ITEM 1.
BUSINESS
General
We are a Maryland corporation, incorporated in 2005, and a real estate finance company that is organized and conducts our operations to qualify as a real estate investment trust, or REIT, for federal income tax purposes under Subchapter M of the Internal Revenue Code of 1986, as amended, or the Code. Our investment strategy is primarily focused on originating, holding and managing commercial real estate, or CRE, mortgage loans and other commercial real estate-related debt investments. We are externally managed by ACRES Capital, LLC, or our Manager, a subsidiary of ACRES Capital Corp., or collectively, ACRES, a private commercial real estate lender exclusively dedicated to nationwide middle market CRE lending with a focus on multifamily, student housing, hospitality, office and industrial in top United States, or U.S., markets. Our Manager acquired our management contract on July 31, 2020 from our previous manager, Exantas Capital Manager Inc., a subsidiary of C-III Capital Partners LLC, which we refer to as the ACRES acquisition. On February 16, 2021, we amended our certificate of incorporation to change our name to ACRES Commercial Realty Corp. from Exantas Capital Corp. Our Manager draws upon the management team of ACRES and its collective investment experience to provide its services.
Our objective is to provide our stockholders with total returns over time, including quarterly distributions and capital appreciation, while seeking to manage the risks associated with our investment strategies. We finance a substantial portion of our portfolio investments through borrowing strategies seeking to match the maturities and repricing dates of our financings with the maturities and repricing dates of our investments, and, historically, we’ve sought to mitigate interest rate risk through derivative investments.
Our investment strategy targets the following CRE credit investments, including:
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Floating first mortgage loans, which we refer to as whole loans;
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First priority interests in first mortgage loans, which we refer to as A-notes;
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Subordinated interests in first mortgage loans, which we refer to as B-notes;
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Mezzanine debt related to CRE that is senior to the borrower’s equity position but subordinated to other third-party debt;
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Preferred equity investments related to CRE that are subordinate to first mortgage loans and are not collateralized by the property underlying the investment;
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Commercial mortgage-backed securities, which we refer to as CMBS; and
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CRE investments.
We generate our income primarily from the spread between the revenues we receive from our assets and the cost to finance our ownership of those assets, including corporate debt and from hedging interest rate risks.
In December 2019, a novel strain of coronavirus, or COVID-19, was identified. The resulting spread of COVID-19 throughout the globe led the World Health Organization to designate COVID-19 as a pandemic and numerous countries, including the U.S., to declare national emergencies. Many countries have responded to the outbreak by instituting quarantines and restrictions on travel and limiting operations of non-essential offices and retail centers, which has resulted in the closure or remote operation of non-essential businesses and increased rates of unemployment. While certain countries around the world have eased restrictions and financial markets have stabilized to some degree, the pandemic continues to cause uncertainty surrounding its ultimate impact on the global economy, generally, and the CRE business in particular. We continue to actively and responsibly manage corporate liquidity and operations in light of the market disruptions caused by COVID-19. Additionally, nationwide restrictions placed on most businesses in response to COVID-19 are expected to cause significant cash flow disruptions across the economy that will likely impact our borrowers and their ability to stay current with their debt obligations in the near term. We have used and continue to expect to use a variety of legal and structural options to manage that risk effectively, including through forbearance and extension provisions or agreements. It is inherently difficult to accurately assess the impact of COVID-19 on our revenues, profitability and financial position due to uncertainty of the severity and duration of the pandemic. In response, in the near-term, we are focused on prudently retaining and managing sufficient liquidity. We continuously monitor the effects of COVID-19 on our operations and financial position to ensure that we remain responsive and adaptable to the dynamic environment that has been created by the pandemic.
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Historically, we maintained a portfolio of CMBS, including senior and subordinated investment grade CMBS, below investment grade CMBS and unrated CMBS, that we primarily financed using short-term repurchase agreements. However, the COVID-19 pandemic produced material and previously unforeseeable liquidity shocks to the real estate credit markets that led to the receipt of substantial margin calls, and subsequently some default notices, from three of our five CMBS repurchase agreement counterparties. In April 2020, we completed the sale of our portfolio of financed CMBS and settlements were reached on all of our remaining CMBS-related obligations, which were paid in full in April 2020. Currently, we do not expect to invest in a significant CMBS portfolio.
We typically target transitional floating-rate CRE loans between $10.0 million and $80.0 million. While we paused our origination of CRE loans during the second and third quarters of 2020 in connection with the impact of the COVID-19 pandemic, during the year ended December 31, 2020 we originated 21 CRE loans with total commitments of $292.3 million. At December 31, 2020, our CRE loan portfolio comprised approximately $1.5 billion of floating-rate CRE whole loans with a weighted average spread of 3.56% over the one-month London Interbank Offered Rate, or LIBOR. Additionally, our CRE loan portfolio comprised one $4.7 million mezzanine loan and $27.7 million of preferred equity investments at December 31, 2020.
As part of the November 2016 board of directors, or our Board, -approved strategic plan certain underperforming legacy CRE loans were classified as held for sale at December 31, 2016. In December 2020, we sold our remaining CRE asset held for sale.
Our Business Strategy
The core components of our business strategy are:
Investment in CRE assets. We are currently invested in CRE whole loans, CRE mezzanine loans, CRE preferred equity interests and investment grade and non-investment grade CMBS. Our goal is to allocate 90% to 100% of our equity to CRE credit investments. At December 31, 2020, our equity was allocated as follows: 97% in core assets and 3% in non-core assets.
Managing our investment portfolio. At December 31, 2020, we managed $1.7 billion of assets, including $1.3 billion of assets that were financed and held in variable interest entities. The core of our management process is credit analysis, which our Manager, with the assistance of ACRES, uses to actively monitor our existing investments and as a basis for evaluating new investments. Senior management of ACRES have extensive experience in underwriting the credit risk associated with our targeted asset classes and conduct detailed due diligence on all investments. After we make investments, our Manager actively monitors them for early detection of trouble or deterioration. If a default occurs, we will use our senior management team’s asset management experience in seeking to mitigate the severity of any loss and to optimize the recovery from assets collateralizing the investment.
Managing our interest rate, pricing and liquidity risk. We engage in a number of business activities that are vulnerable to interest rate, pricing and liquidity risk and we seek to manage those risks. We historically used derivative financial instruments to hedge a portion of the interest rate risk associated with our borrowings. The risks on our short-term financing agreements, principally repurchase agreements, are managed by limiting our financial exposure under the agreements to either a stated investment amount or a fixed guaranty amount. The risks on our long-term financing agreements, principally our term financing facilities, are managed by seeking to match the maturity and repricing dates of our financed investments with the maturities and repricing dates of our long-term financing facilities. Additionally, we match investment and financing maturity and repricing dates using securitization vehicles structured by our Manager and, subject to the availability of markets for securitization financings, we expect to continue to use securitizations in the future to accomplish our long-term match funding financing strategy.
At December 31, 2020, our CRE securitizations and financing facilities with debt outstanding were as follows (in thousands):
(1)
Securitizations and the senior secured financing facility include deferred debt issuance costs and term warehouse financing facilities include accrued interest payable and deferred debt issuance costs.
(2)
Term warehouse financing facilities include accrued interest receivable and accrued interest payable.
(3)
Includes $678,000 of deferred debt issuance costs at December 31, 2020 from other term warehouse financing facilities with no balance.
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The CRE securitizations and term warehouse financing facilities charge a floating rate of interest. The senior secured financing facility charges a fixed rate of interest. For more information concerning our CRE securitizations, senior secured financing facility and term facilities, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources,” and Note 11 contained in “Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements” of this report. We continuously monitor our compliance with all of the financial covenants. We were in compliance with all financial covenants, as defined in the respective agreements, at December 31, 2020.
Diversification of investments. We manage our investment risk by maintaining a diversified portfolio of CRE mortgage loans and other CRE-related investments. As funds become available for investment or reinvestment, we seek to maintain diversification by property type and geographic location while allocating our capital to investment opportunities that we believe are the most economically attractive. The percentage of assets that we have invested in certain non-qualifying, non-core and other real estate-related investments is subject to the federal income tax requirements for REIT qualification and the requirements for exclusion from regulation under the Investment Company Act of 1940, or the Investment Company Act.
Our Operating Policies
Investment guidelines. We have established investment policies, procedures and guidelines that are reviewed and approved by our Manager’s investment committee and our Board. The investment committee and/or our Board, as applicable, meets regularly to consider and approve proposed specific investments. Our Board monitors the execution of our overall investment strategies and targeted asset classes. We acquire our investments primarily for income. We do not have a policy that requires us to focus our investments in one or more particular geographic areas or industries.
Financing policies. We use leverage in order to increase potential returns to our stockholders and for financing our portfolio. We do not speculate on changes in interest rates. Although we have identified leverage targets for each of our targeted asset classes, our investment policies do not have any minimum or maximum leverage limits. Our Manager’s investment committee has the discretion, without the need for further approval by our Board, to increase the amount of leverage we incur above our targeted range for individual asset classes subject, however, to any leverage constraints that may be imposed by existing financing arrangements.
We use borrowing and securitization strategies to accomplish our long-term match funding financing strategy. Based upon current conditions in the credit markets for collateralized debt obligations and collateralized loan obligations (sometimes, collectively, referred to as CLOs) we expect to modestly increase leverage through new CRE debt securitizations and the continued use of our term repurchase facilities and the use of our new senior secured financing facility in 2021. We may also seek other credit arrangements to finance new investments that we believe can generate attractive risk-adjusted returns, subject to availability.
Hedging and interest rate management policies. Historically, we used derivative instruments to hedge a portion of the interest rate risk associated with our borrowings and pricing risk associated with our fixed-rate loans. Under the federal income tax laws applicable to REITs, we generally had been able to enter into transactions to hedge indebtedness that we incurred, or planned to incur, to acquire or carry real estate assets, provided that our total gross income from qualifying hedges did not exceed 25% of our total gross income and non-qualifying hedges did not exceed 5% of our total gross income. We generally sought to minimize interest rate risk and pricing risk with a strategy that was expected to result in the least amount of volatility under accounting principles generally accepted in the United States of America, or GAAP, while still meeting our strategic economic objectives and maintaining adequate liquidity and flexibility. Hedging transactions have included interest rate swaps, collars, caps or floors, puts, calls, options and foreign currency exchange protection, historically.
Credit and risk management policies. Our Manager focuses its attention on credit and risk assessment from the earliest stage of the investment selection process. In addition, our Manager screens and monitors all potential investments to determine their impact on maintaining our REIT qualification under federal income tax laws and our exclusion from investment company status under the Investment Company Act. Portfolio risks, including risks related to credit losses, interest rate volatility, liquidity and counterparty credit, are generally managed on an asset and portfolio type basis by our Manager.
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General
The table below summarizes the amortized costs and net carrying amounts of our core and non-core investments at December 31, 2020, classified by asset type (dollars in thousands, except amounts in footnotes):
(1)
Net carrying amount includes an allowance for credit losses of $34.3 million at December 31, 2020.
(2)
Classified as CRE loans on the consolidated balance sheet.
(3)
Classified as investment securities available-for-sale on the consolidated balance sheet.
(4)
Classified as other assets on the consolidated balance sheet.
(5)
Comprised of one legacy CRE loan reported at its amortized cost of $11.4 million classified as a CRE loan on the consolidated balance sheet as we intend to hold this loan until payoff.
CRE Debt Investments
Floating-rate whole loans. We predominantly originate floating-rate first mortgage loans, or whole loans, directly to borrowers. The direct origination of whole loans enables us to better control the structure of the loans and to maintain direct lending relationships with borrowers. Additionally, we may acquire whole loans from third parties that conform to our investment strategy. We may create tranches of a loan we originate, consisting of an A-note (described below) and a B-note (described below), as well as mezzanine loans or other participations, which we may hold or sell to third parties. We do not obtain ratings on these investments. With respect to our portfolio at December 31, 2020, our whole loan investments had loan-to-collateral value, or LTV, ratios that typically do not exceed 85%. Typically, our whole loans are structured with an original term of up to three years, with one-year extensions that bring the loan to a maximum term of five years. Substantially all of our CRE loans held at December 31, 2020 were whole loans. We expect to hold our whole loans to maturity.
Senior interests in whole loans (A-notes). We may invest in senior interests in whole loans, referred to as A-notes, either directly originated or purchased from third parties. We do not intend to obtain ratings on these investments. We expect our typical A-note investments to have LTV ratios not exceeding 70%, and will generally be structured with an original term of up to three years, with one-year extensions that bring the loan to a maximum term of five years. We expect to hold any A-note investments to maturity. We did not hold any A-note investments at December 31, 2020.
