held for sale and (iii) residential properties that are held for sale.
Rental residential properties
We record rental residential properties at historical cost less accumulated depreciation. The cost basis of residential rental properties is depreciated using the straight-line method over an estimated useful life of three to 27.5 years based on the nature of the components.
Certain of our rental residential properties may require renovation before being placed in service. Interest and other carrying costs incurred during the renovation period are capitalized until the property is ready for its intended use. Expenditures for ordinary maintenance and repairs are charged to expense as incurred.
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Purchases of residential properties are evaluated to determine whether they meet the definition of an asset acquisition or of a business combination under U.S. GAAP. For asset acquisitions, we capitalize the pre-acquisition costs to the extent such costs would have been capitalized had we owned the asset when the cost was incurred and capitalize closing and other direct acquisition costs. We then allocate the total cost of the property, including the acquisition costs, between land; building; site improvements; furniture, fixtures and equipment and any identified intangible assets and liabilities (including in-place leases). For acquisitions that meet the definition of a business combination, we expense the acquisition costs in the period in which the costs were incurred and allocate the cost of the property among land; building; site improvements; furniture, fixtures and equipment and any identified intangible assets and liabilities.
In-place lease intangibles are recorded at the estimated fair value, which is the estimated costs that would have been incurred to lease the property, and are amortized on a straight-line basis over the remaining life of the related lease or, in the case of acquisitions of real estate pools, over the weighted average remaining life of the related pool of leases.
Real estate owned
Real estate owned includes properties that we identified for disposal that do not yet meet the criteria to be classified as held for sale, including (i) vacant rental properties that are non-strategic, underperforming or are in inefficient markets that are identified for future disposal and (ii) the remaining properties acquired through foreclosure of our previous mortgage loans that do not meet our rental profile. Once a property is ready to be marketed, we reclassify the asset to real estate assets held for sale.
Upon the acquisition of real estate through the completion of foreclosure, we recorded the assets at fair value as of the acquisition date as a component of real estate owned based on information obtained from a BPO, a full appraisal or the price given in a current contract of sale of the property.
For those REO properties that met our rental profile, we reclassified the property to rental residential property and allocated the carrying value between land and rental residential properties in our consolidated balance sheet once the property was placed in rental service.
Real estate assets held for sale
Residential properties are classified as real estate assets held for sale when sale of the assets has been formally approved, the sale is expected to occur in the next twelve months and the property has been listed for sale. We record residential properties held for sale at the lower of the accumulated costs, net of depreciation, or estimated fair value less costs to sell. The fair value of real estate assets held for sale is determined as the lesser of the BPO or the expected selling price (which we consider to be Level 3 inputs). The expected selling price may be based on the current listing price of the property.
Real estate impairment
We perform an impairment analysis of our real estate assets if events or changes in circumstances indicate that the carrying value may be impaired, such as prolonged vacancy, identification of materially adverse legal or environmental factors, changes in expected ownership period or manner of use, significant deterioration in physical condition or indications that the market value of a property has declined to an amount less than the carrying amount.
For our SFR portfolio, we perform a quantitative analysis to determine if any of these indicators of impairment exist, which may require a cash flow analysis on a property-level basis. For our real estate assets held for sale and properties identified for future disposition, we perform a cash flow analysis at the property level. These analyses are based on a number of assumptions that are subject to economic and market uncertainties, including, among others, demand for rental properties, competition for customers, changes in market rental rates, the estimated fair value of the property (based on BPOs), costs to operate each property and expected ownership periods.
If the carrying amount of a property exceeds the sum of its undiscounted future operating and residual cash flows, an impairment loss is recorded for the excess of the carrying amount over the estimated fair value (in the case of rental residential properties and real estate owned) or the estimated fair value less costs to sell (in the case of real estate assets held for sale).
For rental residential properties and real estate owned, we are not able to recover any previously recognized impairments should the estimated fair value subsequently improve. For real estate assets held for sale, we are able to recover impairments to the extent previously recognized in the event that the estimated fair value of impaired properties held for sale subsequently improves.
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We generally estimate the fair value of real estate assets by using BPOs, and, for real estate assets held for sale, we also consider the expected selling price, which may be based on the current listing price of the property. In some instances, appraisal information may be available and is used in addition to BPOs. We engage third party vendors to obtain and evaluate BPOs prepared by other third party brokers for our ultimate use. BPOs are subject to judgments of a particular broker formed by visiting a property, assessing general home values in an area, reviewing comparable listings and reviewing comparable completed sales. These judgments may vary among brokers and may fluctuate over time based on housing market activities and the influx of additional comparable listings and sales. Our results could be materially and adversely affected if the judgments used by brokers in providing BPOs prove to be incorrect or inaccurate.
We have established validation procedures to confirm the values we receive from third party vendors are consistent with our observations of market values. These validation procedures include establishing thresholds to identify changes in value that require further analysis. Our current policies require that we update the fair value estimate of each held-for-sale property at least every six months by obtaining a new BPO, and we obtain new BPOs for a portion of our held-for-use properties each year. These BPOs are subject to the review processes of our third party vendors. In addition, we generally perform further analysis when the value of the property per the new BPO varies from the old BPO by 25% or $75,000 per property. If a newly obtained BPO varies from the old BPO by this established threshold, we perform additional procedures to ensure the BPO accurately reflects the current fair value of the property. These procedures include engaging additional third party vendors to compare the old BPOs to the new BPOs and to assist us in evaluating the appropriateness of comparable properties and property-specific characteristics used in the valuation process. As part of this evaluation, our third party vendors often discuss the differing BPOs with the providing brokers to ensure that proper comparable properties have been identified. These third party vendors also compare the BPOs to past appraisals, if any, of the property to ensure the BPOs are in line with those appraisals. Following the consideration and reconciliation of the BPOs, the third party provider may provide us with a new property value reflecting the analysis they performed or confirm the BPO value we received, in which case we use the new property value or the validated BPO, respectively, for our fair value estimate of the property.
Leasing costs
Expenditures directly related to successful leasing efforts, such as lease commissions, are capitalized as a leasing cost and are included in prepaid expenses and other assets on the accompanying consolidated balance sheet at amortized cost. Such expenditures are part of our operations and, therefore, are classified as operating activities in our consolidated statement of cash flows. Capitalized leasing costs are amortized on a straight-line basis over the lease term of the respective leases, which generally are for one year.
Casualty losses and insurance recoveries
Losses incurred as a result of casualty events, including natural disasters, are included in casualty losses in the consolidated statement of operations in the period in which we identify and are able to estimate the loss. We carry insurance, subject to deductibles, to reimburse us for losses related to property damage and business interruption. We recognize insurance recoveries for property damage to the extent of losses incurred for expected insurance proceeds that are reasonably certain of payment in the consolidated statements of operations in the same period as the related loss. Insurance recoveries in excess of property losses incurred or for business interruption are recognized upon receipt of funds from the insurer.
In September 2017, Hurricanes Harvey and Irma impacted certain of our properties in Texas and Florida, respectively, all of which are covered by wind, flood and business interruption insurance. During the year ended December 31, 2017, our consolidated statement of operations reflects estimated gross casualty losses of $6.0 million, partially offset by estimated insurance recoveries of $3.3 million as a result of these hurricanes. We reversed $1.0 million of these estimated casualty losses as we completed property inspections and finalized repair work orders during the year ended December 31, 2018.
Share-based compensation
With our adoption of ASU 2018-07, Compensation - Stock Compensation (Topic 718) effective April 1, 2018, the grant date fair value of share-based awards is recorded as expense on a straight-line basis over the vesting period for the award with an offsetting increase in stockholders' equity. For service-based restricted stock awards, the grant date fair value is determined based upon the closing share price on the grant date as reported on the New York Stock Exchange. For stock options and restricted stock awards with market-based vesting requirements, we use a Monte Carlo simulation until each market hurdle is met.
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Prior to our adoption of ASU 2018-07 on April 1, 2018, our awards to non-employees were revalued each reporting period. For restricted stock grants to non-employees, the fair value was based on the closing share price on the date that the shares vest, which required the amount to be adjusted in each reporting period based on the fair value of the award at the end of the reporting period until the award vested. For stock options issued to non-employees, we used a Monte Carlo simulation until each market hurdle was met. Subsequent to the market hurdle being met, we calculated the fair value of non-employee stock options issued based on the Black-Scholes model. Subsequent to our adoption of ASU 2018-07, the fair value of these awards is fixed as of the adoption date.
Forfeitures of share-based awards are recognized as they occur.
3. Asset Acquisitions and Dispositions
Real estate assets
HavenBrook Acquisition in 2018
On August 8, 2018, we acquired all of the equity interests of HavenBrook Partners, LLC, a full-service property management company and a Delaware limited liability company (“HavenBrook” or “internal property manager”), and three real estate investment trusts owned by Rental Home Associates, LLC, a Delaware limited liability company (“RHA”), for an aggregate purchase price of $485.0 million. The purchase was accounted for as a business combination because it included the acquisition of a property management company as well as the 3,236 single-family rental properties that it managed (collectively the “HB Acquisition”).
