Item 1. Business.
Overview
We are a real estate credit focused company that originates, structures, funds and manages high yielding commercial real estate investments, including mezzanine loans, first mortgage loans, subordinated mortgage loans and preferred equity investments throughout the United States, which we collectively refer to as our targeted assets. Our loans finance the acquisition, construction, development or redevelopment of quality commercial real estate in the United States. We focus on the origination of middle market loans in the approximately $10 million to $50 million range, to finance properties primarily in primary and secondary markets. We believe loans of this size are subject to less competition, offer higher risk adjusted returns than larger loans with similar risk metrics and facilitate portfolio diversification. We were formed as a Delaware limited liability company on April 24, 2013 and commenced operations on August 8, 2013. We make substantially all of our investments and conduct substantially all of our real estate lending business through our REIT subsidiary, which has elected to be taxed as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2016. Our objectives are to (i) preserve our members’ capital contributions, (ii) realize income from our investments and (iii) make monthly distributions to our members from cash generated from investments. There can be no assurances that we will be successful in meeting our objectives.
As of December 31, 2019, through our REIT subsidiary, we held a net investment portfolio (gross investments less obligations under participation agreements) comprised of 23 investments in 10 states with an aggregate net principal balance of $274.8 million, a weighted average coupon rate of 8.9%, a weighted average loan-to-value ratio of 73.5% and a weighted average remaining term to maturity of 2.3 years.
Each of the loans was originated by Terra Capital Partners or its affiliates. The portfolio is diversified geographically with underlying properties located in 23 markets across 10 states and by loan structure and property type. The portfolio includes diverse property types such as multifamily housing, condominiums, hotels, student housing commercial offices, medical offices and mixed use properties. The profile of these properties ranges from stabilized and value-added properties to pre-development and construction. The loans are structured across mezzanine debt, first mortgages, and preferred equity investments.
We are managed by Terra Fund Advisors or our Manager, a registered investment adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Our REIT subsidiary’s investment activities are externally managed by Terra REIT Advisors, a private investment firm affiliated with us, pursuant to a management agreement dated February 8, 2018. Under the terms of the management agreement, the REIT Manager provides certain services to our REIT subsidiary and our REIT subsidiary pays fees associated with such services.
We believe there are compelling opportunities available to us in the commercial real estate lending market as a result of high demand for property financing, constraints on the availability of credit from banks and other traditional commercial mortgage lenders due to the regulatory environment, and a generally conservative real estate credit culture that evolved in response to the 2008 financial crisis. Demand for property acquisition and development financing continues to be fueled by healthy economic conditions, population growth and the adaptive re-use of properties to accommodate new technologies and lifestyles. In addition, there continues to be a large volume of commercial real estate loans that mature each year that require refinancing proceeds. The confluence of these conditions - reduced lending by traditional lenders and strong demand for commercial real estate financing - has created opportunities for experienced alternative lenders such as us, particularly those with a focus on providing commercial real estate loans to creditworthy borrowers.
We believe that we are well positioned to capitalize on these opportunities through our relationship with our Manager and Terra Capital Partners. Our management team maintains extensive relationships within the real estate industry, including with real estate developers, institutional real estate sponsors and investors, real estate funds, investment and commercial banks, private equity funds, asset originators and broker-dealers, as well as the capital and financing markets generally. We leverage the many years of experience and well-established contacts of our management team and use these relationships for the benefit of our members.
On January 1, 2016, Terra Fund 1, Terra Fund 2, Terra Fund 3 and Terra Fund 4 merged with and into our subsidiaries (individually, each a “Terra Fund” and collectively, the “Terra Funds”) through a series of separate mergers (collectively, the “Merger”). Following the Merger, we contributed the consolidated portfolio of net assets of the Terra Funds to our REIT subsidiary in exchange for all of the common shares of our REIT subsidiary. We elected to engage in these transactions, which we refer to as the “REIT formation transactions,” to make our investments through our REIT subsidiary and to provide our members with a
more broadly diversified portfolio of assets, while at the same time providing us with enhanced access to capital and borrowings, lower operating costs and enhanced opportunities for growth.
Our Manager intends to treat us as a partnership and not as an association or “publicly traded partnership,” taxed as a corporation for U.S. federal income tax purposes. Our REIT subsidiary has elected to be taxed as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2016. So long as our REIT subsidiary qualifies as a REIT, it generally is not subject to U.S. federal income tax on its net taxable income to the extent that it annually distributes all of its net taxable income to its stockholders. We also operate our business in a manner that will permit us to be excluded from registration as an investment company under the 1940 Act.
Our Manager and Terra Capital Partners
Our sole managing member is our Manager. The external manager of our REIT subsidiary is the REIT Manager. Both our Manager and the REIT Manager are registered as investment advisers under the Advisers Act.
The REIT Manager is a subsidiary, and our Manager is an affiliate of, Terra Capital Partners, a real estate credit focused investment manager based in New York City with a 16-year track record focused primarily on the origination and management of mezzanine loans, as well as first mortgage loans, bridge loans and preferred equity investments in all major property types through multiple public and private pooled investment vehicles. Since its formation in 2001 and its commencement of operations in 2002, Terra Capital Partners has been engaged in providing financing on commercial properties of all major property types throughout the United States. In the lead up to the global financial crisis in 2007, believing that the risks associated with commercial real estate markets had grown out of proportion to the potential returns from such markets, Terra Capital Partners sold 100% of its investment management interests prior to the global financial crisis. It was not until mid-2009, after its assessment that commercial mortgage markets would begin a period of stabilization and growth, that Terra Capital Partners began to sponsor new investment vehicles, which included the predecessor private partnerships, to again provide debt capital to commercial real estate markets. The financings provided by all vehicles managed by Terra Capital Partners from January 2004 through December 31, 2019 have been secured by approximately 12.0 million square feet of office properties, 3.5 million square feet of retail properties, 3.8 million square feet of industrial properties, 4,855 hotel rooms and 26,082 apartment units. The value of the properties underlying this capital was approximately $7.9 billion based on appraised values as of the closing dates of each financing. In addition to its extensive experience originating and managing debt financings, Terra Capital Partners and its affiliates owned and operated over six million square feet of office and industrial space between 2005 and 2007, and this operational experience further informs its robust origination and underwriting standards and enables our Manager to effectively operate property underlying a financing upon a foreclosure.
An affiliate (“Axar”) of Axar Capital Management L.P. (“Axar Capital Management”) owns 100% of the voting interest and, together with certain members of the senior management of Terra Capital Partners, 100% of the economic interest in Terra Capital Partners. Axar Capital Management is an investment manager registered under the Advisers Act with over $850 million in assets under management as of December 31, 2019, headquartered in New York City and founded by Andrew M. Axelrod. Axar Capital Management focuses on value-oriented and opportunistic investing across the capital structure and multiple sectors. The firm seeks attractive prices relative to intrinsic value and invests in event-driven situations with clear catalysts and asymmetric return potential. Axar Capital Management’s senior real estate team, which joined Terra Capital Partners in February 2018, has worked together for over five years, having previously built the $3 billion real estate business at Mount Kellett Capital Management, LP. Axar Capital Management has a deep network of industry relationships including institutional investors (for both public and private investments), operators, advisers and senior lenders.
Terra Capital Partners is led by Vikram S. Uppal (Chief Executive Officer), Gregory M. Pinkus (Chief Financial Officer) and Daniel Cooperman (Chief Originations Officer). Mr. Uppal was a Partner of Axar Capital Management and its Head of Real Estate. Prior to Axar Capital Management, Mr. Uppal was a Managing Director on the Investment Team at Fortress Investment Group’s Credit and Real Estate Funds and Co-Head of North American Real Estate Investments at Mount Kellett Capital Management. Members of the Terra Capital Partners management team have broad based, long-term relationships with major financial institutions, property owners and commercial real estate service providers. The entire senior management team has held leadership roles at many top international real estate and investment banking firms, including Mount Kellett Capital Management and Fortress Investment Group.
Objective and Strategy
Our primary investment objectives are to:
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preserve our members’ capital contributions;
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realize income from our investment; and
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make monthly distributions to our members from cash generated by our investment.
We focus on providing commercial real estate loans to creditworthy borrowers and seek to generate an attractive and consistent low volatility cash income stream. Our focus on originating debt and debt-like instruments emphasizes the payment of current returns to investors and the preservation of invested capital.
The management teams of our Manager and the REIT Manager have extensive experience in originating, managing and disposing of real estate-related loans. The REIT Manager seeks to:
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focus on middle market loans of approximately $10 million to $50 million;
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focus on the origination of new loans, not on the acquisition of loans originated by other lenders;
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invest primarily in floating rate rather than fixed rate loans, but the REIT Manager reserves the right to make debt investments that bear interest at a fixed rate;
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originate loans expected to be repaid within one to five years;
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maximize current income;
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lend to creditworthy borrowers;
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construct a portfolio that is diversified by property type, geographic location, tenancy and borrower;
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source off-market transactions; and
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hold loans until maturity unless, in the REIT Manager’s judgment, market conditions warrant earlier disposition.
Our Financing Strategy
We have historically utilized only limited amounts of borrowings as part of our financing strategy. One of the reasons we completed the REIT formation transactions, as described under “- Overview,” is to expand our financing options, access to capital and capital flexibility in order to position us for future growth. We deploy moderate amounts of leverage as part of our operating strategy, which consists of borrowings under first mortgage financings, a revolving credit facility and repurchase agreements. We may in the future also deploy leverage through other credit facilities and we may divide the loans we originate into senior and junior tranches and dispose of the more senior tranches as an additional means of providing financing to our business. In addition, we intend to match our use of floating rate leverage with floating rate investments.
In December 2018, our REIT subsidiary entered into a master repurchase agreement with Goldman Sachs Bank USA (the “master repurchase agreement”) that provides for advances of up to $150 million in the aggregate, which our REIT subsidiary expects to use to finance certain secured performing commercial real estate loans, primarily senior mortgage loans. In June 2019, our REIT subsidiary entered into a credit facility with Israel Discount Bank that provides for revolving credit loans of up to $35.0 million in the aggregate, which our REIT subsidiary expects to use for short term financing needed to bridge the timing of anticipated loan repayments and funding obligations.
As of December 31, 2019, our REIT subsidiary had outstanding indebtedness, consisting of borrowings under a mortgage loan of $44.6 million and borrowings under the master repurchase agreement of $81.1 million. As of December 31, 2019, the amount remaining available under the master repurchase agreement was $68.9 million and the amount remaining available under the credit facility was $35.0 million.
Additionally, as of December 31, 2019, our REIT subsidiary had obligations under participation agreements with an aggregate outstanding principal amount of $102.6 million. However, our REIT subsidiary does not have direct liability to a participant under the participation agreements with respect to the underlying loan and the participants’ share of the investments is repayable only from the proceeds received from the related borrower/issuer of the investments and, therefore, the participants also are subject to credit risk (i.e., risk of default by the underlying borrower/ issuer). With its larger size and enhanced access to capital and capital flexibility, our REIT subsidiary expects to deemphasize its use of participation arrangements. For additional information concerning
our indebtedness, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this annual report on Form 10-K.
Targeted Assets
Real Estate-Related Loans
Through our REIT subsidiary, we originate, structure, fund and manage commercial real estate loans, including mezzanine loans, first mortgage loans, subordinated mortgage loans and preferred equity investments related to high-quality commercial real estate in the United States. We may also, to the extent consistent with our REIT subsidiary’s qualification as a REIT, acquire equity participations in the underlying collateral of some of such loans. Our REIT subsidiary originates, structures and underwrites most if not all of our loans. Our REIT subsidiary, in reliance on the REIT Manager, uses what we consider to be conservative underwriting criteria, and our underwriting process involves comprehensive financial, structural, operational and legal due diligence to assess the risks of financings so that we can optimize pricing and structuring. By originating, not purchasing, loans, our REIT subsidiary is able to structure and underwrite financings that satisfy our standards, utilize our proprietary documentation and establish a direct relationship with our borrower. Described below are some of the types of loans we own and seek to originate with respect to high-quality properties in the United States. We continue to see attractive lending opportunities, and we expect market conditions to remain favorable for our strategy for the foreseeable future.
Mezzanine Loans. These are loans secured by ownership interests in an entity that owns commercial real estate and that generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. Mezzanine loans may be either short-term (one to five years) or long-term (up to 10 years) and may be fixed or floating rate. We may own mezzanine loans directly or we may hold a participation in a mezzanine loan or a sub-participation in a mezzanine loan. These loans generally pay interest on a specified due date (although there may be a portion of the interest that is deferred) and may, to the extent consistent with our REIT subsidiary’s qualification as a REIT, provide for participation in the value or cash flow appreciation of the underlying property as described below. Generally, we invest in mezzanine loans with last dollar loan-to-value ratios ranging from 60% to 85%. As of December 31, 2019, our REIT subsidiary owned seven mezzanine loans with a total net principal amount of $29.6 million, which constituted 10.8% of its net investment portfolio.
Preferred Equity Investments. These are investments in preferred membership interests in an entity that owns commercial real estate and generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. These investments are expected to have characteristics and returns similar to mezzanine loans. As of December 31, 2019, our REIT subsidiary owned seven preferred equity investments with a total net principal amount of $84.2 million, which constituted 30.6% of its net investment portfolio.
First Mortgage Loans. These loans generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. First mortgage loans may be either short-term (one to five years) or long-term (up to 10 years), may be fixed or floating rate and are predominantly current-pay loans. Our Manager originates current-pay first mortgage loans backed by high-quality properties in the United States. that fit our investment strategy. Certain of our first mortgage loans finance the acquisition, rehabilitation and construction of infill land property and for these loans we target a weighted average last dollar loan-to-value of 70%. We may selectively syndicate portions of our first mortgage loans, including senior or junior participations to provide third party financing for a portion of the loan or optimize returns which may include retained origination fees.
First mortgage loans are expected to provide for a higher recovery rate and lower defaults than other debt positions due to the lender’s senior position. However, such loans typically generate lower returns than subordinate debt such as mezzanine loans, B-notes, or preferred equity investments. As of December 31, 2019, our REIT subsidiary owned nine first mortgage loans with a total net principal amount of $161.0 million, which constituted 58.6% of its portfolio. As of December 31, 2019, our REIT subsidiary used $114.8 million of senior mortgage loans as collateral for $81.1 million of borrowings under its master repurchase agreement.
Subordinated Mortgage Loans (B-notes). B-notes include structurally subordinated mortgage loans and junior participations in first mortgage loans or participations in these types of assets. Like first mortgage loans, these loans generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. B-notes may be either short-term (one to five years) or long-term (up to 10 years), may be fixed or floating rate and are predominantly current-pay loans. We may create B-notes by tranching our directly originated first mortgage loans generally through syndications of senior first mortgages or buy these loans directly from third-party originators. As a result of the current credit market disruption related to the most recent recession and the decrease in capital available in this part of the capital structure, we believe that the opportunities to both directly originate and to buy these types of loans from third-parties on favorable terms will continue to be attractive.
Investors in B-notes are compensated for the increased risk of such assets from a pricing perspective but still benefit from a mortgage lien on the related property. Investors typically receive principal and interest payments at the same time as senior debt unless a default occurs, in which case any such payments are made only after any senior debt is made whole. Rights of holders of B-notes are usually governed by participation and other agreements that, subject to certain limitations, typically provide the holders of subordinated positions of the mortgage loan with the ability to cure certain defaults and control certain decisions of holders of senior debt secured by the same properties (or otherwise exercise the right to purchase the senior debt), which provides for additional downside protection and higher recoveries. As of December 31, 2019, our REIT subsidiary did not own any B-notes.
Equity Participations. In connection with our loan origination activities, we may pursue equity participation opportunities, or interests in the projects being financed, in instances when we believe that the risk-reward characteristics of the loan merit additional upside participation because of the possibility of appreciation in value of the underlying properties securing the loan. Equity participations can be paid in the form of additional interest, exit fees or warrants in the borrower. Equity participation can also take the form of a conversion feature, permitting the lender to convert a loan or preferred equity investment into equity in the borrower at a negotiated premium to the current net asset value of the borrower. We expect to obtain equity participations in certain instances where the loan collateral consists of a property that is being repositioned, expanded or improved in some fashion which is anticipated to improve future cash flow. In such case, the borrower may wish to defer some portion of the debt service or obtain higher leverage than might be merited by the pricing and leverage level based on historical performance of the underlying property. We can generate additional revenues from these equity participations as a result of excess cash flows being distributed or as appreciated properties are sold or refinanced. As of December 31, 2019, our REIT subsidiary did not own any equity participations.
Other Real Estate-Related Investments. We may, through our REIT subsidiary, invest in other real estate-related investments, which may include commercial mortgage-backed securities (“CMBS”) or other real estate debt or equity securities, so long as such investments do not constitute more than 15% of our assets. Certain of our real estate-related loans require the borrower to make payments of interest on the fully committed principal amount of the loan regardless of whether the full loan amount is outstanding. As of December 31, 2019, our REIT subsidiary did not own any other real estate-related investments.
Operating Real Estate
From time to time, our REIT subsidiary might acquire operating real estate properties, including properties acquired in connection with foreclosures or deed in lieu of foreclosure. In July 2018, our REIT subsidiary acquired a multi-tenant office building through foreclosure of a first mortgage loan. In January 2019, our REIT subsidiary acquired a 4.9 acre development parcel through deed in lieu of foreclosure. As of December 31, 2019, the office building and the development parcel had a carrying value of $66.2 million, and the mortgage loan payable encumbering the office building had a principal amount of $44.6 million.
Investment Guidelines
Our REIT subsidiary’s board of directors adopts investment guidelines from time to time relating to the criteria to be used by the Manager or its affiliates’ senior management team to evaluate specific investments as well as its overall portfolio composition. Our REIT subsidiary’s board of directors will review its compliance with the investment guidelines periodically and receive an investment report at each quarter-end in conjunction with the review of its quarterly results by its board of directors.
Our REIT subsidiary’s board of directors adopted the following investment guidelines:
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no origination or acquisition shall be made that would cause our REIT subsidiary to fail to qualify as a REIT;
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no origination or acquisition shall be made that would cause our REIT subsidiary or any of its subsidiaries to be required to register as an investment company under the 1940 Act; and
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until appropriate investments can be identified, our REIT subsidiary may invest the proceeds of its equity or debt offerings in interest-bearing, short-term investments, including money market accounts and/or funds, that are consistent with its intention to qualify as a REIT.
These investment guidelines may be changed from time to time by a majority of our REIT subsidiary’s board of directors without the approval of its stockholders.
Disposition Policies
The period our REIT subsidiary holds its investments in real estate-related loans varies depending on the type of asset, interest rates and other factors. Our Manager or its affiliates have developed a well-defined exit strategy for each investment our REIT
subsidiary makes. Our Manager or its affiliates continually perform a hold-sell analysis on each asset in order to determine the optimal time to hold the asset and generate a strong return to our REIT subsidiary’s stockholders. Economic and market conditions may influence our REIT subsidiary to hold investments for different periods of time. Our REIT subsidiary may sell an asset before the end of the expected holding period if it believes that market conditions have maximized its value to us or the sale of the asset would otherwise be in our best interests. Our REIT subsidiary intends to make any such dispositions in a manner consistent with its qualification as a REIT and its desire to avoid being subject to the “prohibited transaction” penalty tax.
Operating and Regulatory Structure
REIT Qualification
Our REIT subsidiary elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”) commencing with its taxable year ended December 31, 2016. We believe that our REIT subsidiary has been organized and have operated in conformity with the requirements for qualification and taxation as a REIT under the Code, and that its manner of operation will enable it to continue to meet the requirements for qualification and taxation as a REIT. To qualify as a REIT, our REIT subsidiary must meet on a continuing basis, through its organization and actual investment and operating results, various requirements under the Code relating to, among other things, the sources of its gross income, the composition and values of its assets, its distribution levels and the diversity of ownership of shares of its stock. If our REIT subsidiary fails to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, it will be subject to U.S. federal income tax at regular corporate rates and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which it failed to qualify as a REIT. Even if our REIT subsidiary qualifies for taxation as a REIT, it may be subject to some U.S. federal, state and local taxes on its income or property. In addition, subject to maintaining our REIT subsidiary’s qualification as a REIT, a portion of its business may be conducted through, and a portion of its income may be earned with respect to, its taxable REIT subsidiaries (“TRSs”), should it decides to form TRSs in the future, which are subject to corporate income tax. Any distributions paid by our REIT subsidiary generally will not be eligible for taxation at the preferential U.S. federal income tax rates that currently apply to certain distributions received by individuals from taxable corporations, unless such distributions are attributable to dividends received by our REIT subsidiary from its TRSs, should it form a TRS in the future.
1940 Act Exclusion
Neither we nor our REIT subsidiary are registered as an investment company under the 1940 Act. If we or our REIT subsidiary were obligated to register as an investment company, we or our REIT subsidiary would have to comply with a variety of substantive requirements under the 1940 Act that impose, among other things:
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limitations on our capital structure or the use of leverage;
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restrictions on specified investments;
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prohibitions on transactions with affiliates; and
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compliance with reporting, record keeping, and other rules and regulations that would significantly change our and our REIT subsidiary’s operations.
We and our REIT subsidiary conduct our operations, and intend to continue to conduct our operations, so that we are not required to register as an investment company under the 1940 Act. Section 3(a)(1)(A) of the 1940 Act defines an investment company as any issuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of the 1940 Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis. Excluded from the term “investment securities,” among other things, are U.S. government securities and securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exemption from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Because we are organized as a holding company and conduct our business primarily through our REIT subsidiary, the value of the “investment securities” held by us must be less than 40% of the value of our total assets on an unconsolidated basis (exclusive of U.S. government securities and cash items). In addition, we conduct our operations so that we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act, as we are not engaged primarily nor do we hold ourselves out as being engaged primarily in the business of investing, reinvesting or trading in securities. Rather, through our REIT subsidiary, we are primarily engaged in the non-investment company businesses of our REIT subsidiary.
Our REIT subsidiary relies on, and certain of its subsidiaries rely on, the exclusion from the definition of an investment company under Section 3(c)(5)(C) of the 1940 Act, or any other exclusions available to our REIT subsidiary and its subsidiaries (other than Section 3(c)(1) or Section 3(c)(7)). Section 3(c)(5)(C) of the 1940 Act is available for entities “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” This exclusion generally requires that at least 55% of our REIT subsidiary’s (and any of its subsidiaries relying on Section 3(c)(5)(C)) portfolio must be comprised of “qualifying real estate” assets and at least 80% of our REIT subsidiary’s (and any of its subsidiaries’, in relying on Section 3(c)(5)(C)) portfolio must be comprised of “qualifying real estate” assets and “real estate-related” assets (and no more than 20% comprised of miscellaneous assets) as determined in accordance with the 1940 Act and the rules and regulations promulgated thereunder. For purposes of the exclusion provided by Section 3(c)(5)(C) of the 1940 Act, our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)) classifies its investments based in large measure on no-action letters issued by the SEC staff and other SEC interpretive guidance and, in the absence of SEC guidance, on our view of what constitutes a “qualifying real estate” asset and a “real estate-related” asset. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)) may face, and a number of these no-action positions were issued more than ten years ago. Pursuant to this guidance, and depending on the characteristics of the specific investments, certain mortgage loans, participations in mortgage loans, mortgage-backed securities, mezzanine loans, joint venture investments, preferred equity and equity securities of other entities may not constitute qualifying real estate assets and therefore investments in these types of assets may be limited. No assurance can be given that the SEC or its staff will concur with our classification of the assets held by our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)). Future revisions to the 1940 Act or further guidance from the SEC or its staff may cause us, our REIT subsidiary, or any of its subsidiaries relying on Section 3(c)(5)(C) to lose our or their exclusion from registration, or force us, our REIT subsidiary, or any of its subsidiaries to re-evaluate our or their portfolios and our or their investment strategy. Such changes may prevent us from operating our business successfully.
Further, in order to maintain an exclusion from registration under the 1940 Act, we may be unable to sell assets that we would otherwise want to sell and may need to sell assets we would otherwise wish to retain. In addition, we may have to acquire additional income or loss generating assets that we might not otherwise have acquired or may have to forgo opportunities to acquire assets that we would otherwise want to acquire and would be important to its strategy.
Although we monitor the portfolio of our REIT subsidiary and its subsidiaries periodically and prior to each acquisition and disposition, our REIT subsidiary or its subsidiaries may not be able to maintain an exclusion from registration as an investment company. If our REIT subsidiary or its subsidiaries were required to register as an investment company, but failed to do so, our REIT subsidiary or its subsidiaries failing to so qualify would be prohibited from engaging in their business, and legal proceedings could be instituted against our REIT subsidiary or any of its subsidiaries failing to so qualify. In addition, the contracts of our REIT subsidiary or any of its subsidiaries failing to so qualify may be unenforceable, and a court could appoint a receiver to take control of our REIT subsidiary or any of its subsidiaries failing to so qualify and liquidate their business.
Emerging Growth Company Status
We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act (the “JOBS Act”) and as such we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, as amended, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and unitholder approval of any golden parachute payments not previously approved. A number of these exemptions are not relevant to us, and in any event we do not currently intend to take advantage of any of these exemptions.
In addition, Section 107 of the JOBS Act provides that an emerging growth company can use the extended transition period provided in Section 13(a) of the Exchange Act for complying with new or revised accounting standards. This permits an emerging growth company to delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to take advantage of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies.
We will remain an “emerging growth company” until the earliest to occur of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1.07 billion, (ii) the date on which we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, (iii) the date on which we have issued more than $1.0 billion in non-convertible debt during the preceding three-year period, and (iv) the end of the year in which the five year anniversary of an initial public offering of our units occurs.