Subordinate interests in whole loans (B-notes). To a lesser extent, we may invest in subordinate interests in whole loans, referred to as B-notes, which we will either directly originate or purchase from third parties. B-notes are loans secured by a first mortgage but are subordinated to an A-note. The subordination of a B-note is generally evidenced by an intercreditor or participation agreement between the holders of the A-note and the B-note. In some instances, the B-note lender may require a security interest in the stock or other equity interests of the borrower as part of the transaction. B-note lenders have the same obligations, collateral and borrower as the A-note lender, but typically are subordinated in recovery upon a default to the A-note lender. B-notes share certain credit characteristics with second mortgages in that both are subject to greater credit risk with respect to the underlying mortgage collateral than the corresponding first mortgage or A-note. We do not intend to obtain ratings on these investments. We expect our typical B-note investments to have LTV ratios between 55% and 80%, and will generally be structured with an original term of up to three years, with one-year extensions that bring the loan to a maximum term of five years. We expect to hold any B-note investments to maturity. We did not hold any B-note investments at December 31, 2020.
In addition to the accrued interest receivable on a B-note, we may earn fees charged to the borrower under the note or additional income by receiving principal payments in excess of the discounted price (below par value) we paid to acquire the note. Our ownership of a B-note with controlling class rights may, in the event the financing fails to perform according to its terms, cause us to pursue our remedies as owner of the B-note, which may include foreclosure on, or modification of, the note. In some cases, the owner of the A-note may be able to foreclose or modify the note against our wishes as owner of the B-note. As a result, our economic and business interests may diverge from the interests of the owner of the A-note.
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Mezzanine financing. We may invest in mezzanine loans that are senior to the borrower’s equity in, and subordinate to the mortgage loan on, a property. A mezzanine loan is typically secured by a pledge of the ownership interests in the entity that directly owns the real property or by a second lien mortgage loan on the property. In addition, mezzanine loans typically include credit enhancements such as letters of credit, personal guarantees of the principals of the borrower, or collateral unrelated to the property. A mezzanine loan may be structured so that we receive a stated fixed or variable interest rate on the loan as well as a percentage of gross revenues and a percentage of the increase in the fair market value of the property securing the loan, payable upon maturity, refinancing or sale of the property. Mezzanine loans may also have prepayment lockouts, penalties, minimum profit hurdles and other mechanisms to protect and enhance returns in the event of premature repayment. We expect our mezzanine investments to have LTV ratios between 65% and 90% with stated maturities from three to five years. We expect to hold mezzanine loans to maturity. At December 31, 2020, our loan portfolio included two mezzanine loans.
Preferred equity investments. We may invest in preferred equity investments in entities that own or acquire CRE properties. These investments are subordinate to first mortgage loans and mezzanine debt and are typically structured to provide some credit enhancement differentiating it from the common equity. We expect our preferred equity investments to have LTV ratios between 65% and 90% with stated maturities from three to eight years. We expect to hold preferred equity investments to maturity. At December 31, 2020, we had two preferred equity investments.
The following charts describe the property type and the geographic breakdown, by National Council of Real Estate Investment Fiduciaries, or NCREIF, region of our CRE loan portfolio at December 31, 2020 (based on carrying value):
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The total loan portfolio, at carrying value, was $1.5 billion at December 31, 2020. “Other” property types included manufactured housing (3.0%) and industrial (0.7%).
The Mountain region constituted 21.4% of our portfolio, of which 9.8% was in Arizona, and its collateral comprised 69.6% multifamily properties and 21.0% hotel properties. The Southwest region constituted 17.9% of our portfolio, of which 17.7% was in Texas, and its collateral comprised 83.2% multifamily properties. The Southeast region constituted 16.1% of our portfolio, of which 8.1% was in Florida, and its collateral comprised 53.3% multifamily properties. We view our investment and credit strategies as being adequately diversified across property types in the Mountain, Southwest and Southeast regions.
CMBS
Historically, we have invested in CMBS, which are securities that are secured by, or evidence interests in, a pool of mortgage loans secured by commercial properties. These securities may be senior or subordinate and may be either investment grade or non-investment grade.
In April 2020, we completed the sale of our portfolio of CMBS and settlements were reached on all of our remaining CMBS-related obligations, which were paid in full in April 2020.
CRE Investments
We may invest directly in the ownership of CRE equity investments by restructuring CRE loans and taking control of the properties where we believe we can protect capital and ultimately generate capital appreciation. We may acquire CRE equity investments through a joint venture or wholly-owned subsidiary. We intend to primarily use an affiliate of our Manager to manage the CRE equity investments when held.
Competition
See “Item 1A.
ITEM 1A.
RISK FACTORS
This section describes material risks affecting our business. In connection with the forward-looking statements that appear in this annual report, you should carefully review the factors discussed below and the cautionary statements referred to in “Forward-Looking Statements.”
Risk Factors Summary
Our risk factors include discussion of risks to our business attributable to the impact of current economic conditions, risks related to our financing, risks related to our operations, risks related to our investments, risks related to our Manager, risks related to our organization and structure, tax risks and general risks, including as follows:
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If current economic and market conditions were to deteriorate, our ability to obtain the capital and financing necessary for growth may be limited, which could limit our profitability, ability to make distributions and the market price of our common stock.
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The outbreak of widespread contagious disease, such as COVID-19, has caused, and may continue to cause, shocks to the United States and global economy and to our business, which has had, and may continue to have, an adverse impact on our financial condition, our results of operations and our liquidity and capital resources.
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Our portfolio has been financed in material part through the use of leverage that may reduce the return on our investments and cash available for distribution.
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Our repurchase agreements, warehouse facilities and other short-term financings have credit risks that could result in losses.
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We are exposed to loss if lenders under our repurchase agreements, warehouse facilities, senior secured financing facility or other short-term financings liquidate the assets securing those facilities. Moreover, assets acquired by us pursuant to our repurchase agreements, warehouse facilities, senior secured financing facility or other short-term financings may not be suitable for refinancing through long-term arrangements that may require us to liquidate some or all of the related assets.
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We will incur losses on our repurchase transactions if the counterparty to the transactions defaults on its obligation to resell the underlying assets back to us at the end of the transaction term, or if the value of the underlying assets has declined as of the end of the term or if we default in our obligations to purchase the assets.
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We may have to repurchase assets that we have sold in connection with CRE debt securitizations and other securitizations.
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Financing our REIT qualifying assets with repurchase agreements and warehouse facilities could adversely affect our ability to qualify as a REIT.
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Historically, we have financed most of our investments through CRE debt securitizations and have retained the equity. CRE debt securitization equity receives distributions from the CRE debt securitization only if the CRE debt securitization generates enough income to first pay the holders of its debt securities and its expenses.
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If our CRE debt securitization financings fail to meet their performance tests, including over-collateralization requirements, our net income and cash flow from these CRE debt securitizations will be eliminated.
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If we issue debt securities, the terms may restrict our ability to make cash distributions, require us to obtain approval to sell our assets or otherwise restrict our operations in ways that could make it difficult to execute our investment strategy and achieve our investment objectives.
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Depending upon market conditions, we intend to seek financing through CRE debt securitizations, which would expose us to risks relating to the accumulation of assets for use in the CRE debt securitizations.
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We may change our investment strategy without stockholder consent, which may result in riskier investments than those currently targeted.
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Our business is highly dependent on communications and information systems, and systems failures or cybersecurity incidents could significantly disrupt our business, which may, in turn, negatively affect the market price of our common stock and our ability to operate our business.
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Declines in the market values of our investments may reduce periodic reported results, credit availability and our ability to make distributions.
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Increases in interest rates and other factors could reduce the value of our investments, result in reduced earnings or losses and reduce our ability to pay distributions.
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Changes in the method for determining the LIBOR or a replacement of LIBOR may adversely affect the value of our loans, investments and borrowings and could affect our results of operations.
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Investing in mezzanine debt, preferred equity, mezzanine or other subordinated tranches of CMBS involves greater risks of loss than senior secured debt investments.
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We record some of our portfolio investments, including those classified as assets held for sale, at fair value as estimated by our management and, as a result, there will be uncertainty as to the value of these investments.
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We may face competition for suitable investments.
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Many of our investments may be illiquid, which may result in our realizing less than their recorded value should we need to sell such investments quickly.
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Our investments in real estate and commercial mortgage loans, mezzanine loans and CRE equity investments are subject to the risks inherent in owning the real estate securing or underlying those investments that could result in losses to us.
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If our allowance for credit losses is not adequate to cover actual future loan and lease losses, our earnings may decline.
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The current expected credit losses, or CECL, model required us to increase our allowance for credit losses and may have a material adverse effect on our business, financial condition and results of operations.
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Our investment portfolio may have material geographic, sector, property-type and sponsor concentrations.
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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.
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We may be exposed to environmental liabilities with respect to properties to which we take title.
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Our investments in preferred equity involve a greater risk of loss than traditional debt financing.
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We depend on our Manager and ACRES to develop and operate our business and may not find suitable replacements if the Management Agreement terminates.
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Our Manager’s fee structure may not create proper incentives, and the incentive compensation we pay our Manager may increase the investment risk of our portfolio.
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Our Manager manages our portfolio pursuant to very broad investment guidelines and our Board does not approve each investment decision, which may result in our making riskier investments.
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Our Manager and ACRES will face conflicts of interest relating to the allocation of investment opportunities and such conflicts may not be resolved in our favor, which could limit our ability to acquire assets and, in turn, limit our ability to make distributions and reduce your overall investment return.
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Our officers and many of the investment professionals that provide services to us through our Manager are also officers or employees of ACRES and may face conflicts regarding the allocation of their time.
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Our charter and bylaws contain provisions that may inhibit potential acquisition bids that you and other stockholders may consider favorable, and the market price of our common stock may be lower as a result.
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Maryland takeover statutes may prevent a change in control of us, and the market price of our common stock may be lower as a result.
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Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in your best interests.
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We have not established a minimum distribution payment level and we cannot assure you of our ability to make distributions in the future. In the future, we may use uninvested offering proceeds or borrowed funds to make distributions.
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Loss of our exclusion from regulation under the Investment Company Act would require significant changes in our operations and could reduce the market price of our common stock and our ability to make distributions.
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Legislative, regulatory or administrative changes could adversely affect our stockholders or us.
Impact of Current Economic Conditions
If current economic and market conditions were to deteriorate, our ability to obtain the capital and financing necessary for growth may be limited, which could limit our profitability, ability to make distributions and the market price of our common stock.
We depend upon the availability of adequate debt and equity capital for growth in our operations. Although historically we have been able to raise both debt and equity capital, recent market and economic conditions have made obtaining additional equity capital highly dilutive to existing shareholders and may possibly affect our ability to raise debt capital. If current economic conditions were to deteriorate, our ability to access debt or equity capital on acceptable terms, could be further limited, which could limit our ability to generate growth, our profitability, our ability to make distributions and the market price of our common stock. In addition, as a REIT, we must distribute annually at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain, to our stockholders and are therefore not able to retain significant amounts of our earnings for new investments. While we may, through our TRSs retain earnings as new capital, we are subject to REIT qualification requirements that limit the value of TRS stock and securities relative to the other assets owned by a REIT.
The outbreak of widespread contagious disease, such as COVID-19, has caused, and may continue to cause, shocks to the U.S. and global economy and to our business, which has had, and may continue to have, an adverse impact on our financial condition, our results of operations and our liquidity and capital resources.
In December 2019, COVID-19 was identified in Wuhan, China. The resulting global proliferation of the virus led the World Health Organization to designate COVID-19 as a pandemic and numerous countries, including the U.S., to declare national emergencies. Many countries have responded to the outbreak by instituting quarantines and restrictions on travel, which has resulted in the closure or remote operation of non-essential businesses. While certain countries have begun to ease restrictions and financial markets have stabilized to some degree, the pandemic continues to plague the overall economy and extend uncertainty over the ultimate impact to the economy. Such actions have produced material and previously unforeseeable shocks to global markets, disruptions to global supply chains, increasing rates of unemployment and adversity to many industries and economies as whole.
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The COVID-19 pandemic has had, and may continue to have, a material adverse impact on our financial condition, liquidity and results of operations and the market price of our common stock and preferred stock. We expect that these impacts are likely to continue to some extent as the pandemic persists. Although many or all facets of our business have been or could be impacted by the COVID-19 pandemic, we currently believe the following impacts to be among the most material to us:
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COVID-19 could have a significant long-term impact on the broader economy and the CRE market generally, which would negatively impact the value of the properties collateralizing our loans. Our portfolio includes loans collateralized by hotel, retail, office, multifamily and other property types that are particularly negatively impacted by the pandemic. While we believe the principal amount of our loans is currently generally adequately protected by underlying value, there can be no assurance that as the pandemic continues these values will not be adversely affected, which could impact our ability to realize the entire principal value of some or all of our investments.