The following table presents the components acquired ($ in thousands):
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(1)
Purchase price adjustments at closing relate primarily to (i) properties sold by RHA subsequent to negotiation of the purchase price and prior to closing and (ii) working capital balances of each acquired entity.
The HB Acquisition was completed using the following sources of funds ($ in thousands):
We incurred $7.2 million of acquisition costs related to the HB Acquisition during the year ended December 31, 2018, which are included in acquisition and integration costs in the consolidated statement of operations. In addition, our acquisition and integration costs for the year ended December 31, 2018 include fees of $18.0 million to Altisource S.à r.l. (“ASPS”) and $5.3 million to Main Street Renewal, LLC (“MSR”) in relation to the transition of our externally managed SFR properties to our internal property management platform.
We recognized $20.3 million of revenues and $10.6 million of net loss related to the operations of HavenBrook and the RHA Acquired Properties in our consolidated statements of operations for the year ended December 31, 2018.
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In accordance with Accounting Standards Codification (“ASC”) 805, Business Combinations, we performed an allocation of the purchase related to the assets acquired and liabilities assumed in the HB Acquisition. The assets and liabilities of HavenBrook and RHA were recorded at their respective estimated fair values at the acquisition date. The allocation of the purchase consideration is as follows ($ in thousands):
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(1)
The value of in-place leases was amortized over the weighted average remaining life of the leases, which was approximately eight months as of the acquisition date.
(2)
Included in prepaid expenses and other assets in the consolidated balance sheet.
Supplemental pro forma financial information of the HB Acquisition (unaudited)
The following supplemental pro forma financial information summarizes our results of operations as if the HB Acquisition occurred on January 1, 2017 ($ in thousands, except per share amounts):
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The following table presents the adjustments included in the above pro forma financial information for the period indicated ($ in thousands):
The supplemental pro forma financial information for all periods presented was adjusted to reflect depreciation and amortization on the acquired properties and related intangible assets and interest expense on the related financing. The supplemental pro forma financial information is for informational purposes only and is not necessarily indicative of the actual results of operations that would have been achieved if the acquisition had taken place on January 1, 2017, nor does it purport to represent or be indicative of the results of operations for future periods.
HOME Flow Transaction in 2017
On March 30, 2017, we entered into an agreement to acquire up to 3,500 SFR properties (the “HOME Flow Transaction”) from entities sponsored by Amherst Holdings, LLC (“Amherst”) in three separate closings. These acquisitions were accounted for as purchases of assets pursuant to our adoption of ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, effective January 1, 2017.
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In the first closing on March 30, 2017, our wholly owned subsidiary, HOME SFR Borrower II, LLC (“HOME Borrower II”), acquired 757 SFR properties for an aggregate purchase price of $106.5 million. The purchase price was initially funded with approximately $79.9 million in a seller financing arrangement (the “HOME II Loan Agreement,” see Note 8), representing 75% of the aggregate purchase price, as well as $26.6 million of cash on hand. We capitalized $1.5 million of acquisition costs related to this portfolio acquisition. The value of in-place leases was estimated at $2.4 million and was amortized over the weighted average remaining life of the leases of approximately seven months as of the acquisition date.
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In the second closing on June 29, 2017, our wholly owned subsidiary, HOME SFR Borrower III, LLC (“HOME Borrower III”), acquired 751 SFR properties for an aggregate purchase price of $117.1 million. The purchase price was initially funded with approximately $87.8 million in a seller financing arrangement (the “HOME III Loan Agreement,” see Note 8), representing 75% of the aggregate purchase price, as well as $29.3 million of cash on hand. We capitalized $1.3 million of acquisition costs related to this portfolio acquisition. The value of in-place leases was estimated at $2.0 million and was amortized over the weighted average remaining life of the leases of approximately nine months as of the acquisition date.
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In the third and final closing on November 29, 2017, our wholly owned subsidiary, HOME SFR Borrower IV, LLC (“HOME Borrower IV”) acquired 1,957 SFR properties for an aggregate purchase price of $305.1 million. The purchase price was funded with approximately $228.8 million in two separate seller financing arrangements (the “HOME IV Loan Agreements,” see Note 8), representing 75% of the aggregate purchase price, as well as $76.3 million of cash on hand. We capitalized $1.9 million of acquisition costs related to this portfolio acquisition. The value of in-place leases was estimated at $5.9 million and was amortized over the weighted average remaining life of the leases of approximately seven months as of the acquisition date. In accordance with the related purchase and sale agreement, certain of the properties were subject to potential purchase price adjustments, which was based on the rental rates achieved for the properties within 24 months after the closing date. The ultimate adjustments that were made to the initial aggregate purchase price was not material.
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For each closing under the HOME Flow Transaction, we allocated the purchase price, including capitalized acquisition costs, based on the relative fair value of the properties acquired as follows ($ in thousands):
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(1)
Includes building, site improvements and furniture, fixtures and equipment.
(2)
Represent estimated lease-in-place intangible asset.
Other Acquisitions
During the years ended December 31, 2019, 2018 and 2017, we acquired 251, 70 and 27 SFR properties, respectively, under our other acquisition programs for an aggregate purchase price of $49.6 million, $8.7 million and $2.7 million, respectively.
Acquisition and integration costs
We incurred $3.1 million, $33.6 million, and $0.8 million of acquisition and integration costs during the years ended December 31, 2019, 2018 and 2017, respectively, which were expensed as incurred. Integration costs consist of incremental or duplicative costs incurred post-acquisition as a result of efforts to integrate and combine the businesses, including legal, due diligence, professional fees, technology costs, duplicative property management fees and severance-related compensation costs.
The following table presents the detail of acquisition and integration costs for the years ended December 31, 2019, 2018, and 2017 ($ in thousands):
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(1)
Represents fees in relation to the transition of our externally managed SFR properties to our internal property management platform. These transition fees have been paid prior to December 31, 2019 except for $3.0 million of the ASPS transition fee, which is payable on the earlier to occur of (i) a change of control of us or (ii) August 8, 2023 and is therefore included in accounts payable and accrued liabilities in our consolidated balance sheets.
Real estate dispositions
During the years ended December 31, 2019, 2018 and 2017, we sold 954, 448, and 1,710 REO properties, respectively. In connection with these sales, we received proceeds of $197.8 million, $79.4 million, and $250.7 million, respectively.
Mortgage loans
Mortgage loan dispositions and resolutions
During the years ended December 31, 2019, 2018 and 2017, we liquidated 70, 27 and 3,115 mortgage loans, respectively. In connection with these sales and resolutions, we received proceeds of $4.2 million, $3.2 million and $521.2 million, respectively.
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Transfers of mortgage loans to real estate owned
When we foreclose upon a home, we take title in lieu of payment to settle the mortgage. At that time, we record the home as an REO property. During the years ended December 31, 2019, 2018 and 2017, we transferred an aggregate of 4, 10 and 248 mortgage loans to REO at an aggregate fair value based on BPOs of $4.1 million, $4.9 million and $40.4 million, respectively. Such transfers occur when the foreclosure sale is complete; however, subsequent to a foreclosure sale, we may be notified that the foreclosure sale was invalidated for certain reasons.
Net gain (loss) on real estate and mortgage loans
The following table presents the components of net gain (loss) on real estate and mortgage loans during the periods indicated ($ in thousands):
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(1)
The year ended December 31, 2019 includes downward purchase price adjustments on prior loan sales of $3.5 million.
4. Real Estate Assets
The following table presents the number of real estate assets held by the Company by status as of the dates indicated:
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For properties held for sale or identified for future sale, management has determined to divest these properties because they do not meet our residential rental property investment criteria.
Impairment on real estate
During the years ended December 31, 2019, 2018 and 2017, we recognized $0, $0.6 million and $3.0 million, respectively, of valuation impairment on real estate held for use, which primarily related to our properties identified for future sale or under evaluation for rental strategy.
During the years ended December 31, 2019, 2018 and 2017, we recognized $4.5 million, $12.1 million and $17.3 million, respectively, of valuation impairment on our real estate held for sale. In addition, for the year ended December 31, 2017, we recognized valuation adjustments related to estimated selling costs upon disposition of held-for-sale real estate of $18.4 million.
5. Mortgage Loans at Fair Value
During the year ended December 31, 2019, we sold the last of our remaining mortgage loans. The following table sets forth information related to our mortgage loans at fair value, the related unpaid principal balance and market value of underlying properties by delinquency status as of December 31, 2018 ($ in thousands):
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(1)
The market value of the underlying properties were estimated based on BPOs.
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6. Fair Value of Financial Instruments
The following table sets forth the fair value of financial assets and liabilities by level within the fair value hierarchy as of December 31, 2019 and 2018 ($ in thousands):
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(1)
Included within prepaid expenses and other assets in the consolidated balance sheets.
We transferred our mortgage loans at fair value from Level 3 to Level 2 during the third quarter of 2019 due to the contract price being the primary input to the fair value of the mortgage loans prior to the sale of the remaining loans on October 7, 2019.