Term and Liquidity
Our amended and restated operating agreement provides that our existence will continue until December 31, 2023, unless sooner terminated. However, we expect that prior to such date we will consummate a liquidity transaction, which may include an orderly liquidation of our assets or an alternative liquidity event such as a sale of our company or an initial public offering and listing of our REIT subsidiary’s shares of common stock on a national securities exchange. Our Manager would pursue an alternative liquidity event only if it believes such a transaction would be in the best interests of our members.
Competition
We compete with REITs, numerous regional and community banks, specialty finance companies, savings and loan associations and other entities, and we expect that others may be organized in the future. The effect of the existence of additional REITs and other institutions may be increased competition for the available supply of our targeted assets suitable for purchase, which may cause the price for such assets to rise.
In the face of this competition, we expect to have access to our Manager’s professionals and their industry expertise, which may provide us with a competitive advantage in sourcing transactions and help us assess origination and acquisition risks and determine appropriate pricing for potential assets. The more conservative underwriting standards used by many large commercial banks and traditional providers of commercial real estate capital following the 2008 downturn has, and we believe, will continue to constrain the lending capacity of these institutions. However, we may not be able to achieve our business goals or expectations due to the competitive risks that we face. For additional information concerning these competitive risks, see “Item 1A.
Item 1A. Risk Factors.
Investing in our units involves a high degree of risk. Investors should carefully consider the following risk factors and all other information contained in this annual report on Form 10-K. If any of the following risks occur, our business, financial condition, liquidity and results of operations could be materially and adversely affected. In that case, the value of our units could decline, and members may lose some or all of their investment. Some statements in this section constitute forward-looking statements. See “Forward-Looking Statements.”
Risks Related to Our Business
Changes in national, regional or local economic, demographic or real estate market conditions may adversely affect our results of operations, the value of our assets and returns to our investors.
We are subject to risks incident to the ownership of real estate-related assets including: changes in national, regional or local economic, demographic or real estate market conditions; changes in supply of, or demand for, similar properties in an area;
increased competition for real estate assets targeted by our investment strategy; bankruptcies, financial difficulties or lease defaults by property owners and tenants; changes in interest rates and availability of financing; and changes in government rules, regulations and fiscal policies, including changes in tax, real estate, environmental and zoning laws. Our assets are also subject to the risk of significant adverse changes in financial market conditions that can result in a deleveraging of the global financial system and the forced sale of large quantities of mortgage-related and other financial assets. Concerns over economic recession, geopolitical issues, including events such as the United Kingdom’s decision to exit from the European Union, unemployment, the availability and cost of finance, or a prolonged government shutdown may contribute to increased volatility and diminished expectations for the economy and markets, which could result in an increase in mortgage defaults or a decline in the value of our assets. In addition, any increase in mortgage defaults in the residential market may have a negative impact on the credit markets generally as well as on economic conditions generally. We do not know whether the values of the property securing our real estate-related loans will remain at the levels existing on the dates of origination of such loans, and we are unable to predict future changes in national, regional or local economic, demographic or real estate market conditions. These conditions, or others we cannot predict, may adversely affect the value of our assets, our results of operations, cash flow and returns to our investors.
The lack of liquidity of our assets may adversely affect our business, including our ability to value and sell our assets.
A portion of the real estate-related loans and other assets we originate or acquire may be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly-traded securities. The illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less value than the value at which we have previously recorded our assets. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.
Our REIT subsidiary’s investments are selected by our Manager or its affiliates and our unitholders will not have input into investment decisions.
Pursuant to the terms of a management agreement between our REIT subsidiary and the REIT Manager, the REIT Manager is responsible for, among other services, managing the investment and reinvestment of our REIT subsidiary’s assets, subject to the oversight and supervision of the board of directors of our REIT subsidiary. Our unitholders will not have input into investment decisions. This will increase the uncertainty, and thus the risk, of investing in our units, as we may make investments with which you may not agree. Our Manager or its affiliates intends to conduct due diligence with respect to each investment and suitable investment opportunities may not be immediately available. The failure of our Manager or its affiliates to find investments that meet our investment criteria in sufficient time or on acceptable terms could result in unfavorable returns, could cause a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our unitholders, and could cause the value of our units to decline. Even if investment opportunities are available, there can be no assurance that the due diligence processes of our Manager or its affiliates will uncover all relevant facts or that any particular investment will be successful.
From time to time, before appropriate real estate-related investments can be identified, our Manager or its affiliates may choose to have us invest in interest-bearing, short-term investments, including money market accounts and/or funds, that are consistent with our REIT subsidiary’s intention to maintain its qualification as a REIT. These short-term, non-real estate-related investments, if any, are expected to provide a lower net return than we will seek to achieve from investments in real estate-related loans and other commercial real estate assets. Furthermore, when our Manager or its affiliates does identify suitable real estate-related loans and other commercial real estate assets that are the types of assets which we target, you will be unable to influence the decision of our Manager or its affiliates ultimately to invest in, or refrain from investing in, such assets.
Our Manager’s or its affiliates’ due diligence of potential real estate-related loans and other commercial real estate assets may not reveal all of the liabilities associated with such assets and may not reveal other weaknesses in our assets, which could lead to investment losses.
Before originating or acquiring a financing, our Manager or its affiliates calculates the level of risk associated with the real estate-related loans and other commercial real estate assets to be originated or acquired based on several factors which include the following: top-down reviews of both the current macroeconomic environment generally and the real estate and commercial real estate loan market specifically; detailed evaluation of the real estate industry and its sectors; bottom-up reviews of each individual investment’s attributes and risk/reward profile relative to the macroeconomic environment; and quantitative cash flow analysis and impact of the potential investment on our portfolio. In making the assessment and otherwise conducting customary due diligence, we employ standard documentation requirements and require appraisals prepared by local independent third-party appraisers selected by us. Additionally, we seek to have borrowers or sellers provide representations and warranties on loans we originate or acquire, and if we are unable to obtain representations and warranties, we factor the increased risk into the price we
pay for such loans. Despite our review process, there can be no assurance that our due diligence process will uncover all relevant facts or that any investment will be successful.
If our Manager or its affiliates underestimates the borrower’s credit analysis or originates loans by using an exception to their loan underwriting guidelines, we may experience losses.
Our Manager or its affiliates values our real estate-related loans based on an initial credit analysis and the investment’s expected risk-adjusted return relative to other comparable investment opportunities available to us, taking into account estimated future losses on the loans, and the estimated impact of these losses on expected future cash flows. The loss estimates may not prove accurate, as actual results may vary from estimates. In the event that our Manager or its affiliates underestimates the losses relative to the price we pay for a particular investment, we may experience losses with respect to such investment.
Further, from time to time and in the ordinary course of business, our Manager or its affiliates may make exceptions to our predetermined loan underwriting guidelines. Loans originated with exceptions may result in a higher number of delinquencies and defaults, which could have a material and adverse effect on our business, results of operations and financial condition.
Deficiencies in appraisal quality in the mortgage loan origination process may result in increased principal loss severity.
During the loan underwriting process, appraisals are generally obtained on the collateral underlying each prospective loan. The quality of these appraisals may vary widely in accuracy and consistency. The appraiser may feel pressure from the broker or lender to provide an appraisal in the amount necessary to enable the originator to make the loan, whether or not the value of the property justifies such an appraised value. Inaccurate or inflated appraisals may result in an increase in the severity of losses on the loans, which could have a material and adverse effect on our business, results of operations and financial condition.
Our Manager or its affiliates utilizes analytical models and data in connection with the valuation of our real estate-related loans and other commercial real estate assets, and any incorrect, misleading or incomplete information used in connection therewith would subject us to potential risks.
As part of the risk management process our Manager or its affiliates uses detailed proprietary models, including loan level non-performing loan models, to evaluate collateral liquidation timelines and price changes by region, along with the impact of different loss mitigation plans. Additionally, our Manager or its affiliates uses information, models and data supplied by third parties. Models and data are used to value potential targeted assets. 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, our Manager or its affiliates may be induced to buy certain targeted assets at prices that are too high, to sell certain other assets at prices that are too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.
Changes in interest rates could adversely affect the demand for our target loans, the value of our loans, CMBS, and other real-estate debt or equity assets and the availability and yield on our targeted assets.
We invest in real estate-related loans and other commercial real estate assets, which are subject to changes in interest rates. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Rising interest rates generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans originated may affect the volume of our targeted assets available to us, which could adversely affect our ability to originate and acquire assets that satisfy our objectives. Rising interest rates may also cause our targeted assets that were issued prior to an interest rate increase to provide yields that are below prevailing market interest rates. If rising interest rates cause us to be unable to originate or acquire a sufficient volume of our targeted assets with a yield that is above our borrowing cost, our ability to satisfy our objectives and to generate income and make distributions may be materially and adversely affected. Conversely, if interest rates decrease, we will be adversely affected to the extent that real estate-related loans are prepaid, because we may not be able to make new loans at the previously higher interest rate.
The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because our loans and CMBS assets generally will bear, on average, interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income and the fair market value of our net assets. Additionally, to the extent cash flows from loans and CMBS assets that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new loans and CMBS assets and available borrowing rates may decline, which would likely
decrease our net income. It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses.
The values of our loans and CMBS assets may decline without any general increase in interest rates for a number of reasons, such as increases or expected increases in defaults, or increases or expected increases in voluntary prepayments for those loans and CMBS assets that are subject to prepayment risk or widening of credit spreads.
In addition, in a period of rising interest rates, our operating results will depend in large part on the difference between the income from our assets and our financing costs. We anticipate that, in most cases, the income from such assets will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income.
Uncertainty regarding LIBOR may adversely impact our assets and borrowings.
In July 2017, the U.K. Financial Conduct Authority announced that it would cease to compel banks to participate in setting the London Interbank Offered Rate (“LIBOR”) as a benchmark by the end of 2021 (the “LIBOR Transition Date”). It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. The Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions convened by the U.S. Federal Reserve, has recommended the Secured Overnight Financing Rate (“SOFR”) as a more robust reference rate alternative to U.S. dollar LIBOR. SOFR is calculated based on overnight transactions under repurchase agreements, backed by Treasury securities. SOFR is observed and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it will be a rate that does not take into account bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. Whether or not SOFR attains market traction as a LIBOR replacement tool remains in question. As such, the future of LIBOR at this time is uncertain.
Our REIT subsidiary’s master repurchase agreement and its credit facility, as well as certain of its floating rate loan assets, are, and other future financings may be, linked to this benchmark rate. Before the LIBOR Transition Date, our REIT subsidiary may need to amend the debt and loan agreements that utilize LIBOR as a factor in determining the interest rate based on a new standard that is established, if any. However, these efforts may not be successful in mitigating the legal and financial risk from changing the reference rate in our legacy agreements. In addition, any resulting differences in interest rate standards among our REIT subsidiary’s assets and its financing arrangements may result in interest rate mismatches between its assets and the borrowings used to fund such assets.
Potential changes, or uncertainty related to such potential changes, may also adversely affect the market for LIBOR-based loans, including our portfolio of LIBOR-indexed, floating-rate loans, or the cost of our borrowings. In addition, changes or reforms to the determination or supervision of LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR, which could have an adverse impact on the market for LIBOR-based loans, including the value of the LIBOR-indexed, floating-rate loans in our REIT subsidiary’s portfolio, or the cost of its borrowings. There is no guarantee that a transition from LIBOR to an alternative will not result in financial market disruptions, significant increases in benchmark rates, or borrowing costs to borrowers, any of which could have an adverse effect on our business, results of operations, financial condition, and the market price of our units.
Future recessions, downturns, disruptions or instability could have a materially adverse effect on our business.
From time to time, the global capital markets may experience periods of disruption and instability, which could cause disruptions in liquidity in the debt capital markets, significant write-offs in the financial services sector, the re-pricing of credit risk in the broadly syndicated credit market and the failure of major financial institutions. Despite actions of U.S. and foreign governments, these events could contribute to worsening general economic conditions that materially and adversely impact the broader financial and credit markets and reduce the availability of debt and equity capital for the market as a whole and financial services firms in particular.
Deterioration of economic and market conditions in the future could negatively impact credit spreads as well as our ability to obtain financing, particularly from the debt markets.
New entrants in the market for commercial loan originations and acquisitions could adversely impact our ability to originate and acquire real estate-related loans at attractive risk-adjusted returns.
New entrants in the market for commercial loan originations and acquisitions could adversely impact our ability to execute our investment strategy on terms favorable to us. In originating and acquiring our targeted assets, we may compete with other REITs, numerous regional and community banks, specialty finance companies, savings and loan associations, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders and other entities, and we expect that others may be organized in the future. The effect of the existence of additional REITs and other institutions may be increased competition for the available supply of assets suitable for investment by us, which may cause the price for such assets to rise, which may limit our ability to generate desired returns. Additionally, origination of our target loans by our competitors may increase the availability of such loans which may result in a reduction of interest rates on these loans. Some competitors may have a lower cost of funds and access to funding sources that may not be available to us. Many of our competitors are not subject to the operating constraints associated with REIT tax compliance or maintenance of an exclusion or exemption from the 1940 Act. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of real estate-related loans and establish more relationships than us.
We cannot assure you that the competitive pressures we may face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, desirable investments in our targeted assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment objectives.
Our loans are dependent on the ability of the commercial property owner to generate net income from operating the property, which may result in the inability of such property owner to repay a loan, as well as the risk of foreclosure.
Our loans may be secured by office, retail, mixed use, commercial or warehouse properties, and are subject to risks of delinquency, foreclosure and of loss that may be greater than similar risks associated with loans made on the security of single-family residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be adversely affected by, among other things:
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tenant mix;
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success of tenant businesses;
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property management decisions;
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property location, condition and design;
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competition from comparable types of properties;
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changes in national, regional or local economic conditions and/or specific industry segments;
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declines in regional or local real estate values;
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declines in regional or local rental or occupancy rates;
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increases in interest rates, real estate tax rates and other operating expenses;
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costs of remediation and liabilities associated with environmental conditions;
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the potential for uninsured or underinsured property losses;
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changes in governmental laws and regulations, including fiscal policies, zoning ordinances and environmental legislation and the related costs of compliance; and
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acts of God, terrorism, social and political unrest, armed conflict, geopolitical events and civil disturbances.
In the event of any default under a mortgage loan held directly by us, we bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loan, which could have a material adverse effect on our cash flow from operations and limit amounts available for distribution to our members. In the event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure can be an expensive and lengthy process, and foreclosing on certain properties where we directly hold the mortgage loan and the borrower’s default under the mortgage loan is continuing could result in actions that could be costly to our operations, in addition to having a substantial negative effect on our anticipated return on the foreclosed mortgage loan. If property securing or underlying loans become real estate owned as a result of foreclosure, we bear the risk of not being able to sell the property and recovering our investment and of being exposed to the risks attendant to the ownership of real property.
Our loan portfolio may at times be concentrated in certain property types or secured by properties concentrated in a limited number of geographic areas, which increases our exposure to economic downturn with respect to those property types or geographic locations.
We are not required to observe specific diversification criteria. Therefore, our portfolio of assets may, at times, be concentrated in certain property types that are subject to higher risk of foreclosure, or secured by properties concentrated in a limited number of geographic locations.
Our REIT subsidiary’s loans are concentrated in California, Georgia, New York, North Carolina and Washington representing approximately 37.4%, 22.5%, 19.3%, 10.3% and 4.9% of its net loan portfolio as of December 31, 2019, respectively. If economic conditions in these or in any other state in which we have a significant concentration of borrowers were to deteriorate, such adverse conditions could have a material and adverse effect on our business by reducing demand for new financings, limiting the ability of customers to repay existing loans and impairing the value of our real estate collateral and real estate owned properties.
In addition, from time to time, there have been proposals to base property taxes on commercial properties on their current market value, without any limit based on purchase price. In California, pursuant to an existing state law commonly referred to as Proposition 13, properties are reassessed to market value only at the time of change in ownership or completion of construction, and thereafter, annual property reassessments are limited to 2% of previously assessed values. As a result, Proposition 13 generally results in significant below-market assessed values over time. From time to time, including recently, lawmakers and political coalitions have initiated efforts to repeal or amend Proposition 13 to eliminate its application to commercial and industrial properties. If successful, a repeal of Proposition 13 could substantially increase the assessed values and property taxes for our customers in California which in turn could limit their ability to borrow funds.
To the extent that our portfolio is concentrated in any region, or by type of property, downturns relating generally to such region, type of borrower or security may result in defaults on a number of our assets within a short time period, which may reduce our net income and the value of our units and accordingly reduce our ability to pay dividends to our members.
We expect that a significant portion of the mortgage loans invested in by us may be development mortgage loans on infill land, which are speculative in nature.
We expect that a significant portion of our REIT subsidiary’s assets may be mortgage loans for the development of real estate, which will initially be secured by infill land. These types of loans are speculative, because:
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until improvement, the property may not generate separate income for the borrower to make loan payments;
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the completion of planned development may require additional development financing by the borrower, which may not be available; and
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there is no assurance that we will be able to sell unimproved infill land promptly if we are forced to foreclose upon it.
If in fact the land is not developed, the borrower may not be able to refinance the loan and, therefore, may not be able to make the balloon payment when due. If a borrower defaults and we foreclose on the collateral, we may not be able to sell the collateral for the amount owed to us by the borrower. In calculating our loan-to-value ratios for the purpose of determining maximum borrowing capacity, we use the estimated value of the property at the time of completion of the project, which increases the risk
that, if we foreclose on the collateral before it is fully developed, we may not be able to sell the collateral for the amount owed to us by the borrower.
Loans to small businesses involve a high degree of business and financial risk, which can result in substantial losses that would adversely affect our business, results of operation and financial condition.
Our operations and activities include loans to small, privately owned businesses to purchase real estate used in their operations or by investors seeking to acquire small office, retail, mixed use or warehouse properties. Additionally, such loans are also often accompanied by personal guarantees. Often, there is little or no publicly available information about these businesses. Accordingly, we must rely on our own due diligence to obtain information in connection with our investment decisions. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by banks. A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or other negative local or more general economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan. In addition, small businesses typically depend on the management talents and efforts of one person or a small group of people for their success. The loss of services of one or more of these persons could have a material and adverse impact on the operations of the small business. Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need additional capital to expand or compete. These factors may have an impact on loans involving such businesses. Loans to small businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses.
Our REIT subsidiary’s investments may include subordinated tranches of CMBS, which are subordinate in right of payment to more senior securities.
Our REIT subsidiary’s investments may include subordinated tranches of CMBS, which are subordinated classes of securities in a structure of securities collateralized by a pool of assets consisting primarily of commercial loans and, accordingly, are the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Additionally, estimated fair values of these subordinated interests tend to be more sensitive to changes in economic conditions than more senior securities. As a result, such subordinated interests generally are not actively traded and may not provide holders thereof with liquid investments.
Any credit ratings assigned to our loans and CMBS assets will be subject to ongoing evaluations and revisions and we cannot assure you that those ratings will not be downgraded.
Some of our loan and CMBS assets may be rated by Moody’s Investors Service, Standard & Poor’s or Fitch Ratings. Any credit ratings on our loans and CMBS assets are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. Rating agencies may assign a lower than expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our loans and CMBS assets in the future. In addition, we may originate or acquire assets with no rating or with below investment grade ratings. If the rating agencies take adverse action with respect to the rating of our loans and CMBS assets or if our unrated assets are illiquid, the value of these loans and CMBS assets could significantly decline, which would adversely affect the value of our investment portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt service obligations to us.
The mezzanine loans, preferred equity and other subordinated loans in which we invest involve greater risks of loss than senior loans secured by income-producing commercial properties.
We invest in mezzanine loans that take the form of subordinated loans secured by second mortgages on the underlying real property or loans secured by a pledge of the ownership interests of the entity owning the real property. These types of investments involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property because the investment may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to such loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our investment. In addition, mezzanine loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the real property and increasing the risk of loss of principal.
Our investments in B-notes are generally subject to losses. The B-notes in which we may invest may be subject to additional risks relating to the privately negotiated structure and terms of the transaction, which may result in losses to us.
As part of our whole loan origination platform, we may retain from whole loans we originate or acquire, subordinate interests referred to as B-notes. B-notes are commercial real estate loans secured by a first mortgage on a single large commercial property or group of related properties and subordinated to a senior interest, referred to as an A-note. As a result, if a borrower defaults, there may not be sufficient funds remaining for B-note owners after payment to the A-note owners. In addition, our rights to control the process following a borrower default may be subject to the rights of A-note owners whose interests may not be aligned with ours. B-notes reflect similar credit risks to comparably rated CMBS. However, since each transaction is privately negotiated, B-notes can vary in their structural characteristics and risks. For example, the rights of holders of B-notes to control the process following a borrower default may be limited in certain investments. We cannot predict the terms of each B-note investment. Significant losses related to our B-notes would result in operating losses for us and may limit our ability to make distributions to our members.
Any disruption in the availability and/or functionality of our technology infrastructure and systems and any failure or our security measures related to these systems could adversely impact our business.
Our ability to originate and acquire real estate-related loans and manage any related interest rate risks and credit risks is critical to our success and is highly dependent upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. For example, we rely on our proprietary database to track and maintain all loan performance and servicing activity data for loans in our portfolio. This data is used to manage the portfolio, track loan performance, and develop and execute asset disposition strategies. In addition, this data is used to evaluate and price new investment opportunities. If we lost access to our loan servicing activity data or other important business information due to a network or utility failure, our ability to effectively manage our business could be impaired.
Some of these systems are located at our facility and some are maintained by third party vendors. Any significant interruption in the availability and functionality of these systems could harm our business. In the event of a systems failure or interruption by our third-party vendors, we will have limited ability to affect the timing and success of systems restoration. If such systems failures or interruptions continue for a prolonged period of time, there could be a material and adverse impact on our business, results of operations and financial condition.
In addition, some of our security measures may not effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or misappropriate valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.
Cybersecurity risk and cyber incidents may adversely affect our business by causing a disruption to our operations, a compromise or corruption of our confidential information and/or damage to our business relationships, all of which could negatively impact our financial results.
A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of our information resources. These incidents may be an intentional attack or an unintentional event and could involve gaining unauthorized access to our information systems for purposes of misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. The result of these incidents may include disrupted operations, misstated or unreliable financial data, liability for stolen assets or information, increased cybersecurity protection and insurance cost, litigation and damage to our relationships. As our reliance on technology has increased, so have the risks posed to our information systems both internal and those provided by our Manager, the REIT Manager, Terra Capital Partners, its affiliates and third-party service providers. With respect to cybersecurity risk oversight, our REIT subsidiary’s board of directors and its audit committee receive periodic reports and updates from management on the primary cybersecurity risks facing us and the Manager and its affiliates and the measures the Manager and its affiliates are taking to mitigate such risks. In addition to such periodic reports, our REIT subsidiary’s board of directors and its audit committee receive updates from management as to changes to us and the Manager and its affiliates’ cybersecurity risk profile or certain newly identified risks. However, these measures, as well as our increased awareness of the nature and extent of a risk of a cyber incident, do not guarantee that our financial results, operations or confidential information will not be negatively impacted by such an incident.
Risks Related to Regulation
Returns on our real estate-related loans may be limited by regulations.
Our loan investments may be subject to regulation by federal, state and local authorities and subject to various laws and judicial and administrative decisions. We may determine not to make or invest in real estate-related loans in any jurisdiction in which we believe we have not complied in all material respects with applicable requirements, which could reduce the amount of income we would otherwise receive.
The increasing number of proposed U.S. federal, state and local laws may affect certain mortgage-related assets in which we invest and could materially increase our cost of doing business.
Various bankruptcy legislation has been proposed that, among other provisions, could allow judges to modify the terms of residential mortgages in bankruptcy proceedings, could hinder the ability of the servicer to foreclose promptly on defaulted mortgage loans or permit limited assignee liability for certain violations in the mortgage loan origination process, any or all of which could adversely affect our business or result in us being held responsible for violations in the mortgage loan origination process even where we were not the originator of the loan. We do not know what impact this type of legislation, which has been primarily, if not entirely, focused on residential mortgage originations, would have on the commercial loan market. We are unable to predict whether U.S. federal, state or local authorities, or other pertinent bodies, will enact legislation, laws, rules, regulations, handbooks, guidelines or similar provisions that will affect our business or require changes in our practices in the future, and any such changes could materially and adversely affect our cost of doing business and profitability.
Failure to obtain or maintain required approvals and/or state licenses necessary to operate our mortgage-related activities may adversely impact our investment strategy.
We may be required to obtain and maintain various approvals and/or licenses from federal or state governmental authorities, government sponsored entities or similar bodies in connection with some or all of our activities. There is no assurance that we can obtain and maintain any or all of the approvals and licenses that we desire or that we will avoid experiencing significant delays in seeking such approvals and licenses. Furthermore, we may be subject to various disclosure and other requirements to obtain and maintain these approvals and licenses, and there is no assurance that we will satisfy those requirements. Our failure to obtain or maintain licenses will restrict our options and ability to engage in desired activities, and could subject us to fines, suspensions, terminations and various other adverse actions if it is determined that we have engaged without the requisite approvals or licenses in activities that required an approval or license, which could have a material and adverse effect on our business, results of operation and financial condition.