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We are actively engaged in discussions with our borrowers, some of whom we expect may face challenges in complying with the terms of their loans. We have executed extension and forbearance agreements of CRE loans, nine of which are active as of December 31, 2020 with a weighted average remaining life of approximately six months, in an effort to reduce the credit risk created as a result of financial difficulties related to the pandemic. We anticipate the future execution of modifications of our loans and potentially instances of default or foreclosure on assets underlying our loans, which may adversely affect the credit profile and realizable value of our assets, our results of operations and our financial condition.
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The shocks to global markets, particularly the real estate credit markets, adversely impacted the market pricing of our CRE securities. Depending on the magnitude and duration of the pandemic’s impact, the assets underlying these securities may default on their terms, requiring that we incur credit losses on our portfolio.
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We have warehouse facilities with numerous lenders and, when utilized, continuously engage in discussions around the value of pledged assets as defined in our agreements with such lenders, potential deleveraging, the application of certain provisions of such agreements to these circumstances and other structural elements under the agreements. When utilized, if we do not have the funds available to make required payments, it would likely result in defaults under the particular facilities affected that, because of cross-default provisions, could result in defaults under other debt instruments as well as potential loss of our assets to the lenders unless we are able to raise the funds from alternative sources, including by selling or financing assets or raising capital, each of which we may be required to do under adverse market conditions or at an inopportune time or on unfavorable terms, or may be unable to do at all. The COVID-19 pandemic has made it very difficult for businesses generally, including us, to access liquidity sources at terms commensurate with those prior to this pandemic, or at all. Pledging additional collateral or otherwise paying down facilities to satisfy our lenders and avoid potential margin calls and loan defaults would reduce our cash available to meet subsequent margin calls and/or future funding requests as well as make other, higher yielding investments, thereby decreasing our liquidity, return on equity, available cash, net income and ability to implement our investment strategy. If we cannot meet lender requirements related to margin calls or other terms of our credit agreements, the lender or counterparty could accelerate our indebtedness, increase the interest rate on advanced funds and terminate our ability to borrow additional funds, which would materially and adversely affect our financial condition and ability to implement our investment strategy.
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The COVID-19 pandemic has reduced, and likely will continue to reduce, the availability of liquidity sources, but our requirements for liquidity, including future funding commitments and margin calls, likely will not be commensurately reduced. If we do not have funds available to meet our obligations, we would have to raise funds from alternative sources, which may be at unfavorable terms or may not be available to us due to the impacts of COVID-19. We expect that the adverse impact of the COVID-19 pandemic will likely adversely affect our liquidity position and could limit our ability to grow our business and fully execute our business strategy. We seek to preserve and build our liquidity to best position us to weather near-term market uncertainty, satisfy our loan future funding requests and to potentially make new investments, which will cause us to take some or all of the following actions: borrow additional capital, sell assets and /or change our dividend distributions consistent with real estate investment trust distribution requirements. In furtherance of this goal, we suspended common stock distributions since the first quarter of 2020.
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Interest rates and credit spreads have been significantly impacted since the outbreak of COVID-19. This can result in volatile changes to the fair value of our floating rate loans, fixed-rate loans and CRE securities and also the interest obligations on our floating-rate borrowings, which could result in an increase to our interest expense.
We also have experienced and may continue to experience other negative impacts to our business as a result of the pandemic that could exacerbate other risks, including:
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lack of liquidity in our assets;
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greater risk of loss on our mezzanine loans and preferred equity investments;
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risk associated with loans that are in transition;
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the concentration of our loans and investments in certain geographies, property types or relationships in areas that may be disproportionately affected by the pandemic;
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risks associated with our securitizations that we use to finance our loans;
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downgrades in credit ratings assigned to our investments;
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investments in interest rate derivative contracts and risks associated with our hedging and derivatives;
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the difficulty of estimating provisions for credit losses;
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borrower and counterparty risks;
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operational impacts on ourselves and our third-party advisors, service providers, vendors and counterparties;
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limitations on our ability to ensure business continuity in the event our, or our third-party advisors’ and service providers’, continuity of operations plan is not effective or improperly implemented or deployed during the disruption caused by the pandemic;
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an inability to review potential investments in affected areas as a result of quarantines, restrictions on travel, “shelter in place” rules, restrictions on types of businesses that may continue to operate and restrictions on types of construction projects that may continue; and
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an extended period of remote working by our Manager’s and/or its affiliate’s employees could strain our technology resources and introduce operational risks, including heightened cybersecurity risk. Remote working environments may be less secure and more susceptible to hacking attacks, including phishing and social engineering attempts that seek to exploit the COVID-19 pandemic.
The rapid development of the pandemic and the resulting economic effects have created uncertainty surrounding the ultimate impact of the COVID-19 pandemic on the global economy generally, and the CRE business in particular. As a result, we cannot project the ultimate adverse impact of the COVID-19 pandemic on the global economy or our business, including our financial condition and performance. The extent of the impact of COVID-19 will depend on future developments, including new information that may emerge about the severity of the pandemic, the extension of quarantines and restrictions on travel, the discovery and implementation of successful treatments and the ensuing reactions by consumers, companies, governmental entities and global markets.
Risks Related to Our Financing
Our portfolio has been financed in material part through the use of leverage that may reduce the return on our investments and cash available for distribution.
Our portfolio has been financed in material part through the use of leverage and, as credit market conditions permit, we will seek such financing in the future. Using leverage subjects us to risks associated with debt financing, including the risks that:
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the cash provided by our operating activities will not be sufficient to meet required payments of principal and interest,
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the cost of financing may increase relative to the income from the assets financed, reducing the income we have available to pay distributions, and
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our investments may have maturities that differ from the maturities of the related financing and, consequently, the risk that the terms of any refinancing we obtain will not be as favorable as the terms of existing financing.
If we are unable to secure refinancing of our currently outstanding financing, when due, on acceptable terms, we may be forced to dispose of some of our assets at disadvantageous terms or to obtain financing at unfavorable terms, either of which may result in losses to us or reduce the cash flow available to meet our debt service obligations or to pay distributions.
Financing that we may obtain and financing we have obtained through CRE debt securitizations typically require, or will require, us to maintain a specified ratio of the amount of the financing to the value of the assets financed. A decrease in the value of these assets may lead to margin calls or calls for the pledge of additional assets, which we will have to satisfy. We may not have sufficient funds or unpledged assets to satisfy any such calls, which could result in our loss of distributions from and interests in affected CRE debt securitizations, which would reduce our assets, income and ability to make distributions.
Our repurchase agreements, warehouse facilities and other short-term financings have credit risks that could result in losses.
If we accumulate assets for a CRE debt securitization on a short-term credit facility and do not complete the CRE debt securitization financing, or if a default occurs under the facility, the short-term lender will sell the assets and we would be responsible for the amount by which the original purchase price of the assets exceeds their sale price, up to the amount of our investment or guaranty.
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We may lose money on our repurchase transactions if the counterparty to the transaction defaults on its obligation to resell the underlying security back to us at the end of the transaction term, or if the value of the underlying security has declined as of the end of the term or if we default on our obligations under the repurchase agreements.
We are exposed to loss if lenders under our repurchase agreements, warehouse facilities, senior secured financing facility or other short-term financings liquidate the assets securing those facilities. Moreover, assets acquired by us pursuant to our repurchase agreements, warehouse facilities, senior secured financing facility or other short-term financings may not be suitable for refinancing through long-term arrangements and may require us to liquidate some or all of the related assets.
We have entered into repurchase agreements, warehouse facilities and senior secured financing facility and expect in the future to seek additional debt to finance our growth. Lenders typically have the right to liquidate assets securing or acquired under these facilities upon the occurrence of specified events, such as an event of default. We are exposed to loss if the proceeds received by the lender upon liquidation are insufficient to satisfy our obligation to the lender. We are also subject to the risk that the assets subject to such repurchase agreements, warehouse facilities or other debt might not be suitable for long-term refinancing or securitization transactions. If we are unable to refinance these assets on a long-term basis, or if long-term financing is more expensive than we anticipated at the time of our acquisition of the assets to be financed, we might be required to liquidate assets.
We will incur losses on our repurchase transactions if the counterparty to the transactions defaults on its obligation to resell the underlying assets back to us at the end of the transaction term, or if the value of the underlying assets has declined as of the end of the term or if we default in our obligations to purchase the assets.
When engaged in repurchase transactions, we generally sell assets to the transaction counterparty and receive cash from the counterparty. The counterparty must resell the assets back to us at the end of the term of the transaction. Because the cash we receive from the counterparty when we initially sell the assets is less than the market value of those assets, if the counterparty defaults on its obligation to resell the assets back to us we will incur a loss on the transaction. We will also incur a loss if the value of the underlying assets has declined as of the end of the transaction term, as we will have to repurchase the assets for their initial value but would receive assets worth less than that amount. If we default upon our obligation to repurchase the assets, the counterparty may liquidate them at a loss, which we are obligated to repay. Any losses we incur on our repurchase transactions would reduce our equity and our earnings, and thus our cash available for distribution to our stockholders.
We may have to repurchase assets that we have sold in connection with CRE debt securitizations and other securitizations.
If any of the assets that we originate or acquire and sell or securitize do not comply with representations and warranties that we make about them, we may have to repurchase these assets from the CRE debt securitization or securitization vehicle, or replace them. In addition, we may have to indemnify purchasers for losses or expenses incurred as a result of a breach of a representation or warranty. Any significant repurchases or indemnification payments could materially reduce our liquidity, earnings and ability to make distributions.
Financing our REIT qualifying assets with repurchase agreements and warehouse facilities could adversely affect our ability to qualify as a REIT.
We have entered into and intend to enter into, sale and repurchase agreements under which we nominally sell certain REIT qualifying assets to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that we will be treated for U.S. federal income tax purposes as the owner of the assets that are the subject of any such agreement, notwithstanding that we 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, or IRS, could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case our ability to qualify as a REIT would be adversely affected. If any of our REIT qualifying assets are subject to a repurchase agreement and are sold by the counterparty in connection with a margin call, the loss of those assets could impair our ability to qualify as a REIT. Accordingly, unlike other REITs, we may be subject to additional risk regarding our ability to qualify and maintain our qualification as a REIT.
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Historically, we have financed most of our investments through CRE debt securitizations and have retained the equity. CRE debt securitization equity receives distributions from the CRE debt securitization only if the CRE debt securitization generates enough income to first pay the holders of its debt securities and its expenses.
Historically, we have financed most of our investments through CRE debt securitizations in which we retained the equity interest. Depending on market conditions and credit availability, we intend to use CRE debt securitizations to finance our investments in the future. The equity interests of a CRE debt securitization are subordinate in right of payment to all other securities issued by the CRE debt securitization. The equity is usually entitled to all of the income generated by the CRE debt securitization after the CRE debt securitization pays all of the interest due on the debt securities and its other expenses. However, there will be little or no income available to the CLO equity if there are excessive defaults by the issuers of the underlying collateral, which would significantly reduce the value of that interest. Reductions in the value of the equity interests we have in a CRE debt securitization, if we determine that they are other-than-temporary, will reduce our earnings. In addition, the liquidity of the equity securities of CLOs is constrained and, because they represent a leveraged investment in the CRE debt securitization’s assets, the value of the equity securities will generally have greater fluctuations than the value of the underlying collateral.
If our CRE debt securitization financings fail to meet their performance tests, including over-collateralization requirements, our net income and cash flow from these CRE debt securitizations will be eliminated.
Our CRE debt securitizations generally provide that the principal amount of their assets must exceed the principal balance of the related securities issued by them by a certain amount, commonly referred to as “over-collateralization.” If delinquencies and/or losses exceed specified levels, based on the analysis by the rating agencies (or any financial guaranty insurer) of the characteristics of the assets collateralizing the securities issued by the CRE debt securitization issuer, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses or delinquencies did not exceed those levels. A failure by a CRE debt securitization to satisfy an over-collateralization test typically results in accelerated distributions to the holders of the senior debt securities issued by the CRE debt securitization entity, resulting in a reduction or elimination of distributions to more junior securities until the over-collateralization requirements have been met or the senior debt securities have been paid in full.
Our equity holdings and, when we acquire debt interests in CRE debt securitizations, our debt interests, if any, generally are subordinate in right of payment to the other classes of debt securities issued by the CRE debt securitization entity. Accordingly, if over-collateralization tests are not met, distributions on the subordinated debt and equity we hold in these CLOs will cease, resulting in a substantial reduction in our cash flow. Other tests (based on delinquency levels, interest coverage or other criteria) may restrict our ability to receive cash distributions from assets collateralizing the securities issued by the CRE debt securitization entity. Although at December 31, 2020, all of our CRE debt securitizations met their performance tests, we cannot assure you that our CRE debt securitizations will satisfy the performance tests in the future. For information concerning compliance by our CRE debt securitizations with their over-collateralization tests, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources.”