Prior to transferring the mortgage loans from Level 3 to Level 2, the fair value of our mortgage loans was estimated based on (i) market information, to the extent available and as adjusted for factors specific to individual mortgage loans, or (ii) as determined by AAMC's proprietary discounted cash flow model. The fair value of our interest rate cap derivatives are estimated using a discounted cash flow analysis based on the contractual terms of the derivatives.
Except as described above, we have not transferred any assets from one level to another level during the years ended December 31, 2019 and 2018.
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The following table sets forth the changes in our Level 3 assets, which consisted solely of mortgage loans at fair value, for the years ended December 31, 2019 and 2018 ($ in thousands):
_____________
(1)
Transferred from Level 3 to Level 2 because observable market data became available and was the primary valuation input. These mortgage loans were sold on October 7, 2019.
(2)
Included in net gain (loss) on real estate and mortgage loans in the consolidated statements of operations.
The significant unobservable inputs used in the fair value measurement of our mortgage loans were discount rates, forecasts of future home prices, alternate loan resolution probabilities, resolution timelines and the value of underlying properties. Significant changes in any of these inputs in isolation could have resulted in a significant change to the fair value measurement. A decline in the discount rate in isolation would have increased the fair value. A decrease in the housing pricing index in isolation would have decreased the fair value. Individual loan characteristics such as location and value of underlying collateral affected the loan resolution probabilities and timelines. An increase in the loan resolution timeline in isolation would have decreased the fair value. A decrease in the value of underlying properties in isolation would have decreased the fair value.
The following table sets forth quantitative information about the significant unobservable inputs used to measure the fair value of certain of our mortgage loans:
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7. Leases
Front Yard as Lessor
Future minimum rental revenues under existing leases for the 13,711 properties that were leased as of December 31, 2019 are as follows ($ in thousands):
For the year ended December 31, 2019, rental revenues included $7.3 million of variable lease payments.
Front Yard as Lessee
Operating Leases
As of December 31, 2019, we applied a weighted average discount rate of 4.70% to our office leases. We determine the discount rate for each lease to be either the discount rate stated in the lease agreement or the rate that we would be charged to finance real estate assets. Our weighted average remaining lease term was 1.9 years.
During the year ended December 31, 2019, our operating leases resulted in rent expense related to long-term leases of $0.6 million, which is allocated amongst residential property operating expenses, property management expenses and general and administrative expenses. At December 31, 2019, we had operating lease right-of-use assets of $0.9 million.
The following table presents a maturity analysis of our operating leases as of December 31, 2019 ($ in thousands):
Finance Leases
At December 31, 2019, the weighted average discount rate applied to our vehicle leases was 6.87% based on the rates implied in the individual lease agreements, and our weighted average remaining lease term was 3.7 years.
During the year ended December 31, 2019, our finance leases resulted in $0.7 million of amortization of our lease right-of-use assets, which is allocated amongst residential property operating expense, property management expenses and general and administrative expenses. At December 31, 2019, we had net finance lease right-of-use assets of $2.9 million.
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The following table presents a maturity analysis of our finance leases as of December 31, 2019 ($ in thousands):
8. Borrowings
Our operating partnership and certain of its Delaware statutory trust and/or limited liability company subsidiaries, as applicable, have entered into master repurchase agreements and loan agreements to finance the acquisition and ownership of our SFR and REO properties. We have effective control of the assets associated with these agreements and therefore have concluded these are financing arrangements.
We pay interest on all of our borrowings as well as certain other customary fees, administrative costs and expenses each month. As of December 31, 2019, the weighted average annualized interest rate on borrowings under our repurchase and loan agreements was 4.10%, excluding amortization of deferred issuance costs and loan discounts.
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The following table sets forth data with respect to our repurchase and loan agreements as of December 31, 2019 and 2018 ($ in thousands):
_____________
(1)
On February 13, 2020, we extended the maturity date to May 15, 2020.
(2)
Represents current maturity date as of the reporting date. We have the option to extend the maturity date for up to three successive one-year extensions, the first of which we exercised on November 9, 2019.
(3)
The interest rate is capped at 4.40% under an interest rate cap derivative. See Note 12.
(4)
The interest rate is capped at 4.30% under an interest rate cap derivative. See Note 12.
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Additional details regarding the above repurchase and loan agreements are as follows:
CS Repurchase Agreement
Credit Suisse AG (“CS”) is the lender on the repurchase agreement entered into on March 22, 2013, (the “CS Repurchase Agreement”), which has been amended on several occasions. Under the terms of the CS Repurchase Agreement, as collateral for the funds drawn thereunder, subject to certain conditions, our operating partnership and/or one or more of our limited liability company subsidiaries will sell to the lender equity interests in the Delaware statutory trust subsidiary that owns the applicable underlying real estate assets on our behalf. In the event the lender determines the value of the collateral has decreased, the lender has the right to initiate a margin call and require us, or the applicable trust subsidiary, to post additional collateral or to repay a portion of the outstanding borrowings. The price paid by the lender for each asset we finance under the CS Repurchase Agreement is based on a percentage of the market value of the asset. With respect to funds drawn under the CS Repurchase Agreement, our applicable subsidiary is required to pay the lender interest monthly and certain other customary fees, administrative costs and expenses to maintain and administer the CS Repurchase Agreement. We do not collateralize any of our repurchase facilities with cash. The CS Repurchase Agreement contains customary events of default and is fully guaranteed by us.
Nomura Loan Agreement
Nomura Corporate Funding Americas, LLC (“Nomura”) is the lender under a loan agreement dated April 10, 2015 (the “Nomura Loan Agreement”), which has been amended on several occasions. As of December 31, 2019, the maximum funding capacity of the Nomura Loan Agreement was $250.0 million, all of which is uncommitted but available to us subject to our meeting certain eligibility requirements.
Under the terms of the Nomura Loan Agreement, subject to certain conditions, Nomura may advance funds to us from time to time, with such advances collateralized by SFR properties and other REO properties. The advances paid under the Nomura Loan Agreement with respect to the applicable properties from time to time will be based on a percentage of the market value of the properties. We may be required to repay a portion of the amounts outstanding under the Nomura Loan Agreement should the loan-to-value ratio of the funded collateral decline.
The Nomura Loan Agreement contains events of default (subject to certain materiality thresholds and grace periods), including payment defaults, breaches of covenants and/or certain representations and warranties, cross-defaults, certain material adverse changes, bankruptcy or insolvency proceedings and other events of default customary for this type of transaction. The remedies for such events of default are also customary for this type of transaction and include the acceleration of the principal amount outstanding under the Nomura Loan Agreement and the liquidation by Nomura of the SFR and REO properties then subject thereto. The Nomura Loan Agreement is fully guaranteed by us.
Seller Financing Arrangements
We have entered into the following seller financing arrangements:
•
In connection with the seller financing related to the first closing under the HOME Flow Transaction on March 30, 2017, HOME Borrower II entered into the HOME II Loan Agreement with entities sponsored by Amherst. On November 13, 2017, HOME Borrower II entered into an amended and restated loan agreement, which was acquired by Metropolitan Life Insurance Company (“MetLife”). HOME Borrower II has the option to extend the HOME II Loan Agreement beyond the initial maturity date for three successive one-year extensions (the first of which was exercised on November 9, 2019), provided, among other things, that there is no event of default under the HOME II Loan Agreement on each maturity date. The HOME II Loan Agreement is cross-defaulted and cross-collateralized with the HOME III Loan Agreement.
•
In connection with the seller financing related to the second closing under the HOME Flow Transaction on June 29, 2017, HOME Borrower III entered into the HOME III Loan Agreement with entities sponsored by Amherst. On November 13, 2017, HOME Borrower III entered into an amended and restated loan agreement, which was acquired by MetLife. HOME Borrower III has the option to extend the HOME III Loan Agreement beyond the initial maturity date for three successive one-year extensions (the first of which was exercised on November 9, 2019), provided, among other things, that there is no event of default under the HOME III Loan Agreement on each maturity date. The HOME III Loan Agreement is cross-defaulted and cross-collateralized with the HOME II Loan Agreement.
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•
In connection with the seller financing related to the third and final closing under the HOME Flow Transaction on November 29, 2017, HOME Borrower IV entered into the two separate loan agreements with entities sponsored by Amherst (collectively, the “HOME IV Loan Agreements”). The HOME IV Loan Agreements were acquired by MetLife on November 29, 2017.
Under the terms of the HOME II Loan Agreement, the HOME III Loan Agreement and the HOME IV Loan Agreements, each of the facilities are non-recourse to us and are secured by a lien on the membership interests of HOME Borrower II, HOME Borrower III, HOME Borrower IV and the acquired properties and other assets of each entity, respectively. The assets of each entity are the primary source of repayment and interest on their respective loan agreements, thereby making the cash proceeds of rent payments and any sales of the acquired properties the primary sources of the payment of interest and principal by each entity to the respective lenders.