The impact of financial reform legislation and legislation promulgated thereunder on us is uncertain.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) enacted in 2010 instituted a wide range of reforms that will have an impact on all financial institutions. Many of the requirements called for in the Dodd-Frank Act will be implemented over time, most of which will be subject to implementing regulations over the course of several years. Many of these regulations have yet to be promulgated or are only recently promulgated. In February 2017, President Donald J. Trump signed an executive order for a broad review of federal regulation of the U.S. financial system by the Secretary of the Treasury, in consultation with the heads of the member agencies of the Financial Stability Oversight Council, a panel comprising top U.S. financial regulators. In May 2018, the Congress passed, and President Trump signed, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “EGRRCPA”), which among other things, modifies certain provisions of the Dodd-Frank Act related to mortgage lending, consumer protection, regulatory relief for large banks, regulatory relief for community banks and regulatory relief in securities markets. The EGRRCPA will relax or eliminate so-called “enhanced regulation” of banks falling into certain ranges of asset value and will impact the application of the Volcker Rule and the Basel III guidelines as to certain banks. Specifically, the EGRRCPA relaxes (or eliminates) certain risk-based capital and leverage requirements for community banks with less than $10 billion in assets that maintain a certain “community bank leverage ratio” that bank regulators are directed to develop, but the impact and effect of the foregoing on market liquidity is uncertain.
In addition, the substance of regulatory supervision may be influenced through the appointment of individuals to the Federal Reserve Board and other financial regulatory bodies. Measures focused on deregulation of the U.S. financial services industry may, among other things, decrease the restrictions on banks and other financial institutions and allow them to compete with us for investment opportunities that were previously not available to them. Measures focused on deregulation of the U.S. financial services industry may have the effect of increasing competition for our business. Increased competition from banks and other financial institutions in the credit markets could have the effect of reducing credit spreads, which may adversely affect our revenues.
Given the uncertainty associated with financial reform legislation, including the implementation of the Dodd-Frank Act, the full impact such requirements will have on our business, results of operations or financial condition is unclear. The changes resulting from the Dodd-Frank Act, the EGRRCPA, and other legislative actions may require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements or address resulting changes in the mortgage loan market. Failure to comply with any such laws, regulations or principles, or changes thereto, or to adapt to any changes in the marketplace, may negatively impact our business, results of operations and financial condition. While we cannot predict what effect any changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to us and our unitholders.
Accounting rules for certain of our transactions are highly complex and involve significant judgment and assumptions, and changes in such rules, accounting interpretations or our assumptions could adversely impact our ability to timely and accurately prepare our consolidated financial statements.
We are subject to Financial Accounting Standards Board (“FASB”) interpretations that can result in significant accounting changes that could have a material and adverse impact on our results of operations and financial condition. Accounting rules for financial instruments, including the origination, acquisition and sales or securitization of mortgage loans, derivatives, investment consolidations and other aspects of our anticipated operations are highly complex and involve significant judgment and assumptions. For example, our estimates and judgments are based on a number of factors, including projected cash flows from the collateral securing our loans, the likelihood of repayment in full at the maturity of a loan, potential for a loan refinancing opportunity in the future and expected market discount rates for varying property types. These complexities could lead to a delay in the preparation of financial information and the delivery of this information to our members.
Changes in accounting rules, interpretations or our assumptions could also undermine our ability to prepare timely and accurate financial statements, which could result in a lack of investor confidence in our financial information and could materially and adversely affect the market price of our units.
We are an “emerging growth company” and a “smaller reporting company” and we cannot be certain if the reduced reporting requirements applicable to emerging growth companies or smaller reporting companies will make an investment in our units less attractive to investors. In particular, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act.
We are an “emerging growth company” as defined in the JOBS Act. We will remain an “emerging growth company” until the earliest to occur of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1.07 billion, (ii) the date on which we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, (iii) the date on which we have issued more than $1.0 billion in non-convertible debt during the preceding three-year period, and (iv) the end of the year in which the five year anniversary of an initial public offering of our units occurs. We may take advantage of exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements.
Section 404 of the Sarbanes-Oxley Act requires annual management assessments of the effectiveness of our internal control over financial reporting, and generally requires in the same report a report by our independent registered public accounting firm on the effectiveness of our internal control over financial reporting. Under the JOBS Act, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act until we are no longer an “emerging growth company.”
In addition, we are also a smaller reporting company, as defined in Rule 12b-2 under the Exchange Act. In the event that we are still considered a smaller reporting company at such time as we cease being an emerging growth company, the disclosure we will be required to provide in our SEC filings will increase, but will still be less than it would be if we were not considered either an emerging growth company or a smaller reporting company.
Rule 12b-2 of the Exchange Act defines a “smaller reporting company” as an issuer that is not an investment company, an asset-backed issuer or a majority-owned subsidiary of a parent that is not a smaller reporting company and that:
(1)
had a public float of less than $250 million; or
(2)
had annual revenues of less than $100 million during the most recently completed fiscal year for which audited financial statements are available and either had no public float or a public float of less than $700 million.
Similar to emerging growth companies, smaller reporting companies are able to provide simplified executive compensation disclosures in their filings, and have certain other decreased disclosure obligations in their SEC filings, including, among other things, being required to provide only two years of audited financial statements in annual reports.
To the extent we take advantage of some or all of the reduced reporting requirements applicable to emerging growth companies or smaller reporting companies, an investment in our units may be less attractive to investors.
We may be exposed to environmental liabilities with respect to properties to which we take title, which may in turn decrease the value of the underlying properties.
In the course of our business, we may take title to real estate, and, as a result, we could be subject to environmental liabilities with respect to these properties. In such a circumstance, we may be held liable to a governmental entity or to third-parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity, and results of operations could be materially and adversely affected. In addition, an owner or operator of real property may become liable under various federal, state and local laws, for the costs of removal of certain hazardous substances released on its property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. The presence of hazardous substances may adversely affect an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of an underlying property becomes liable for removal costs, the ability of the owner to make debt payments may be reduced, which in turn may adversely affect the value of the relevant mortgage-related assets held by us.
Insurance on the properties underlying our loans may not adequately cover all losses and uninsured losses could materially and adversely affect us.
Generally, our borrowers will be responsible for the costs of insurance coverage for the properties we lease, including for casualty, liability, fire, floods, earthquakes, extended coverage and rental or business interruption loss. However, there are certain risks, such as losses from terrorism, that are not generally insured against, or that are not generally fully insured against, because it is not deemed economically feasible or prudent to do so. In addition, changes in the cost or availability of insurance could expose us to uninsured casualty losses. Under certain circumstances insurance proceeds may not be sufficient to restore our economic position with respect to an affected property, and we could be materially and adversely affected. Furthermore, we do not have any insurance designated to limit any losses that we may incur as a result of known or unknown environmental conditions which are not caused by an insured event.
In addition, certain of the properties underlying our loans may be located in areas that are more susceptible to, and could be significantly affected by, natural disasters that could cause significant damage to the properties. If we or our borrowers experience a loss, due to such natural disasters or other relevant factors, that is uninsured or that exceeds policy limits, we could incur significant costs, which could materially and adversely affect our business, financial condition, liquidity and results of operations.
Maintenance of our 1940 Act exclusion imposes limits on our operations.
Neither we nor our REIT subsidiary are registered as an investment company under the 1940 Act. If we or our REIT subsidiary were obligated to register as an investment company, we or our REIT subsidiary would have to comply with a variety of substantive requirements under the 1940 Act that impose, among other things:
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limitations on our capital structure and the use of leverage;
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restrictions on specified investments;
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prohibitions on transactions with affiliates; and
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compliance with reporting, record keeping, and other rules and regulations that would significantly change our and our REIT subsidiary’s operations.
We and our REIT subsidiary conduct our operations, and intend to continue to conduct our operations, so that we are not required to register as an investment company under the 1940 Act. Section 3(a)(1)(A) of the 1940 Act defines an investment company as any issuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of the 1940 Act defines an investment company as any issuer that is engaged or proposes to engage
in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis. Excluded from the term “investment securities,” among other things, are U.S. government securities and securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exemption from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Because we are organized as a holding company and conduct our business primarily through our REIT subsidiary, the value of the “investment securities” held by us must be less than 40% of the value of our total assets on an unconsolidated basis (exclusive of U.S. government securities and cash items). In addition, we conduct our operations so that we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act, as we are not engaged primarily nor do we hold ourselves out as being engaged primarily in the business of investing, reinvesting or trading in securities. Rather, through our REIT subsidiary, we are primarily engaged in the non-investment company businesses of our REIT subsidiary.
Our REIT subsidiary relies on, and certain of its subsidiaries rely on, the exclusion from the definition of an investment company under Section 3(c)(5)(C) of the 1940 Act, or any other exclusions available to our REIT subsidiary and its subsidiaries (other than Section 3(c)(1) or Section 3(c)(7)). Section 3(c)(5)(C) of the 1940 Act is available for entities “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” This exclusion generally requires that at least 55% of our REIT subsidiary’s (and any of its subsidiaries relying on Section 3(c)(5)(C)) portfolio must be comprised of “qualifying real estate” assets and at least 80% of our REIT subsidiary’s (and any of its subsidiaries’, in relying on Section 3(c)(5)(C)) portfolio must be comprised of “qualifying real estate” assets and “real estate-related” assets (and no more than 20% comprised of miscellaneous assets) as determined in accordance with the 1940 Act and the rules and regulations promulgated thereunder. For purposes of the exclusion provided by Section 3(c)(5)(C) of the 1940 Act, our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)) classifies its investments based in large measure on no-action letters issued by the SEC staff and other SEC interpretive guidance and, in the absence of SEC guidance, on our view of what constitutes a “qualifying real estate” asset and a “real estate-related” asset. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)) may face, and a number of these no-action positions were issued more than ten years ago. Pursuant to this guidance, and depending on the characteristics of the specific investments, certain mortgage loans, participations in mortgage loans, mortgage-backed securities, mezzanine loans, joint venture investments, preferred equity and equity securities of other entities may not constitute qualifying real estate assets and therefore investments in these types of assets may be limited. No assurance can be given that the SEC or its staff will concur with our classification of the assets held by our REIT subsidiary (and any of its subsidiaries relying on Section 3(c)(5)(C)). Future revisions to the 1940 Act or further guidance from the SEC or its staff may cause us, our REIT subsidiary, or any of its subsidiaries relying on Section 3(c)(5)(C) to lose our or their exclusion from registration, or force us, our REIT subsidiary, or any of its subsidiaries to re-evaluate our or their portfolios and our or their investment strategy. Such changes may prevent us from operating our business successfully.
Further, in order to maintain an exclusion from registration under the 1940 Act, we may be unable to sell assets that we would otherwise want to sell and may need to sell assets we would otherwise wish to retain. In addition, we may have to acquire additional income or loss generating assets that we might not otherwise have acquired or may have to forgo opportunities to acquire assets that we would otherwise want to acquire and would be important to its strategy.
Although we monitor the portfolio of our REIT subsidiary and its subsidiaries periodically and prior to each acquisition and disposition, our REIT subsidiary or its subsidiaries may not be able to maintain an exclusion from registration as an investment company. If our REIT subsidiary or its subsidiaries were required to register as an investment company, but failed to do so, our REIT subsidiary or its subsidiaries failing to so qualify would be prohibited from engaging in their business, and legal proceedings could be instituted against our REIT subsidiary or any of its subsidiaries failing to so qualify. In addition, the contracts of our REIT subsidiary or any of its subsidiaries failing to so qualify may be unenforceable, and a court could appoint a receiver to take control of our REIT subsidiary or any of its subsidiaries failing to so qualify and liquidate their business.
Risks Related to Our Management and Our Relationship With Our Manager and its Affiliates
We rely entirely on our Manager or its affiliates and the directors, employees and officers of our Manager or its affiliates for our day-to-day operations, and the directors, officers and employees of our Manager or its affiliates will face competing demands to their allocation of time and investment opportunities.
We have no employees and do not intend to have employees in the future. We rely entirely on the management team and employees of our Manger and its affiliates for our day-to-day operations, and our Manager and its affiliates have significant discretion as to the implementation of our operating policies and strategies. Our success depends substantially on the efforts and abilities of the directors and officers of our Manager and its affiliates, including Messrs. Uppal, Pinkus and Cooperman and our REIT Manager’s debt finance professionals. If our Manager or its affiliates were to lose the benefit of the experience, efforts and
abilities of any of these individuals at the expiration of their employment agreement or otherwise, our operating results could suffer.
Certain other companies managed by our Manager or its affiliates, which have investment objectives similar to ours, also rely on many of these same officers and professionals. Our Manager or its affiliates may face conflicts of interest if we enter into transactions with an affiliate. In these circumstances, the persons who serve as the management team of our Manager or its affiliates may have a fiduciary responsibility to both us and the affiliate. Transactions between us and such affiliates will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated parties, possibly causing us to enter into a transaction that is not in our best interest and that may negatively impact our performance. Further, many investment opportunities that are suitable for us may also be suitable for other affiliates advised by our Manager or its affiliates. When the officers of our Manager or its affiliates identify an investment opportunity that may be suitable for us as well as an affiliated entity, they, in their sole discretion, will first evaluate the investment objectives of each program to determine if the opportunity is suitable for each program. If the proposed investment is appropriate for more than one program, our Manager or its affiliates will then evaluate the portfolio of each program, in terms of diversity of geography, underlying property type, tenant concentration and borrower, to determine if the investment is most suitable for one program in order to create portfolio diversification. If such analysis is not determinative, our Manager or its affiliates will allocate the investment to the program with uncommitted funds available for the longest period or, to the extent feasible, prorate the investment between the programs in accordance with uninvested funds. As a result, the officers of our Manager or its affiliates could direct attractive investment opportunities to other affiliated entities or investors. Such events could result in the fund acquiring investments that provide less attractive returns, which would reduce the level of distributions we may be able to pay you.
Our Manager and certain of its affiliates are presently, and plan in the future to continue to be, involved with activities that are unrelated to us. As a result of these activities, our Manager, its employees and certain of its affiliates will have conflicts of interest in allocating their time between us and the other activities in which they are or may become involved, including the management of Fund 5 International, Terra Fund 6, Terra International, Terra International Fund 3 and Terra Fund 7. The employees of our Manager or its affiliates will devote only as much of its or their time to our business as it and its employees, in their judgment, determine is reasonably required, which may be substantially less than their full time. Therefore, our Manager, its personnel and certain affiliates may experience conflicts of interest in allocating management time, services and functions among us and any other business ventures in which they or any of their key personnel, as applicable, are or may become involved. This could result in actions that are more favorable to other affiliated entities than to us. Should our Manager or its affiliates, or the members of our Manager’s or its affiliates’ management teams, devote insufficient time or resources to our business, our returns on our direct or indirect investments, and the value of our units, may decline.
We face certain conflicts of interest with respect to our operations and our relationship with our Manager and our REIT subsidiary’s relationship with the REIT Manager.
We are subject to conflicts of interest arising out of our and our REIT subsidiary’s respective relationships with our Manager, the REIT Manager and their affiliates. We may enter into additional transactions with our Manager, its affiliates, or entities managed by our Manager or its affiliates. In particular, we may invest in, or acquire, certain of our investments through joint ventures or co-investments with other affiliates or purchase assets from, sell assets to or arrange financing from or provide financing to other affiliates or engage in other transactions with entities managed by our Manager or its affiliates. Future joint venture investments could be adversely affected by our lack of sole decision-making authority, or reliance on our Manager’s and its affiliates’ financial condition and liquidity, and disputes between us and our Manager or its affiliates. Certain of those transactions will be subject to certain regulatory restrictions as a result of the 1940 Act or the conditions of an order granting exemptive relief to our affiliate, Terra Fund 6. There can be no assurance that any procedural protections will be sufficient to assure that these transactions will be made on terms that will be at least as favorable to us as those that would have been obtained in an arm’s-length transaction.
Our Manager and its affiliates may be subject to conflicts of interest in making investment decisions on assets on our behalf as opposed to other entities that have similar investment objectives. Our Manager and its affiliates may have different incentives in determining when to sell assets with respect to which it is entitled to fees and compensation and such determinations may not be in our best interest.
Our Manager and its affiliates serve as manager of certain other funds and investment vehicles, all of which have investment objectives that overlap with ours. In addition, future programs may be sponsored by our Manager and its affiliates and Terra Capital Markets may serve as the dealer manager for these future programs. As a result, our Manager, Terra Capital Markets and their affiliates may face conflicts of interest arising from potential competition with other programs for investors and investment opportunities. There may be periods during which one or more programs managed by our Manager or its affiliates and distributed by Terra Capital Markets or its affiliates will be raising capital and which might compete with us for investment capital. Such
conflicts may not be resolved in our favor and our investors will not have the opportunity to evaluate the manner in which these conflicts of interest are resolved before or after making their investment.
The compensation that the REIT Manager receives was not determined on an arm’s-length basis and therefore may not be on the same terms as we could achieve from a third-party.
The compensation paid by our REIT subsidiary to the REIT Manager or its affiliates for services they provide to our REIT subsidiary were not determined on an arm’s-length basis. We cannot assure you that a third party unaffiliated with us would not be able to provide such services to us at a lower price.
The base management fee the REIT Manager receives for managing our REIT subsidiary may reduce its incentive to devote its time and effort to seeking attractive assets for our portfolio because the fee is payable regardless of our performance.
Our REIT subsidiary pays the REIT Manager a base management fee regardless of the performance of our portfolio. The REIT Manager’s entitlement to non-performance-based compensation might reduce its incentive to devote its time and effort to seeking assets that provide attractive risk-adjusted returns for our portfolio. This in turn could hurt both our ability to make distributions and the value of our units.
We cannot predict the amounts of compensation to be paid to the REIT Manager and its affiliates.
Because the fees that our REIT subsidiary will pay to the REIT Manager and its affiliates are based in part on the level of our business activity, it is not possible to predict the amounts of compensation that our REIT subsidiary will be required to pay these entities. In addition, because key employees of the REIT Manager and its affiliates are given broad discretion to determine when to consummate a transaction, we will rely on these key persons to dictate the level of our business activity. Fees paid to the REIT Manager and its affiliates reduce funds available for payment of distributions. Because we cannot predict the amount of fees due to these parties, we cannot predict how precisely such fees will impact such payments.
If our Manager or its affiliates causes us to enter into a transaction with an affiliate, our Manager or its affiliates may face conflicts of interest that would not exist if such transaction had been negotiated at arm’s-length with an independent party.
Our Manager and its affiliates may face conflicts of interests if we enter into transactions with an affiliate. In these circumstances, the persons who serve as the management team of our Manager or its affiliates may have a fiduciary responsibility to both us and the affiliate. Transactions between us and our Manager’s affiliates, including entities managed by our Manager or its affiliates, will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated parties. This conflict of interest may cause our Manager or its affiliates to sacrifice our best interests in favor of its affiliate or the entity it or its affiliates manage, thereby causing us to enter into a transaction that is not in our best interest and that may negatively impact our performance.
Our Manager and its affiliates have limited prior experience operating a REIT and therefore may have difficulty in successfully and profitably operating our business or complying with regulatory requirements, including REIT provisions of the Internal Revenue Code, which may hinder their ability to achieve our objectives or result in loss of our REIT subsidiary’s qualification as a REIT.
Prior to the completion of the REIT formation transactions, our Manager and its affiliates had no experience operating a REIT or complying with regulatory requirements, including the REIT provisions of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). The REIT rules and regulations are highly technical and complex, and the failure to comply with the income, asset, and other limitations imposed by these rules and regulations could prevent us from qualifying as a REIT or could force us to pay unexpected taxes and penalties. Our Manager and its affiliates have limited experience operating a business in compliance with the numerous technical restrictions and limitations set forth in the Internal Revenue Code or the 1940 Act applicable to REITs. We cannot assure you that our Manager, its affiliates or our management team will perform on our behalf as they have in their previous endeavors. The inexperience of our Manager and its affiliates described above may hinder its ability to achieve our objectives or result in loss of our REIT subsidiary’s qualification as a REIT, or payment of taxes and penalties. As a result, we cannot assure you that we have been able to or will continue to be able to successfully operate as a REIT, execute our business strategies or comply with regulatory requirements applicable to REITs.
Risks Related to Financing and Hedging
Our REIT subsidiary’s board of directors may change our REIT subsidiary’s leverage policy, and/or investment strategy and guidelines, asset allocation and financing strategy, without the consent of its common stockholders.
We currently have outstanding indebtedness and expect to deploy moderate amounts of additional leverage as part of our operating strategy. Our governing documents contain no limit on the amount of debt we may incur, and, subject to compliance with financial covenants under our REIT subsidiary’s borrowings, including under its master repurchase agreement and revolving credit facility, we may significantly increase the amount of leverage we utilize at any time without approval of our unitholders or our REIT subsidiary’s stockholders. Depending on market conditions, additional borrowings may include credit facilities, additional repurchase agreements, additional first mortgage loans and securitizations. In addition, we may divide the loans we originate into senior and junior tranches and dispose of the more senior tranches as an additional means of providing financing to our business. To the extent that we use leverage to finance our assets, we would expect to have a larger portfolio of loan assets, but our financing costs relating to our borrowings will reduce cash available for distributions to our unitholders. We may not be able to meet our financing obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to liquidation or sale to satisfy such obligations. To the extent we use repurchase agreements to finance the purchase of assets, a decrease in the value of these assets may lead to margin calls which we will have to satisfy. We may not have the funds available to satisfy any such margin calls and may be forced to sell assets at significantly depressed prices due to market conditions or otherwise, which may result in losses. Any reduction in distributions to our unitholders may cause the value of our units to decline.
Our Manager is authorized to follow broad investment guidelines that have been approved by our REIT subsidiary’s board of directors. Those investment guidelines, as well as our target assets, investment strategy, financing strategy and hedging policies with respect to investments, originations, acquisitions, growth, operations, indebtedness, capitalization and distributions, may be changed at any time without notice to, or the consent of, our unitholders or our REIT subsidiary’s stockholders. This could result in a loan portfolio with a different risk profile. A change in our investment strategy may increase our exposure to interest rate risk, default risk and real estate market fluctuations. Furthermore, a change in our asset allocation could result in our making investments in asset categories different from those described herein. These changes could materially and adversely affect us.
We may pursue and not be able to successfully complete securitization transactions, which could limit potential future sources of financing and could inhibit the growth of our business.
We may use additional credit facilities, repurchase agreements, first mortgage loans or other borrowings to finance the origination and/or structuring of real estate-related loans until a sufficient quantity of eligible assets has been accumulated, at which time we may decide to refinance these short-term facilities or repurchase agreements through the securitization market which could include the creation of CMBS, collateralized debt obligations (“CDO”s), or the private placement of loan participations or other long-term financing. If we employ this strategy, we are subject to the risk that we would not be able to obtain, during the period that our short-term financing arrangements are available, a sufficient amount of eligible assets to maximize the efficiency of a CMBS, CDO or private placement issuance. We are also subject to the risk that we are not able to obtain short-term financing arrangements or are not able to renew any short-term financing arrangements after they expire should we find it necessary to extend such short-term financing arrangements to allow more time to obtain the necessary eligible assets for a long-term financing.
The inability to consummate securitizations of our portfolio to finance our real estate-related loans on a long-term basis could require us to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price, which could have a material and adverse effect on our business, financial condition and results of operations.
We may be required to repurchase loans or indemnify investors if we breach representations and warranties, which could harm our earnings.
We may, on occasion, consistent with our REIT subsidiary’s qualification as a REIT and our desire to avoid being subject to the “prohibited transaction” penalty tax, sell some of our loans in the secondary market or as a part of a securitization of a portfolio of our loans. If we sell loans, we would be required to make customary representations and warranties about such loans to the loan purchaser. Our loan sale agreements may require us to repurchase or substitute loans in the event we breach a representation or warranty given to the loan purchaser. In addition, we may be required to repurchase loans as a result of borrower fraud or in the event of early payment default on a loan. Likewise, we may be required to repurchase or substitute loans if we breach a representation or warranty in connection with our securitizations, if any.
The remedies available to a purchaser of loans are generally broader than those available to us against the originating broker or correspondent. Further, if a purchaser enforces its remedies against us, we may not be able to enforce the remedies we have against the sellers. The repurchased loans typically can only be financed at a steep discount to their repurchase price, if at all. They
are also typically sold at a significant discount to the unpaid principal balance (“UPB”). Significant repurchase activity could harm our cash flow, results of operations, financial condition and business prospects.
The documents governing our master repurchase agreement contain, and additional financing arrangements may contain, financial covenants that could restrict our borrowings or subject us to additional risks.
We borrow funds under our master repurchase agreement. The documents that govern the master repurchase agreement contain, and additional financing arrangements may contain, various financial and other restrictive covenants, including covenants that require us or our REIT subsidiary to maintain a certain interest coverage ratio and net asset value and that create a maximum balance sheet leverage ratio. The guarantee agreement relating to our master repurchase agreement requires our REIT subsidiary to maintain: (i) liquidity of at least 10% of the then-current outstanding amount under the master repurchase agreement; (ii) cash liquidity of at least the greater of $5 million or 5% of the then-current outstanding amount under the master repurchase agreement; (iii) tangible net worth at an amount equal to or greater than 75% of our REIT subsidiary’s tangible net worth as of December 12, 2018, plus 75% of new capital contributions thereafter; (iv) an EBITDA to interest expense ratio of not less than 1.50 to 1.00; and (v) a total indebtedness to tangible net worth ratio of not more than 3.00 to 1.00. If we or our REIT subsidiary fail to satisfy any of the financial or other restrictive covenants, or otherwise default under these agreements, the lender will have the right to accelerate repayment and terminate the facility. Accelerating repayment and terminating the facility will require immediate repayment by us or our REIT subsidiary, as applicable, of the borrowed funds, which may require us to liquidate assets at a disadvantageous time, causing us or our REIT subsidiary to incur further losses and adversely affecting our results of operations and financial condition, which may impair our ability to maintain our current level of distributions.
Our inability to access funding could have a material adverse effect on our results of operations, financial condition and business. We may rely on short-term financing and thus are especially exposed to changes in the availability of financing.