If any of our CRE debt securitizations fail to meet collateralization or other tests relevant to the most senior debt issued and outstanding by the CRE debt securitization issuer, an event of default may occur under that CRE debt securitization. If that occurs, our Manager’s ability to manage the CRE debt securitization likely would be terminated and our ability to attempt to cure any defaults in the CRE debt securitization would be limited, which would increase the likelihood of a reduction or elimination of cash flow and returns to us in those CLOs for an indefinite time.
If we issue debt securities, the terms may restrict our ability to make cash distributions, require us to obtain approval to sell our assets or otherwise restrict our operations in ways that could make it difficult to execute our investment strategy and achieve our investment objectives.
Any debt securities we may issue in the future will likely be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Holders of senior securities may be granted the right to hold a perfected security interest in certain of our assets, to accelerate payments due under the indenture if we breach financial or other covenants, to restrict distributions, and to require us to obtain their approval to sell assets. These covenants could limit our ability to operate our business or manage our assets effectively. Additionally, any convertible or exchangeable securities that we issue may have rights, preferences and privileges more favorable than those of our common stock. We, and indirectly our stockholders, will bear the cost of issuing and servicing such securities.
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Depending upon market conditions, we intend to seek financing through CRE debt securitizations, which would expose us to risks relating to the accumulation of assets for use in the CRE debt securitizations.
Historically, we have financed a significant portion of our assets through the use of CRE debt securitizations, and have accumulated assets for these financings through short-term credit facilities, typically repurchase agreements or warehouse facilities. Depending upon market conditions, and, consequently, the extent to which such financing is available to us, we expect to seek similar financing arrangements in the future. In addition to risks discussed above, these arrangements could expose us to other credit risks, including the following:
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An event of default under one short-term facility may constitute a default under other credit facilities we may have, potentially resulting in asset sales and losses to us, as well as increasing our financing costs or reducing the amount of investable funds available to us.
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We may be unable to acquire a sufficient amount of eligible assets to maximize the efficiency of a CRE debt securitization issuance, which would require us to seek other forms of term financing or liquidate the assets. We may not be able to obtain term financing on acceptable terms, or at all, and liquidation of the assets may be at prices less than those we paid, resulting in losses to us.
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Using short-term financing to accumulate assets for a CRE debt securitization issuance may require us to obtain new financing as the short-term financing matures. Residual financing may not be available on acceptable terms, or at all. Moreover, an increase in short-term interest rates at the time that we seek to enter into new borrowings may reduce the spread between the income on our assets and the cost of our borrowings. This would reduce returns on our assets, which would reduce earnings and, in turn, cash available for distribution to our stockholders.
Risks Related to Our Operations
We may change our investment strategy without stockholder consent, which may result in riskier investments than those currently targeted.
Subject to maintaining our qualification as a REIT and our exclusion from regulation under the Investment Company Act, we may change our investment strategy, including the percentage of assets that may be invested in each asset class, or in the case of securities, in a single issuer, at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, the investments described in this report. A change in our investment strategy may increase our exposure to interest rate, credit market and real estate market fluctuations, all of which may reduce the market price of our common stock and reduce our ability to make distributions to stockholders. Furthermore, a change in our asset allocation could result in our making investments in asset categories different from those described in this report.
We believe core earnings, a Non-GAAP financial measure, is an appropriate measure of our operating performance; however, in certain instances core earnings may not be reflective of actual economic results.
We utilize core earnings as a measure of our operating performance and believe that it is useful to analysts, investors and other parties in the evaluations of REITs. We believe core earnings is a useful measure of our operating performance because it excludes the effects of certain transactions and GAAP adjustments that we believe are not necessarily indicative of our current CRE loan origination portfolio and other CRE-related investments and operations. Core earnings exclude (i) non-cash equity compensation expense, (ii) unrealized gains or losses, (iii) non-cash provision for loan losses, (iv) non-cash impairments on securities, (v) non-cash amortization of discounts or premiums associated with borrowings, (vi) net income or loss from limited partnership interests owned at the initial measurement date, (vii) net income or loss from non-core assets, (viii) real estate depreciation and amortization, (ix) foreign currency gains or losses and (x) income or losses from discontinued operations. Core earnings may also be adjusted periodically to exclude certain one-time events pursuant to changes in GAAP and certain non-cash items. Although pursuant to the Management Agreement we calculate incentive compensation using core earnings excluding incentive compensation payable to our Manager, we include incentive compensation payable to our Manager in core earnings for reporting purposes. Core earnings does not represent net income or cash generated from operating activities and should not be considered as an alternative to GAAP net income or as a measure of liquidity under GAAP. Our methodology for calculating core earnings may differ from methodologies used by other companies to calculate similar supplemental performance measures, and accordingly, our reported core earnings may not be comparable to similar performance measures used by other companies.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud.
If we fail to maintain an effective system of internal control, fail to correct any flaws in the design or operating effectiveness of internal controls over financial reporting and disclosure, or fail to prevent fraud, our stockholders could lose confidence in our financial and other reporting, which could harm our business and the trading price of our common stock.
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Our due diligence may not reveal all of an investment’s weaknesses.
Before investing in any asset, we will assess the strength and skills of the asset’s management and operations, the value of the asset and, for debt investments, the value of any collateral securing the debt, the ability of the asset or underlying collateral to service the debt and other factors that we believe are material to the performance of the investment. In making the assessment and otherwise conducting customary due diligence, we will rely on the resources available to us and, in some cases, an investigation by third parties. This process is particularly important and subjective with respect to investments in newly-organized entities because there may be little or no information publicly available about the entities or, with respect to debt securities, any underlying collateral. Our due diligence processes, however, may not uncover all facts that may be relevant to an investment decision.
Our business is highly dependent on communications and information systems, and systems failures or cybersecurity incidents could significantly disrupt our business, which may, in turn, negatively affect the market price of our common stock and our ability to operate our business.
We depend on the information systems of our Manager, ACRES and third parties. Any failure or interruption of our systems or cyber-attacks or security breaches of our networks or systems could cause delays or other problems in our securities trading activities, including mortgage-backed securities, or MBS, trading activities. A disruption or breach could also lead to unauthorized access to and release, misuse, loss or destruction of our confidential information or personal or confidential information of our Manager, ACRES or third parties, which could lead to regulatory fines, litigation, costs of remediating the breach and reputational harm. In addition, we also face the risk of operational failure, termination or capacity constraints of any of the third parties with which we do business or that facilitate our business activities, including clearing agents or other financial intermediaries we use to facilitate our securities transactions, if their respective systems experience failure, interruption, cyber-attacks, or security breaches. We may face increased costs as we continue to evolve our cyber defenses in order to contend with changing risks. These costs and losses associated with these risks are difficult to predict and quantify, but could have a significant adverse effect on our operating results.
Computer malware, viruses, computer hacking and phishing attacks have become more prevalent in our industry and may occur on our systems. We rely heavily on our financial, accounting and other data processing systems. Although we have not detected a material cybersecurity breach to date, other financial services institutions have reported material breaches of their systems, some of which have been significant. Even with all reasonable security efforts, not every breach can be prevented or even detected. It is possible that we have experienced an undetected breach. There is no assurance that we, or the third parties that facilitate our business activities, have not or will not experience a breach. It is difficult to determine what, if any, negative impact may directly result from any specific interruption or cyber-attacks or security breaches of our networks or systems (or the networks or systems of third parties that facilitate our business activities) or any failure to maintain performance, reliability and security of our technical infrastructure, but such computer malware, viruses and computer hacking and phishing attacks may negatively affect our operations.
Risks Related to Our Investments
Declines in the market values of our investments may reduce periodic reported results, credit availability and our ability to make distributions.
We classify a substantial portion of our assets for accounting purposes as “available-for-sale.” As a result, reductions in the market values of those assets are directly charged to accumulated other comprehensive income (loss) and reduce our stockholders’ equity. A decline in these values will reduce the book value of our assets. Moreover, if the decline in value of an available-for-sale asset is other-than-temporary, we are required by GAAP to record the decline as an asset impairment, which will reduce our earnings.
A decline in the market value of our assets may also adversely affect us in instances where we have borrowed money based on the market value of those assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we are unable to post the additional collateral, we would have to repay some portion or all of the loan, which may require us to sell assets, which could potentially be under adverse market conditions. As a result, our earnings would be reduced or we could sustain losses, and cash available to make distributions could be reduced or eliminated.
Increases in interest rates and other factors could reduce the value of our investments, result in reduced earnings or losses and reduce our ability to pay distributions.
A significant risk associated with our investment in CRE-related loans, CMBS and other debt investments is the risk that either or both of long-term and short-term interest rates increase significantly. If long-term rates increase, the market value of our assets would decline. Even if assets underlying investments we may own in the future are guaranteed by one or more persons, including government or government-sponsored agencies, those guarantees do not protect against declines in market value of the related assets caused by interest rate changes. At the same time, with respect to assets that are not match-funded or that have been acquired with variable rate or short-term financing, an increase in short-term interest rates would increase our interest expense, reducing our net interest spread or possibly result in negative cash flow from those assets. This could result in reduced profitability and distributions or losses.
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Changes in the method for determining the LIBOR or a replacement of LIBOR may adversely affect the value of our loans, investments and borrowings and could affect our results of operations.
We utilize LIBOR as a benchmark interest rate for the pricing of our CRE loans and are exposed to LIBOR through our issuance of notes on our securitizations and the use of term facilities and repurchase agreements. In July 2017, the U.K. Financial Conduct Authority, or “FCA,” announced that it would phase out LIBOR as a benchmark by the end of 2021. In November 2020, the FCA announced that subject to confirmation following its consultation with the administrator of LIBOR, it would cease publication of the one-week and two-month USD LIBOR immediately after December 31, 2021 and cease publication of the remaining tenors immediately after June 30, 2023. Additionally, the U.S. Federal Reserve encouraged companies to cease using LIBOR as a benchmark rate by December 31, 2021. While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, the U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprising large U.S. financial institutions, has identified the Secured Overnight Financing Rate, or SOFR, a new index calculated by short-term repurchase agreements, backed by U.S. Treasury securities, as its preferred alternative rate for LIBOR. When LIBOR ceases to exist, we may need to amend our loan and borrowing agreements that utilize LIBOR as a factor in determining the interest rate or hedge against fluctuations in LIBOR based on a new standard that is established, if any. Any resulting differences in interest rate standards among our assets and our borrowings may result in interest rate mismatches between our assets and the borrowings used to fund such assets. There is no guarantee that a transition from LIBOR to SOFR or to another alternative rate will not result in financial market disruptions and significant increases in benchmark rates, resulting in increased financing costs to us, any of which could have an adverse effect on our business, results of operations, financial condition, and the market price of our common stock.
Investing in mezzanine debt, preferred equity, mezzanine or other subordinated tranches of CMBS involves greater risks of loss than senior secured debt investments.
Subject to maintaining our qualification as a REIT and exclusion from regulation under the Investment Company Act, we may invest in mezzanine debt, preferred equity and mezzanine or other subordinated tranches of CMBS. We currently have investments in mezzanine debt and preferred equity. These types of investments carry a higher degree of risk of loss than senior secured debt investments such as our whole loan investments because, in the event of default and foreclosure, holders of senior liens will be paid in full before mezzanine investors. Depending on the value of the underlying collateral at the time of foreclosure, there may not be sufficient assets to pay all or any part of amounts owed to mezzanine investors. Moreover, mezzanine and other subordinate debt investments may have higher LTV than conventional senior lien financing, resulting in less equity in the collateral and increasing the risk of loss of principal. If a borrower defaults or declares bankruptcy, we may be subject to agreements restricting or eliminating our rights as a creditor, including rights to call a default, cure a default, foreclose on collateral, and accelerate maturity or control decisions made in bankruptcy proceedings. In addition, the prices of lower credit quality securities are generally less sensitive to interest rate changes than more highly rated investments, but more sensitive to economic downturns or individual issuer developments because the ability of obligors of investments underlying the securities to make principal and interest payments may be impaired. In such event, existing credit support relating to the securities’ structure may not be sufficient to protect us against loss of our principal. For additional risks regarding real estate-related loans, see “Risks Related to Investments.”
We record some of our portfolio investments, including those classified as assets held for sale, at fair value as estimated by our management and, as a result, there will be uncertainty as to the value of these investments.