Each loan agreement also includes customary events of default, the occurrence of which would allow the respective lenders to accelerate payment of all amounts outstanding thereunder. We have limited indemnification obligations for wrongful acts taken by HOME Borrower II, HOME Borrower III or HOME Borrower IV under their respective loan agreements in connection with the secured collateral. Even though the HOME II Loan Agreement, the HOME III Loan Agreement and the HOME IV Loan Agreements are non-recourse to us and all of our subsidiaries other than the entities party to the respective loan agreements, we have agreed to limited bad act indemnification obligations to the respective lenders for the payment of (i) certain losses arising out of certain bad or wrongful acts of our subsidiaries that are party to the respective loan agreements and (ii) the principal amount of each of the facilities and all other obligations thereunder in the event we cause certain voluntary bankruptcy events of the respective subsidiaries party to the loan agreements. Any of such liabilities could have a material adverse effect on our results of operations and/or our financial condition.
Term Loan Agreement
On April 6, 2017, RESI TL1 Borrower, LLC (“TL1 Borrower”), our indirect wholly owned subsidiary, entered into a credit and security agreement (the “Term Loan Agreement”) with American Money Management Corporation, as agent, on behalf of Great American Life Insurance Company and Great American Insurance Company as initial lenders, and each other lender added from time to time as a party to the Term Loan Agreement. We may be required to make prepayments of a portion of the amounts outstanding under the Term Loan Agreement under certain circumstances, including certain levels of declines in collateral value.
The Term Loan Agreement includes customary events of default, the occurrence of which would allow the lenders to accelerate payment of all amounts outstanding thereunder. The Term Loan Agreement is non-recourse to us and is secured by a lien on the membership interests of TL1 Borrower and the properties and other assets of TL1 Borrower. The assets of TL1 Borrower are the primary source of repayment and interest on the Term Loan Agreement, thereby making the cash proceeds received by TL1 Borrower from rent payments and any sales of the underlying properties the primary sources of the payment of interest and principal by TL1 Borrower to the lenders. We have limited indemnification obligations for wrongful acts taken by TL1 Borrower and RESI TL1 Pledgor, LLC, the sole member of TL1 Borrower, in connection with the secured collateral for the Term Loan Agreement.
FYR SFR Loan Agreement
On August 8, 2018, FYR SFR Borrower, LLC (“FYR SFR Borrower”), our wholly-owned subsidiary, entered into loan agreement (the “FYR SFR Loan Agreement”) with Berkadia Commercial Mortgage LLC, as lender (“Berkadia”) secured by 2,798 of the RHA Acquired Properties as well as 2,015 other properties already owned by us and previously financed on our existing warehouse facilities with other lenders. The FYR SFR Loan Agreement was originated as part of the Federal Home Loan Mortgage Corporation’s (“Freddie Mac”) single-family rental pilot program and has been purchased from Berkadia by Freddie Mac. The FYR SFR Loan Agreement contains customary events of default and is secured by the equity interests of FYR SFR Borrower and mortgages on the collateral properties. In connection with the FYR SFR Loan Agreement, we maintained $0.6 million and $2.9 million in escrow for future payments of property taxes and repairs and maintenance as of December 31, 2019 and 2018, respectively.
MS Loan Agreement
On December 7, 2018, HOME Borrower entered into a loan agreement (the “MS Loan Agreement”) among HOME Borrower, as borrower; Morgan Stanley Bank, N.A. (“Morgan Stanley”) and such other persons that may from time to time become a party to the MS Loan, as lenders; Morgan Stanley Mortgage Capital Holdings LLC, as administrative agent; and Wells Fargo
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Bank, N.A., as paying agent and calculation agent. The MS Loan Agreement can be prepaid without penalty at any time after December 7, 2021. The MS Loan Agreement contains customary events of default and is secured by the equity interests in HOME Borrower and mortgages on its 4,262 SFR properties. In connection with the MS Loan Agreement, we maintained $4.9 million and $8.2 million in escrow for future payments of property taxes, HOA dues and repairs and maintenance as of December 31, 2019 and 2018, respectively.
Compliance with covenants
Our repurchase and loan agreements require us and certain of our subsidiaries to maintain various financial and other covenants customary to these types of indebtedness. The covenants of each facility may include, without limitation, the following:
•
reporting requirements to the agent or lender,
•
minimum adjusted tangible net worth requirements,
•
minimum net asset requirements,
•
limitations on the indebtedness,
•
minimum levels of liquidity, including specified levels of unrestricted cash,
•
limitations on sales and dispositions of properties collateralizing certain of the loan agreements,
•
various restrictions on the use of cash generated by the operations of properties, and
•
a minimum fixed charge coverage ratio.
We are currently in compliance with the covenants and other requirements with respect to the repurchase and loan agreements.
Counterparty risk
We monitor our lending partners’ ability to perform under the repurchase and loan agreements, including the obligation of lenders under repurchase agreements to resell the same assets back to us at the end of the term of the transaction, and have concluded there is currently no reason to doubt that they will continue to perform under the repurchase and loan agreements as contractually obligated.
Reliance on financing arrangements
Our business model relies to a significant degree on both short-term financing and longer duration asset-backed financing arrangements, and we generally do not carry sufficient liquid funds to retire any of our short-term obligations upon their maturity. Prior to or upon such short-term maturities, management generally expects to (1) refinance the remaining outstanding short-term facilities, obtain additional financing or replace the short-term facilities with longer-term facilities and (2) continue to liquidate certain non-core real estate and mortgage loan assets, which will generate cash to reduce the related financing. We are in continuous dialogue with our lenders, and we are currently not aware of any circumstances that would adversely affect our ability to complete such refinancings. We believe we will be successful in our efforts to refinance or obtain additional financing based on our recent success in renewing our outstanding facilities and obtaining additional financing with new counterparties and our ongoing relationships with lenders.
The following table presents the principal amount of our debt due at maturity by year, including applicable extensions ($ in thousands):
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9. Commitments and Contingencies
Litigation, claims and assessments
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. Set forth below is a summary of legal proceedings to which we are a party as of December 31, 2019 or which settled during 2019:
Martin v. Altisource Residential Corporation et al.
On March 27, 2015, a putative stockholder class action complaint was filed in the United States District Court of the Virgin Islands by a purported stockholder of the Company under the caption Martin v. Altisource Residential Corporation, et al., 15-cv-00024. The action names as defendants the Company, our former Chairman, William C. Erbey, and certain officers and a former officer of the Company and alleges that the defendants violated federal securities laws by, among other things, making materially false statements and/or failing to disclose material information to the Company's stockholders regarding the Company's relationship and transactions with AAMC, Ocwen Financial Corporation (“Ocwen”) and Home Loan Servicing Solutions, Ltd. These alleged misstatements and omissions include allegations that the defendants failed to adequately disclose the Company's reliance on Ocwen and the risks relating to its relationship with Ocwen, including that Ocwen was not properly servicing and selling loans, that Ocwen was under investigation by regulators for violating state and federal laws regarding servicing of loans and Ocwen’s lack of proper internal controls. The complaint also contains allegations that certain of the Company's disclosure documents were false and misleading because they failed to disclose fully the entire details of a certain asset management agreement between the Company and AAMC that allegedly benefited AAMC to the detriment of the Company's stockholders. The action seeks, among other things, an award of monetary damages to the putative class in an unspecified amount and an award of attorney’s and other fees and expenses.
In May 2015, two of our purported stockholders filed competing motions with the court to be appointed lead plaintiff and for selection of lead counsel in the action. Subsequently, opposition and reply briefs were filed by the purported stockholders with respect to these motions. On October 7, 2015, the court entered an order granting the motion of Lei Shi to be lead plaintiff and denying the other motion to be lead plaintiff.
On January 23, 2016, the lead plaintiff filed an amended complaint.
On March 22, 2016, defendants filed a motion to dismiss all claims in the action. The plaintiff filed opposition papers on May 20, 2016, and the defendants filed a reply brief in support of the motion to dismiss the amended complaint on July 11, 2016.
On November 14, 2016, the Martin case was reassigned to Judge Anne E. Thompson of the United States District Court of New Jersey. In a hearing on December 19, 2016, the parties made oral arguments on the motion to dismiss, and on March 16, 2017 the Court issued an order that the motion to dismiss had been denied. On April 17, 2017, the defendants filed a motion for reconsideration of the Court’s decision to deny the motion to dismiss. On April 21, 2017, the defendants filed their answer and affirmative defenses. Plaintiff filed an opposition to defendants’ motion for reconsideration on May 8, 2017. On May 30, 2017, the Court issued an order that the motion for reconsideration had been denied. Shortly thereafter, discovery commenced.
On October 10, 2018, the lead plaintiff filed a second amended complaint, which added a second lead plaintiff to the case. The allegations and causes of action asserted by the plaintiffs were virtually identical to the prior complaint, except that they added what the plaintiffs claimed was additional detail in support of their allegations.