We currently have outstanding indebtedness and expect to use additional borrowings, such as first mortgage financings, credit facilities, repurchase agreements and other financings, as part of our operating strategy. Our use of financings exposes us to the risk that our lenders may respond to market conditions by making it more difficult for us to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew our then existing short-term facilities or arrange for new financing on terms acceptable to us, or if we default on our covenants or are otherwise unable to access funds under these types of financing, we may have to curtail our asset origination activities and/or dispose of assets.
It is possible that the lenders that provide us with financing could experience changes in their ability to advance funds to us, independent of our performance or the performance of our portfolio of assets. Further, if many of our potential lenders are unwilling or unable to provide us with financing, we could be forced to sell our assets at an inopportune time when prices are depressed. In addition, if the regulatory capital requirements imposed on our lenders change, they may be required to significantly increase the cost of the financing that they provide to us. Our lenders also may revise their eligibility requirements for the types of assets they are willing to finance or the terms of such financings, based on, among other factors, the regulatory environment and their management of perceived risk, particularly with respect to assignee liability. Moreover, the amount of financing we receive under our short-term borrowing arrangements will be directly related to the lenders’ valuation of our targeted assets that cover the outstanding borrowings.
The dislocations in the mortgage sector in the financial crisis that began in 2007 have caused many lenders to tighten their lending standards, reduce their lending capacity or exit the market altogether. Further contraction among lenders, insolvency of lenders or other general market disruptions could adversely affect one or more of our potential lenders and could cause one or more of our potential lenders to be unwilling or unable to provide us with financing on attractive terms or at all. This could increase our financing costs and reduce our access to liquidity.
Repurchase agreements that we use to finance our assets restrict us from leveraging our assets as fully as desired, and may require us to provide additional collateral.
We use repurchase agreements to finance our assets. If the market value of the assets pledged or sold by our REIT subsidiary under our master repurchase agreement declines, our REIT subsidiary will be required to pay down a portion of the funds advanced, but our REIT subsidiary may not have the funds available to do so, which could result in defaults. Repurchase agreements that we may use in the future may also require us to provide additional collateral if the market value of the assets pledged or sold by us to a financing institution declines. Posting additional collateral to support our credit will reduce our liquidity and limit our ability to leverage our assets, which could adversely affect our business. In the event we do not have sufficient liquidity to meet such requirements, financing institutions can accelerate repayment of our indebtedness, increase interest rates, liquidate our collateral or terminate our ability to borrow. Such a situation would likely result in a rapid deterioration of our financial condition and possibly necessitate a filing for bankruptcy protection. In the event of our insolvency or bankruptcy, certain repurchase
agreements may qualify for special treatment under the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code.
Further, any financial institutions providing the repurchase facilities may require us to maintain a certain amount of cash that is not invested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. If we are unable to meet these collateral obligations, our financial condition could deteriorate rapidly.
An increase in our borrowing costs relative to the interest we receive on our leveraged assets may adversely affect our profitability and our cash available for distribution to our unitholders.
As our financings mature, we will be required either to enter into new borrowings or to sell certain of our assets. An increase in short-term interest rates at the time that we seek to enter into new borrowings would reduce the spread between the returns on our assets and the cost of our borrowings. This would adversely affect the returns on our assets, which might reduce earnings and, in turn, cash available for distribution to our unitholders.
We may enter into hedging transactions that could expose us to contingent liabilities in the future and adversely impact our financial condition.
Subject to maintaining our REIT subsidiary’s qualification as a REIT, part of our strategy may involve entering into hedging transactions that could require us to fund cash payments in certain circumstances (such as the early termination of a hedging instrument caused by an event of default or other early termination event). The amount due would be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges, and these economic losses will be reflected in our results of operations. We may also be required to provide margin to our counterparties to collateralize our obligations under hedging agreements. Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to fund these obligations could adversely impact our financial condition.
If we attempt to qualify for fair value hedge accounting treatment for any derivative instruments, but we fail to so qualify, we may suffer because losses on the derivatives that we enter into may not be offset by a change in the fair value of the related hedged transaction.
If we attempt to qualify for hedge accounting treatment for any derivative instruments, but we fail to so qualify for a number of reasons, including if we use instruments that do not meet the definition of a derivative (such as short sales), if we fail to satisfy hedge documentation and hedge effectiveness assessment requirements, or if our instruments are not highly effective, we may suffer because losses on any derivatives we hold which may not be offset by a change in the fair value of the related hedged transaction.
Risks Related to Owning Our Units
The interests of our company and our unitholders in respect of the matters covered by the voting agreement may differ from or conflict with the interests of our REIT subsidiary, the REIT Manager and its affiliates.
In connection with the Axar Transaction described in “Item 13. Certain Relationships and Related Transactions, and Director Independence - Axar Transaction”, our company, the REIT Manager and our REIT subsidiary entered into a voting agreement in respect of the shares of common stock of our REIT subsidiary owned by our company (the “Voting Agreement”), which was intended, in part, to provide for continuity on the board of directors of our REIT subsidiary. For additional details related to the Voting Agreement, see “Item 13. Certain Relationships and Related Transactions, and Director Independence - Voting Agreement”. The nomination and voting terms contained in the Voting Agreement give the holders of such rights the ability to exercise substantial influence over our REIT subsidiary and may otherwise limit the ability of the board of directors of the REIT subsidiary to appoint certain members to its board of directors which could adversely impact the composition of the board. In any of these matters, the interests of our company and our unitholders may differ from or conflict with the interests of our REIT subsidiary, the REIT Manager and its affiliates.
Units issued by us that you hold are not freely transferrable; thus investors may not be able to liquidate their investment.
The issuance of our units in the REIT formation transactions and the concurrent private placement were not registered under the Securities Act or the securities laws of any state. Our units were offered in reliance upon an exclusion or exemption from the registration provisions of the Securities Act and state securities laws applicable only to offers and sales to investors meeting the suitability requirements set forth herein.
Each member has been required to represent that, unless waived by our Manager, he or she (i) is an “accredited investor” within the meaning of Rule 501(a) of the Securities Act at the time of acquisition of the units, (ii) acquired the units for investment and not with a view to distribution or resale, and (iii) understood that our units have not been registered under the Securities Act or any state “blue sky” or securities laws, are not freely transferable, and that such member must bear the economic risk of investment in the units for an indefinite period, and the units cannot be sold unless they are subsequently registered or an exclusion or exemption from such registration is available and such member complies with the other applicable provisions of our amended and restated operating agreement. There is no public market for the units and members cannot expect to be able to liquidate their units in the case of an emergency. Further, the sale of the units may have adverse federal income tax consequences. Our members may not sell, assign or transfer all or a portion of their units without the prior written consent of our Manager, which consent may be withheld in our Manager’s sole and absolute discretion.
The value you may receive upon the occurrence of an alternative liquidity transaction is uncertain, and there can be no assurance that you will receive a full return of your invested capital.
Under our amended and restated operating agreement, our Manager may cause us to consummate an alternative liquidity transaction without the approval of members. If we pursue and consummate an alternative liquidity transaction, the value you will receive upon the occurrence of such transaction will depend on the loans in the portfolio at the time of such transaction, the performance of the loans, market conditions, and other factors. There is no assurance that we will pursue or consummate an alternative liquidity transaction. In addition, if we pursue and consummate an alternative liquidity transaction, we cannot predict the value you will receive in such transaction, nor can we provide any assurance that you will receive a full return of your invested capital.
If we complete an alternative liquidity transaction by pursuing an initial public offering or listing of our REIT subsidiary’s common stock in the future, you will be subject to additional risks.
Examples of the alternative liquidity transactions that may be available to us include a sale of our REIT subsidiary or an initial public offering and listing of our REIT subsidiary’s shares on a national securities exchange. If we complete an alternative liquidity transaction that involves our REIT subsidiary becoming a publicly traded company through an initial public offering or listing of our REIT subsidiary’s shares on an exchange, you will subject to the following additional risks:
Trading Value of our REIT Subsidiary’s Shares: If an alternative liquidity transaction involves our REIT subsidiary becoming a publicly traded company through an initial public offering or listing of our REIT subsidiary’s shares on a national securities exchange, our REIT subsidiary’s shares will be publicly traded and investors will be able to assess the value of their shares by reference to their public trading prices.
Distributions: If an alternative liquidity event involves our REIT subsidiary becoming a publicly traded company through an initial public offering listing of our REIT subsidiary on an exchange we do not expect that the distributions investors receive following any such liquidity event would be adversely impacted. Following any such transaction, our REIT subsidiary would be expected to pay regular monthly distributions to its stockholders and would continue to be required to distribute 90% of its taxable income (excluding net capital gains) to its investors each year in order to maintain its qualification as a REIT.
Manager Compensation: If an alternative liquidity event involves our REIT subsidiary becoming a publicly traded company through an initial public offering or listing of our REIT subsidiary, it is expected that our REIT subsidiary will enter into a new management agreement with our Manager or an affiliate of our Manager. The base management fees, incentive distributions or other amounts that would be payable to our Manager in the case of any such transaction are expected to be market-based fees determined in the case of any initial public offering by discussions between our Manager and the underwriters involved in the initial public offering. Any such fees are expected to be paid in lieu of the fees currently payable to our Manager by us or our REIT subsidiary. In addition, if in connection with any such alternative liquidity event or other transaction, we distribute shares of our REIT subsidiary to our members, our Manager may be entitled to receive a portion of such distributed shares based on its incentive distribution interest in our Fund, with shares of our REIT subsidiary being valued at the date of distribution at their book value (if distributed prior to an liquidity event), at the initial public offering price in the case of an initial public offering (if distributed within 60 days after such initial public offering) or at the trading value for such shares over the 10-trading period prior to such distribution (if distributed at any time after the expiration of such 60-day period).
Transfer Restrictions: If an alternative liquidity event involves our REIT subsidiary becoming a publicly traded company through an initial public offering or listing of our REIT subsidiary on a national securities exchange, it is expected that, after the expiration of any lock-up period, our members will become the direct owners of shares of our REIT subsidiary by way of a distribution of shares of our REIT subsidiary to our members as described above. Our REIT subsidiary’s shares distributed to
members will constitute restricted securities under the Securities Act and will be subject to restrictions on transfer under applicable U.S. securities laws.
Investors’ return may be reduced as a result of the additional expense of operating as a reporting company under the Exchange Act.
We are subject to the periodic and current reporting requirements of the Exchange Act. As a reporting company, we have to comply with a variety of substantive requirements under the Exchange Act that impose, among other things:
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preparation and filing of current reports on Form 8-K;
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preparation and filing of quarterly reports on Form 10-Q; and
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preparation and filing of annual reports on Form 10-K.
We are subject to these reporting and other requirements even though we have not yet completed an initial public offering or listed our units. Compliance with the Exchange Act will increase our operating expenses, which may reduce our ability to make distributions and the value of our units.
A compulsory redemption could result in adverse tax and economic consequences for members.
Our Manager may, in its sole discretion, require a compulsory redemption of all or a portion of a member’s units, including but not limited to cases in which the ownership of units would result in our assets being deemed “plan assets” for Employee Retirement Income Security Act of 1974 (“ERISA”) purposes, as defined under ERISA or by any regulation of the U.S. Department of Labor, or other federal agency having jurisdiction, or the units have been transferred without our permission, or a member has acquired units otherwise than in compliance with applicable rules and regulations. Such compulsory redemption may result in adverse tax or economic consequences for the member.
Your interests may be diluted if we issue additional units in the future.
Members will not have preemptive rights to acquire any units issued by us in the future. Therefore, investors may experience dilution of their investment if we sell additional units in the future.
Our members do not have legal representation.
Pursuant to the terms of our amended and restated operating agreement, each of our members acknowledges and agrees that counsel representing us, our Manager and its affiliates does not represent and shall not be deemed under the applicable codes of professional responsibility to have represented or to be representing any or all of our members in any respect.
We may not have sufficient funds to make cash distributions.
Following the completion of the REIT formation transactions, our Manager approved an increase in the monthly distribution payable in respect of each unit in respect of the first full quarterly period following the closing of the REIT formation transactions to 9.0% per annum on $50,000 per unit. The timing and amount of future distributions and payments will continue to be made at the sole discretion of our Manager and subject to such factors our Manager considers to be relevant, including the amount of funds available for distribution or payment, our financial condition, whether to reinvest or distribute such funds, capital expenditure and reserve requirements and general operational requirements. Because we cannot predict future cash flows or the performance of our REIT subsidiary, no assurance can be given that we will be able to continue to maintain in future periods distributions on units at levels approved by our Manager.
Rapid changes in the values of our assets may make it more difficult for our REIT subsidiary to maintain its qualification as a REIT or our exclusion from the 1940 Act.
If the fair market value or income potential of our assets declines as a result of increased interest rates, prepayment rates, general market conditions, government actions or other factors, we may need to increase our real estate assets and income or liquidate our non-qualifying assets to maintain our REIT subsidiary’s or its subsidiaries’ qualification or our exclusion from the 1940 Act. If the decline in real estate asset values or income occurs quickly, this may be especially difficult to accomplish. We may have to make decisions that we otherwise would not make absent the REIT and 1940 Act considerations.
Tax Risks
Tax risks in general.
An investment in us involves complex U.S. federal, state and local income tax considerations that will differ for each investor. We intend to be treated as a partnership for U.S. federal income tax purposes. Assuming that we are so treated, we will not be subject to U.S. federal income tax, and each member will be required to include its allocable share of the items of our income, gain, loss and deduction in computing its U.S. federal income tax liability. We may, however, be subject to state and local tax, depending on the location and scope of our activities. In addition, entities through which we may make investments, including our REIT subsidiary, may in certain circumstances be subject to U.S. federal, state, local or foreign tax.
No Internal Revenue Service ruling.
We have not sought rulings from the Internal Revenue Service with respect to any of the U.S. federal income tax considerations discussed herein. Thus, positions to be taken by the Internal Revenue Service as to tax consequences could differ from the positions taken by us.
Publicly traded partnership risk.
If we were treated as a publicly traded partnership (“PTP”) taxable as a corporation, we would be subject to U.S. federal income tax and applicable state and local taxes on our income, which would result in reduced returns to our members.
Our Manager intends to treat us as a partnership and not as an association or PTP taxed as a corporation for U.S. federal income tax purposes. No assurance can be given that the Internal Revenue Service will not challenge such classification or that a court will not sustain any such challenge.
A PTP is a partnership the interests in which are: (i) traded on an established securities market; or (ii) readily tradable on a secondary market or the substantial equivalent thereof. We may not qualify for any of the safe harbors set forth in the applicable Treasury regulations under which a partnership is not treated as a PTP. However, our Manager intends to operate us in such a manner so that we will not be classified as a PTP. Even if the Internal Revenue Service were to assert that we are a PTP, we will not be taxable as a corporation within a particular taxable year if 90% or more of our gross income is “qualifying income” for each taxable year in which we were a PTP and we were not required to register under the 1940 Act. Qualifying income generally includes interest (other than interest generated from a financial business), dividends, real property rents, gain from the sale of assets that produce qualifying income and certain other items. Since we conduct our real estate business through our REIT subsidiary, substantially all of our income should be dividends from our REIT subsidiary, which would be qualifying income. If, for any reason, we were treated as an association taxable as a corporation, we would be subject to U.S. federal income tax and applicable state and local taxes on our income.
Legislative, regulatory or administrative changes could adversely affect us.
Legislative, regulatory or administrative changes could be enacted or promulgated at any time, either prospectively or with retroactive effect, and may adversely affect us. No assurance can be given as to whether, when, or in what form, the U.S. federal income tax laws applicable to us and our members may be enacted. Changes to the U.S. federal income tax laws and interpretations of U.S. federal tax laws could adversely affect an investment in our units. On December 22, 2017, Congress enacted H.R. 1, also known as the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The TCJA made major changes to the Internal Revenue Code, including the reduction of the tax rates applicable to individuals and subchapter C corporations, a reduction or elimination of certain deductions (including new limitations on the deductibility of interest expense), and permitting immediate expensing of capital expenditures. The effect of the significant changes made by the TCJA remains uncertain, and additional administrative guidance is still required in order to fully evaluate the effect of many provisions. In addition, final Treasury regulations implementing certain of these new rules have not yet been issued, and additional changes and corrections may still be forthcoming. While we do not currently expect this reform to have a significant impact to us, our members, and prospective investors are urged to consult with their tax advisors regarding the effects of the TCJA or other legislative, regulatory or administrative developments on an investment in our units.
Income taxes of members may exceed cash distributions.
Even if we have income or gains for U.S. federal income tax purposes, we will not be required to make distributions (or may lack sufficient cash available for distributions) to enable our members to pay their U.S. federal, state and local taxes as a result of such income or gain allocations. For example, in order to qualify as a REIT, our REIT subsidiary must distribute at least 90% of
its net income (excluding net capital gain) to its shareholders on an annual basis. Differences in timing between the recognition of taxable income and the actual receipt of cash may occur for our REIT subsidiary, resulting in “phantom income,” which could impact our REIT subsidiary’s ability to satisfy its annual distribution requirements. For example, our REIT subsidiary generally will be required to recognize certain amounts in income no later than the time such amounts are reflected on its financial statements. The application of this rule may require our REIT subsidiary to accrue certain items of income with respect to its debt instruments earlier than would be the case under the otherwise applicable tax rules; however, on September 5, 2019, the Treasury Department and Internal Revenue Service released proposed Treasury regulations, which may be relied upon by taxpayers, which exclude original issue discount and market discount income from the requirement that taxpayers must take into account such income no later than the time such amounts are reflected on the taxpayer’s applicable financial statements. This rule could in certain circumstances increase our REIT subsidiary’s “phantom income,” which may require our REIT subsidiary to borrow funds or take other action to satisfy its REIT distribution requirements. For example, our REIT subsidiary may request that we and its other shareholders, if any, agree to a consent dividend in order to meet the annual distribution requirements or avoid paying corporate tax on any undistributed net income. When a REIT makes a consent dividend, the REIT and its stockholders are generally treated for U.S. federal income tax purposes as if the REIT distributed cash to the stockholders and the stockholders immediately re-contributed the cash to the REIT as a contribution to capital. A consent dividend would result in the recognition of income by our members as if an actual distribution were made, but without any distribution of cash. As a result, our members would be required to utilize other resources to satisfy tax liabilities and would not be able resort to distributions made by us to assist in satisfying such tax liabilities.
If our REIT subsidiary does not qualify or maintain its qualification as a REIT, it will be subject to tax as a regular corporation and could face a substantial tax liability as a result, which would result in reduced returns to our members.
We expect to make substantially all of our investments through our REIT subsidiary. Our Manager believes that it has taken and intends to continue to take such actions as are necessary or appropriate to cause our REIT subsidiary to qualify for taxation as a REIT within the meaning of the Internal Revenue Code. However, qualification as a REIT involves the application of highly technical and complex provisions of the Internal Revenue Code for which only limited judicial and administrative authorities exist and, accordingly, may require interpretations of such provisions, which could be successfully challenged by the Internal Revenue Service. Even a technical or inadvertent mistake could jeopardize the REIT qualification of our REIT subsidiary. The continued REIT qualification of our REIT subsidiary will depend on the ability of our REIT subsidiary to satisfy certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis.
Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it difficult or impossible for our REIT subsidiary to qualify as a REIT. If our REIT subsidiary were to fail to qualify as a REIT in any taxable year, then: (i) the REIT subsidiary would be unable to deduct dividends it distributes in computing taxable income and would be subject to U.S. federal income tax on its taxable income at regular corporate rates; (ii) the REIT subsidiary would no longer be required to distribute substantially all of its taxable income to us, and (iii) unless it were entitled to relief under applicable statutory provisions, our REIT subsidiary would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which it failed to qualify.
Accordingly, our REIT subsidiary’s failure to maintain its qualification as a REIT could have an adverse effect on our income, general financial condition and ability to pay distributions.
Complying with the REIT requirements may force our REIT subsidiary to liquidate or forego otherwise attractive investments.
In order to qualify as a REIT, our REIT subsidiary annually must satisfy two gross income requirements. First, at least 75% of its gross income for each taxable year, excluding gross income from prohibited transactions and certain hedging and foreign currency transactions, must be derived from investments relating to real property or mortgages on real property, including “rents from real property,” dividends received from and gain from the disposition of shares of other REITs, interest income derived from mortgage loans secured by real property (including certain types of qualified mezzanine loans and mortgage-backed securities), and gains from the sale of real estate assets, as well as income from certain kinds of qualified temporary investments. Second, at least 95% of our REIT subsidiary’s gross income in each taxable year, excluding gross income from prohibited transactions and certain hedging and foreign currency transactions, must be derived from some combination of income that qualifies under the 75% income test described above, as well as other dividends, interest, and gain from the sale or disposition of stock or securities, which need not have any relation to real property.
Further, at the end of each calendar quarter, at least 75% of the value of our REIT subsidiary’s total assets must consist of cash, cash items, government securities, shares in other REITs and other qualifying real estate assets, including certain mortgage loans, mezzanine loans and certain kinds of mortgage-backed securities. The remainder of our REIT subsidiary’s investment in securities (other than government securities, securities issued by a TRS and securities that are qualifying real estate assets) generally
cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our REIT subsidiary’s total assets (other than government securities, TRS securities and securities that are qualifying real estate assets) can consist of the securities of any one issuer, no more than 20% of the value of our REIT subsidiary’s total assets can be represented by securities of one or more TRSs it may own, and no more than 25% of the value of our REIT subsidiary’s total assets can consist of debt instruments issued by publicly offered REITs that are not otherwise secured by real property. If our REIT subsidiary fails to comply with these requirements at the end of any calendar quarter, it must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing its REIT qualification and suffering adverse tax consequences.
As a result, our REIT subsidiary may be required to liquidate from its portfolio, or contribute to a TRS, should it decide to form one in the future, otherwise attractive investments, and may be unable to pursue investments that would be otherwise advantageous to it in order to satisfy the source of income or asset diversification requirements for qualifying as a REIT. These actions could have the effect of reducing our REIT subsidiary’s income and amounts available for distribution to us. Thus, compliance with the REIT requirements may hinder our REIT subsidiary’s ability to make, and, in certain cases, maintain ownership of certain attractive investments.
Our REIT subsidiary’s preferred equity and mezzanine loan investments may fail to qualify as real estate assets for purposes of the REIT gross income and asset tests, which could jeopardize our REIT subsidiary’s ability to qualify as a REIT.
The Internal Revenue Service has issued Revenue Procedure 2003-65, which provides a safe harbor pursuant to which a mezzanine loan that is secured by interests in a partnership or other pass-through entity will be treated by the Internal Revenue Service as a real estate asset for purposes of the REIT assets tests, and interest derived from such a loan will be treated as qualifying mortgage interest for purposes of the REIT 75% and 95% income tests. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. Our REIT subsidiary owns, and may acquire in the future, certain mezzanine loans and preferred equity investments (which it intends to treat as mezzanine loans for U.S. federal income tax purposes) that do not satisfy all of the requirements for reliance on the safe harbor set forth in the Revenue Procedure. Consequently, there can be no assurance that the Internal Revenue Service will not successfully challenge the tax treatment of such mezzanine loans or preferred equity investments as qualifying real estate assets. To the extent that such mezzanine loans or preferred equity investments do not qualify as real estate assets, the interest income from such mezzanine loans or preferred equity investments would be qualifying income for the REIT 95% gross income test, but not for the REIT 75% gross income test and such mezzanine loans or preferred equity investments would not be qualifying assets for the REIT 75% asset test and would be subject to the REIT 5% and 10% asset tests, which could jeopardize our REIT subsidiary’s ability to qualify as a REIT.
Risk of the Internal Revenue Service successfully challenging our REIT subsidiary’s treatment of its preferred equity and mezzanine loan investments as debt for U.S. federal income tax purposes.
Our REIT subsidiary invests in certain real estate related investments, including mezzanine loans, first mortgage loans, and preferred equity investments. There is limited case law and administrative guidance addressing whether certain preferred equity investments or mezzanine loans will be treated as equity or debt for U.S. federal income tax purposes. Our Manager received an opinion of prior tax counsel regarding the treatment of one of our REIT subsidiary’s fixed return preferred equity investments and future similarly structured investments as debt for U.S. federal income tax purposes. Our REIT subsidiary treats the preferred equity investments which it currently holds as debt for U.S. federal income tax purposes and as mezzanine loans that qualify as real estate assets, as discussed above. No private letter rulings have been obtained on the characterization of these investments for U.S. federal income tax purposes and an opinion of counsel is not binding on the Internal Revenue Service; therefore, no assurance can be given that the Internal Revenue Service will not successfully challenge the treatment of such preferred equity investments as debt and as qualifying real estate assets. If a preferred equity investment or mezzanine loan owned by our REIT subsidiary was treated as equity for U.S. federal income tax purposes, our REIT subsidiary would be treated as owning its proportionate share of the assets and earning its proportionate share of the gross income of the partnership or limited liability company that issued the preferred equity interest. Certain of these partnerships and limited liability companies are engaged in activities, which could cause our REIT subsidiary to be considered as earning significant nonqualifying income which would likely cause our REIT subsidiary to fail to qualify as a REIT or pay a significant penalty tax to maintain its REIT qualification.
The failure of assets subject to repurchase agreements that our REIT subsidiary enters into to qualify as real estate assets could adversely affect the ability of our REIT subsidiary to qualify as a REIT.