We currently hold, and expect that we will hold in the future, portfolio investments that are not publicly traded. The fair value of securities and other investments that are not publicly traded may not be readily determinable. We value these investments quarterly at fair value as determined under policies approved by our Board. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that we would have obtained if a ready market for them existed. The value of our common stock will likely decrease if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal.
We may face competition for suitable investments.
There are numerous REITs and other financial investors seeking to invest in the types of assets we target. This competition may cause us to forgo particular investments or to accept economic terms or structural features that we would not otherwise have accepted, and it may cause us to seek investments outside of our currently targeted areas. Competition for investment assets may slow our growth or limit our profitability and ability to make distributions to our stockholders.
We may not have control over certain of our loans and investments.
Our ability to manage our portfolio of loans and investments may be limited by the form in which they are made. In certain situations, we may:
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acquire investments subject to rights of senior classes and servicers under inter-creditor or servicing agreements;
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acquire only a minority and/or non-controlling participation in an underlying investment;
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co-invest with third parties through partnerships, joint ventures or other entities, thereby acquiring non-controlling interests; or
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rely on independent third-party management or strategic partners with respect to the management of an asset.
Therefore, we may not be able to exercise control over the loan or investment. Such financial assets may involve risks not present in investments where senior creditors, servicers or third-party controlling investors are not involved. Our rights to control the process following a borrower default may be subject to the rights of senior creditors or servicers whose interests may not be aligned with ours. A third party partner or co-venturer may have financial difficulties resulting in a negative impact on such asset, may have economic or business interest or goals which are inconsistent with ours, or may be in a position to take action contrary to our investment objectives. In addition, in certain circumstances we may be liable for the actions of our third-party partners or co-venturers.
Many of our investments may be illiquid, which may result in our realizing less than their recorded value should we need to sell such investments quickly.
If we determine to sell one or more of our investments, we may encounter difficulties in finding buyers in a timely manner as real estate debt and other of our investments generally cannot be disposed of quickly, especially when market conditions are poor. Moreover, some of these assets may be subject to legal and other restrictions on resale. If we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. In addition, we may face other restrictions on our ability to liquidate an investment in a business entity to the extent that we, our Manager or ACRES has or could be attributed with material non-public information regarding such business entity. These factors may limit our ability to vary our portfolio promptly in response to changes in economic or other conditions and may also limit our ability to use portfolio sales as a source of liquidity, which could limit our ability to make distributions to our stockholders or repay debt.
Our investments in real estate and commercial mortgage loans, mezzanine loans and CRE equity investments are subject to the risks inherent in owning the real estate securing or underlying those investments that could result in losses to us.
Commercial mortgage loans are secured by, and mezzanine loans and CRE equity investments depend on, the performance of the underlying property and are subject to risks of delinquency and foreclosure, and risks of loss, that are greater than similar risks associated with loans made on the security of single-family residential properties. The ability of a borrower to repay a loan or make distributions secured by or dependent upon an income-producing property typically depends primarily upon the successful operation of the 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 or ability to make distributions may be impaired. Net operating income of an income producing property can be affected by, among other things:
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tenant mix, success of tenant businesses, tenant bankruptcies and property management decisions;
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property location and condition;
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competition from comparable types of properties;
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changes in laws that increase operating expenses or limit rents that may be charged;
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any need to address environmental contamination at the property;
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the occurrence of any uninsured casualty at the property;
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changes in national, regional or local economic conditions and/or the conditions of specific industry segments in which the lessees may operate;
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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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the availability of debt or equity financing;
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increases in costs of construction material;
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changes in governmental rules, regulations and fiscal policies, including environmental legislation and zoning laws; and
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acts of God, terrorism, pandemic, social unrest and civil disturbances.
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We risk loss of principal on defaulted CRE loans we hold to the extent of any deficiency between the value we can realize from the sale of the collateral securing the loan upon foreclosure and the loan’s principal and accrued interest. Moreover, foreclosure of a mortgage loan can be an expensive and lengthy process that could reduce the net amount we can realize on the foreclosed mortgage loan. In a bankruptcy of a mortgage loan borrower, the mortgage loan 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.
For a discussion of additional risks associated with mezzanine loans, see - “Risks Related to Our Investments - Investing in mezzanine debt, preferred equity and mezzanine or other subordinated tranches of CMBS involves greater risks of loss than senior secured debt investments.”
If our allowance for credit losses is not adequate to cover actual future loan losses, our earnings may decline.
We maintain an allowance for credit losses to provide for loan defaults and non-performance by borrowers of their obligations. Our allowance for credit losses may not be adequate to cover actual future loan losses and future provisions for credit losses could materially reduce our income. We base our allowance for credit losses on historical loss experience, current portfolio and market conditions and reasonable and supportable forecasts for the duration of each respective loan. However, losses have in the past, and may in the future, exceed our current estimates, and the difference could be substantial. The amount of future losses is susceptible to changes in economic, operating and other conditions that may be beyond our control, including changes in interest rates, changes in borrowers’ creditworthiness and the value of collateral securing loans. Additionally, if we seek to expand our loan portfolios, we may need to make additional provisions for credit losses to ensure that the allowance remains at levels deemed appropriate by our management for the size and quality of our portfolios. While we believe that our allowance for credit losses at December 31, 2020 is adequate to cover our anticipated losses, we cannot assure you that it will not increase in the future. Any increase in our allowance for credit losses will reduce our income and, if sufficiently large, could cause us to incur significant losses.
The CECL model required us to increase our allowance for credit losses and may have a material adverse effect on our business, financial condition and results of operations.
The CECL allowance required is a valuation account that is deducted from the related loans’ and debt securities’ amortized cost basis on our consolidated balance sheets, which reduced our total stockholders’ equity. The initial CECL reserve recorded on January 1, 2020 was reflected as a direct charge to retained earnings; however additional changes to the CECL reserve are recognized through net income on our consolidated statements of operations. While the guidance does not require any particular method for determining the CECL allowance, it does specify the allowance should be based on relevant information about past events, including historical loss experience, current portfolio and market conditions, and reasonable and supportable forecasts for the duration of each respective loan. Because our methodology for determining CECL allowances may differ from the methodologies employed by other companies, our CECL allowances may not be comparable with the CECL allowances reported by other companies. In addition, other than pursuant to a few narrow exceptions, the guidance requires that all financial instruments subject to the CECL model have some amount of reserve to reflect the GAAP principal underlying the CECL model that all loans, debt securities, and similar assets have some inherent risk of loss, regardless of credit quality, subordinate capital, or other mitigating factors. Accordingly, the adoption of the CECL model materially affected our determination of the allowance for credit losses and has required us to increase our allowance and recognize provisions for credit losses earlier in the lending cycle. Moreover, the CECL model has created more volatility in the level of our allowance for credit losses. If we are required to materially increase our level of allowance for credit losses for any reason, such increase could adversely affect our business, financial condition and results of operations.
Our investment portfolio may have material geographic, sector, property-type and sponsor concentrations.
We may have material geographic concentrations related to our direct or indirect investments in real estate loans and properties. We also may have material concentrations in the property types and industry sectors that are in our loan portfolio. Where we have any kind of concentration risk in our investments, we may be affected by sector-specific economic or other problems that are not reflected in the national economy generally or in more diverse portfolios. Where we have a significant concentration of investments with a small number of sponsors, we may be materially affected by an individual sponsors’ performance. An adverse development in that area of concentration could reduce the value of our investment and our return on that investment and, if the concentration affects a material amount of our investments, impair our ability to execute our investment strategies successfully, reduce our earnings and reduce our ability to make distributions.
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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.
We may invest in B-notes. A B-note is a loan typically secured by a first mortgage on a single large commercial property or group of related properties and subordinated to a senior note secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for B-note owners after payment to the senior note owners. 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. Depending upon market and economic conditions, we may make B-note investments at any time. B-notes are less liquid than other forms of CRE debt investments, such as CMBS, and, as a result, we may be able to dispose of underperforming or non-performing B-note investments only at a significant discount to book value.
We may be exposed to environmental liabilities with respect to properties to which we take title.
In the course of our business, we have taken title to, and expect we will in the future take title to, real estate through foreclosure on collateral underlying real estate debt investments. When we do take title to any property, we could be subject to environmental liabilities with respect to it. 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 they incur as a result of environmental contamination, or may have 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 and could reduce our income and ability to make distributions.
Our investments in preferred equity involve a greater risk of loss than traditional debt financing.
We may make preferred equity investments in entities that own or acquire CRE properties. Preferred equity investments involve a higher degree of risk than first mortgage loans due to a variety of factors, including the risk that, similar to mezzanine loans, such investments are subordinate to first mortgage loans and are not collateralized by property underlying the investment. Unlike mezzanine loans, preferred equity investments generally do not have a pledge of the ownership interests of the entity that owns the interest in the entity owning the property. Although as a holder of preferred equity we may enhance our position with covenants that limit the activities of the entity in which we hold an interest and protect our equity by obtaining an exclusive right to control the underlying property after an event of default, should such a default occur on our investment, we would only be able to proceed against the entity in which we hold an interest, and not the property owned by such entity and underlying our investment. As a result, we may not recover some or all of our investment.
Risks Related to Our Manager
We depend on our Manager and ACRES to develop and operate our business and may not find suitable replacements if the Management Agreement terminates.
We have no direct employees other than 4 employees acquired in connection with an REO property in the Northeast region that was delivered as collateral in a deed in lieu of foreclosure transaction in November 2020. Our officers, portfolio managers, administrative personnel and support personnel are employees of ACRES. We have no separate facilities and completely rely on our Manager; and ACRES has significant discretion as to the implementation of our operating policies and investment strategies. If our Management Agreement terminates, we may be unable to find a suitable replacement for our Manager. Moreover, we believe that our success depends to a significant extent upon the experience of the portfolio managers and officers of our Manager and ACRES who provide services to us, whose continued service is not guaranteed. The departure of any such persons could harm our investment performance.
Our Manager’s fee structure may not create proper incentives, and the incentive compensation we pay our Manager may increase the investment risk of our portfolio.
Our Manager is entitled to receive a base management fee equal to 1/12th of our equity, as defined in the Management Agreement, multiplied by 1.50%; provided, however, that for each calendar month through July 31, 2022, such fee shall be equal to a minimum of $442,000. Since the base management fee is based on our outstanding equity, our Manager could be incentivized to recommend strategies that increase our equity, and there may be circumstances where increasing our equity will not optimize the returns for our stockholders.
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In addition to its base management fee, our Manager is entitled to receive incentive compensation, calculated quarterly until the quarter ended December 31, 2022, equal to 20% of the amount by which our Core Earnings, as defined in the Management Agreement, for a quarter exceeds the product of the weighted average of the book value divided by 10,293,783 and the per share price (including the conversion price, if applicable) paid for our common shares in each offering (or issuance upon the conversion of convertible securities) by us subsequent to September 30, 2017, multiplied by the greater of 1.75% or 0.4375% plus one-fourth of the average ten-year U.S. Treasury rate for such quarter, multiplied by the weighted average number of common shares outstanding during the quarter, subject to certain adjustments. In evaluating investments and other management strategies, the opportunity to earn incentive compensation based on Core Earnings may lead our Manager to place undue emphasis on the maximization of Core Earnings at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation. Investments with higher yields generally have higher risk of loss than investments with lower yields. If our interests and those of our Manager are not aligned, the execution of our business plan and our results of operations could be adversely affected, which could adversely affect our results of operations and financial condition.
Our Manager manages our portfolio pursuant to very broad investment guidelines and our Board does not approve each investment decision, which may result in our making riskier investments.
Our Manager is authorized to follow very broad investment guidelines. While our directors periodically review our investment guidelines and our investment portfolio, they do not review all of our proposed investments. In addition, in conducting periodic reviews, the directors may rely primarily on information provided to them by our Manager. Furthermore, our Manager may use complex strategies, and transactions entered into by our Manager, which may be difficult or impossible to unwind by the time they are reviewed by the directors. Our Manager has great latitude within the broad investment guidelines in determining the types of investments it makes for us. Poor investment decisions could impair our ability to make distributions to our stockholders.
Termination of the Management Agreement by us without cause is difficult and could be costly.
Termination of our Management Agreement without cause is difficult and could be costly. We may terminate the Management Agreement without cause only annually upon the affirmative vote of at least two-thirds of our independent directors or by a vote of the holders of at least a majority of our outstanding common stock, based upon unsatisfactory performance by our Manager that is materially detrimental to us or a determination that the management fee payable to our Manager is not fair. Moreover, with respect to a determination that the management fee is not fair, our Manager may prevent termination by accepting a mutually acceptable reduction of management fees. We must give not less than 180 days’ prior notice of any termination. Upon any termination without cause, our Manager will be paid a termination fee equal to four times the sum of the average annual base management fee and the average annual incentive compensation earned by it during the two 12-month periods immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter before the date of termination.