On December 7, 2018, the Defendants moved to dismiss the second amended complaint in its entirety. Plaintiffs filed their opposition to the motion on December 31, 2018, and Defendants filed their reply brief on January 24, 2019. On February 21, 2019, Judge Thompson issued an order that granted Defendants’ motion and dismissed the second amended complaint in its entirety.
On February 26, 2019, the Court granted Plaintiffs’ request for leave to file a Third Amended Complaint within 14 days. On March 12, 2019, Plaintiffs filed their Third Amended Complaint, and on April 12, 2019, Defendants moved to dismiss the Third Amended Complaint in its entirety. Plaintiffs filed their opposition to the motion to dismiss on May 13, 2019, and Defendants filed their reply in support of the motion on May 31, 2019. On June 12, 2019, Judge Thompson issued an Order granting in part and denying in part Defendants’ motion to dismiss the Third Amended Complaint. Specifically, Judge Thompson granted Defendants’ motion to dismiss any alleged misrepresentation made after each Plaintiff’s final purchase of securities. Judge Thompson denied Defendants’ motion to dismiss on the remaining grounds.
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On June 26, 2019, Defendants filed a motion to certify interlocutory appeal to the Third Circuit of Judge Thompson’s Order granting in part and denying in part Defendants’ motion to dismiss the Third Amended Complaint. Plaintiffs filed their opposition to the motion on July 10, 2019 and Defendants’ reply in support of the motion was filed on July 24, 2019. On August 6, 2019, Judge Thompson denied Defendants’ motion to certify interlocutory appeal.
Separately, on July 5, 2019, Judge Thompson accepted the case schedule proposed by the parties, and discovery resumed. The deadline for the completion of fact discovery was November 8, 2019, the deadline for the completion of expert discovery was January 30, 2020, and the deadline to submit dispositive motions was February 27, 2020.
On October 8, 2019, based on input from a mediator, we entered into a stipulation and agreement of settlement with Plaintiffs to settle the litigation for $15.5 million in exchange for, among various other terms, a full release of claims by Plaintiffs on behalf of the purported class of shareholders. On the same date, Plaintiffs filed their unopposed motion for preliminary approval of the settlement and ancillary documents, which included the stipulation and agreement of settlement. On October 17, 2019, the court issued an order granting preliminary approval of the settlement, approving the form and manner of notice and setting a hearing date for final approval of the settlement for January 30, 2020. The approval hearing was rescheduled to and occurred on February 5, 2020. Following the hearing, on February 13, 2020, Judge Thompson entered a final order and judgment approving the settlement and an order awarding attorneys’ fees and expenses. The settlement amount was paid in two installments: (i) a payment of $10 million on November 28, 2019; and (ii) a payment of $5.5 million on January 28, 2020. Proceeds from the directors' and officers' insurance policies will fund $5.5 million of the settlement. We have included the settlement amount, net of insurance coverage, as a component of other expense within the consolidated statement of operations for the year ended December 31, 2019.
Potential purchase adjustments of certain properties sold
In January 2020, we received notice regarding potential purchase price adjustment/indemnification claims of up to $1.2 million relating to certain real estate sold in January 2019. We are investigating these claims, and, if they are determined to be valid, we may be required to repay a portion of the sales proceeds to the purchaser, based on the terms of the purchase agreement. At this time, we are not able to predict the ultimate outcome of these claims, nor can we estimate the range of possible adjustment/indemnification obligation, if any.
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10. Related-party Transactions
We are externally managed by AAMC, an asset management company that provides portfolio management and corporate governance services. Pursuant to the asset management agreement, amongst other duties, AAMC provides the following services to us: (1) performing and administering certain of our day-to-day operations; (2) implementing the investment criteria in our investment policy approved by our Board of Directors; (3) sourcing, analyzing and executing asset acquisitions, including the related financing activities; (4) overseeing the renovation, leasing and property management of our SFR properties; (5) analyzing and executing sales of certain rental properties; (6) performing asset management duties and (7) performing corporate governance and other management functions, including financial, accounting and tax management services.
AAMC provides us with a management team and support personnel who have substantial experience in the acquisition and management of residential properties. AAMC’s management also has significant corporate governance experience that enables it to manage our business and organizational structure efficiently. AAMC has agreed not to provide the same or substantially similar services without the prior written consent of our Board of Directors to any business or entity competing against us in (a) the acquisition or sale of SFR and/or REO properties, non-performing and re-performing mortgage loans or other similar assets, (b) the carrying on of an SFR business or (c) any other activity in which we engage. Notwithstanding the foregoing, AAMC may engage in any other business or render similar or different services to any businesses engaged in lending or insurance activities or any other activity other than those described above. Further, at any time following our determination and announcement that we will no longer engage in any of the above-described competitive activities, AAMC would be entitled to provide advisory or other services to businesses or entities in such competitive activities without our prior consent.
Terms of the Amended AMA
Front Yard and AAMC entered into an amended and restated asset management agreement (the “Amended AMA”) on May 7, 2019 (the “Effective Date”). The Amended AMA amends and restates, in its entirety, the asset management agreement previously entered into on March 31, 2015, as amended on April 7, 2015. The Amended AMA has an initial term of five years and will renew automatically each year thereafter for an additional one-year term, subject in each case to the termination provisions further described below.
Management Fees
The Amended AMA provides for the following management fee structure, which is subject to certain performance thresholds and an Aggregate Fee Cap (as described below):
•
Base Management Fee. Front Yard will pay a quarterly base management fee (the “Base Management Fee”) to AAMC as follows:
◦
Initially, commencing on the Effective Date and until the Reset Date (as defined below), the quarterly Base Management Fee will be (i) $3,584,000 (the “Minimum Base Fee”) plus (ii) an additional amount (the “Additional Base Fee”), if any, of 50% of the amount by which Front Yard's per share Adjusted AFFO (as defined in the Amended AMA) for the quarter exceeds $0.15 per share (provided that the Base Management Fee for any calendar quarter prior to the Reset Date cannot be less than the Minimum Base Fee or greater than $5,250,000). Beginning in 2021, the Base Management Fee may be reduced, but not below the Minimum Base Fee, in the fourth quarter of each year by the amount that Front Yard's AFFO (as defined below) on a per share basis is less than an aggregate of $0.60 for the applicable calendar year (the “AFFO Adjustment Amount”); and
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◦
Thereafter, commencing in the first quarter after which the quarterly Base Management Fee first reaches $5,250,000 (the “Reset Date”), the Base Management Fee will be 25% of the sum of (i) the applicable Annual Base Fee Floor plus (ii) the amount calculated by multiplying the applicable Manager Base Fee Percentage by the amount, if any, that Front Yard's Gross Real Estate Assets (as defined below) exceeds the applicable Gross Real Estate Assets Floor (in each case of the foregoing clauses (i) and (ii), as set forth in the table below), minus (iii) solely in the case of the fourth quarter of a calendar year, the AFFO Adjustment Amount (if any); provided, that the Base Management Fee for any calendar quarter shall not be less than the Minimum Base Fee.
_______________
(1)
Gross Real Estate Assets is generally defined as the aggregate book value of all residential real estate assets owned by Front Yard and its subsidiaries before reserves for depreciation, impairment or other non-cash reserves as computed in accordance with GAAP.
In determining the Base Management Fee, “AFFO” is generally calculated as GAAP net income (or loss) adjusted for (i) gains or losses from debt restructuring and sales of property; (ii) depreciation, amortization and impairment on residential real estate assets; (iii) unconsolidated partnerships and joint ventures; (iv) acquisition and related expenses, equity based compensation expenses and other non-recurring or non-cash items; (v) recurring capital expenditures on all real estate assets and (vi) the cost of leasing commissions.
For any partial quarter during the term of the Amended AMA, the Base Management Fee is subject to proration based on the number of calendar days under the Amended AMA in such period.
•
Incentive Fee. AAMC may earn an annual Incentive Fee to the extent that Front Yard's AFFO exceeds certain performance thresholds. The annual Incentive Fee, if any, shall be an amount equal to 20% of the amount by which Front Yard's AFFO for the calendar year (after the deduction of Base Management Fees but prior to the deduction of Incentive Fees) exceeds 5% of Gross Shareholder Equity (as defined below).
In each calendar year, the Incentive Fee will be limited to the extent that any portion of the Incentive Fee for such calendar year (after taking into account any AFFO Adjustment Amount and the payment of the Incentive Fee) would cause the AFFO per share for such calendar year to be less than $0.60 (the “Incentive Fee Adjustment”). For any partial calendar year under the Amended AMA, the Incentive Fee amount (and Incentive Fee Adjustment, if any) for that partial calendar year is subject to proration based on the number of calendar days of the year that the Amended AMA is in effect.
Gross Shareholder Equity for purposes of the Amended AMA is generally defined as the arithmetic average of all shareholder equity as computed in accordance with GAAP and adding back all accumulated depreciation and changes due to non-cash valuations (including those recorded as a component of accumulated other comprehensive income) and other non-cash adjustments, in each case, as of the first day of such calendar year, the first day of each of the second, third and fourth calendar quarters of such calendar year and the first day of the succeeding calendar year.