Our REIT subsidiary has entered into financing arrangements that are structured as sale and repurchase agreements pursuant to which our REIT subsidiary sells certain of its assets to a counterparty and simultaneously enters into an agreement to repurchase such assets at a later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold pursuant thereto. We believe that our REIT subsidiary will be treated for REIT asset and income test purposes as the
owner of the assets that are the subject of such sale and repurchase agreement notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the Internal Revenue Service could assert that our REIT subsidiary is not the owner of the assets during the term of the sale and repurchase agreement, in which case our REIT subsidiary could fail to qualify as a REIT.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate and currency risks will generally be excluded from gross income for purposes of the 75% and 95% gross income tests if (i) the instrument (A) hedges interest rate risk or foreign currency exposure on liabilities used to carry or acquire real estate assets, (B) hedges risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the 75% or 95% gross income tests or (C) hedges an instrument described in clause (A) or (B) for a period following the extinguishment of the liability or the disposition of the asset that was previously hedged by the hedged instrument, and (ii) such instrument is properly identified under the applicable regulations promulgated by the Treasury Regulations.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our administrative and principal executive offices are located at 550 Fifth Avenue, 6th Floor, New York, New York 10036. We believe that our office facilities are suitable and adequate for our business as it is presently conducted.
Item 3.
Item 3. Legal Proceedings.
Neither we, our REIT subsidiary nor our Manager is currently subject to any material legal proceedings, nor, to our knowledge, are material legal proceedings threatened against us, our REIT subsidiary or our Manager. From time to time, we, our REIT subsidiary and individuals employed by our Manager or its affiliates may be a party to certain legal proceedings in the ordinary course of business. While the outcome of these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information
There is no established trading market for our units. As of December 31, 2019, we had 6,637.7 units outstanding held by a total of approximately 3,158 investors. As of December 31, 2019, there were no outstanding options, warrants to purchase our units or securities convertible into our units.
We currently expect that comparable cash dividends will continue to be paid in the future. However, these dividends will be made at the discretion of our Manager and will depend upon, among other things, our actual results of operations and liquidity.
Unregistered Sales of Equity Securities
Sales of Unregistered Securities
On January 1, 2016, we consummated the REIT formation transactions as described in “Item 1. Business.” In connection with the REIT formation transaction, we issued 3,206.64 units to investors in Funds 1 through 4 who wished to continue their investment in our Fund (as reorganized in the REIT formation transactions) and 463.69 Termination Units to investors in Funds 1 through 4 who wished to enter the liquidity phase of their investment, in each case in exchange for their existing interests in Funds 1 through 4. We also issued 573.46 units to investors in a private placement concurrent with the REIT formation transactions at a price of $47,000 per unit, which reflects the reduced front-end load relative to the existing members’ initial investment of $50,000 per unit.
The aforementioned units and Termination Units were issued in reliance upon an exemption from registration under the federal securities laws provided by Regulation D promulgated under Section 4(a)(2) of the Securities Act and Regulation S promulgated thereunder, and from qualification under state securities laws. Each investor who received units and Termination Units has represented that it (i) is an “accredited investor” within the meaning of Rule 501(a) of the Securities Act and (ii) has acquired such securities for its own account for investment purposes only and not for resale or distribution.
Issuer Purchases of Equity Securities
The following table provides information with respect to repurchases of our units during the year ended December 31, 2019:
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(1)
Represents Continuing Income Units redeemed at a 15% discount of the most recently published net asset value.
Item 6.
Item 6. Selected Financial Data.
The selected financial data presented below under the captions “Statement of operations data”, “Per unit data”, “Other information” and “Balance sheet data” as of and for the years ended December 31, 2019 and 2018 are derived from our consolidated financial statements, which have been audited by KPMG LLP, an independent registered public accounting firm. The data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The information contained in this section should be read in conjunction with our audited consolidated financial statements and related notes thereto and other financial information included elsewhere in this annual report on Form 10-K.
Overview
We are a real estate credit focused company that originates, structures, funds and manages high yielding commercial real estate investments, including mezzanine loans, first mortgage loans, subordinated mortgage loans and preferred equity investments throughout the United States. Our loans finance the acquisition, construction, development or redevelopment of quality commercial real estate in the United States. We focus on the origination of middle market loans in the approximately $10 million to $50 million range, to finance properties primarily in primary and secondary markets. We believe loans of this size are subject to less competition, offer higher risk adjusted returns than larger loans with similar risk metrics and facilitate portfolio diversification. We were formed as a Delaware limited liability company on April 24, 2013 and commenced operations on August 8, 2013. We make substantially all of our investments and conduct substantially all of our real estate lending business through our REIT subsidiary, which has elected to be taxed as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2016. Our objectives are to (i) preserve our members’ capital contributions, (ii) realize income from our investments and (iii) make
monthly distributions to our members from cash generated from investments. There can be no assurances that we will be successful in meeting our objectives.
On January 1, 2016, the Terra Funds completed the Merger. Following the Merger, we contributed the consolidated portfolio of net assets of the Terra Funds to our REIT subsidiary in exchange for all of the common shares of our REIT subsidiary. We elected to engage in these transactions to make our investments through our REIT subsidiary and to provide our members with a more broadly diversified portfolio of assets, while at the same time providing us with enhanced access to capital and borrowings, lower operating costs and enhanced opportunities for growth.
On February 8, 2018, Terra Capital Partners caused (i) a new subsidiary of Terra Capital Partners, Terra REIT Advisors, to become the external manager of our REIT subsidiary, (ii) a new subsidiary of Terra Capital Partners, Terra Fund Advisors, to be admitted as the replacement manager of the Company and the equity interests in Terra Fund Advisors to be distributed to the equity owners of Terra Capital Partners on a pro rata basis and (iii) the equity interests in another subsidiary of Terra Capital Partners, Terra Income Advisors, which also serves as the external advisor to Terra Fund 6, to be distributed to the equity owners of Terra Capital Partners on a pro rata basis. After the completion of the above steps, Axar entered into an investment agreement with Terra Capital Partners and its affiliates, pursuant to which Axar acquired from the respective owners thereof: (i) a 49% economic interest in Terra Fund Advisors; (ii) a 65.7% economic and voting interest in Terra Capital Partners (and thereby Terra REIT Advisors); and (iii) an initial 49% economic interest in Terra Income Advisors. On November 30, 2018, Axar acquired the remaining 34.3% economic interest in Terra Capital Partners. On April 30, 2019, Axar acquired the remaining 51% economic interest in Terra Income Advisors. When used herein the term “Manager” refers to Terra Income Advisors for periods prior to February 8, 2018 and refers to Terra Fund Advisors beginning on such date.
Portfolio Summary
The following tables provide a summary of our REIT subsidiary’s net loan portfolio as of December 31, 2019 and 2018:
_______________
(1)
These loans pay a coupon rate of LIBOR plus a fixed spread. Coupon rate shown was determined using LIBOR of 1.76% and 2.50% as of December 31, 2019 and 2018.
(2)
As of December 31, 2019 and 2018, amounts included $114.8 million and $57.0 million, respectively, of senior mortgages used as collateral for $81.1 million and $34.2 million, respectively, of borrowings under a repurchase agreement. These borrowings bear interest at an annual rate of LIBOR plus a spread ranging from 2.25% to 2.50% as of December 31, 2019 and LIBOR plus 2.5% as of December 31, 2018.
(3)
As of December 31, 2019 and 2018, twelve and eight of these loans, respectively, are subject to a LIBOR floor.
In addition to its net loan portfolio, as of December 31, 2019, our REIT subsidiary owns 4.9 acres of adjacent land acquired via deed in lieu of foreclosure and a multi-tenant office building acquired via foreclosure. The land and building and related lease intangible assets and liabilities had a net carrying value of $66.2 million and $56.0 million as of December 31, 2019 and 2018, respectively. The mortgage loan payable encumbering the office building had an outstanding principal amount of $44.6 million and $45.0 million as of December 31, 2019 and 2018, respectively.
Portfolio Investment Activity
For the years ended December 31, 2019 and 2018, our REIT subsidiary invested $53.5 million and $123.2 million in new and add-on loans, respectively, and had $84.3 million and $111.6 million of repayments, respectively, resulting in net repayments of $30.8 million and net investments of $11.6 million, respectively. Amounts are net of obligations under participation agreements, mortgage loan payable and borrowings under the master repurchase agreement and the revolving credit facility. In addition, on January 9, 2019, our REIT subsidiary acquired 4.9 acres of adjacent land encumbering a $14.3 million first mortgage via deed in lieu of foreclosure in exchange for the release of the first mortgage and related fees and expenses.
Portfolio Information
The tables below set forth the types of loans in our REIT subsidiary’s loan portfolio, as well as the property type and geographic location of the properties securing these loans, on a net loan basis, which represents our REIT subsidiary’s proportionate share of the loans, based on its economic ownership of these loans.
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(1)
Other includes $0.3 million of unused portion of a credit facility and a $1.7 million loan with collateral located in Kansas at December 31, 2019. Other also includes a $1.9 million loan with collateral located in South Carolina at December 31, 2019 and 2018.
Factors Impacting Operating Results
Our results of operations are affected by a number of factors and primarily depend on, among other things, the level of the interest income generated by our REIT subsidiary from targeted assets, the market value of our assets and the supply of, and demand for, real estate-related loans, including mezzanine loans, first mortgage loans, subordinated mortgage loans, preferred equity investments and other loans related to high quality commercial real estate in the United States, and the financing and other costs associated with our business. Interest income and borrowing costs of our REIT subsidiary may vary as a result of changes in interest rates, which could impact the net interest we receive on our assets. Our operating results may also be impacted by conditions in the financial markets and unanticipated credit events experienced by borrowers under our loan assets.
Market Risk
Our REIT subsidiary’s loans are highly illiquid and there is no assurance that it will achieve its investment objectives, including targeted returns. Due to the illiquidity of the loans, valuation of our REIT subsidiary’s loans may be difficult, as there generally will be no established markets for these loans.
Credit Risk
Credit risk represents the potential loss that our REIT subsidiary would incur if the borrowers failed to perform pursuant to the terms of their obligations to our REIT subsidiary. Our REIT subsidiary manages exposure to credit risk by limiting exposure to any one individual borrower and any one asset class. Additionally, our REIT subsidiary employs an asset management approach and monitors the portfolio of loans, through, at a minimum, quarterly financial review of property performance including net operating income, loan-to-value ratio, debt service coverage ratio, and the debt yield. Our REIT subsidiary also requires certain borrowers to establish a cash reserve, as a form of additional collateral, for the purpose of providing for future interest or property-related operating payments.
The performance and value of our REIT subsidiary’s loans depend upon the sponsors’ ability to operate or manage the development of the respective properties that serve as collateral so that each property’s value ultimately supports the repayment of the loan balance. Mezzanine loans and preferred equity investments are subordinate to senior mortgage loans and, therefore, involve a higher degree of risk. In the event of a default, mezzanine loans and preferred equity investments will be satisfied only
after the senior lender’s investment is fully recovered. As a result, in the event of a default, our REIT subsidiary may not recover all of its investments.
In addition, our REIT subsidiary is exposed to the risks generally associated with the commercial real estate market, including variances in occupancy rates, capitalization rates, absorption rates, and other macroeconomic factors beyond its control. Our REIT subsidiary seeks to manage these risks through its underwriting and asset management processes.
We and our REIT subsidiary maintain all of our cash at financial institutions which, at times, may exceed the amount insured by the Federal Deposit Insurance Corporation.
Concentration Risk
Our REIT subsidiary holds real estate-related loans. Thus, its loan portfolio may be subject to a more rapid change in value than would be the case if it were required to maintain a wide diversification among industries, companies and types of loans. The result of such concentration in real estate assets is that a loss in such loans could materially reduce our REIT subsidiary’s capital.
Liquidity Risk
Liquidity risk represents the possibility that we may not be able to sell our equity interest in our REIT subsidiary at a reasonable price in times of low trading volume, high volatility and financial stress.
Interest Rate Risk
Interest rate risk represents the effect from a change in interest rates, which could result in an adverse change in the fair value of our interest-bearing financial instruments. With respect to our REIT subsidiary’s business operations, increases in interest rates, in general, may over time cause: (i) the interest expense associated with variable rate borrowings to increase; (ii) the value of real estate-related loans to decline; (iii) coupons on variable rate loans to reset, although on a delayed basis, to higher interest rates; (iv) to the extent applicable under the terms of our REIT subsidiary’s investments, prepayments on real estate-related loans to slow, and (v) to the extent we enter into interest rate swap agreements as part of our REIT subsidiary’s hedging strategy, the value of these agreements to increase. Conversely, decreases in interest rates, in general, may over time cause: (i) the interest expense associated with variable rate borrowings to decrease; (ii) the value of real estate-related loans to increase; (iii) coupons on variable rate real estate-related loans to reset, although on a delayed basis, to lower interest rates (iv) to the extent applicable under the terms of our REIT subsidiary’s investments, prepayments on real estate-related loans to increase, and (v) to the extent our REIT subsidiary enters into interest rate swap agreements as part of its hedging strategy, the value of these agreements to decrease.
Prepayment Risk
Prepayments can either positively or adversely affect the yields on our REIT subsidiary’s loans. Prepayments on debt instruments, where permitted under the debt documents, are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, such prepayment rates cannot be predicted with certainty. If our REIT subsidiary does not collect a prepayment fee in connection with a prepayment or are unable to invest the proceeds of such prepayments received, the yield on the portfolio will decline. In addition, our REIT subsidiary may acquire assets at a discount or premium and if the asset does not repay when expected, the anticipated yield may be impacted. Under certain interest rate and prepayment scenarios our REIT subsidiary may fail to recoup fully its cost of acquisition of certain loans.
Extension Risk
Extension risk is the risk that our REIT subsidiary’s assets will be repaid at a slower rate than anticipated and generally increases when interest rates rise. In which case, to the extent our REIT subsidiary has financed the acquisition of an asset, our REIT subsidiary may have to finance its asset at potentially higher costs without the ability to reinvest principal into higher yielding securities because borrowers prepay their mortgages at a slower pace than originally expected, adversely impacting its net interest spread, and thus its net interest income.
Real Estate Risk
The market values of commercial and residential mortgage assets 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; changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In
addition, decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay the underlying loans, which could also cause our REIT subsidiary to suffer losses.
Use of Leverage
Our REIT subsidiary deploys moderate amounts of leverage as part of its operating strategy, which may consist of borrowings under first mortgage financings, warehouse facilities, repurchase agreements and other credit facilities. While borrowing and leverage present opportunities for increasing total return, they may have the effect of potentially creating or increasing losses.
Results of Operations
The following table presents the comparative results of our operations for the years ended December 31, 2019 and 2018:
Dividend Income
Dividend income associated with our ownership of our REIT subsidiary primarily represents our REIT subsidiary’s net income for the period. Any excess of distributions received from our REIT subsidiary over its net income is recorded as return of capital.
For the years ended December 31, 2019 and 2018, we received distributions of $30.3 million and $32.7 million, respectively, or $2.03 and $2.19 per share, respectively, from our REIT subsidiary, of which $9.0 million and $22.5 million was recorded as dividend income, respectively, and $21.3 million and $10.2 million was recorded as return of capital, respectively.
For the years ended December 31, 2019 as compared to the same period in 2018, our REIT subsidiary’s net income decreased by $13.4 million, primarily due to (i) a $5.3 million decrease in net interest income as a result of a decrease in the weighted average outstanding principal balance of net investments resulting from a higher volume of loan repayments than new loan originations and a decrease in the weighted average interest rate on net investments driven by new loan originations having lower coupon rates than those of the loans that were repaid; and (ii) $2.4 million of professional fees directly incurred, and which were previously deferred, in contemplation of our REIT subsidiary consummating an initial public offering which, in the second quarter of 2019, management decided to postpone indefinitely. Our REIT subsidiary’s net income also decreased as a result of a $2.0 million decrease in prepayment fee received, an $1.6 million impairment charge recorded for the year ended December 31, 2019 on a piece of land in order to reduce the carrying value of the land to its estimated fair value and an increase of $1.2 million in operating expenses reimbursed to the REIT Manager as a result of an increase in gross allocable costs as well as an increase in its allocation ratio in relation to affiliated funds managed by the REIT Manager and its affiliates.
Net Loan Portfolio
In assessing the performance of our REIT subsidiary’s loans, we believe it is appropriate to evaluate the loans on an economic basis, that is, gross loans net of obligations under participation agreements, mortgage loan payable and repurchase agreement payable.
The following tables present a reconciliation of our REIT subsidiary’s loan portfolio from a gross basis to a net basis for the years ended December 31, 2019 and 2018:
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(1)
Amount is calculated based on the number of days each loan is outstanding.
(2)
Amount is calculated based on the underlying principal amount of each loan.
(3)
The weighted average coupon rate represents net interest income over the period calculated using the weighted average coupon rate and weighted average principal amount shown on the table (interest income on the loans less interest expense) divided by the weighted average principal amount of the net loans during the period.
(4)
Subordinated loans include mezzanine loans, preferred equity investments and credit facilities.
For the year ended December 31, 2019 as compared to the same period in 2018, the decrease in weighted average coupon rate was primarily due to a higher volume of loan originations with lower coupon rates.
Net Change in Unrealized Appreciation (Depreciation) on Investment
Net change in unrealized appreciation or depreciation on investment reflects the change in our REIT subsidiary’s fair value during the reporting period. There may be fluctuations in unrealized gains and losses of the underlying portfolio as loans within the portfolio approach their respective maturity dates. In addition, the unrealized gains or losses in the portfolio may fluctuate over time due to changes in the market yields.
2019 - For the year ended December 31, 2019, we recorded an increase in unrealized appreciation on investments of $5.4 million as the fair value of the Company’s investment in our REIT subsidiary went up as a result of higher fair values of the underlying loans and assets.
2018 - For the year ended December 31, 2018, we recorded a decrease in the unrealized appreciation on investment of $2.1 million as the fair value of the Company’s investment in our REIT subsidiary decline at slightly less than the cost primarily due to higher discount rates applied to certain of the underlying loans during the period.
Net Increase in Members’ Capital Resulting from Operations
For the year ended December 31, 2019 as compared to the same period in 2018, the resulting net increase in members’ capital results from operations decreased by $6.0 million.
Financial Condition, Liquidity and Capital Resources
Liquidity is a measure of our ability to meet potential cash requirements, including funding and maintaining our assets and operations, making distributions to our members and other general business needs. Our primary cash requirements for the next twelve months are making the discretionary recurring distributions to our members. We expect to use cash distributions received from our REIT subsidiary to meet such cash requirements. A total of $18.0 million of our REIT subsidiary’s obligations under participation agreements will mature in the next twelve months and our REIT subsidiary expects to use the proceeds from the repayment of the corresponding investments to repay the participation obligations. Additionally, our REIT subsidiary expects to fund approximately $89.0 million of the unfunded commitments to borrowers during the next twelve months. Our REIT subsidiary expects to maintain sufficient cash on hand to fund such commitments through matching these commitments with principal repayments on outstanding loans. In addition, our REIT subsidiary may also issue additional equity, equity-related and debt securities to fund its investment strategies. Our REIT subsidiary may issue these securities to unaffiliated third parties or to vehicles advised by affiliates of Terra Capital Partners or third parties. As part of its capital raising transactions, our REIT subsidiary may grant to one or more of these vehicles certain control rights over its activities including rights to approve major decisions it takes as part of its business.
On December 12, 2018, our REIT subsidiary entered into a master repurchase agreement that provides for advances of up to $150 million in the aggregate, which our REIT subsidiary expects to use to finance certain secured performing commercial real estate loans, including senior mortgage loans. Advances under the master repurchase agreement accrue interest at an annual rate equal to the sum of (i) the 30-day LIBOR and (ii) the applicable spread, which ranges from 2.25% to 3.00%, and have a maturity date of December 12, 2020. As of December 31, 2019, the weighted average interest rate on borrowings outstanding under the master repurchase agreement was approximately 4.3%, calculated using the 30-day LIBOR of 1.76% as of December 31, 2019. As of December 31, 2019, the amount remaining available under the repurchase agreement was $68.9 million.
Under the master repurchase agreement, on the second anniversary of the closing date and on each anniversary thereafter, our REIT subsidiary is required to pay the buyer the difference, if positive, between $4.2 million and the interest paid during the immediately preceding 12-month period. Our REIT subsidiary currently expects to utilize the master repurchase agreement in the next twelve months so that the actual interest paid will be in excess of $4.2 million.
On June 20, 2019, our REIT subsidiary entered into a credit agreement that provides for revolving credit loans of up to $35.0 million in the aggregate, which our REIT subsidiary expects to use solely for short term financing needed to bridge the timing of anticipated loans repayments and funding obligations. Borrowings under the revolving credit facility can be either prime rate loans or LIBOR rate loans and accrue interest at an annual rate of prime rate plus 1% or LIBOR plus 4% with a floor of 6%. The credit facility matures on June 20, 2020. As of December 31, 2019, the amount remaining available under the credit facility was $35.0 million.
Cash Flows Provided by Operating Activities
2019 - For the year ended December 31, 2019, cash flows provided by operating activities were $29.9 million, primarily due to $30.3 million of dividends received from our REIT subsidiary, of which $21.3 million was recorded as a return of capital.
2018 - For the year ended December 31, 2018, cash flows provided by operating activities were $32.3 million, primarily due to $32.7 million of dividends received from our REIT subsidiary, of which $10.2 million was recorded as a return of capital.
Cash Flows used in Financing Activities
2019 - For the year ended December 31, 2019, cash flows used in financing activities were $29.9 million primarily related to distributions paid to members.
2018 - For the year ended December 31, 2018, cash flows used in financing activities was $32.3 million, consisting of distributions paid to members of $30.0 million, and $2.4 million used to redeem 50.4 Termination Units and 8.6 Continuing Income Units.
Critical Accounting Policies and Use of Estimates
Our consolidated financial statements are prepared in conformity with United States generally accepted accounting principles (“U.S. GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Critical accounting policies are those that require the application of management’s most difficult, subjective or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing the consolidated financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing the consolidated financial statements, management has utilized available information, including industry standards and the current economic environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results may differ from these estimates. In addition, other companies may utilize different estimates, which may impact the comparability of our results of operations to those of companies in similar businesses. As we execute our expected operating plans, we will describe additional critical accounting policies in the notes to our future consolidated financial statements in addition to those discussed below.
Fair Value Measurements
The fair value of our investment is categorized based on the priority of the inputs to the valuation technique and categorized into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.
Our investment was recorded at fair value on our consolidated statements of assets and liabilities and were categorized based on the inputs valuation techniques as follows:
•
Level 1. Quoted prices for identical assets or liabilities in an active market.
•
Level 2. Financial assets and liabilities whose values are based on the following:
◦Quoted prices for similar assets or liabilities in active markets.
◦Quoted prices for identical or similar assets or liabilities in non-active markets.
◦Pricing models whose inputs are observable for substantially the full term of the asset or liability.
◦Pricing models whose inputs are derived principally from or corroborated by observable market data for
substantially full term of the asset or liability.
•
Level 3. Prices or valuation techniques based on inputs that are both unobservable and significant to the overall fair value measurement.
Unobservable inputs reflect our assumptions about the factors that market participants would use in pricing an asset or liability, and would be based on the best information available.
Any changes to the valuation methodology will be reviewed by management to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, we will continue to refine our valuation methodologies. The methods used may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we anticipate that our valuation methods will be appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. We will use inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.
Income Taxes
No provision for U.S. federal and state income taxes has been made in the accompanying consolidated financial statements, as individual members are responsible for their proportionate share of our taxable income. We, however, may be liable for New York City Unincorporated Business Tax (the “NYC UBT”) and similar taxes of various other municipalities. New York City imposes the NYC UBT at a statutory rate of 4% on net income generated from ordinary business activities carried on in New York City. For the years ended December 31, 2019 and 2018, none of our income was subject to the NYC UBT.
We did not have any uncertain tax positions that met the recognition or measurement criteria of Accounting Standards Codification 740-10-25, Income Taxes, nor did we have any unrecognized tax benefits as of the periods presented herein. We recognize interest and penalties, if any, related to unrecognized tax liabilities as income tax expense in our consolidated statements of operations. For the years ended December 31, 2019 and 2018, we did not incur any interest or penalties. Although we file federal and state tax returns, our major tax jurisdiction is federal. Our 2015-2019 federal tax years remain subject to examination by the Internal Revenue Service.
Contractual Obligations of Our REIT Subsidiary
The following table provides a summary of our REIT subsidiary’s contractual obligations at December 31, 2019:
___________________________
(1)
In the normal course of business, our REIT subsidiary enters into participation agreements with related parties, and to a lesser extent, non-related parties, whereby it transfers a portion of the loans to them. These loan participations do not qualify for sale treatment. As such, the loans remain on its consolidated balance sheets and the proceeds are recorded as obligations under participation agreements. Similarly, interest earned on the entire loan balance is recorded within “Interest income” and the interest related to the participation interest is recorded within “Interest expense from obligations under participation agreements” in the consolidated statements of operations. Our REIT subsidiary has no direct liability to a participant under our participation agreements with respect to the underlying loan, and the participants’ share of the loan is repayable only from the proceeds received from the related borrower/issuer of the loans.
(2)
Our REIT subsidiary has an option to extend the maturity of the loan by two years subject to certain conditions provided in the loan agreement. Amount excludes unamortized origination and exit fees of $0.1 million.
(3)
Our REIT subsidiary may extend the maturity date of the master repurchase agreement for a period of one year. Amount excludes unamortized deferred financing costs of $1.5 million.
(4)
Interest was calculated using the applicable annual variable interest rate and balance outstanding at December 31, 2019. Amount represents interest expense through maturity plus exit fee as application.
(5)
Certain of our REIT subsidiary’s loans provide for a commitment to fund the borrower at a future date. As of December 31, 2019, our REIT subsidiary had eight of such loans with total funding commitments of $292.4 million, of which $175.7 million had been funded.
(6)
Represents rental obligation under the ground lease, inclusive of imputed interest, for our REIT subsidiary’s office building that it acquired through foreclosure.