Our Manager and ACRES will face conflicts of interest relating to the allocation of investment opportunities and such conflicts may not be resolved in our favor, which could limit our ability to acquire assets and, in turn, limit our ability to make distributions and reduce your overall investment return.
Our Management Agreement does not prohibit our Manager, or ACRES from investing in or managing entities that invest in asset classes that are the same as, or similar to, our targeted asset classes, except that they may not raise funds for, sponsor or advise any new publicly-traded REIT that invests primarily in MBS in the U.S. We rely on our Manager to identify suitable investment opportunities for us. Our executive officers and several of the other key real estate professionals, acting on behalf of our Manager, are also the key real estate professionals acting on behalf of the advisors of other investment programs sponsored by, and other clients managed by, ACRES. As such, these investment programs and clients rely on many of the same real estate professionals as will future programs and vehicles sponsored by ACRES. Many investment opportunities that are suitable for us may also be suitable for one or more of these investment programs or clients. When an investment opportunity becomes available, the applicable allocation committee established by ACRES, in accordance with its investment allocation policies and procedures, will offer the opportunity to the investment program or client for which the investment opportunity is most suitable based on the investment objectives, portfolio and criteria of each. Thus, the allocation committees could direct attractive investment opportunities to an investment program or client other than us, which could result in us not investing in investment opportunities that could provide an attractive return or investing in investment opportunities that provide less attractive returns. Any of the foregoing may reduce our ability to make distributions to you.
Our officers and many of the investment professionals that provide services to us through our Manager are also officers or employees of ACRES and may face conflicts regarding the allocation of their time.
Our officers, other than our Chief Financial Officer, Chief Accounting Officer and several accounting and tax professionals on their staff, as well as the officers, directors and employees of ACRES who provide services to us, are not required to work full time on our affairs, and devote significant time to the affairs of ACRES. As a result, there may be significant conflicts between us, on the one hand, and our Manager and ACRES on the other, regarding allocation of our Manager’s and ACRES’s resources to the management of our investment portfolio.
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We have engaged in and may again engage in transactions with entities affiliated with our Manager. Our policies and procedures may be insufficient to address any conflicts of interest that may arise.
We have established policies and procedures regarding review, approval and ratification of transactions that may give rise to a conflict of interest between persons affiliated or associated with our Manager and us. In the ordinary course of our business, we have ongoing relationships and have engaged in and may again engage in transactions with entities affiliated or associated with our Manager. See “Item 13. Certain Relationships and Related Transactions and Director Independence - Relationships and Related Transactions” in this report. Our policies and procedures may not be sufficient to address any conflicts of interest that arise.
Our Manager’s liability is limited under the Management Agreement, and we have agreed to indemnify our Manager against certain liabilities.
Our Manager does not assume any responsibility other than to render the services called for under the Management Agreement, and will not be responsible for any action of our Board in following or declining to follow its advice or recommendations. ACRES, our Manager, their directors, managers, officers, employees and affiliates will not be liable to us, any subsidiary of ours, our directors, our stockholders or any subsidiary’s stockholders for acts performed in accordance with and pursuant to the Management Agreement, except for acts constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the Management Agreement. We have agreed to indemnify the parties for all damages and claims arising from acts not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of duties, performed in good faith in accordance with and pursuant to the Management Agreement.
Risks Related to Our Organization and Structure
Our charter and bylaws contain provisions that may inhibit potential acquisition bids that you and other stockholders may consider favorable, and the market price of our common stock may be lower as a result.
Our charter and bylaws contain provisions that may have an anti-takeover effect and inhibit a change in our Board. These provisions include the following:
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There are ownership limits and restrictions on transferability and ownership in our charter. For purposes of assisting us in maintaining our REIT qualification under the Code, our charter generally prohibits any person from beneficially or constructively owning more than 9.8% in value or number of shares, whichever is more restrictive, of any class or series of our outstanding capital stock. This restriction may:
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discourage a tender offer or other transactions or a change in the composition of our Board or control that might involve a premium price for our shares or otherwise be in the best interests of our stockholders; or
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result in shares issued or transferred in violation of such restrictions being automatically transferred to a trust for a charitable beneficiary, resulting in the forfeiture of those shares.
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Our charter permits our Board to issue stock with terms that may discourage a third-party from acquiring us. Our Board may amend our charter without stockholder approval to increase the total number of authorized shares of stock or the number of shares of any class or series and issue common or preferred stock having preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications, or terms or conditions of redemption as determined by our Board. Thus, our Board could authorize the issuance of stock with terms and conditions that could have the effect of discouraging a takeover or other transaction in which holders of some or a majority of our shares might receive a premium for their shares over the then-prevailing market price.
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Our charter and bylaws contain other possible anti-takeover provisions. Our charter and bylaws contain other provisions, including advance notice procedures for the introduction of business and the nomination of directors, that may have the effect of delaying or preventing a change in control of us or the removal of existing directors and, as a result, could prevent our stockholders from being paid a premium for their common stock over the then-prevailing market price.
Maryland takeover statutes may prevent a change in control of us, and the market price of our common stock may be lower as a result.
Maryland Control Share Acquisition Act. Maryland law provides that “control shares” of a corporation acquired in a “control share acquisition” will have no voting rights except to the extent approved by a vote of two-thirds of the votes eligible to be cast on the matter under the Maryland Control Share Acquisition Act, or the Maryland Act. The Maryland Act defines “control shares” as voting shares of stock that, if aggregated with all other shares of stock owned by the acquirer or in respect of which the acquirer is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting power: one-tenth or more but less than one-third, one-third or more but less than a majority, or a majority or more of all voting power. A “control share acquisition” means the acquisition of control shares, subject to specific exceptions.
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If voting rights or control shares acquired in a control share acquisition are not approved at a stockholders’ meeting or if the acquiring person does not deliver an acquiring person statement as required by the Maryland Act then, subject to specific conditions and limitations, the issuer may redeem any or all of the control shares for fair value. If voting rights of such control shares are approved at a stockholders’ meeting and the acquirer becomes entitled to vote a majority of the shares entitled to vote, all other stockholders may exercise appraisal rights.
Our bylaws contain a provision exempting acquisitions of our shares from the Maryland Act. However, our Board may amend our bylaws in the future to repeal this exemption.
Business combinations. Under Maryland law, “business combinations” between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. An interested stockholder is defined as:
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any person who beneficially owns ten percent or more of the voting power of the corporation’s shares; or
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an affiliate or associate of the corporation who, at any time within the two-year period before the date in question, was the beneficial owner of ten percent or more of the voting power of the then outstanding voting stock of the corporation.
A person is not an interested stockholder under the statute if the board of directors approved in advance the transaction by which such person otherwise would have become an interested stockholder. However, in approving a transaction, the board of directors may provide that its approval is subject to compliance, at or after the time of approval, with any terms and conditions determined by the board.
After the five-year prohibition, any business combination between the Maryland corporation and an interested stockholder generally must be recommended by the board of directors of the corporation and approved by the affirmative vote of at least:
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80% of the votes entitled to be cast by holders of outstanding shares of voting stock of the corporation; and
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two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder.
These super-majority vote requirements do not apply if the corporation’s common stockholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares.
The statute permits exemptions from its provisions, including business combinations that are exempted by the board of directors before the time that the interested stockholder becomes an interested stockholder.
Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in your best interests.
Our charter limits the liability of our directors and officers to our stockholders and us for money damages, except for liability resulting from:
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actual receipt of an improper benefit or profit in money, property or services; or
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a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.
In addition, our charter authorizes us to, and we do, indemnify our present and former directors and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each present or former director or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made, or threatened to be made, a party by reason of his or her service to us. In addition, we may be obligated to fund the defense costs incurred by our directors and officers.
Our right to take action against our Manager is limited.
The obligation of our Manager under the Management Agreement is to render its services in good faith. It will not be responsible for any action taken by our Board or investment committee in following or declining to follow its advice and recommendations. Furthermore, as discussed above under - “Risks Related to Our Manager,” it will be difficult and costly for us to terminate the Management Agreement without cause. In addition, we will indemnify our Manager, ACRES and their officers and affiliates for any actions taken by them in good faith.
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We have not established a minimum distribution payment level and we cannot assure you of our ability to make distributions in the future. In the future, we may use uninvested offering proceeds or borrowed funds to make distributions.
We expect to make quarterly distributions to our stockholders in amounts such that we distribute all or substantially all of our taxable income in each year, subject to certain adjustments. We have not established a minimum distribution payment level, and our ability to make distributions may be impaired by the risk factors described in this report. All distributions will be made at the discretion of our Board and will depend on our earnings, our financial condition, maintenance of our REIT qualification and other factors as our Board may deem relevant from time to time. We may not be able to make distributions in the future. In addition, some of our distributions may include a return of capital. To the extent that we decide to make distributions in excess of our current and accumulated taxable earnings and profits, such distributions would generally be considered a return of capital for federal income tax purposes. A return of capital is not taxable, but it has the effect of reducing the holder’s tax basis in its investment. Although we currently do not expect that we will do so, we have in the past and may in the future also use proceeds from any offering of our securities that we have not invested or borrowed funds to make distributions. If we use uninvested offering proceeds to pay distributions in the future, we will have less funds available for investment and, as a result, our earnings and cash available for distribution would be less than we might otherwise have realized had such funds been invested. Similarly, if we borrow to fund distributions, our future interest costs would increase, thereby reducing our future earnings and cash available for distribution from what they otherwise would have been.
Loss of our exclusion from regulation under the Investment Company Act would require significant changes in our operations and could reduce the market price of our common stock and our ability to make distributions.
We rely on an exclusion from registration as an investment company afforded by Section 3(a)(1)(C) of the Investment Company Act. To qualify for this exclusion, we do not engage in the business of investing, reinvesting, owning, holding, or trading securities and we do not own “investment securities” with a value that exceeds 40% of the value of our total assets (exclusive of government securities and cash items) on an unconsolidated basis. We may not be able to maintain such a mix of assets in the future, and attempts to maintain such an asset mix may impair our ability to pursue otherwise attractive investments. In addition, these rules are subject to change and such changes may have an adverse impact on us. We may need to avail ourselves of alternative exclusions and exemptions that may require a change in the organizational structure of our business.
Furthermore, as it relates to our investment in our real estate subsidiary, ACRES RF, we rely on an exclusion from registration as an investment company afforded by Section 3(c)(5)(C) of the Investment Company Act. Given the material size of ACRES RF relative to our 3(a)(1)(C) exclusion, were ACRES RF to be deemed to be an investment company (other than by application of the Section 3(c)(1) exemption for closely held companies and the Section 3(c)(7) exemption for companies owned by “qualified purchasers”), we would not qualify for our 3(a)(1)(C) exclusion. Under the Section 3(c)(5)(C) exclusion, ACRES RF is required to maintain, on the basis of positions taken by the SEC staff in interpretive and no-action letters, a minimum of 55% of the value of the total assets of its portfolio in Qualifying Interests and a minimum of 80% in Qualifying Interests and real estate-related assets, with the remainder permitted to be miscellaneous assets. Because registration as an investment company would significantly affect ACRES RF’s ability to engage in certain transactions or to organize itself in the manner it is currently organized, we intend to maintain its qualification for this exclusion from registration.
We treat our investments in CMBS, B-notes and mezzanine loans as Qualifying Interests for purposes of determining our eligibility for the exclusion provided by Section 3(c)(5)(C) to the extent such treatment is consistent with guidance provided by the SEC or its staff. In the absence of specific guidance or guidance that otherwise supports the treatment of these investments as Qualifying Interests, we will treat them, for purposes of determining our eligibility for the exclusion provided by Section 3(c)(5)(C), as real estate-related assets or miscellaneous assets, as appropriate.
If ACRES RF’s portfolio does not comply with the requirements of the exclusion we rely upon, it could be forced to alter its portfolio by selling or otherwise disposing of a substantial portion of the assets that are not Qualifying Interests or by acquiring a significant position in assets that are Qualifying Interests. Altering its portfolio in this manner may have an adverse effect on its investments if it is forced to dispose of or acquire assets in an unfavorable market, and may adversely affect our stock price.
If it were established that we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the SEC that we would be unable to enforce contracts with third parties, that third parties could seek to obtain rescission of transactions undertaken during the period it was established that we were an unregistered investment company, and that we would be subject to limitations on corporate leverage that would have an adverse impact on our investment returns.
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Rapid changes in the values of our real estate-related investments may make it more difficult for us to maintain our qualification as a REIT or exclusion from regulation under the Investment Company Act.