Front Yard has the flexibility to pay up to 25% of the annual Incentive Fee to AAMC in shares of its common stock, subject to certain conditions specified in the Amended AMA.
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Aggregate Fee Cap
The aggregate amount of the Base Management Fees and Incentive Fees payable to AAMC in any calendar year cannot exceed the “Aggregate Fee Cap,” which is generally defined as follows:
•
For any calendar year in which average Gross Real Estate Assets is less than $2,250,000,000, the aggregate fees payable to AAMC shall not exceed $21,000,000; or
•
For any calendar year in which average Gross Real Estate Assets exceeds $2,250,000,000, the aggregate fees payable to AAMC shall not exceed the sum of (i) the applicable Aggregate Fee Floor plus (ii) the amount calculated by multiplying the applicable Aggregate Fee Percentage by the amount, if any, by which average Gross Real Estate Assets exceed the applicable Gross Real Estate Assets Floor, in each case as set forth in the table below.
Expenses and Expense Budget
AAMC is responsible for all of its own costs and expenses other than the expenses related to compensation of Front Yard’s dedicated general counsel and, beginning in January 2020, four specified employees who provide direct property management services to Front Yard. Front Yard and its subsidiaries pay their own costs and expenses, and, to the extent such Front Yard expenses are initially paid by AAMC, Front Yard is required to reimburse AAMC for such reasonable costs and expenses.
Termination Provisions
The Amended AMA may be terminated without cause (i) by Front Yard for any reason, or no reason, or (ii) by Front Yard or AAMC in connection with the expiration of the initial term or any renewal term, in either case with 180 days' prior written notice. If the Amended AMA is terminated by Front Yard without cause or in connection with the expiration of the initial term or any renewal term, Front Yard shall pay a termination fee (the “Termination Fee”) to AAMC in an amount generally equal to three times the arithmetical mean of the aggregate fees actually paid or payable with respect to each of the three immediately preceding completed calendar years (including any such prior years that may have occurred prior to the Effective Date). Upon any such termination by Front Yard, Front Yard shall have the right, at its option, to license certain intellectual property and technology assets from AAMC.
If the Termination Fee becomes payable (except in connection with a termination by AAMC for cause, which would require the payment of the entire Termination Fee in cash), at least 50% of the Termination Fee must be paid in cash on the termination date and the remainder of the Termination Fee may be paid, at Front Yard’s option, either in cash or, subject to certain conditions specified in the Amended AMA, in Front Yard common stock in up to 3 equal quarterly installments (without interest) on each of the six-, nine- and twelve-month anniversaries of the termination date until the Termination Fee has been paid in full.
Front Yard may also terminate the Amended AMA, without the payment of a Termination Fee, upon a change of control of AAMC as described in the Amended AMA and “for cause” upon the occurrence of certain events including, without limitation,
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a final judgment that AAMC or any of its agents, assignees or controlled affiliates has committed a felony or materially violated securities laws; AAMC’s bankruptcy; the liquidation or dissolution of AAMC; a court determination that AAMC has committed fraud or embezzled funds from Front Yard; a failure of Front Yard to qualify as a REIT as a result of any action or inaction of AAMC; an uncured material breach of a material provision of the Amended AMA; or receipt of certain qualified opinions from AAMC or Front Yard's independent public accounting firm that (i) with respect to such opinions relating to AAMC, are reasonably expected to materially adversely affect either AAMC’s ability to perform under the Amended AMA or Front Yard, or (ii) with respect to such opinions relating to Front Yard, such opinions are a result of AAMC's actions or inaction; in each case, subject to the exceptions and conditions set forth in the Amended AMA. AAMC may terminate the Amended AMA upon an uncured default by Front Yard under the Amended AMA and receive the Termination Fee. A termination “for cause” may be effected by Front Yard with 30 days' written notice or by AAMC with 60 days' written notice. Upon any termination by Front Yard “for cause,” Front Yard shall have the right, at its option, to license certain intellectual property and technology assets from AAMC.
Transition Following Termination
Following any termination of the Amended AMA, AAMC is required to cooperate in executing an orderly transition to a new manager or otherwise in accordance with Front Yard’s direction including by providing transition services as requested by Front Yard for up to one (1) year after termination or such longer period as may be mutually agreed (including by assisting Front Yard with the recruiting, hiring and/or training of new replacement employees) at cost (but not more than the Base Management Fee at the time of termination).
If the Amended AMA with AAMC were terminated, our financial position and future prospects for revenues and growth could be materially adversely affected.
Terms of the Former AMA with AAMC
On March 31, 2015, we entered into an asset management agreement (the “Former AMA”) with AAMC. The Former AMA, which became effective on April 1, 2015, provided for a management fee structure as follows:
•
Base Management Fee. AAMC was entitled to a quarterly base management fee equal to 1.5% of the product of (i) our average invested capital (as defined in the Former AMA) for the quarter multiplied by (ii) 0.25, while we had fewer than 2,500 SFR properties actually rented (“Rental Properties”). The base management fee percentage increased to 1.75% of invested capital while we had between 2,500 and 4,499 Rental Properties and increased to 2.0% of invested capital while we had 4,500 or more Rental Properties;
•
Incentive Management Fee. AAMC was entitled to a quarterly incentive management fee equal to 20% of the amount by which our return on invested capital (based on AFFO defined as our net income attributable to holders of common stock calculated in accordance with GAAP plus real estate depreciation expense minus recurring capital expenditures on all of our real estate assets owned) exceeded an annual hurdle return rate of between 7.0% and 8.25% (or 1.75% and 2.06% per quarter), depending on the 10-year treasury rate. To the extent we had an aggregate shortfall in its return rate over the previous seven quarters, that aggregate return rate shortfall was added to the normal quarterly return hurdle for the next quarter before AAMC is entitled to an incentive management fee. The incentive management fee increased to 22.5% while we had between 2,500 and 4,499 Rental Properties and increased to 25% while we had 4,500 or more Rental Properties. No incentive management fee under the Former AMA has been payable to AAMC because our return on invested capital (as defined in the Former AMA) did not exceed the cumulative required hurdle rate; and
•
Conversion Fee. AAMC was entitled to a quarterly conversion fee equal to 1.5% of the market value of the SFR homes leased by us for the first time during the applicable quarter.
Because we had more than 4,500 Rental Properties, AAMC was entitled to receive a base management fee of 2.0% of our invested capital and a potential incentive management fee percentage of 25% of the amount by which we exceeded our then-required return on invested capital threshold.
Under the Former AMA, we reimbursed AAMC for the compensation and benefits of the General Counsel dedicated to us and certain operating expenses incurred by AAMC on our behalf.
The Former AMA required that AAMC continue to serve as our exclusive asset manager for an initial term of 15 years from April 1, 2015, with two potential five-year extensions, subject to our achieving an average annual return on invested capital of
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at least 7.0%. Neither party was entitled to terminate the Former AMA prior to the end of the initial term, or each renewal term, other than termination by (a) us and/or AAMC “for cause” for certain events such as a material breach of the AMA and failure to cure such breach, (b) us for certain other reasons such as our failure to achieve a return on invested capital of at least 7.0% for two consecutive fiscal years after the third anniversary of the AMA and (c) us in connection with certain change of control events.
Summary of related-party transactions
The following table presents our significant transactions with AAMC, which is a related party, for the periods indicated ($ in thousands):
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(1)
Included in management fees to AAMC in the consolidated statements of operations.
(2)
Included in general and administrative expenses in the consolidated statements of operations.
11. Share-based Payments
Our non-management directors each receive annual grants of restricted stock units. These restricted stock units are eligible for settlement in the number of shares of our common stock having a grant date fair market value of $80,000 for the 2019-2020 service year ($75,000 for the 2018-2019 service year and $60,000 for the 2017-2018 service year). Subject to accelerated vesting in limited circumstances, the restricted stock units vest on the earlier of the first anniversary of the date of grant or the next annual meeting of stockholders, with distribution mandatorily deferred for an additional two years thereafter until the third anniversary of grant (subject to earlier distribution or forfeiture upon the respective director’s separation from the Board of Directors). The awards were issued together with dividend equivalent rights. In respect of dividends paid to our stockholders prior to the vesting date, dividend equivalent rights accumulate and are expected to be paid in a lump sum in cash following the vesting date, contingent on the vesting of the underlying award. During any period thereafter when the award vests but remain subject to settlement, dividend equivalent rights are expected to be paid in cash on the same timeline as underlying dividends are paid to our stockholders.
We have also made grants of restricted stock units and stock options to certain employees of AAMC with service-based or market-based vesting criteria. Our service-based awards vest in equal annual installments on each of the first three anniversaries of the grant date, subject to acceleration or forfeiture. Our market-based awards vest in three equal annual installments on the later of (i) the first, second and third anniversary of the date of the award and (ii) the date of the satisfaction of certain performance criteria, subject to acceleration or forfeiture. The performance criteria is satisfied on the date on which the sum of (a) the average price per share for the consecutive 20-trading-day period ending on such date plus (b) the amount of all reinvested dividends, calculated on a per-share basis from the date of grant through such date, shall equal or exceed 125% of the price per share on the date of grant (the “Performance Goal”); provided however that the Performance Goal must be attained no later than the fourth anniversary of the grant date. In the event that the Performance Goal is not attained prior to the fourth anniversary of the grant date, the stock options shall expire.