Management Agreement with Terra REIT Advisors
As part of the Axar Transaction (as defined in “Item 13. Certain Relationships and Related Transactions, and Director Independence - Axar Transaction” below), Terra Income Advisors assigned all of its rights, title and interest in and to its current external management agreement with our REIT subsidiary to Terra REIT Advisors and immediately thereafter, Terra REIT Advisors
and our REIT subsidiary amended and restated such management agreement. Such amended and restated management agreement has the same economic terms and is in all material respects otherwise on the same terms as the management agreement between Terra Income Advisors and our REIT subsidiary in effect immediately prior to the Axar Transaction, except for the identity of our manager.
Our REIT subsidiary currently pays the following fees to Terra REIT Advisors pursuant to a management agreement:
Origination and Extension Fee. An origination fee in the amount of 1.0% of the amount used to originate, acquire, fund, acquire or structure real estate-related loans, including any third-party expenses related to such loan. In the event that the term of any real estate-related loan is extended, Terra REIT Advisors also receives an extension fee equal to the lesser of (i) 1.0% of the principal amount of the loan being extended or (ii) the amount of fee paid by the borrower in connection with such extension.
Asset Management Fee. A monthly asset management fee at an annual rate equal to 1.0% of the aggregate funds under management, which includes the loan origination amount or aggregate gross acquisition cost, as applicable, for each real estate-related loan and cash held by our REIT subsidiary.
Asset Servicing Fee. A monthly asset servicing fee at an annual rate equal to 0.25% of the aggregate gross origination price or aggregate gross acquisition price for each real estate related loan then held by our REIT subsidiary (inclusive of closing costs and expenses).
Disposition Fee. A disposition fee in the amount of 1.0% of the gross sale price received by our REIT subsidiary from the disposition of each loan, but not upon the maturity, prepayment, workout, modification or extension of a loan unless there is a corresponding fee paid by the borrower, in which case the disposition fee will be the lesser of (i) 1.0% of the principal amount of the loan and (ii) the amount of the fee paid by the borrower in connection with such transaction. If our REIT subsidiary takes ownership of a property as a result of a workout or foreclosure of a loan, our REIT subsidiary will pay a disposition fee upon the sale of such property equal to 1.0% of the sales price.
Transaction Breakup Fee. In the event that our REIT subsidiary receives any “breakup fees,” “busted-deal fees,” termination fees, or similar fees or liquidated damages from a third-party in connection with the termination or non-consummation of any loan or disposition transaction, Terra REIT Advisors will be entitled to receive one-half of such amounts, in addition to the reimbursement of all out-of-pocket fees and expenses incurred by Terra REIT Advisors with respect to its evaluation and pursuit of such transactions.
In addition to the fees described above, our REIT subsidiary reimburses Terra REIT Advisors for operating expenses incurred in connection with services provided to the operations of our REIT subsidiary, including our REIT subsidiary’s allocable share of Terra REIT Advisors’ overhead, such as rent, employee costs, utilities, and technology costs.
The following table presents a summary of fees paid and costs reimbursed to the predecessor to Terra REIT Advisors and Terra REIT Advisors in the aggregate in connection with providing services to our REIT subsidiary:
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(1)
Origination and extension fee expense is generally offset with origination and extension fee income. Any excess is deferred and amortized to interest income over the term of the loan.
(2)
Disposition fee is generally offset with exit fee income and included in interest income on the consolidated statements of operations.
Off-Balance Sheet Arrangements
Other than contractual commitments and other legal contingencies incurred in the normal course of our business, we do not have any off-balance sheet financings or liabilities.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We may be subject to financial market risks, including changes in interest rates. To the extent that we borrow money to make investments, our net investment income will be dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. In periods of rising interest rates, our cost of funds would increase, which may reduce our net investment income. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income.
As of December 31, 2019, our REIT subsidiary had 15 investments with an aggregate principal balance of $230.7 million, net of obligations under participation agreements, that provide for interest income at an annual rate of LIBOR plus a spread, 12 of which are subject to a LIBOR floor. A decrease of 100 basis points in LIBOR would decrease our annual interest income, net of interest expense on participation agreements, by approximately $0.7 million, and an increase of 100 basis points in LIBOR would increase our REIT subsidiary’s annual interest income, net of interest expense on participation agreements, by approximately $1.7 million. Additionally, our REIT subsidiary had $44.6 million of borrowings outstanding under a mortgage loan payable that bear interest at an annual rate of LIBOR plus 3.85% with a LIBOR floor of 2.23%, that is collateralized by an office building; and $81.1 million of borrowings outstanding under a repurchase agreement that bear interest at an annual rate of LIBOR plus a spread ranging from 2.25% to 2.50% with a LIBOR floor ranging from no floor to 2.49% and collateralized by $114.8 million of first mortgages. A decrease of 100 basis points in LIBOR would decrease our REIT subsidiary’s total annual interest expense by approximately $0.2 million and an increase of 100 basis points in LIBOR would increase our REIT subsidiary’s annual interest expense by approximately $0.9 million.
In July 2017, the U.K. Financial Conduct Authority announced that it would cease to compel banks to participate in setting LIBOR as a benchmark by the end of 2021, or the LIBOR Transition Date. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. The Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions convened by the U.S. Federal Reserve, has recommended SOFR as a more robust reference rate alternative to U.S. dollar LIBOR. SOFR is calculated based on overnight transactions under repurchase agreements, backed by Treasury securities. SOFR is observed and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it will be a rate that does not take into account bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. Whether or not SOFR attains market traction as a LIBOR replacement tool remains in question. As such, the future of LIBOR at this time is uncertain.
Potential changes, or uncertainty related to such potential changes, may adversely affect the market for LIBOR-based loans, including our REIT subsidiary’s portfolio of LIBOR-indexed, floating-rate loans, or the cost of its borrowings. In addition, changes or reforms to the determination or supervision of LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR, which could have an adverse impact on the market for LIBOR-based loans, including the value of the LIBOR-indexed, floating-rate loans in our REIT subsidiary’s portfolio, or the cost of its borrowings. The potential effect of the phase-out or replacement of LIBOR on our REIT subsidiary’s cost of capital and net investment income cannot yet be determined.
We may hedge against interest rate fluctuations by using standard hedging instruments, such as futures, options and forward contracts, subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in benefits of lower interest rates with respect to our portfolio of investments with fixed interest rates. For the years ended December 31, 2019 and 2018, we did not engage in interest rate hedging activities.
In addition, we may have risks regarding portfolio valuation. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Fair Value Measurements” in this annual report on Form 10-K.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Our financial statements are annexed to this annual report on Form 10-K beginning 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
As required by Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including the chief executive officer and chief financial officer of our Manager (performing functions equivalent to those a principal executive officer and principal financial officer of our company would perform if we had any officers), of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2019. Based on that evaluation, the chief executive officer and chief financial officer of our Manager concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute assurance that it will detect or uncover failures within our company to disclose material information otherwise required to be set forth in our periodic reports.
Evaluation of Internal Controls over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial statements for external purposes in accordance with generally accepted accounting principles. Our 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 our assets, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our Manager, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements in our consolidated financial statements. 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.
Under the supervision and with the participation of our management, including the chief executive officer and chief financial officer of our Manager (performing functions equivalent to those a principal executive officer and principal financial officer of our company would perform if we had any officers), we conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on its evaluation, our management concluded that our internal control over financial reporting was effective as of the end of the fiscal year covered by this Annual Report on Form 10-K.
This Annual Report on Form 10-K does not include an attestation report of our registered accounting firm due to a transition period established by the rules of the SEC for “emerging growth companies.”
Changes in Internal Control Over Financial Reporting
During the most recent fiscal quarter, there was no change in our internal controls over financial reporting, as defined under
Rule 13a-15(f) under the Exchange Act, that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The sole managing member of our Fund is our Manager, which is responsible for managing our business and affairs. In such capacity, our Manager controls decisions taken by us relating to our ownership of shares of common stock of our REIT subsidiary, subject to the Voting Agreement described below, and advises us on all matters related to our operations and administration, which encompasses managing our relationship and communications with our members, managing our liquidity and the payment of monthly and liquidating distributions to our members, and preparing financial statements, tax returns and member tax statements.
Board of Directors of Our REIT Subsidiary
We do not have any officers, directors or employees. We conduct substantially all of our business through our REIT subsidiary, which is supervised by its board of directors, comprised of eight directors, pursuant to the terms and provisions of our REIT subsidiary’s charter and bylaws. The name, age, position and biography of each member of our REIT subsidiary’s board of directors is set forth below:
Andrew M. Axelrod has served as Chairman of the board of directors of our REIT subsidiary, Terra Capital Partners and the Terra Property Trust 2 since February 8, 2018. Mr. Axelrod founded Axar Capital Management in April 2015 and currently serves as its Managing Partner and Portfolio Manager, and is responsible for all investment, risk and business management functions. He has been the Chief Executive Officer and Executive Chairman of the board of directors of Axar Acquisition Corp. since October 2016. Before founding Axar Capital Management in 2015, Mr. Axelrod worked at Mount Kellett Capital Management, a private investment organization from 2009 to 2014. At Mount Kellett Capital Management, he was promoted to Co-Head of North America Investments in 2011 and became a Partner in 2013. Prior to joining Mount Kellett Capital Management, Mr. Axelrod worked at Kohlberg Kravis Roberts & Co. L.P. from 2007 to 2008 and The Goldman Sachs Group, Inc. from 2005 to 2006. Mr. Axelrod graduated magna cum laude with a B.S. in Economics from Duke University.
Bruce D. Batkin has served as one of our REIT subsidiary's directors since January 2016, and as the Vice Chairman of our REIT subsidiary's board of directors since December 2018. Mr. Batkin also serves as the Vice Chairman of the board of directors (or managers, as applicable) of Terra International, Terra Income Advisors, Terra Fund Advisors, Terra Capital Partners, Fund 5 International and Terra Property Trust 2, and as Chairman of the board of directors of Terra Fund 6. He served as Chief Executive Officer for our REIT subsidiary from January 2016 to November 2018. He has also served as Chief Executive Officer of Terra Capital Advisors, Terra Capital Advisors 2, Terra Income Advisors 2, our Manager, Terra Fund 2, Terra Fund 3, Terra Fund 4, Fund 5 International, Terra Fund 6, Terra International and Terra Fund 7 since April 2009, September 2012, October 2016, September 2017, May 2011, January 2012, September 2012, June 2014, March 2015, October 2016 and October 2016, respectively, until November 30, 2018. Mr. Batkin has also served as President of Terra Fund 1 since July 2009 until November 30, 2018. He has also served as Chief Executive Officer and director of Terra Fund 6, from May 2013 to April 2019 and as Chief Executive Officer of Terra Income Advisors from May 2013 to April 2019. As a co-founder of Terra Capital Partners, he served as its President and Chief Executive Officer from its formation in 2001 and its commencement of operations in 2002 to November 2018, managing its real estate debt and equity investment programs. Mr. Batkin has over 40 years’ experience in real estate acquisition, finance, development, management and investment banking. Prior to founding Terra Capital Partners, he held senior management positions at Merrill Lynch & Co. Inc., Donaldson, Lufkin & Jenrette Securities Corporation (now Credit Suisse (USA) Inc.), ABN AMRO Bank N.V. and several private real estate development partnerships. Mr. Batkin has acquired major commercial properties throughout the United States and has acted as managing partner in over $5 billion of real estate investments for domestic and foreign investors. He is a member of the Harvard Alumni Real Estate Board and the Cornell Real Estate Council and the Committee for Economic Development; he sits on the Advisory Board of the Baker Program in Real Estate at Cornell University and the Dean's Advisory Council of the College of Art, Architecture and Planning at Cornell University; and he is a participant in the
semiannual Yale CEO Summit. Mr. Batkin received a Bachelor of Architecture from Cornell University and an M.B.A. from Harvard Business School.
Vikram S. Uppal has served as a director of our REIT subsidiary since February 8, 2018 and as Chief Executive Officer for our REIT subsidiary, the REIT Manager, our Manager and Terra Capital Partners since December 1, 2018. Mr. Uppal has also served as Chief Investment Officer for our REIT subsidiary, Terra Capital Partners and the REIT Manager since February 8, 2018. Mr. Uppal is also the Chief Executive Officer of Terra Income Advisors and Terra Fund 6 since April 2019 and the Chairman of the board of director of Terra Fund 6 since November 2019. Prior to joining Terra Capital Partners, Mr. Uppal was a Partner and Head of Real Estate at Axar Capital Management since 2016. Prior to Axar Capital Management, Mr. Uppal was a Managing Director on the Investment Team at Fortress Investment Group's Credit and Real Estate Funds from 2015 to 2016. From 2012 to 2015, Mr. Uppal worked at Mount Kellett Capital Management, a private investment organization, and served as Co-Head of North American Real Estate Investments. Mr. Uppal holds a B.S. from the University of St. Thomas and a M.S. from Columbia University.
Jeffrey M. Altman has served as one of our REIT subsidiary’s independent directors since October 2017. Mr. Altman has served as a director of Terra Fund 6 since April 2016. Since May 2019, Mr. Altman has been a Managing Director and Co-Head of U.S. Lodging & Leisure within the real estate, gaming and lodging investment banking group (REGAL) of Jefferies LLC, an investment bank. From 2011 to 2019, Mr. Altman was a Managing Director in Houlihan Lokey’s real estate and lodging investment banking group and from December 1998 to May 2011, he served as a Director of Lazard Fréres & Co. LLC REGAL, where he led the firm’s global hospitality and leisure effort. Mr. Altman has advised on over $100 billion of real estate transactions in his career and is a frequent speaker at real estate and lodging conferences. He is currently a member of the New York Hospitality Council, the National Association of Real Estate Investment Trusts, the International Council of Shopping Centers and the Samuel Zell and Robert Lurie Real Estate Center of the Wharton School of the University of Pennsylvania. Mr. Altman received a B.S., magna cum laude, with a concentration in accounting and finance, and an M.B.A., with a concentration in finance, from the John M. Olin School of Business at Washington University.
Roger H. Beless has served as one of our REIT subsidiary’s independent directors since February 2018. Since May 2016, Mr. Beless has served as Chief Operating Officer at Street Lights Residential, where he oversees capital markets, asset and portfolio management and acquisitions, and company operations. From June 2012 until March 2016, Mr. Beless served as Managing Director for Mount Kellett Capital Management, where he oversaw global real estate asset management. Prior to joining Mount Kellett, Mr. Beless spent nearly 20 years with Goldman Sachs/Archon Group where he held a number of positions, including co-head of US Real Estate and Chief Operating Officer for Archon Residential, where he oversaw acquisitions, asset management, property management and dispositions. Mr. Beless also spent four years in Tokyo, Japan where he led the startup of Goldman Sachs Realty Japan, Ltd. He currently serves on the board of Lion Heart Children’s Academy and the advisory board of Apartment Life. Mr. Beless holds a Bachelor’s of B.A. in Economics and Finance from Baylor University and a M.B.A from Southern Methodist University.
Michael L. Evans has served as one of our REIT subsidiary’s independent directors since October 2017. Mr. Evans has served since March 2015 as a member of the board of directors of Terra Capital Partners, where he is the audit committee chair and a member of the valuation committee and as a director of Terra Fund 6 from March 2015 to April 2019. Since December 2012, Mr. Evans has been the Managing Director of Newport Board Group, a CEO and board advisory firm. From June 2010 to September 2011, Mr. Evans served as the Interim Country Manager and Advisory Board Member for Concern Worldwide U.S. Inc., a non-profit humanitarian organization. From January 1977 until June 2010, Mr. Evans was with Ernst & Young, LLP, or Ernst & Young, and served as a partner since 1984. During his nearly 34 years with Ernst & Young, he served as a tax, audit and consulting services partner, specializing in real estate companies and publicly-traded entities. Mr. Evans currently serves on the Advisory Board of Marcus & Millichap, Inc., the Independent Counsel Board of Prologis Targeted U.S. Logistics Fund and the board of directors of Newport Board Group, CyArk.org and InfinteSmile.org. Mr. Evans is a licensed attorney and a C.P.A. (inactive) in California. He is currently a contributing business writer for Forbes.com and Allbusiness.com. Mr. Evans received a B.S.B. in accounting from the University of Minnesota, a J.D. from William Mitchell College of Law and an M.B.A. from Golden Gate University.
Spencer E. Goldenberg has served as one of our REIT subsidiary’s independent directors since February 2018. He has served since April 2019 as a member of the board of directors of Terra Fund 6 since April 2019 . He has served since June 2015 as Vice President of Corporate Development at Menin Hospitality. Prior to his time at Menin, Mr. Goldenberg was employed as an accountant at the firm of Gerstle, Rosen & Goldenberg P.A. from February 2008 to June 2015. From October 2005 until February 2008, he served as a legislative aide to Florida State Senator Gwen Margolis. Mr. Goldenberg holds an active certified public accountant’s license in the state of Florida. He holds a Bachelor of Arts in International Affairs from Florida State University.
John S. Gregorits has served as one of our REIT subsidiary’s independent directors since October 2017. Mr. Gregorits retired in 2014 from his position with the Specialized Funds Group at Prudential Real Estate Investors, or PREI, the real estate investment management business of Prudential Financial, where he worked since 1998. Mr. Gregorits was responsible for certain of PREI’s funds in its U.S. business, totaling approximately $10 billion in gross assets. While at PREI, Mr. Gregorits served on the U.S. Executive Committee and Investment Committee. Before joining PREI, Mr. Gregorits managed a variety of multi-billion dollar equity and debt portfolios on behalf of Prudential Financial’s General Account, gaining extensive experience in portfolio and asset management, development, acquisitions, sales, leasing, and joint venture management. His 36 years in real estate includes serving on a variety of industry associations as well as the board of directors of several privately held companies. Mr. Gregorits holds a Bachelor of Art in economics and psychology from Duke University and a Master of Arts in organizational behavior from Fairleigh Dickson University.
Executive Officers of the REIT Manager and our Manager
The sole managing member of our Fund is our Manager, and our REIT subsidiary has entered into a management agreement with the REIT Manager, pursuant to which the REIT Manager provides certain services to our REIT subsidiary and our REIT subsidiary pays fees associated with such services. The REIT Manager is responsible for managing our REIT subsidiary’s day-to-day operations and all matters affecting its business and affairs, including responsibility for determining when to buy and sell real estate-related assets. The REIT Manager is not obligated under the management agreement to dedicate any of its personnel exclusively to our REIT subsidiary, nor is it or its personnel obligated to dedicate any specific portion of its or their time to the business.
The names, ages, positions and biographies of the officers of the REIT Manager and our Manager are as follows:
(1)
The REIT Manager is managed by Terra Capital Partners and does not have a board of managers. Messrs. Axelrod and Batkin are members of the board of managers of Terra Capital Partners.
For biographical information regarding Messrs. Axelrod, Batkin and Uppal, see “Item 10. - Board of Directors of Our REIT Subsidiary” above.
Simon J. Mildé has served as the Chairman of our Manager since September 2017. He served as the Vice Chairman of Terra Income Advisors until February 2020. He served as Chairman of the board of directors of our REIT subsidiary from January 2016 to February 2018. Mr. Mildé co-founded Terra Capital Partners and served as the Chairman of its board of directors from its formation in 2001 and its commencement of operations in 2002 until February 8, 2018 and as the Vice Chairman of its board of directors from February 8, 2018 until November 2019. He also served as the Chairman of Fund 5 International, Terra International and Terra Fund 7 from June 2014, October 2016 and October 2016, respectively, until February 26, 2020. He also served as the Chairman of Terra Fund 6 from May 2013 until April 30, 2019. He has over 40 years’ experience in global real estate finance, investment and management. Prior to founding Terra Capital Partners, Mr. Mildé was founder, CEO and Chairman of Jones Lang Wootton North America (which subsequently became Jones Lang LaSalle Incorporated and now JLL), the second-largest commercial real estate broker in the world, from 1977 to 1994. He was also one of the founders of JLW Realty Advisors, which has grown into a $50 billion global real estate investment management business. Today, its successor company ranks as one of the largest real estate investment managers in the world. Mr. Mildé has also served as the Chairman and CEO of The Greenwich Group International, a global real estate investment banking firm, and Capital District Properties, a commercial real estate development and investment company since 1995 and 2004, respectively. He was a former member of the Royal Institution of Chartered Surveyors and was a former Governor of the Real Estate Board of New York and former member of the Advisory Board of the Real Estate Institute of New York University. Mr. Mildé attended Regent Street Tech College in London, England and the Royal Institution of Chartered Surveyors in England.
Gregory M. Pinkus has served as the Chief Financial Officer, Treasurer and Secretary of our REIT subsidiary and Chief Operating Officer of our Manager, the REIT Manager and Terra Income Advisors since January 2016, October 2017, and May
2013, respectively. He has served as (i) the Chief Financial Officer of Terra Capital Advisors, Terra Capital Advisors 2 and Terra Income Advisors 2 since May 2012, September 12 and October 2016; (ii) the Chief Operating Officer of Terra Capital Advisors, Terra Capital Advisors 2 and Terra Capital Partners since July 2014; (iii) the Chief Operating Officer of Terra Income Advisors 2 since October 2016; (iv) the Chief Financial Officer, Treasurer and Secretary of Terra Fund 6 since May 2013 and Chief Operating Officer of Terra Fund 6 since July 2014; and (v) the Chief Financial Officer and Chief Operating Officer of Fund 5 International, Terra International, Terra Fund 7 and Terra Property 2 since June 2014, October 2016, October 2016 and September 2016, respectively. Prior to joining Terra Capital Partners in May 2012, he served as Assistant Controller for W.P. Carey & Co. from 2006 to August 2010 and as Controller from August 2010 to May 2012. Mr. Pinkus also served as Controller and Vice President of Finance for several early-stage technology companies during the period of 1999 to 2005. Additionally, he managed large-scale information technology budgets at New York Life Insurance Company from 2003 to 2004 and oversaw an international reporting group at Bank of America from 1992 to 1996. Mr. Pinkus is a Certified Public Accountant and member of the American Institute of Certified Public Accountants. He holds a B.S. in Accounting from the Leonard N. Stern School of Business at New York University.
Daniel J. Cooperman has served as Chief Originations Officer of our REIT subsidiary, our Manager, the REIT Manager and Terra Income Advisors since January 2016, September 2017, September 2017 and February 2015, respectively. Mr. Cooperman has served as Chief Originations Officer of (i) each of Terra Capital Advisors and Terra Capital Advisors 2 since January 2015, having previously served as Managing Director of Originations until January 2015 of Terra Capital Advisors and Terra Capital Advisors 2 since April 2009 and September 2012, respectively; (ii) Fund 5 International since January 2015, having previously served as Managing Director of Originations from June 2014 to June 2014; (iii) Terra Property Trust 2 since September 2016; (iv) Terra Fund 6 since February 2015, having previously served as Managing Director of Originations from May 2013 until February 2015; and (v) each of Terra Income Advisors 2, Terra International, and Terra Fund 7 since October 2016. Mr. Cooperman has 18 years’ experience in the acquisition, financing, leasing and asset management of commercial real estate with an aggregate value of over $5 billion. Prior to the formation of Terra Capital Partners in 2001 and its commencement of operations in 2002, Mr. Cooperman handled mortgage and mezzanine placement activities for The Greenwich Group International, LLC. Prior to joining The Greenwich Group, Mr. Cooperman worked in Chase Manhattan Bank’s Global Properties Group, where he was responsible for financial analysis and due diligence for the bank’s strategic real estate acquisitions and divestitures. Prior to that time, he was responsible for acquisitions and asset management for JGS, a Japanese conglomerate with global real estate holdings. Mr. Cooperman holds a B.S. in Finance from the University of Colorado at Boulder.
Code of Ethics
Our Manager or its affiliates has adopted a Code of Business Conduct and Ethics (the “Code of Ethics”) pursuant to Rule 17j-1 of the 1940 Act, which applies to, among others, the senior officers of our Manager, including the Chief Executive Officer and the Chief Financial Officer, as well as every officer, director, employee and “access person” (as defined within the Code of Ethics). We will also provide the Code of Ethics, free of charge, to unitholders who request it. Requests should be directed to Bernadette Murphy, at Terra Secured Income Fund 5, LLC, 550 Fifth Avenue, 6th Floor, New York, New York 10036.
Audit Committee
Our REIT subsidiary has established an audit committee of the Board (the “Audit Committee”) that operates pursuant to a charter and consists of three members. The Audit Committee is responsible for selecting, engaging and supervising our REIT subsidiary’s independent accountants, reviewing the plans, scope and results of the audit engagement with its independent accountants, approving professional services provided by its independent accountants (including compensation therefor), reviewing the independence of its independent accountants and reviewing the adequacy of its internal controls over financial reporting. The members of the Audit Committee are Messrs. Altman, Goldenberg and Evans, each of whom is independent. Mr. Evens serves as the chairman of the Audit Committee. The Board has determined that Mr. Evens is an “audit committee financial expert” as defined under Item 407 of regulation S-K promulgated under the Exchange Act. The Board has determined that each of Messrs. Altman, Goldenberg and Evans meets the current independence and experience requirements of Rule 10A-3 of the Exchange Act.
Item 11.
Item 11. Executive Compensation.
The sole managing member of our Fund is our Manager, and we do not have any officers, directors or employees. Our REIT subsidiary has entered into a management agreement with the REIT Manager, pursuant to which the REIT Manager provides certain services to our REIT subsidiary and our REIT subsidiary pays fees associated with such services. The officers of our Manager and the REIT Manager do not receive any compensation from our Fund. The REIT Manager is responsible for managing our REIT subsidiary’s day-to-day operations and all matters affecting its business and affairs, including responsibility for determining when to buy and sell real estate-related assets. The REIT Manager is not obligated under the management agreement
to dedicate any of its personnel exclusively to our REIT subsidiary, nor is it or its personnel obligated to dedicate any specific portion of its or their time to the business.