If the market value or income potential of our real estate-related investments declines as a result of economic conditions, increased interest rates, prepayment rates or other factors, we may need to increase our real estate-related investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exclusion from registration under the Investment Company Act. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish. We may have to make investment decisions that we otherwise would not make absent REIT qualification and Investment Company Act considerations.
Tax Risks
Complying with REIT requirements may cause us to forgo otherwise attractive opportunities.
To qualify as a REIT for federal income tax purposes, we must continually satisfy various tests regarding the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our common stock. In order to meet these tests, we may be required to forgo investments we might otherwise make. Thus, compliance with the REIT requirements may hinder our investment performance.
In particular, at least 75% of our assets at the end of each calendar quarter must consist of real estate assets, government securities, cash and cash items. For this purpose, “real estate assets” generally include interests in real property, such as land, buildings, leasehold interests in real property, stock of other entities that qualify as REITs, interests in mortgage loans secured by real property, investments in stock or debt investments during the one-year period following the receipt of new capital and regular or residual interests in a real estate mortgage investment conduit, or REMIC. In addition, the amount of securities of a single issuer, other than a TRS, that we hold must generally not exceed either 5% of the value of our gross assets or 10% of the vote or value of such issuer’s outstanding securities.
Certain of the assets that we hold are not qualified and will not be qualified real estate assets for purposes of the REIT asset tests. CMBS securities should generally qualify as real estate assets. However, to the extent that we own non-REMIC collateralized mortgage obligations or other debt investments secured by mortgage loans (rather than by real property) or secured by non-real estate assets, or debt securities that are not secured by mortgages on real property, those securities are likely not qualifying real estate assets for purposes of the REIT asset test, and will not produce qualifying real estate income. Further, whether securities held by warehouse lenders or financed using repurchase agreements are treated as qualifying assets or as generating qualifying real estate income for purposes of the REIT asset and income tests depends on the terms of the warehouse or repurchase financing arrangement.
We generally will be treated as the owner of any assets that collateralize CRE debt securitization transactions to the extent that we retain all of the equity of the securitization vehicle and do not make an election to treat such securitization vehicle as a TRS, as described in further detail below. It may be possible to reduce the impact of the REIT asset and gross income requirements by holding certain assets through our TRSs, subject to certain limitations as described below.
Our qualification as a REIT and exemption from U.S. federal income tax with respect to certain assets may depend on the accuracy of legal opinions or advice rendered or given or statements by the issuers of securities in which we invest, and the inaccuracy of any such opinions, advice or statements may adversely affect our REIT qualification and result in significant corporate level tax.
When purchasing securities, we have relied and may rely on opinions or advice of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining whether such securities represent debt or equity securities for U.S. federal income tax purposes, and also to what extent those securities constitute REIT real estate assets for purposes of the REIT asset tests and produce income that qualifies under the 75% REIT gross income test. In addition, when purchasing CDO equity, we have relied and may rely on opinions or advice of counsel regarding the qualification of interests in the debt of such CDOs for U.S. federal income tax purposes. The inaccuracy of any such opinions, advice or statements may adversely affect our REIT qualification and result in significant corporate-level tax.
We may realize excess inclusion income that would increase our tax liability and that of our stockholders.
If we realize excess inclusion income and allocate it to stockholders, this income cannot be offset by net operating losses of the stockholders. If the stockholder is a tax-exempt entity, then this income would be fully taxable as unrelated business taxable income under Section 512 of the Code. If the stockholder is a foreign person, it would be subject to federal income tax withholding on this income without reduction or exemption pursuant to any otherwise applicable income tax treaty.
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Excess inclusion income could result if we hold a residual interest in a REMIC. Excess inclusion income also could be generated if we issue debt obligations, such as certain CRE debt securitizations, with two or more maturities and the terms of the payments on these obligations bore a relationship to the payments that we received on our mortgage related securities securing those debt obligations (i.e., if we were to own an interest in a taxable mortgage pool). While we do not expect to acquire significant amounts of residual interests in REMICs, nor do we currently own residual interests in taxable mortgage pools, we do issue debt in certain CRE debt securitizations that may generate excess inclusion income.
If we realize excess inclusion income, we will be taxed at the highest corporate income tax rate on a portion of such income that is allocable to the percentage of our stock held in record name by “disqualified organizations,” which are generally cooperatives, governmental entities and tax-exempt organizations that are exempt from unrelated business taxable income. To the extent that our stock owned by “disqualified organizations” is held in record name by a broker-dealer or other nominee, the broker/dealer or other nominee would be liable for the corporate level tax on the portion of our excess inclusion income allocable to the stock held by the broker-dealer or other nominee on behalf of “disqualified organizations.” We expect that disqualified organizations will own our stock. Because this tax would be imposed on us, all of our investors, including investors that are not disqualified organizations, would bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable mortgage pool. A regulated investment company or other pass through entity owning stock in record name will be subject to tax at the highest corporate rate on any excess inclusion income allocated to its owners that are disqualified organizations. Finally, if we fail to qualify as a REIT, our taxable mortgage pool securitizations will be treated as separate corporations, for federal income tax purposes that cannot be included in any consolidated corporate tax return.
Failure to qualify as a REIT would subject us to federal income tax, which would reduce the cash available for distribution to our stockholders.
We believe that we have been organized and operated in a manner that has enabled us to qualify as a REIT for federal income tax purposes commencing with our taxable year ended on December 31, 2005. However, the federal income tax laws governing REITs are extremely complex, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis.
If we fail to qualify as a REIT in any calendar year and we do not qualify for certain statutory relief provisions, we will be subject to federal income tax, including any applicable alternative minimum tax on our taxable income, at regular corporate rates. Distributions to stockholders would not be deductible in computing our taxable income. Corporate tax liability would reduce the amount of cash available for distribution to our stockholders. Under some circumstances, we might need to borrow money or sell assets in order to pay that tax. Furthermore, if we fail to maintain our qualification as a REIT and we do not qualify for the statutory relief provisions, we no longer would be required to distribute substantially all of our REIT taxable income, determined without regard to the dividends paid deduction and excluding net capital gains, to our stockholders. Unless our failure to qualify as a REIT was excused under federal tax laws, we could not re-elect to qualify as a REIT until the fifth calendar year following the year in which we failed to qualify. In addition, if we fail to qualify as a REIT, our taxable mortgage pool securitizations will be treated as separate corporations for U.S. federal income tax purposes.
A determination that we have not made required distributions would subject us to tax or require us to pay a deficiency dividend; payment of tax would reduce the cash available for distribution to our stockholders.
In order to qualify as a REIT, in each calendar year we must distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed income. In addition, we will incur a 4% nondeductible excise tax on the amount, if any, by which our distributions in any calendar year are less than the sum of:
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85% of our ordinary income for that year;
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95% of our capital gain net income for that year; and
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100% our undistributed taxable income from prior years.
We intend to make distributions to our stockholders in a manner intended to satisfy the 90% distribution requirement and to distribute all or substantially all of our net taxable income to avoid both corporate income tax and the 4% nondeductible excise tax. There is no requirement that a domestic TRS distribute its after-tax net income to its parent REIT or their stockholders and our U.S. TRSs may determine not to make any distributions to us. However, non-U.S. TRSs will generally be deemed to distribute their earnings to us on an annual basis for federal income tax purposes, regardless of whether such TRSs actually distribute their earnings.
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Our taxable income may substantially exceed our net income as determined by GAAP because, for example, realized capital losses will be deducted in determining our GAAP net income but may not be deductible in computing our taxable income. In addition, we may invest in assets that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets, referred to as phantom income. Although some types of phantom income are excluded to the extent they exceed 5% of our REIT taxable income in determining the 90% distribution requirement, we will incur corporate income tax and the 4% nondeductible excise tax with respect to any phantom income items if we do not distribute those items on an annual basis. As a result, we may generate less cash flow than taxable income in a particular year. It is also possible that a loss that we treat as an ordinary loss would be recharacterized as a capital loss. In such event we might have to pay tax for the year in question or pay a deficiency dividend so that we meet the dividends paid requirement for that year. In all such events, we may be required to use cash reserves, incur debt, or liquidate non-cash assets at rates or times that we regard as unfavorable in order to satisfy the distribution requirement and to avoid corporate income tax and the 4% nondeductible excise tax in that year.
If we make distributions in excess of our current and accumulated earnings and profits, they will be treated as a return of capital, which will reduce the adjusted basis of your stock. To the extent such distributions exceed your adjusted basis, you may recognize a capital gain upon distribution.
Unless you are a tax-exempt entity, distributions that we make to you generally will be subject to tax as ordinary income to the extent of our current and accumulated earnings and profits as determined for federal income tax purposes. If the amount we distribute to you exceeds your allocable share of our current and accumulated earnings and profits, the excess will be treated as a return of capital to the extent of your adjusted basis in your stock, which will reduce your basis in your stock but will not be subject to tax. To the extent the amount we distribute to you exceeds both your allocable share of our current and accumulated earnings and profits and your adjusted basis, this excess amount will be treated as a gain from the sale or exchange of a capital asset. For risks related to the use of uninvested offering proceeds or borrowings to fund distributions to stockholders, see - “Risks Related to Our Organization and Structure. - We have not established a minimum distribution payment level and we cannot assure you of our ability to make distributions in the future.”
Our ownership of and relationship with our TRSs will be limited and a failure to comply with the limits would jeopardize our REIT qualification and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the securities of one or more TRSs. A TRS may earn specified types of income or hold specified assets that would not be qualifying income or assets if earned or held directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. A TRS will pay federal, state and local income tax at regular corporate rates on any income that it earns, whether or not it distributes that income to us. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis.
XAN RE TRS will pay federal, state and local income tax on its taxable income, and its after-tax net income is available for distribution to us but is not required to be distributed to us. Income that is not distributed to us by our U.S. TRS will not be subject to the REIT 90% distribution requirement and therefore will not be available for distributions to our stockholders. We anticipate that the aggregate value of the securities we hold in our TRS will be less than 20% of the value of our total assets, including our TRS securities. We will monitor the compliance of our investments in TRSs with the rules relating to value of assets and transactions not on an arm’s-length basis. We cannot assure you, however, that we will be able to comply with such rules.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Code substantially limit our ability to hedge MBS and related borrowings. Under these provisions, our annual gross income from qualifying and non-qualifying hedges of our borrowings, together with any other income not generated from qualifying real estate assets, cannot exceed 25% of our gross income. In addition, our aggregate gross income from non-qualifying hedges, fees and certain other non-qualifying sources cannot exceed 5% of our annual gross income determined without regard to income from qualifying hedges. As a result, we might have to limit our use of advantageous hedging techniques or implement those hedges through XAN RE TRS. This could increase the cost of our hedging activities or expose us to greater risks associated with changes in interest rates than we would otherwise want to bear.
The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans that would be treated as sales for federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were able to sell or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial to us.
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Legislative, regulatory or administrative changes could adversely affect our stockholders or us.
Legislative, regulatory or administrative changes could be enacted or promulgated at any time, either prospectively or with retroactive effect, and may adversely affect our stockholders and/or us.
The Tax Cuts and Jobs Act, or TCJA, made significant changes to the U.S. federal income tax rules for taxation of individuals and corporations, generally effective for taxable years beginning after December 31, 2017. In addition to reducing corporate and individual tax rates, the TCJA eliminates or restricts various deductions. Most of the changes applicable to individuals are temporary and apply only to taxable years beginning after December 31, 2017 and before January 1, 2026. The TCJA makes numerous large and small changes to the tax rules that do not affect the REIT qualification rules directly but may otherwise affect us or our stockholders.
While the changes in the TCJA generally appear to be favorable with respect to REITs, the extensive changes to non-REIT provisions in the Code may have unanticipated effects on our stockholders or us. Moreover, Congressional leaders have recognized that the process of adopting extensive tax legislation in a short amount of time without hearings and substantial time for review is likely to have led to drafting errors, issues needing clarification and unintended consequences that will have to be revisited in subsequent tax legislation. It is not clear if or when Congress will address these issues or when the IRS will issue administrative guidance on the changes made in the TCJA.
We urge you to consult with your own tax advisor with respect to the status of the TCJA and other legislative, regulatory or administrative developments and proposals and their potential effect on an investment in shares of our common stock.
Dividends paid by REITs do not qualify for the reduced tax rates provided for under current law.