2012 Conversion Option Plan and 2012 Special Conversion Option Plan
On December 21, 2012, as part of our separation transaction from ASPS, we issued stock options under the 2012 Conversion Option Plan and 2012 Special Conversion Option Plan to holders of ASPS stock options to purchase shares of our common stock in a ratio of one share of our common stock to every three shares of ASPS common stock. The options were granted as part of our separation to employees of ASPS and/or Ocwen solely to give effect to the exchange ratio in the separation, and we do not include share-based compensation expense related to these options in our consolidated statements of operations because they are not related to our incentive compensation.
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Stock Options
During the years ended December 31, 2019, 2018 and 2017, we recorded $0.2 million, a nominal amount, and $1.4 million, respectively, of compensation expense related to our grants of stock options. As of December 31, 2019 and 2018, we had a nominal amount and $0.2 million, respectively, of unrecognized share-based compensation cost remaining with respect to grants of stock options to be recognized over a weighted average remaining estimated term of 0.4 years and 0.8 years, respectively.
The following table sets forth the activity of our outstanding options:
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(1) The intrinsic value of stock options exercised during the years ended December 31, 2019, 2018 and 2017 was $0.3 million, $0.3 million and $0.6 million, respectively.
The total outstanding options issued under all of our share-based compensation plans as of December 31, 2019 had a weighted average remaining life of 4.0 years with total intrinsic value of $1.6 million.
We have 681,600 options exercisable as of December 31, 2019 with a weighted average exercise price of $9.95, weighted average remaining life of 3.6 years and intrinsic value of $1.6 million. Of these exercisable options, none had an exercise price higher than the market price of our common stock as of December 31, 2019.
We calculated the grant date fair value of stock options granted in 2017 using a Monte Carlo simulation and amortize the resulting compensation expense over the respective vesting or service period. The fair value of stock options granted during the period indicated was determined using the following assumptions:
_____________
(1)
Represents the interest rate as of the grant date on US treasury bonds having the same life as the estimated life of the stock option grants.
(2)
Based on our historical stock price volatility.
Restricted stock
We recorded $5.7 million, $3.0 million and $2.7 million of compensation expense related to our grants of restricted stock for the year ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019 and 2018, we had $4.7 million and $3.9 million, respectively, of unrecognized share-based compensation cost remaining with respect to our grants of restricted stock to be recognized over a weighted average remaining estimated term of 1.1 years and 1.2 years, respectively.
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The following table sets forth the activity of our restricted stock:
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(1) The vesting date fair value of restricted stock that vested during the years ended December 31, 2019, 2018 and 2017 was $4.1 million, $1.9 million and $1.3 million, respectively.
We calculated the grant date fair value of the restricted stock with market-based vesting criteria using a Monte Carlo simulation and amortize the resulting compensation expense over the respective vesting or service period. The fair value of market-based restricted stock granted was determined using the following assumptions:
_____________
(1)
Represents the interest rate as of the grant date on US treasury bonds having the same life as the estimated life of the grants.
(2)
Because the vesting of market-based restricted stock awards include accumulated dividends and the awards accrue dividend equivalent payments, no dividend yield assumption was included in the grant date fair value calculation.
(3)
Based on our historical stock price volatility.
The following table sets forth the number of shares of common stock reserved for future issuance. We generally will issue new shares upon the exercise of stock options or the vesting of restricted stock.
As of December 31, 2019, we had 146,066,425 remaining shares of common stock authorized to be issued under our charter.
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12. Derivatives
We may enter into derivative contracts from time to time in order to mitigate the risk associated with our variable rate debt. We do not enter into derivatives for investment or trading purposes. Derivatives are carried at fair value within prepaid expenses and other assets in our consolidated balance sheets. Upon execution, we may or may not designate such derivatives as accounting hedges.
Designated Hedges
We have entered into various interest rate cap agreements to mitigate potential increases in interest payments on our floating rate debt. Our interest rate caps have been designated as and are being accounted for as cash flow hedges with changes in fair value recorded in other comprehensive income or loss each reporting period. No gain or loss was recognized related to hedge ineffectiveness or to amounts excluded from effectiveness testing on our cash flow hedges during the years ended December 31, 2019. Prior to the fourth quarter of 2018, none of our derivatives were designated as hedges.
Amounts reported in accumulated other comprehensive income or loss related to derivatives will be reclassified to interest expense as interest payments are made on our variable rate debt. During 2020, we estimate that $5.7 million will be reclassified to interest expense.
The table below summarizes our interest rate cap instruments as of December 31, 2019 ($ in thousands):
Non-Designated Hedges
On September 29, 2016, we entered into an interest rate cap to manage the economic risk of increases in the floating rate portion of the MSR Loan Agreement. The interest rate cap has a strike rate on the one-month LIBOR of 2.938%, a notional amount of $489.3 million and a termination date of November 15, 2018. On March 16, 2018, we paid a premium of $0.9 million to amend the strike rate to 1.80%. We did not designate the interest rate cap as an accounting hedge; therefore, changes in the fair value of the interest rate cap were recorded as a component of interest expense in our consolidated statements of operations.
Tabular Disclosure of Fair Values of Derivative Instruments on the Consolidated Balance Sheets
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Tabular Disclosure of the Effect of Derivative Instruments on the Consolidated Statements of Operations
13. Income Taxes
As a REIT, we must meet certain organizational and operational requirements, including the requirement to distribute at least 90% of our annual REIT taxable income excluding capital gains to our stockholders. As a REIT, we generally will not be subject to federal income tax to the extent we distribute our REIT taxable income to our stockholders and provided we satisfy the REIT requirements, including certain asset, income, distribution and stock ownership tests. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which our REIT qualification was lost. As a REIT, we may also be subject to federal taxes if we engage in certain types of transactions.
During 2019, we paid cash distributions of $32.2 million to our stockholders, all of which is classified as a return of capital for tax purposes. For 2019, given that we incurred a taxable loss, no aggregate minimum distribution to stockholders was required to maintain our REIT status.
Our consolidated financial statements include the operations of our TRS, which is subject to federal, state and local income taxes on its taxable income. Our TRS had gross deferred tax assets of $52.6 million and $53.5 million as of December 31, 2019 and 2018, respectively. From inception through December 31, 2019, the TRS operated at a cumulative taxable loss, which has resulted in these deferred tax assets being fully offset by a valuation allowance.
As of December 31, 2019 and 2018, we did not accrue interest or penalties associated with any unrecognized tax benefits during the years ended December 31, 2019 and 2018. We recorded nominal state and local tax expense along with nominal penalties and interest on income taxes for the years ended December 31, 2019 and 2018.
Our subsidiaries and we remain subject to tax examination for the period from January 1, 2016 to December 31, 2019. The Company and its subsidiaries file income tax returns in the U.S. and various state and local jurisdictions.
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14. Earnings per Share
The following table sets forth the components of diluted loss per share (in thousands, except share and per share amounts):
We excluded the items presented below from the calculation of diluted loss per share as they were antidilutive for the periods indicated:
Pursuant to the Amended AMA and Former AMA, we have the flexibility to pay up to 25% of the Incentive Fee to AAMC in shares of our common stock. In addition, up to 50% of a Termination Fee, if payable, may be paid in shares of our common stock. Should we choose to make any such payments in shares of our common stock, our earnings available to common stockholders would be diluted to the extent of such issuance.
15. Segment Information
Our primary business is the acquisition and ownership of SFR assets. Our primary sourcing strategy is to acquire these assets by purchasing SFR properties, either on an individual basis or in pools. As a result, we operate in a single segment focused on the acquisition and ownership of rental residential properties.
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16. Quarterly Financial Information (Unaudited)
The following tables set forth our quarterly financial information (unaudited, $ in thousands except per share amounts):
17. Subsequent Events
Management has evaluated the impact of all events subsequent to December 31, 2019 and through the issuance of these consolidated financial statements and has determined that there were no subsequent events requiring adjustment or disclosure in the financial statements, except as follows:
Merger Agreement
On February 17, 2020, the Company entered into the Merger Agreement with Parent and Merger Sub, each affiliates of Amherst, providing for the acquisition of the Company by Parent.
The Merger Agreement provides that, among other things, upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger (“Effective Time”), the Company will merge with and into Merger Sub (the “Merger”), with Merger Sub continuing as the surviving company and a wholly owned subsidiary of Parent.
Pursuant to the Merger Agreement, each share of common stock, par value $0.01 per share, of the Company (the “Shares” and each, a “Share”) issued and outstanding immediately prior to the Effective Time (other than Shares owned by Parent, Merger Sub or any Company Subsidiary) shall be converted into the right to receive $12.50 per Share in cash without interest and subject to deduction for any required withholding tax (the “Merger Consideration”).