Compensation of the Directors of Our REIT Subsidiary
We do not pay compensation to the directors of our REIT subsidiary.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The following table sets forth, as of February 28, 2020, certain information regarding the ownership of units of our Manager and any person who is known by us to be the beneficial owner of more than 5% of our units. The sole managing member of our Fund is our Manager, and we do not have any officers, directors or employees.
Each listed person’s beneficial ownership includes:
•
all units the investor actually owns beneficially or of record;
•
all units over which the investor has or shares voting or dispositive control (such as in the capacity as a general partner of an investment fund); and
•
all units the investor has the right to acquire within 60 days.
Unless otherwise indicated, all units are owned directly, and the indicated person has sole voting and investment power. Except as indicated in the footnotes to the table below, the business address of the members listed below is the address of our principal executive office, 550 Fifth Avenue, 6th Floor, New York, NY 10036.
_______________
* Less than 1% of the outstanding units.
(1)
Based on a total of 6,637.7 units issued and outstanding as of February 28, 2020.
(2)
Consists of: (i) 303.3 units owned by the Sonnentag Foundation Ltd. for which Mr. Sonnentag serves as President and Director and has the sole voting and investment power over these shares and (ii) 202.2 units owned by the John J. Sonnentag Living Trust for which Mr. Sonnentag serves as trustee and has sole voting and investment power.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Various conflicts of interest exist in the relationship between us and our Manager and its affiliates. Our Manager has sole control over our organization and operations and will resolve conflicts of interest through the exercise of its judgment. Our Manager has a fiduciary responsibility for the safekeeping and use of all of our funds and assets, whether or not in our immediate possession and control, and may not use or permit another to use such funds or assets in any manner except for our exclusive benefit. In addition, our amended and restated operating agreement contains provisions designed to guard against conflicts of interest. However, our amended and restated operating agreement does not directly address each potential conflict and does not provide for any particular mechanism to fully resolve these conflicts. There is a possibility that not all conflicts will be resolved in a manner favorable to us. Potential conflicts include those set forth below.
The Axar Transaction
On February 8, 2018, Axar, wholly owned by a pooled investment vehicle advised by Axar Capital Management , a Delaware limited partnership, entered into an investment agreement with Terra Capital Partners and its affiliates (which we refer to collectively as the “Axar Transaction”). As a result of the Axar Transaction, Terra REIT Advisors, a newly formed subsidiary of Terra Capital Partners, became our REIT subsidiary’s external manager, Terra Fund Advisors was admitted as our replacement Manager, the equity interests in Terra Fund Advisors were distributed to the equity owners of Terra Capital Partners on a pro rata basis, and the equity interests in another subsidiary of Terra Capital Partners, Terra Income Advisors, which serves as the external advisor to
Terra Fund 6, were distributed to the equity owners of Terra Capital Partners on a pro rata basis. In addition, as a result of the Axar Transaction and subsequent transactions on November 30, 2018 and April 30, 2019, Axar acquired 100% of the equity interests of Terra Capital Partners, 49% of the economic interests in Terra Fund Advisors, and 100% of the equity interests in Terra Income Advisors. The Axar Transaction was approved unanimously by the independent directors of our REIT subsidiary and the independent directors of Terra Fund 6, with each having formed a special committee to evaluate the Axar Transaction. In connection with the transaction, Andrew M. Axelrod, Founder of Axar Capital Management, was appointed as Chairman of Terra Capital Partners and as Chairman of the board of directors of our REIT subsidiary and Vikram S. Uppal, Head of Real Estate of Axar Capital Management prior to the Axar Transaction, was appointed as Chief Investment Officer of Terra Capital Partners and as a member of the board of directors of Terra Capital Partners and our REIT subsidiary. Axar Capital Management received certain approval rights over certain major decisions impacting our Manager and Terra Income Advisors and also arranged for certain nomination and voting rights in respect of the board of directors of our REIT subsidiary. At the same time, the prior owners of Terra Capital Partners retained certain approval rights over major decisions impacting Terra Capital Partners (and thereby Terra REIT Advisors).
Terra International Fund 3
On September 30, 2019, our REIT subsidiary entered into a Contribution and Repurchase Agreement with Terra International Fund 3 and Terra International Fund 3 REIT, a wholly-owned subsidiary of Terra International Fund 3, which our REIT subsidiary amended and restated on November 13, 2019.
Pursuant to this agreement, Terra International Fund 3, through Terra International Fund 3 REIT, contributed cash in the amount of $3,620,000 to us in exchange for 212,690.95 shares of common stock of our REIT subsidiary, at a price of $17.02 per share. In addition, Terra International Fund 3 agreed to contribute to our REIT subsidiary future cash proceeds, if any, raised from time to time by it, and our REIT subsidiary agreed to issue shares of common stock to International Fund 3 in exchange for any such future cash proceeds, in each case pursuant to and in accordance with the terms and conditions specified in the agreement. The shares were issued in a private placement in reliance on Section 4(a)(2) of the Securities Act, and the rules and regulations promulgated thereunder.
The REIT Manager also serves as adviser to the Terra International Fund 3 and Terra International Fund 3 REIT. In addition, the general partner of Terra International Fund 3 is Terra International Fund 3 GP, LLC, which is an affiliate of Terra Fund Advisors, our Manager.
Voting Agreement involving our REIT Subsidiary
On February 8, 2018, we, our REIT subsidiary and Terra REIT Advisors entered into the Voting Agreement, pursuant to which the board of directors of our REIT subsidiary was increased to eight members.
Pursuant to the terms of the Voting Agreement, for so long as Terra REIT Advisors remains the external manager of our REIT subsidiary, Terra REIT Advisors will have the right to nominate two individuals to serve as directors of our REIT subsidiary (which nominees need not be independent directors) and for so long as we hold at least 10% of the outstanding shares of common stock of our REIT subsidiary, we will have the right to nominate one individual to serve as a director of our REIT subsidiary (who need not be an independent director).
Except as otherwise required by law or the provisions of other agreements to which the parties are or may in the future become bound, the parties have agreed to vote all shares of common stock of our REIT subsidiary directly or indirectly owned in favor (or against removal) of the directors properly nominated in accordance with the Voting Agreement. Other than with respect to the election of directors, the Voting Agreement requires that we vote all shares of common stock of our REIT subsidiary directly or indirectly owned by us in accordance with the recommendations made by the board of our REIT subsidiary.
Management Agreement
As part of the Axar Transaction, Terra Income Advisors assigned all of its rights, title and interest in and to its current external management agreement with our REIT subsidiary to Terra REIT Advisors and immediately thereafter, Terra REIT Advisors and our REIT subsidiary amended and restated such management agreement. Such amended and restated management agreement has the same economic terms and is in all material respects otherwise on the same terms as the management agreement between Terra Income Advisors and our REIT subsidiary in effect immediately prior to the Axar Transaction, except for the identity of the manager.
Receipt of Fees and Other Compensation by Our Manager and its Affiliates
Our REIT subsidiary will pay substantial fees to the REIT Manager and its affiliates. Further, we and our REIT subsidiary must reimburse the REIT Manager and its affiliates for costs incurred by them in managing our REIT subsidiary and its portfolio of real estate-related loans.
Our REIT subsidiary has entered into a management agreement with the REIT Manager pursuant to which the REIT Manager provides certain management services to our REIT subsidiary, subject to oversight by its board of directors. The REIT Manager’s responsibilities to our REIT subsidiary include, among others, investing in, and disposing of, assets, borrowing money, entering into contracts and agreements in connection with our REIT subsidiary’s business and purpose, providing administrative support and performing such other services as are delegated to the REIT Manager by our REIT subsidiary’s board of directors. In performing its duties, the REIT Manager is subject to a fiduciary responsibility for the safekeeping and use of all funds and assets of our REIT subsidiary. In consideration of its providing such services, the REIT Manager is entitled to certain fees from our REIT subsidiary as described below. The original management agreement between Terra Capital Advisors and our REIT subsidiary was entered into on January 1, 2016. On September 1, 2016, our REIT subsidiary terminated the original management agreement and entered a management agreement with Terra Income Advisors. As described above, as part of the Axar Transaction, Terra Income Advisors assigned all of its rights, title and interest in and to its current external management agreement with our REIT subsidiary to the REIT Manager and immediately thereafter, the REIT Manager and our REIT subsidiary amended and restated such management agreement. The current management agreement runs co-terminus with our amended and restated operating agreement, which terminates on December 31, 2023, unless sooner dissolved in accordance with the terms of our amended and restated operating agreement.
During the years ended December 31, 2019 and 2018, our REIT subsidiary paid the predecessor to the REIT Manager and the REIT Manager in the aggregate the following fees under the management agreement: $3.7 million and $3.1 million in asset management fee, respectively, $0.9 million and $0.7 million in asset servicing fees, respectively, $2.0 million and $2.5 million in origination fees, respectively; $1.4 million and $1.2 million in disposition and extension fees, respectively, and $4.9 million and $3.7 million of operating expense reimbursements, respectively.
Subject to its fiduciary responsibilities and the terms of our amended and restated operating agreement, our Manager has sole discretion with respect to the terms and timing of our investments, although it is anticipated that those investments will be consistent with our investment objectives and strategy. It is further anticipated that the REIT Manager will exercise its discretion through the management agreement with our REIT subsidiary. The agreements and arrangements, including those relating to compensation, between our REIT subsidiary and the REIT Manager and its affiliates are not the result of arm’s-length negotiations and may create conflicts between the interests of our Manager, the REIT Manager and their affiliates, on the one hand, and us, our members and our REIT subsidiary on the other.
Our Manager and its Affiliates May Compete With Us
Our Manager and its affiliates may engage in real estate-related transactions on their own behalf or on behalf of other entities.
Our Manager and its affiliates have, and in the future will have, legal and financial obligations with respect to its other programs that are similar to our Manager’s obligations to us. For example, affiliates of our Manager are the external managers to Fund 5 International, Terra Fund 6, Terra International and Terra Fund 7, all of which follow investment strategies that are similar to our strategy. Competition for investments among the real estate-related investment programs sponsored by our Manager and its affiliates will create a conflict of interest. In determining which program should receive an investment opportunity, our Manager will first evaluate the investment objectives of each program to determine if the opportunity is suitable for each program. If the proposed investment is appropriate for more than one program, our Manager will then evaluate the portfolio of each program, in terms of diversity of geography, underlying property type, tenant concentration and borrower, to determine if the investment is most suitable for one program in order to create portfolio diversification. If such analysis is not determinative, our Manager will allocate the investment to the program with uncommitted funds available for the longest period or, to the extent feasible, prorate the investment between the programs in accordance with uninvested funds.
Related Party Transactions
Related party transactions are those where we or our Manager on our behalf, transact with affiliated companies. Our Manager and its affiliates are permitted to enter into certain transactions and perform certain services for us. Although those transactions will be subject to the limitations set forth in our amended and restated operating agreement, those transactions, or the potential for those transactions, could cause conflicts for our Manager with respect to performing its duties. Related party transactions will not be the result of an arm’s-length negotiation.
Allocation of Our Manager’s Time
We rely on our Manager or its affiliates to manage our day-to-day activities and to implement our investment strategy. Our Manager and certain of its affiliates are presently, and plan in the future to continue to be, involved with activities that are unrelated to us. As a result of these activities, our Manager, its employees and certain of its affiliates will have conflicts of interest in allocating their time between us and the other activities in which they are or may become involved, including the management of Fund 5 International, Terra Fund 6, Terra International and Terra Fund 7. The employees of our Manager or its affiliates will devote only as much of its or their time to our business as it and its employees, in their judgment, determine is reasonably required, which may be substantially less than their full time. Therefore, our Manager, its personnel and certain affiliates may experience conflicts of interest in allocating management time, services and functions among us and any other business ventures in which they or any of their key personnel, as applicable, are or may become involved. This could result in actions that are more favorable to other affiliated entities than to us.
However, we believe that the members of our Manager’s senior management and the other key debt finance professionals performing services for us on behalf of our Manager have sufficient time to fully discharge their responsibilities to us and to the other businesses in which they are involved. We believe that our Manager’s executive officers will devote the time required to manage our business and expect that the amount of time a particular executive officer or affiliate devotes to us will vary during the course of the year and depend on business activities at the given time. We expect that these executive officers and affiliates will generally devote more time to programs raising and investing capital than to programs that have completed their offering stages, though from time to time each program will have its unique demands. Because many of the operational aspects of Terra Capital Partners-sponsored programs are very similar, there are significant efficiencies created by the same team of individuals at our Manager providing services to multiple programs. For example, our Manager has streamlined the structure for financial reporting, internal controls and investment approval processes for the programs.
Competition and Allocation of Investment Opportunities
Employees of our Manager or its affiliates are simultaneously providing investment advisory or management services to other affiliated entities, including Fund 5 International, Terra Fund 6, Terra International, Terra International Fund 3, Terra International Fund 3 REIT, Terra Fund 7 and Terra Property Trust 2.
Our Manager may determine it appropriate for us and one or more other investment programs managed by our Manager or any of its affiliates to participate in an investment opportunity. To the extent we are able to make co-investments with investment programs managed by our Manager or its affiliates, these co-investment opportunities may give rise to conflicts of interest or perceived conflicts of interest among us and the other participating programs. In addition, conflicts of interest or perceived conflicts of interest may also arise in determining which investment opportunities should be presented to us and other participating programs.
To mitigate these conflicts, our Manager will seek to execute such transactions on a fair and equitable basis and in accordance with its allocation policies, taking into account various factors, which may include: the source of origination of the investment opportunity; objectives and strategies; tax considerations; risk, diversification or investment concentration parameters; characteristics of the security; size of available investment; available liquidity and liquidity requirements; regulatory restrictions; and/or such other factors as may be relevant to a particular transaction.
Receipt of Compensation by Affiliates
The payments to the REIT Manager and certain of its affiliates have not been determined through arm’s-length negotiations, and are payable regardless of our profitability. The REIT Manager and its affiliates receive fees for their services, including an origination fee, asset management fee, asset servicing fee, disposition fee and transaction break-up fee. In addition, our Manager is entitled to receive incentive distributions equal to 15% of distributions paid by us once we pay cumulative distributions to holders of units equal to the capital invested by such members plus a preferred return ranging from 8.5% to 9.0%, depending on the historical preferred return applicable to their Terra Fund units. The preferred return applicable to the units sold in the private placement concurrent with the REIT formation transactions is 8.5%.
To the extent the terms of the management arrangement with the REIT Manager are amended in the future, including if we enter into a new management agreement with the REIT Manager or its affiliates, the terms of any such arrangement will not have been determined through arm’s-length negotiations and may be payable, in whole or in part, regardless of profitability.
Loans Involving Affiliates
We do not make any loans to our Manager or to any of its affiliates. In addition, we do not make any loans to its dealer manager, Terra Capital Markets or any entities or individuals affiliated with its dealer manager.
Under our amended and restated operating agreement, our Manager or its affiliates may, but will have no obligation to, make loans to us to acquire assets or to pay our operating expenses. Any such loan will bear interest at the actual cost of funds to our Manager and provide for the payment of principal and any accrued but unpaid interest in accordance with the terms of the promissory note evidencing such loan, but in no event later than our dissolution. Any such loans would not be the result of arm’s-length negotiations and could create conflicts between the interests of our Manager and its affiliates on the one hand and us and our members on the other.
The Resolution of Conflicts Will Be Undertaken by Employees of Our Manager and its Affiliates
In the event of a conflict between us and our Manager or our Manager’s affiliates, the conflict will be resolved by our Manager. Although our Manager has certain fiduciary responsibilities to us and to our members, a conflict of interest policy relating to the resolution of conflicts between us or our REIT subsidiary, the REIT Manager and our Manager and its affiliates does not exist.
No Independent Counsel
Pursuant to the terms of our amended and restated operating agreement, each of our members acknowledges and agrees that counsel representing us, our Manager and its affiliates does not represent and shall not be deemed under the applicable codes of professional responsibility to have represented or to be representing any or all of our members in any respect.
Representation in Tax Audit Proceedings
Our Manager is designated as our “tax matters partner” and is authorized and directed by our amended and restated operating agreement to represent us and our members, at our expense, in connection with all examinations of our affairs by federal tax authorities, including any resulting administrative or judicial proceedings. Those proceedings may involve or affect other programs for which our Manager or its affiliates act as manager. In those situations, the positions taken by our Manager with respect to us may have differing effects on us and the other programs. Any decisions made by our Manager with respect to those matters will be made in a manner consistent with its duties to us and to our members.
Other Conflicts of Interest
We will be subject to conflicts of interest arising out of our relationship with our Manager and its affiliates. In the future, we may enter into additional transactions with Terra Capital Partners or its affiliates. In particular, we may invest in, or acquire, certain of our investments through joint ventures with Terra Capital Partners or its affiliates or purchase assets from, sell assets to or arrange financing from or provide financing to its other vehicles. Any such transactions will require approval of our Manager. There can be no assurance that any procedural protections will be sufficient to assure that these transactions will be made on terms that will be at least as favorable to us as those that would have been obtained in an arm’s-length transaction.
Item 14.
Item 14. Principal Accounting Fees and Services.
During the years ended December 31, 2019 and 2018, KPMG LLP (“KPMG”) served as our independent auditor and provided certain tax and other services. Our Manager currently anticipates that it will engage KPMG as our independent auditor to audit our financial statements for the year ending December 31, 2020, subject to agreeing on fee estimates for the audit work. Our Manager reserves the right, however, to select a new auditor at any time in the future in its discretion if it deems such decision to be in the best interests of us and our members. Any such decision would be disclosed to the members in accordance with applicable securities laws.
The following table displays fees for professional services by KPMG for the years ended December 31, 2019 and 2018:
Audit Fees. Audit fees include fees for services that normally would be provided by KPMG in connection with statutory and regulatory filings or engagements and that generally only an independent accountant can provide. In addition to fees for the audit of our annual financial statements and the review of our quarterly financial statements in accordance with generally accepted auditing standard, this category contains fees for comfort letters, statutory audits, consents, and assistance with and review of documents filed with the SEC.
Audit-Related Fees. Audit-related services consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements and are not reported under “Audit Fees.” These services include attest services that are not required by statute or regulation and consultations concerning financial accounting and reporting standards.
Tax Services Fees. Tax services fees consist of fees billed for professional tax services. These services also include assistance regarding federal, state, and local tax compliance.
All Other Fees. Other fees would include fees for products and services other than the services reported above.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
The following exhibits are included, or incorporated by reference, in this annual report on Form 10-K:
(1) Financial Statements
The index to our financial statements and schedule is on page of this annual report on Form 10-K.
Other Financial Statements:
Terra Property Trust, Inc. (Incorporated by reference to Annual Report on Form 10-K (File No. 000-56117) filed with the SEC on February 28, 2020 by Terra Property Trust, Inc.)
(2) Financial Statement Schedule
None
(3) Exhibits
The following exhibits are filed with this report. Documents other than those designated as being filed herewith are incorporated herein by reference.
_______________
* Filed herewith.
** Furnished herewith.
Item 16. Form 10-K Summary.
None.
Terra Secured Income Fund 5, LLC
Index to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Members and Managing Member
Terra Secured Income Fund 5, LLC:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated statements of financial condition of Terra Secured Income Fund 5, LLC and subsidiaries (the Company), including the consolidated schedule of investment, as of December 31, 2019 and 2018, the related consolidated statements of operations, changes in members’ capital, and cash flows for the years then ended, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (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 consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated 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 consolidated 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 consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ KPMG LLP
We have served as the Company’s auditor since 2016.
New York, New York
February 28, 2020
Terra Secured Income Fund 5, LLC
Consolidated Statements of Financial Condition
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Statements of Operations
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Statements of Changes in Members’ Capital
Years Ended December 31, 2019 and 2018
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Statements of Cash Flows
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment
December 31, 2019 and 2018
As of December 31, 2019 and 2018, the Company’s only investment is its equity interest in a majority-owned subsidiary as presented below:
As of December 31, 2019, the Company owned 98.6% of the outstanding shares of common stock of Terra Property Trust, Inc. (“Terra Property Trust”). The following table presents a schedule of loans held for investment by Terra Property Trust at 100% and the Company’s pro-rata share of the fair value at December 31, 2019:
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment (Continued)
December 31, 2019 and 2018
Terra Property Trust’s Schedule of Loans Held for Investment as of December 31, 2019 (Continued):
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment (Continued)
December 31, 2019 and 2018
Terra Property Trust’s Schedule of Loans Held for Investment as of December 31, 2019 (Continued):
___________________________
(1)
Because there is no readily available market for these loans, these loans were valued using significant unobservable inputs under Level 3 of the fair value hierarchy and were approved in good faith by Terra REIT Advisors, LLC (“Terra REIT Advisors”), Terra Property Trust’s manager, pursuant to Terra Property Trust’s valuation policy.
(2)
Amount represents the Company’s portion, or 98.6%, of the fair value or net investment value.
(3)
Percentage is based on the Company’s pro rata share of the fair value or net investment value over the Company’s total members’ capital of $247.1 million at December 31, 2019.
(4)
Terra Property Trust sold a portion of its interests in these loans via participation agreements to Terra Secured Income Fund 5 International, an affiliated fund advised by Terra REIT Advisors.
(5)
Terra Property Trust sold a portion of its interests in these loans via participation agreements to Terra Income Fund International, an affiliated fund advised by Terra REIT Advisors.
(6)
The loan participations from Terra Property Trust do not qualify for sale accounting and therefore, the gross amount of these loans remain in the consolidated statements of financial condition.
(7)
Terra Property Trust sold a portion of its interest in this loan through a participation agreement to Terra Income Fund 6, Inc., an affiliated fund advised by Terra Income Advisors, LLC (“Terra Income Advisors”), an affiliate of our sponsor and Terra Property Trust’s manager.
(8)
Terra Property Trust sold a portion of its interest in this loan through a participation agreement to Terra Property Trust 2, Inc., an affiliated fund managed by Terra REIT Advisors.
(9)
On June 27, 2018, Terra Property Trust entered into a participation agreement with Terra Income Fund 6, Inc. to purchase a 25% interest, or $4.3 million, in a mezzanine loan. As of December 31, 2019, the unfunded commitment was $1.1 million.
(10)
Terra Property Trust sold a portion of its interest in this loan via a participation agreement to a third-party.
(11)
These loans were used as collateral for $81.1 million of borrowings under a repurchase agreement.
(12)
Terra Property Trust acquired this property through foreclosure of a $54.0 million first mortgage. Real estate owned, net amount includes building and building improvements, tenant improvements and lease intangible assets and liabilities, net of accumulated depreciation and amortization.
(13)
Terra Property Trust acquired the collateral for this loan via deed in lieu of foreclosure. On June 30, 2019, Terra Property Trust recorded an impairment charge of $1.6 million on the land in order to reduce the carrying value of the land to its estimated fair value, which is the estimated selling price less the cost of sale.
(14)
Percentage is based on Terra Property Trust’s net exposure on the property (real estate owned less encumbrance).
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment (Continued)
December 31, 2019 and 2018
The following table presents a schedule of loans held for investment held by Terra Property Trust as of December 31, 2018:
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment (Continued)
December 31, 2019 and 2018
Terra Property Trust’s Schedule of Loans Held for Investment as of December 31, 2018 (Continued):
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Consolidated Schedule of Investment (Continued)
December 31, 2019 and 2018
Terra Property Trust’s Schedule of Loans Held for Investment as of December 31, 2018 (Continued):
___________________________
(1)
Because there is no readily available market for these loans, these loans were valued using significant unobservable inputs under Level 3 of the fair value hierarchy and were approved in good faith by Terra REIT Advisors, Terra Property Trust’s manager, pursuant to Terra Property Trust’s valuation policy.
(2)
Percentages are based on the fair value of the Company’s investment in Terra Property Trust of $263.1 million as of December 31, 2018.
(3)
Terra Property Trust sold a portion of its interests in these loans via participation agreements to Terra Secured Income Fund 5 International, an affiliated fund advised by Terra REIT Advisors.
(4)
Terra Property Trust sold a portion of its interests in these loans via participation agreements to Terra Income Fund International, an affiliated fund advised by Terra REIT Advisors.
(5)
The loan participations from Terra Property Trust do not qualify for sale accounting and therefore, the gross amount of these loans remain in the consolidated statements of financial condition.
(6)
Terra Property Trust sold a portion of its interest in this loan through a participation agreement to Terra Income Fund 6, Inc., an affiliated fund advised by Terra Income Advisors, an affiliate of our sponsor and Terra Property Trust’s manager.
(7)
Terra Property Trust sold a portion of its interest in this loan through a participation agreement to Terra Property Trust 2, Inc., an affiliated fund managed by Terra REIT Advisors.
(8)
In January 2019, the borrower extended the maturity of the loan to December 16, 2019
(9)
On June 27, 2018, Terra Property Trust entered into a participation agreement with Terra Income Fund 6, Inc. to purchase a 25% interest, or $4.3 million, in a mezzanine loan. As of December 31, 2018, none of the commitment has been funded.
(10)
This loan was repaid in January 2019.
(11)
In February 2019, Terra Property Trust entered into a forbearance agreement with the borrower whereby the borrower has until April 15, 2019 to repay the loan in full.
(12)
This loan was used as collateral for a $34.2 million borrowing under a repurchase agreement.
(13)
In January 2019, Terra Property Trust acquired the collateral for this loan via deed in lieu of foreclosure.
(14)
In January 2019, the borrower made a partial repayment of $18.5 million on this loan. In connection with the repayment, the maturity of the loan was extended to March 5, 2019. On March 5, 2019, the loan was repaid in full.
(15)
Terra Property Trust acquired this property through foreclosure of a $54.0 million first mortgage. Amount includes building and building improvements, tenant improvements and lease intangible assets and liabilities, net of accumulated depreciation and amortization.
(16)
Percentage is based on Terra Property Trust’s net exposure on the property (real estate owned less encumbrance).
See notes to consolidated financial statements.
Terra Secured Income Fund 5, LLC
Notes to Consolidated Financial Statements
December 31, 2019
Note 1. Business
Terra Secured Income Fund 5, LLC (and, together with its consolidated subsidiaries, the “Company”), is a real estate credit focused company that originates, structures, funds and manages high yielding commercial real estate investments, including mezzanine loans, first mortgage loans, subordinated mortgage loans and preferred equity investments throughout the United States. The Company’s loans finance the acquisition, construction, development or redevelopment of quality commercial real estate in the United States. The Company focuses on the origination of middle market loans in the approximately $10 million to $50 million range, to finance properties in primary and secondary markets. The Company believes loans of this size are subject to less competition, offer higher risk adjusted returns than larger loans with similar risk metrics and facilitate portfolio diversification. The Company was formed as a Delaware limited liability company on April 24, 2013 and commenced operations on August 8, 2013. The Company makes substantially all of its investments and conducts substantially all of its real estate lending business through Terra Property Trust, which has elected to be taxed as a real estate investment trust (“REIT”) for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2016. The Company’s objectives are to (i) preserve its members’ capital contributions, (ii) realize income from its investments and (iii) make monthly distributions to its members from cash generated from investments. There can be no assurances that the Company will be successful in meeting its objectives.
In December 2015, the members approved the merger of Terra Secured Income Fund, LLC (“Terra Fund 1”), Terra Secured Income Fund 2, LLC (“Terra Fund 2”), Terra Secured Income Fund 3, LLC (“Terra Fund 3”) and Terra Secured Income Fund 4, LLC (“Terra Fund 4”) with and into subsidiaries of the Company (individually, each a “Terra Fund” and collectively, the “Terra Funds”) through a series of separate mergers effective January 1, 2016 (collectively, the “Merger”). Following the Merger, the Company contributed the consolidated portfolio of net assets of the five Terra Funds to Terra Property Trust, a newly-formed and wholly-owned subsidiary of the Company that elected to be taxed as a REIT, in exchange for the shares of common stock of Terra Property Trust. Upon completion of the Merger, the Company became the parent company of Terra Funds 1 through 4 and the direct and indirect sole common stockholder of, and began conducting substantially all of its real estate lending business through, Terra Property Trust. As of December 31, 2019, the Company owned 14,912,990 shares, or 98.6%, of Terra Property Trust’s outstanding common stock. The Company does not consolidate Terra Property Trust as Terra Property Trust is not an investment company.
The Company’s investment activities were externally managed by Terra Income Advisors, a private investment firm affiliated with the Company until February 8, 2018 when Terra Capital Partners, LLC (“Terra Capital Partners”), the Company’s sponsor, caused a new subsidiary of Terra Capital Partners, Terra Fund Advisors, LLC (“Terra Fund Advisors”), to be admitted as the replacement manager of the Company. When used herein the term “Manager” refers to Terra Income Advisors for periods prior to February 8, 2018 and refers to Terra Fund Advisors beginning on such date. The Company does not currently have any employees and does not expect to have any employees. Services necessary for the Company’s business are provided by individuals who are employees of the Manager or its affiliates or by individuals who were contracted by the Company or by the Manager or its affiliates to work on behalf of the Company pursuant to the terms of the operating agreement, as amended.
The Company’s amended and restated operating agreement provides that the Company’s existence will continue until December 31, 2023, unless sooner terminated. However, the Company expects that prior to such date it will consummate a liquidity transaction, which may include an orderly liquidation of its assets or an alternative liquidity event such as a sale of the Company or an initial public offering and listing of Terra Property Trust’s shares of common stock on a national securities exchange. The Manager would pursue an alternative liquidity event only if it believes such a transaction would be in the best interests of the Company’s members.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation and Principles of Consolidation
The consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”) and include all of the Company’s accounts and those of its consolidated subsidiaries. All intercompany balances and transactions have been eliminated. The accompanying financial statements of the Company and related financial information have been prepared pursuant to the requirements for reporting on Form 10-K and Articles 6 or 10 of Regulation S-X. The Company is an investment company, as defined under U.S. GAAP, and applies accounting and reporting guidance in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 946, Financial Services - Investment Companies.
Notes to Consolidated Financial Statements
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of gains (losses), income and expenses during the reporting period. Actual results could significantly differ from those estimates. The most significant estimates inherent in the preparation of the Company’s consolidated financial statements is the valuation of its investment (Note 3).
Equity Investment in Terra Property Trust
Equity investment in Terra Property Trust represents the Company’s equity interest in Terra Property Trust, which was initially recorded at cost. Subsequent to the asset contribution, the equity investment is reported, at each reporting date, at fair value on the consolidated statements of financial condition. Change in fair value is reported in net change in unrealized appreciation or depreciation on investment on the consolidated statements of operations.
Revenue Recognition
Dividend Income: Dividend income associated with the Company’s ownership of Terra Property Trust is recognized on the record date as declared by Terra Property Trust. Any excess of distributions over Terra Property Trust’s cumulative net income are recorded as return of capital.
Other Operating Income: All other income is recognized when earned.
Cash and Cash Equivalents
The Company considers all highly liquid investments, with original maturities of ninety days or less when purchased, as cash equivalents. Cash and cash equivalents are exposed to concentrations of credit risk. The Company maintains all of its cash at financial institutions which, at times, may exceed the amount insured by the Federal Deposit Insurance Corporation.
Income Taxes
No provision for U.S. federal and state income taxes has been made in the accompanying consolidated financial statements, as individual members are responsible for their proportionate share of the Company’s taxable income. The Company, however, may be liable for New York City Unincorporated Business Tax (the “NYC UBT”) and similar taxes of various other municipalities. New York City imposes the NYC UBT at a statutory rate of 4% on net income generated from ordinary business activities carried on in New York City. For the years ended December 31, 2019 and 2018, none of the Company’s income was subject to the NYC UBT.
Deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the consolidated financial statements and tax basis assets and liabilities using enacted tax rates in effect for the year in which differences are expected to reverse. Such deferred tax assets and liabilities were not material.
The Company did not have any uncertain tax positions that met the recognition or measurement criteria of ASC 740-10-25, Income Taxes, nor did the Company have any unrecognized tax benefits as of the periods presented herein. The Company recognizes interest and penalties, if any, related to unrecognized tax liabilities as income tax expense in its consolidated statements of operations. For the years ended December 31, 2019 and 2018, the Company did not incur any interest or penalties. Although the Company files federal and state tax returns, its primary tax jurisdiction is federal. The Company’s 2015-2019 federal tax years remain subject to examination by the Internal Revenue Service.
Recent Accounting Pronouncement
In February 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 outlines a new model for accounting by lessees, whereby their rights and obligations under substantially all leases, existing and new, would be capitalized and recorded on the balance sheet. For lessors, however, the accounting remains largely unchanged from the model under ASC 840, Leases (“ASC 840”), with the distinction between operating and financing leases retained, but updated to align with certain changes to the lessee model and the new revenue recognition standard. The new standard also replaces the sale-leaseback guidance under ASC 840 with a new model applicable to both lessees and lessors. Additionally, the new standard requires extensive quantitative and qualitative disclosures. ASU 2016-02 was effective for U.S.
Notes to Consolidated Financial Statements
GAAP public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company adopted ASU 2016-02 on January 1, 2019. The adoption of ASU 2016-02 did not have any impact on the Company’s consolidated financial statements and disclosures as the Company does not have any lease arrangements.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure framework - Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”). The objective of ASU 2018-13 is to improve the effectiveness of disclosures in the notes to financial statements by facilitating clear communication of information required by U.S. GAAP. The amendments in ASU 2018-13 added, removed and modified certain fair value measurement disclosure requirements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted upon issuance of ASU 2018-13. The Company does not expect the adoption of ASU 2018-13 to have a material impact on its consolidated financial statements and disclosures.
In August 2018, the Securities and Exchange Commission (the “SEC”) adopted a final rule that eliminates or amends disclosure requirements that have become duplicative, overlapping, or outdated in light of other SEC disclosure requirements, U.S. GAAP, or changes in the information environment (the “Final Rule”). The Final Rule is intended to simplify and update the disclosure of information to investors and reduce compliance burdens for companies, without significantly altering the total mix of information available to investors. Among other items, the Final Rule requires registrants to include in their interim financial statements a reconciliation of changes in net assets or stockholders’ equity in the notes or as a separate statement. The Final Rule was effective for all filings made on or after November 5, 2018; however, the SEC would not object if a filer’s first presentation of the changes in net assets or stockholders’ equity was included in its Form 10-Q for the quarter that begins after the effective date of the Final Rule. The Company adopted the Final Rule in the first quarter of fiscal year 2019. The adoption of the Final Rule did not have a material impact on the Company’s consolidated financial statements and disclosures.
Note 3. Investment and Fair Value
Equity Investment in Terra Property Trust
The Company invests substantially all of its equity capital in the purchase of common shares of Terra Property Trust.
The following table presents a summary of the Company’s investment at December 31, 2019 and December 31, 2018:
For the years ended December 31, 2019 and 2018, the Company received approximately $30.3 million and $32.7 million of distributions from Terra Property Trust, respectively, of which $21.3 million and $10.2 million were returns of capital, respectively.
Notes to Consolidated Financial Statements
The following tables present the summarized financial information of Terra Property Trust:
Fair Value Measurements
The Company adopted the provisions of ASC 820, Fair Value Measurement (“ASC 820”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. ASC 820 established a fair value hierarchy that prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is impacted by a number of factors, including the type of investment, the characteristics specific to the investment, and the state of the marketplace (including the existence and transparency of transactions between market participants). Investments with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in an orderly market will generally have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Investments measured and reported at fair value are classified and disclosed into one of the following categories based on the inputs as follows:
Level 1 - Quoted prices (unadjusted) in active markets for identical assets and liabilities that the Company has the ability to access.
Level 2 - Pricing inputs are other than quoted prices in active markets, including, but not limited to, quoted prices for similar assets and liabilities in markets that are active, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the assets or liabilities (such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates) or other market corroborated inputs.
Level 3 - Significant unobservable inputs are based on the best information available in the circumstances, to the extent observable inputs are not available, including the Company’s own assumptions used in determining the fair value of investments. Fair value for these investments are determined using valuation methodologies that consider a range of factors, including but not limited to the price at which the investment was acquired, the nature of the investment, local market conditions, trading values on public exchanges for comparable securities, current and projected operating performance, and financing transactions subsequent to the acquisition of the investment. The inputs into the determination of fair value require significant management judgment.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment.
Notes to Consolidated Financial Statements
Assets and Liabilities Reported at Fair Value
The following table summarizes the Company’s equity investment in Terra Property Trust at fair value on a recurring basis as of December 31, 2019 and 2018:
Changes in Level 3 investment for the years ended December 31, 2019 and 2018 were as follows:
Transfers between levels, if any, are recognized at the beginning of the period in which transfers occur. For the years ended December 31, 2019 and 2018, there were no transfers.
The Company estimated that its other financial assets and liabilities had fair values that approximated their carrying values at December 31, 2019 and 2018 due to their short-term nature.
Valuation Process for Fair Value Measurement
Market quotations are not readily available for the Company’s investment in Terra Property Trust, which is included in Level 3 of the fair value hierarchy. The fair value of the Company’s sole investment takes into consideration the fair value of Terra Property Trust’s assets and liabilities which are valued utilizing a yield approach, i.e. a discounted cash flow methodology. In following this methodology, loans are evaluated individually, and management takes into account, in determining the risk-adjusted discount rate for each of Terra Property Trust’s loans, relevant factors, including available current market data on applicable yields of comparable debt/preferred equity instruments; market credit spreads and yield curves; the investment’s yield; covenants of the investment, including prepayment provisions; the portfolio company’s ability to make payments, its net operating income, debt-service coverage ratio; construction progress reports and construction budget analysis; the nature, quality, and realizable value of any collateral (and loan-to-value ratio); and the forces that influence the local markets in which the asset (the collateral) is purchased and sold, such as capitalization rates, occupancy rates, rental rates, replacement costs and the anticipated duration of each real estate-related loan.
The Manager designates a valuation committee to oversee the entire valuation process of Terra Property Trust’s Level 3 investments. The valuation committee is comprised of members of the Manager’s senior management, deal and portfolio management teams, who meet on a quarterly basis, or more frequently as needed, to review Terra Property Trust investments being valued as well as the inputs used in the proprietary valuation model. Valuations determined by the valuation committee are supported
Notes to Consolidated Financial Statements
by pertinent data and, in addition to a proprietary valuation model, are based on market data, third-party valuation data and discount rates or other methods the valuation committee deems to be appropriate.
The following tables summarize the valuation techniques and significant unobservable inputs used by the Company to value the Level 3 investments as of December 31, 2019 and 2018. The tables are not intended to be all-inclusive, but instead identify the significant unobservable inputs relevant to the determination of fair values.
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(1)
Discounted cash flows and discount rates applied to Terra Property Trust’s assets and liabilities.
Risks and Uncertainties
The Company’s investment in Terra Property Trust is highly illiquid and there is no assurance that the Company will achieve its investment objectives, including targeted returns. Terra Property Trust’s loans are highly illiquid. Due to the illiquidity of the loans, valuation of the loans may be difficult, as there generally will be no established markets for these loans. As the Company’s investment is carried at fair value with fair value changes recognized in the consolidated statements of operations, any changes in fair value would directly affect the Company’s members’ capital.
Note 4. Related Party Transactions
Axar Transaction
On February 8, 2018, Terra Capital Partners caused (i) a new subsidiary of Terra Capital Partners, Terra REIT Advisors to become the external manager of Terra Property Trust, (ii) a new subsidiary of Terra Capital Partners, Terra Fund Advisors, to be admitted as the replacement manager of the Company and the equity interests in Terra Fund Advisors to be distributed to the equity owners of Terra Capital Partners on a pro rata basis and (iii) the equity interests in another subsidiary of Terra Capital Partners, Terra Income Advisors, which also serves as the external adviser to Terra Income Fund 6, Inc. (“Terra Fund 6”), to be distributed to the equity owners of Terra Capital Partners on a pro rata basis. After the completion of the above steps, a pooled investment vehicle advised by Axar Capital Management L.P. (“Axar”) entered into an investment agreement with Terra Capital Partners and its affiliates (which is referred to collectively as the “Axar Transaction”), pursuant to which Axar acquired from the respective owners thereof: (i) a 49% economic interest in Terra Fund Advisors; (ii) a 65.7% economic and voting interest in Terra Capital Partners (and thereby Terra REIT Advisors); and (iii) an initial 49% economic interest in Terra Income Advisors. On November 30, 2018, Axar acquired the remaining 34.3% economic interest in Terra Capital Partners. On April 30, 2019, Axar acquired the remaining 51% economic interest in Terra Income Advisors.
Operating Agreement
The Company had an operating agreement, as amended, with Terra Income Advisors whereby Terra Income Advisors was responsible for the Company’s day-to-day operations. As part of the Axar Transaction, on February 8, 2018, Terra Income Advisors assigned all of its rights, title and interest in the Company pursuant to the Amended and Restated Limited Liability Company Agreement of the Company, dated January 1, 2016, to Terra Fund Advisors. The operating agreement, as amended, is scheduled to terminate on December 31, 2023 unless the Company is dissolved earlier. Starting January 1, 2016, the Company conducts all of its real estate lending business through Terra Property Trust. As such, Terra Property Trust is responsible for management compensation paid and operating expenses reimbursed to its manager pursuant to a management agreement with the manager.
Notes to Consolidated Financial Statements
Management Agreement
As part of the Axar Transaction, Terra Income Advisors, Terra Property Trust’s manager prior to February 8, 2018, assigned all of its rights, title and interest in and to its then current external management agreement with Terra Property Trust to Terra REIT Advisors and immediately thereafter, Terra REIT Advisors and Terra Property Trust amended and restated such management agreement. Such amended and restated management agreement has the same economic terms and is in all material respects otherwise on the same terms as the management agreement between Terra Income Advisors and Terra Property Trust in effect immediately prior to the Axar Transaction, except for the identity of the manager.
Dividend Income
As discussed in Note 3, for the years ended December 31, 2019 and 2018, the Company received approximately $30.3 million and $32.7 million of distributions from Terra Property Trust, respectively, of which $21.3 million and $10.2 million was a return of capital, respectively.
Terra International 3
On September 30, 2019, Terra Property Trust entered into a Contribution and Repurchase Agreement with Terra International Fund 3, L.P. (“Terra International 3”) and Terra International Fund 3 REIT, LLC (“Terra International Fund 3 REIT”), a wholly-owned subsidiary of Terra International 3.
Pursuant to this agreement, Terra International 3, through Terra International Fund 3 REIT, contributed cash in the amount of $3.6 million to Terra Property Trust in exchange for 212,691 shares of common stock, at a price of $17.02 per share. In addition, Terra International 3 agreed to contribute to Terra Property Trust future cash proceeds, if any, raised from time to time by it, and Terra Property Trust agreed to issue shares of common stock to International Fund 3 in exchange for any such future cash proceeds, in each case pursuant to and in accordance with the terms and conditions specified in the agreement. The shares were issued in a private placement in reliance on Section 4(a)(2) of the Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder.
Terra REIT Advisors also serves as adviser to the Terra International 3 and Terra International Fund 3 REIT. In addition, the general partner of Terra International 3 is Terra International Fund 3 GP, LLC, which is an affiliate of Terra Fund Advisors, our manager.
Due to Related Party
As of December 31, 2019, amount due to related party was $0.04 million, related to an invoice an affiliate paid on behalf of the Company.
Note 5. Commitments and Contingencies
The Company enters into contracts that contain a variety of indemnification provisions. The Company’s maximum exposure under these arrangements is unknown; however, the Company has not had prior claims or losses pursuant to these contracts. The Manager has reviewed the Company’s existing contracts and expects the risk of loss to the Company to be remote.
The Company is not currently subject to any material legal proceedings and, to the Company’s knowledge, no material legal proceedings are threatened against the Company. From time to time, the Company may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of the Company’s rights under contracts with its portfolio companies. While the outcome of any legal proceedings cannot be predicted with certainty, the Company does not expect that any such proceedings will have a material adverse effect upon its financial condition or results of operations.
Note 6. Members’ Capital
As of December 31, 2019 and 2018, the Company had 6,637.7 units and 6,638.4 units outstanding, respectively, and the net asset value per unit was $37,222 and $39,630, respectively.
Notes to Consolidated Financial Statements
Capital Contributions
As of January 31, 2015, the offering period ended, and the Company stopped accepting capital contributions. In connection with the Merger, the Company offered existing members of the Terra Funds the opportunity to invest in the Company through purchase of additional units (the “Rights Offering”). The Rights Offering was completed on May 17, 2016.
Capital Distributions
At the discretion of the Manager, the Company may make distributions from net cash flow from operations, net disposition proceeds, or other cash available for distribution. Distributions are made to holders of Continuing Income Units (regular units of limited liability company interest in the Company) in proportion to their unit holdings until they receive a return of their initial Deemed Capital Contribution, as defined in the operating agreement, plus a preferred return ranging from 8.5% to 9.0% depending on the historical preferred return applicable to their Terra Fund units, after which time distributions are made 15% to the Manager which the Company refers to as the carried interest distribution, and 85% to the holders of Continuing Income Units. The preferred return applicable to the Continuing Income Units sold in the offering concurrent with the Merger is 8.5%.
In addition, holders of Termination Units (membership interest in the Company that were issued to members of Terra Funds 1 through 4 who chose to enter the liquidation phase of their investments) received monthly distributions at a fixed rate of 6.0% per annum of the Unreturned Invested Capital (capital contributions less cumulative stated distributions of principal and less any amounts paid in redemption).
For the years ended December 31, 2019 and 2018, the Company made total distributions to non-manager members of $29.9 million and $30.0 million, respectively. For the years ended December 31, 2019 and 2018, the Company did not make any carried interest distributions to the Manager.
Capital Redemptions
In the Merger, members of Terra Funds 1 through 4 who wished to enter the liquidation phase of their investments chose to receive Termination Units as merger consideration. These Termination Units were redeemed on the original expected liquidation dates of the funds. As of December 31, 2019 and 2018, there were no Termination Units outstanding. For the year ended December 31, 2019, the Company redeemed 0.7 Continuing Income Units for $0.03 million. For the year ended December 31, 2018, the Company redeemed 8.6 Continuing Income Units for $0.3 million and 50.4 Termination Units for $2.1 million.
At the discretion of the Manager, a reserve of 5% of cash from operations may be established in order to repurchase units from non-managing members. The Manager is under no obligation to redeem non-managing members’ units. As of December 31, 2019 and 2018, no such reserve was established.
Allocation of Income (Loss)
Profits and losses are allocated to the members in proportion to the units held in a given calendar year.
Member Units
Each membership interest through the original offering was offered for a price of $50,000 per unit. The membership interests in Terra Funds 1 through 4 were exchanged for units of the Company at a price of $43,410 per unit, which was the exchange value per unit of the Company on December 31, 2015, and the units in the Rights Offering were offered at a price of $47,000 per unit. The following table provides a roll forward of the units outstanding of the Company for the years ended December 31, 2019 and 2018:
Notes to Consolidated Financial Statements
Note 7. Selected Quarterly Financial Data (unaudited)
Note 8. Financial Highlights
The financial highlights represent the per unit operating performance, return and ratios for the non-managing members’ class, taken as a whole, for the years ended December 31, 2019 and 2018. These financial highlights consist of the operating performance, the internal rate of return (“IRR”) since inception of the Company, and the expense and net investment income ratios.
The IRR, net of all fees and carried interest (if any), is computed based on actual dates of the cash inflows (capital contributions), outflows (capital distributions), and the ending capital at the end of the respective period (residual value) of the non-managing members’ capital account.
Notes to Consolidated Financial Statements
The following summarizes the Company’s financial highlights for the years ended December 31, 2019 and 2018:
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(1)
The per unit data was derived by using the weighted average units outstanding during the applicable periods, which were 6,638 units and 6,662 units for the years ended December 31, 2019 and 2018, respectively.
(2)
The per unit data for distributions reflects the actual amount of distributions paid per unit during the periods.
Note 9. Subsequent Events
Management has evaluated subsequent events through the date the consolidated financial statements were available to be issued. Management has determined that there are no material events other than the ones below that would require adjustment to, or disclosure in, the Company’s consolidated financial statements.
On February 27, 2020, the board of directors of Terra Property Trust approved the potential acquisition by Terra Property Trust of Terra Property Trust 2, Inc. (“TPT2”). As of December 31, 2019, TPT2’s assets consisted of approximately $17.5 million of participation interests in loans also held by the Company and approximately $17.6 million in cash. The transaction, if consummated, is expected to be structured as a merger pursuant to which TPT2 will be merged with and into Terra Property Trust, with Terra Property Trust continuing as the surviving company (the “Merger”). In connection with the Merger, each share of common stock, par value $0.01 per share, of TPT2 issued and outstanding immediately prior to the effective time of the Merger is expected to be converted into the right to receive from Terra Property Trust a number of shares of common stock, par value $0.01 per share, of Terra Property Trust equal to an exchange ratio, which is expected to be 1.20. The exchange ratio will be based on the relative net asset values of Terra Property Trust and TPT2. As a result, Terra Secured Income Fund 7, LLC, the sole stockholder of TPT2, is expected to receive approximately 2,110,102 shares of common stock of Terra Property Trust as consideration in the Merger. In addition, each issued and outstanding share of TPT2’s 12.5% Series A Redeemable Cumulative Preferred Stock will be converted into the right to receive approximately $1,026 in cash. In connection with the Merger, the size of the board of directors of Terra Property Trust is expected to be reduced from eight directors to four directors, with Andrew M. Axelrod, Vikram S. Uppal, Roger H. Beless and Michael L. Evans continuing as directors of Terra Property Trust. The consummation of the Merger is subject to the execution by the parties of a definitive agreement and certain other conditions, and there can be no assurance that the transaction will be completed.
In addition, on February 27, 2020, the board of directors of Terra Property Trust approved the potential acquisition by Terra Property Trust of approximately $32.0 million of participation interests in loans also held by Terra Property Trust and approximately $9.2 million in cash (collectively, the“Assets”) from Terra International Fund 3 REIT, all of which will be acquired from Terra Secured Income Fund 5 International and Terra Income Fund International. If the transaction is consummated, Terra Property Trust expects to issue to Terra International Fund 3 REIT approximately 2,481,020 shares of common stock of Terra Property Trust at a price per share equal to $16.58 in exchange for the Assets. The shares of common stock will be issued in a private
Notes to Consolidated Financial Statements
placement in reliance on Section 4(a)(2) under the Securities Act, as amended, and the rules and regulations promulgated thereunder. The consummation of the transaction is subject to the execution by the parties of a definitive agreement and certain other conditions, and there can be no assurance that the transaction will be completed.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities indicated* thereunto duly authorized.
Date: February 28, 2020
TERRA SECURED INCOME FUND 5, LLC
By:
/s/ Vikram S. Uppal
Vikram S. Uppal
Chief Executive Officer
(Principal Executive Officer)
By:
/s/ Gregory M. Pinkus
Gregory M. Pinkus
Chief Financial Officer and Chief Operating Officer,
(Principal Financial and Accounting Officer)
___________
* The registrant is a limited liability company managed by Terra Fund Advisors, LLC, its sole and managing member and the persons are signing in their respective capacities as officers of Terra Fund Advisors, LLC.