At the Effective Time, with respect to each outstanding option to purchase Shares (a “Company Option”) granted under the Front Yard Residential Corporation Conversion Option Plan, the Front Yard Residential Corporation Special Conversion Option Plan, the Front Yard Residential Corporation 2016 Equity Incentive Plan or the Front Yard Residential Corporation 2019 Equity Incentive Plan (collectively, the “Company Stock Plans”), whether vested or unvested, (i) if the exercise price of such Company Option is equal to or greater than the Merger Consideration, such Company Option shall terminate and be canceled as of immediately prior to the Effective Time, without any consideration being payable in respect thereof, and have no further force or effect and (ii) if the exercise price of such Company Option is less than the Merger Consideration, such Company Option shall terminate and be canceled as of immediately prior to the Effective Time in exchange for the right to receive a lump sum cash payment in the amount equal to (A) the number of Shares underlying the Company Option immediately prior to the Effective Time (irrespective of whether the performance goals have been met), multiplied by (B) the Merger Consideration minus the applicable exercise price.
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Each outstanding restricted stock unit (a “Company Director-Granted RSU”) that was granted to the Company’s non-employee directors, each outstanding service-based restricted stock unit (a “Company Service-Based RSU”) and each outstanding market-based restricted stock unit (a “Company Market-Based RSU” and, together with each Company Director-Granted RSU and Company Service-Based, the “Company RSUs”), in each case, that was granted under the Company Stock Plans that is outstanding or payable as of immediately prior to the Effective Time, whether vested or unvested, shall terminate and be canceled as of immediately prior to the Effective Time in exchange for the right to receive a lump sum cash payment equal to (i) (A) the number of Shares underlying such Company RSU (in the case of each Company Market-Based RSU, irrespective of whether the performance goals have been met), multiplied by (B) the Merger Consideration plus (ii) the value as of the Effective Time of all accrued but unpaid dividend equivalents with respect to such Company RSU.
The parties’ obligation to consummate the Merger is subject to the satisfaction or waiver of conditions set forth in the Merger Agreement, including: (i) the approval of the Merger by the holders of a majority of the outstanding Shares entitled to vote thereon, (ii) the absence of any law or governmental order prohibiting the Merger, (iii) the Company’s receipt of a tax opinion relating to the REIT status of the Company, (iv) each of the lender consents (the “Existing Lender Consents”) to the Merger under the Company’s existing credit facilities that will remain in effect following the Effective Time that are effective as of the date of the Merger Agreement shall remain in full force and effect, and each Existing Lender Consent (if any) that is in escrow pending consummation of the Merger shall be released from such escrow, and shall be effective not later than, substantially concurrently with the consummation of the Merger, (v) the absence of any event of default under certain of the Company’s existing credit facilities and the absence of any imminent event of default thereunder, (vi) no provisions of the Company’s existing credit facilities having been waived, amended, modified, supplemented or changed in a manner adverse to the Company, subject to certain exceptions, (vii) the Company will be in compliance with certain financial covenants in certain of its existing credit facilities that will remain outstanding after the Effective Time and (viii) certain other customary conditions relating to the parties’ representations and warranties in the Merger Agreement and the performance of their respective obligations.
The Company has made customary representations and warranties in the Merger Agreement. The Merger Agreement also contains customary covenants and agreements, including covenants and agreements relating to the conduct of the Company’s business between the date of the signing of the Merger Agreement and the closing of the transactions contemplated under the Merger Agreement. The representations and warranties made by the Company are, subject to certain limited exceptions, qualified by disclosures made in its disclosure schedules and Securities and Exchange Commission filings.
The Merger Agreement also contains covenants by the Company not to participate in any discussions or negotiations with any person making any proposal for an alternative transaction, and requiring the board of directors of the Company (the “Board”) to recommend to its stockholders that they approve the transactions contemplated by the Merger Agreement, in each case subject to certain exceptions. The Board may change its recommendation in certain circumstances specified in the Merger Agreement in response to an unsolicited proposal for an alternative transaction or following an intervening event.
The Merger Agreement also contains covenants by the Company (i) to use commercially reasonable efforts to comply with the terms of each of the Continuing Credit Facilities and refrain from taking any action that would reasonably be expected to lead to a breach, violation or default under any of the Continuing Credit Facilities and (ii) except as otherwise permitted in the Merger Agreement, not to enter into any waiver, amendment or modification or otherwise supplement or change any of the Continuing Credit Facilities.
The Merger Agreement also contains covenants by the Company not to take certain actions that would lead to the “internalization” of its asset management or corporate governance services.
Under the Merger Agreement, each of the Company and Parent has also agreed to use reasonable best efforts to consummate the Merger.
Parent has obtained equity and debt financing commitments for the transactions contemplated by the Merger Agreement, the proceeds of which will be used by Parent to pay the Merger Consideration and all related fees and expenses. Amherst has committed to capitalize Parent with an equity contribution and has provided the Company with a limited guarantee in favor of the Company guaranteeing the payment of certain monetary obligations that may be owed by Parent pursuant to the Merger Agreement, including any Parent Termination Fee (as defined below) that may become payable by Parent.
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Pursuant to the terms and conditions set forth in the debt commitment letter dated February 17, 2020 (the “Debt Commitment Letter”), the lender identified therein as the Commitment Lender (the “Lender”) has committed to provide Merger Sub with debt financing in an amount greater than or equal to the full amount of the new debt financing required to consummate the Merger on the terms contemplated by the Merger Agreement. The obligation of the Lender under the Debt Commitment Letter is subject to a number of customary conditions.
The Merger Agreement contains certain termination rights for the Company and Parent, and provides that, upon termination of the Merger Agreement by the Company or Parent upon specified conditions, the Company will be required (i) to pay Parent a termination fee equal to $24,000,000 and (ii) to reimburse up to $8,200,000 of Parent’s reasonable and documented out-of-pocket fees and expenses.
The Merger Agreement also provides that Parent will be required to pay the Company a reverse termination fee of $48,000,000 (the “Parent Termination Fee”) upon the termination of the Merger Agreement by the Company or Parent under specified conditions. Amherst Single Family Residential Partners VI, LP has entered into a limited guarantee with the Company to guarantee Parent’s obligation to pay the Company the Parent Termination Fee and make certain other specified payments to the Company, subject to the terms and conditions set forth in the limited guarantee.
In addition to the foregoing termination rights, and subject to certain limitations, either party may terminate the Merger Agreement if the Merger is not consummated by August 14, 2020.
In connection with the Merger Agreement, Parent has entered voting and support agreements (the “Voting Agreements”) with certain stockholders (collectively representing approximately 18% of the outstanding Shares) pursuant to which such stockholders have agreed to vote in favor of the Transaction. The Voting Agreements terminate upon termination of the Merger Agreement.
The foregoing description of the Merger Agreement and the Merger does not purport to be complete and is qualified in its entirety by the terms and conditions of the Merger Agreement and any related agreements. The Merger Agreement contains representations, warranties and covenants that the respective parties made to each other as of the date of such agreement or other specific dates. The assertions embodied in those representations, warranties and covenants were made for purposes of the contract among the respective parties and are subject to important qualifications and limitations agreed to by the parties in connection with negotiating such agreement. The Merger Agreement has been attached to provide investors with information regarding its terms. It is not intended to provide any other factual information about the Company, Parent or any other party to the Merger Agreement or any related agreement. In particular, the representations, warranties, covenants and agreements contained in the Merger Agreement, which were made only for purposes of such agreement and as of specific dates, were for the benefit of the parties to the Merger Agreement, may be subject to limitations agreed upon by the contracting parties (including being qualified by confidential disclosures made for the purposes of allocating contractual risk between the parties to the Merger Agreement instead of establishing these matters as facts) and may be subject to standards of materiality applicable to the contracting parties that differ from those applicable to investors and security holders. Investors and security holders are not third-party beneficiaries under the Merger Agreement and should not rely on the representations, warranties, covenants and agreements, or any descriptions thereof, as characterizations of the actual state of facts or condition of any party to the Merger Agreement. Moreover, information concerning the subject matter of the representations and warranties may change after the date of the Merger Agreement, which subsequent information may or may not be fully reflected in the Company’s public disclosures.
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Front Yard Residential Corporation
Schedule III - Real Estate and Accumulated Depreciation
December 31, 2019
($ in thousands)
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(1)
Weighted average age is based on the age of the property weighted by gross amount at which carried at close of period.
(2)
The following table sets forth the activity of real estate assets and accumulated depreciation ($ in thousands):
___________
(1) The aggregate cost for federal income tax purposes is $2,188.9 million as of December 31, 2019.
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Front Yard Residential Corporation
Schedule IV - Mortgage Loans on Real Estate
December 31, 2019
($ in thousands)
We held no mortgage loans as of December 31, 2019. The following table sets forth the activity of mortgage loans for the periods indicated ($ in thousands):