Dividends paid by REITs are generally not eligible for the reduced 15% maximum tax rate for dividends paid to individuals (20% for those with taxable income above certain thresholds that are adjusted annually under current law). The more favorable rates applicable to regular corporate dividends could cause stockholders who are individuals to perceive investments in REITs to be relatively less attractive than investments in the stock of non-REIT corporations that pay dividends to which more favorable rates apply, which could reduce the value of the stocks of REITs. However, under the TCJA, regular dividends from REITs are treated as income from a pass-through entity and are eligible for a 20% deduction. As a result, our regular dividends are taxed at 80% of an individual’s marginal tax rate. The current maximum rate is 37% resulting in a maximum tax rate of 29.6%. Dividends from REITs as well as regular corporate dividends will also be subject to a 3.8% Medicare surtax for taxpayers with modified adjusted gross income above $200,000 (if single) or $250,000 (if married and filing jointly).
We may lose our REIT qualification or be subject to a penalty tax if the IRS successfully challenges our characterization of income inclusions from our foreign TRSs.
We likely will be required to include in our income, even without the receipt of actual distributions, earnings from our foreign TRSs, including from our previous investments in CDOs, such as our investment in Apidos CDO I, Ltd., Apidos CDO III, Ltd. and Apidos Cinco CDO. We intend to treat certain of these income inclusions as qualifying income for purposes of the 95% gross income test applicable to REITs but not for purposes of the REIT 75% gross income test. The provisions that set forth what income is qualifying income for purposes of the 95% gross income test provide that gross income derived from dividends, interest and other enumerated classes of passive income qualify for purposes of the 95% gross income test. Income inclusions from equity investments in our foreign TRSs are technically neither dividends nor any of the other enumerated categories of income specified in the 95% gross income test for U.S. federal income tax purposes, and there is no clear precedent with respect to the qualification of such income for purposes of the REIT gross income tests. However, based on advice of counsel, we intend to treat such income inclusions, to the extent distributed by a foreign TRS in the year accrued, as qualifying income for purposes of the 95% gross income test. In addition, in 2011, the IRS issued a private letter ruling to a REIT reaching a result consistent with our treatment. Nevertheless, because this income does not meet the literal requirements of the REIT provisions, it is possible that the IRS could successfully take the position that it is not qualifying income. In the event that it was determined not to qualify for the 95% gross income test, we would be subject to a penalty tax with respect to the income to the extent it and other nonqualifying income exceeds 5% of our gross income and/or we could fail to qualify as a REIT. See “Federal Income Tax Consequences of Our Qualification as a REIT.” In addition, if such income was determined not to qualify for the 95% gross income test, we would need to invest in sufficient qualifying assets, or sell some of our interests in our foreign TRSs to ensure that the income recognized by us from our foreign TRSs or such other corporations does not exceed 5% of our gross income, or cease to qualify as a REIT.
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We may lose our REIT qualification or be subject to a penalty tax if we modify mortgage loans or acquire distressed debt in a way that causes us to fail our REIT gross income or asset tests.
Many of the terms of our mortgage loans, mezzanine loans and B-notes and the loans supporting our MBS have been modified and may in the future be modified to avoid foreclosure actions and for other reasons. If the terms of the loan are modified in a manner constituting a “significant modification,” such modification triggers a deemed exchange for tax purposes of the original loan for the modified loan. Under existing Treasury Regulations, if a loan is secured by real property and other property and the highest principal amount of the loan outstanding during a taxable year exceeds the fair market value of the real property securing the loan as of (1) the date we agreed to acquire or originate the loan or (2) in the event of certain significant modifications, the date we modified the loan, then a portion of the interest income from such a loan will not be qualifying income for purposes of the 75% gross income test, but will be qualifying income for purposes of the 95% gross income test. Although the law is not entirely clear, a portion of the loan may not be treated as a qualifying “real estate asset” for purposes of the 75% asset test. The non-qualifying portion of such a loan would be subject to, among other requirements, the 10% value test.
Revenue Procedure 2011-16, as modified and superseded by Revenue Procedure 2014-51, provides a safe harbor pursuant to which we will not be required to redetermine the fair market value of the real property securing a loan for purposes of the REIT gross income and asset tests in connection with a loan modification that is: (1) occasioned by a borrower default; or (2) made at a time when we reasonably believe that the modification to the loan will substantially reduce a significant risk of default on the original loan. We cannot assure you that all of our loan modifications have qualified or will qualify for the safe harbor in Revenue Procedure 2011-16, as modified and superseded by Revenue Procedure 2014-51. To the extent we significantly modify loans in a manner that does not qualify for that safe harbor, we will be required to redetermine the value of the real property securing the loan at the time it was significantly modified. In determining the value of the real property securing such a loan, we may not obtain third-party appraisals, but rather may rely on internal valuations. No assurance can be provided that the IRS will not successfully challenge our internal valuations. If the terms of our mortgage loans, mezzanine loans and B-notes and loans supporting our MBS are significantly modified in a manner that does not qualify for the safe harbor in Revenue Procedure 2011-16, as modified and superseded by Revenue Procedure 2014-51, and the fair market value of the real property securing such loans has decreased significantly, we could fail the 75% gross income test, the 75% asset test and/or the 10% value test. Unless we qualified for relief under certain cure provisions in the Code, such failures could cause us to fail to qualify as a REIT.
Our subsidiaries and we have invested and may invest in the future in distressed debt, including distressed mortgage loans, mezzanine loans, B-notes and MBS. Revenue Procedure 2011-16, as modified and superseded by Revenue Procedure 2014-51, provides that the IRS will treat a distressed mortgage loan acquired by a REIT that is secured by real property and other property as producing in part non-qualifying income for the 75% gross income test. Specifically, Revenue Procedure 2011-16, as modified and superseded by Revenue Procedure 2014-51, indicates that interest income on a loan will be treated as qualifying income based on the ratio of (1) the fair market value of the real property securing the loan determined as of the date the REIT committed to acquire the loan and (2) the face amount of the loan (and not the purchase price or current value of the loan). The face amount of a distressed mortgage loan and other distressed debt will typically exceed the fair market value of the real property securing the debt on the date the REIT commits to acquire the debt. We believe that we will continue to invest in distressed debt in a manner consistent with complying with the 75% gross income test and maintaining our qualification as a REIT.
The failure of a loan subject to a repurchase agreement, a mezzanine loan or a preferred equity investment to qualify as a real estate asset would adversely affect our ability to qualify as a REIT.
We have entered into and we intend to continue to enter into sale and repurchase agreements under which we nominally sell certain of our loan assets to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that we have been and will be treated for U.S. federal income tax purposes as the owner of the loan assets that are the subject of any such agreement notwithstanding that the agreement may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the loan assets during the term of the sale and repurchase agreement, in which case we could fail to qualify as a REIT.
In addition, we have acquired in the past and may continue to acquire mezzanine loans, which are loans secured by equity interest in a partnership or limited liability company that directly or indirectly owns real property, and preferred equity investments, which are senior equity interests in entities that own or acquire real properties. In Revenue Procedure 2003-65, or the Revenue Procedure, the IRS provided a safe harbor pursuant to which a mezzanine loan, if it meets each of the requirements contained in the Revenue Procedure, will be treated by the IRS as a real estate asset for purposes of the REIT asset tests, and interest derived from the mezzanine loan will be treated as qualifying mortgage interest for purposes of the REIT 75% income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We have acquired and may continue to acquire mezzanine loans that may not meet all of the requirements for reliance on this safe harbor. In the event we own a mezzanine loan that does not meet the safe harbor, the IRS could challenge the loan’s treatment as a real estate asset for purposes of the REIT asset and income tests, and if the challenge were sustained, we could fail to qualify as a REIT.
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General Risks
We cannot predict the effects on us of actions taken by the U.S. government and governmental agencies in response to economic conditions in the U.S.
In response to economic and market conditions, U.S. and foreign governments and governmental agencies have established or proposed a number of programs designed to improve the financial system and credit markets, and to stimulate economic growth. Many governments, including federal, state and local governments in the U.S., are incurring substantial budget deficits and seeking financing in international and national credit markets as well as proposing or enacting austerity programs that seek to reduce government spending, raise taxes, or both. Many credit providers, including banks, may need to obtain additional capital before they will be able to expand their lending activities. We are unable to evaluate the effects these programs and conditions will have upon our financial condition, income, or ability to make distributions to our stockholders.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
We maintain offices in Westbury, New York and Philadelphia, Pennsylvania. Our principal office is located in leased space at 865 Merrick Avenue, Suite 200 S, Westbury, New York 11590. We do not own any material principal real property.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
Refer to “Item II - Item 8. Financial Statements and Supplementary Data - Note 23 - Commitments and Contingencies” for the applicable disclosures.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is listed on the New York Stock Exchange, or NYSE, under the symbol “ACR”, formerly listed under the symbol “XAN.”
We are organized and conduct our operations to qualify as a real estate investment trust, or REIT, which requires that we distribute at least 90% of our REIT taxable income. During the year ended December 31, 2020, we did not pay distributions on our common shares as we were focused on prudently retaining and managing sufficient excess liquidity in connection with the economic impact of the novel coronavirus (“COVID-19”) pandemic. As we continue to take steps necessary to stabilize our financial condition and capital position in light of the COVID-19 pandemic, our board of directors (our “Board”) will establish a plan for the prudent resumption of the payment of common share distributions. No assurance, however, can be given as to the amounts or timing of future distributions as such distributions are subject to our earnings, financial condition, capital requirements and such other factors as our Board deems relevant.
On February 16, 2021, we completed a one-for-three reverse stock split, which reduced the number of shares of our common stock that were issued and outstanding immediately prior to the effectiveness of the reverse stock split. The number of shares of our authorized common stock was not affected by the reverse stock split and the par value of our common stock remained unchanged at $0.001 per share. The reverse stock split reduced the number of shares of our common stock that were outstanding at February 16, 2021 from 29,194,460 to 9,731,371 after the cancellation of all fractional shares. No fractional shares were issued in connection with the reverse stock split. Stockholders who otherwise held fractional shares of our common stock as a result of the reverse stock split received a cash payment in lieu of such fractional shares. All amounts related to number of shares and per share amounts have been retroactively restated in these consolidated financial statements.
At March 8, 2021, there were 9,507,024 shares of common stock outstanding held by 224 holders of record. The 224 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of our common stock. Such information was obtained through our registrar and transfer agent.
The following table summarizes certain information about our 2005 Stock Incentive Plan and Second Amended and Restated Omnibus Equity Compensation Plan at December 31, 2020:
(1)
All restricted stock awards consist of unvested shares.
Our 8.625% Fixed-to-Floating Series C Cumulative Redeemable Preferred Stock, or Series C Preferred Stock, is listed on the NYSE and trades under the symbol “ACRPrC”, formerly listed under the symbol “XANPrC.” We have declared and paid the specified quarterly dividend per share of $0.5390625 through January 2021. No dividends are currently in arrears on the Series C Preferred Stock.
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Issuer Purchases of Equity Securities
In March 2016, our Board approved a securities repurchase program for up to $50.0 million of our outstanding securities. In November 2020, our Board authorized and approved the continued use of our existing share repurchase program in order to repurchase up to $20.0 million of our outstanding shares of common stock through March 31, 2021. In March 2021, our Board authorized the extension of the previous $20.0 million authorization through the second quarter of 2021 or until the $20.0 million is fully deployed. During the year ended December 31, 2020, we repurchased 535,485 shares, or $5.4 million, of our common stock through this program. At December 31, 2020, $14.6 million remains available in this repurchase plan. From January 1, 2021 to February 28, 2021, we repurchased 565,285 shares, or $6.9 million, of our common stock through this program. At February 28, 2021, $7.7 million remains available under this repurchase plan.
The following table presents information about our common stock repurchases made during the year ended December 31, 2020 in accordance with our repurchase program (dollars in thousands, except per-share amounts):
(1)
The average price paid per share as reflected above includes broker fees and commissions.
Performance Graph
The following line graph presentation compares cumulative total shareholder returns on our common stock with the Russell 2000 Index and the FTSE NAREIT All REIT Index for the period from December 31, 2015 to December 31, 2020. The graph and table assume that $100 was invested in each of our common stock, the Russell 2000 Index and the FTSE NAREIT All REIT Index on December 31, 2015, and that all dividends were reinvested. This data is furnished by the Research Data Group.
*$100 invested on December 31, 2015 in stock or index, including reinvestment of dividends.
ITEM 6.
ITEM 6.
[REMOVED AND RESERVED]
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ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in “Item 8. Financial Statements and Supplementary Data” of this annual report on Form 10-K.
We have omitted discussion of the earliest of the three years covered by our consolidated financial statements presented in this report as that disclosure is included in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the Securities and Exchange Commission (“SEC”) on March 10, 2020. You are encouraged to reference the discussion and analysis of our results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2019 in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” within that report.
Overview
We are a Maryland corporation and an externally managed real estate investment trust (“REIT”) that is primarily focused on originating, holding and managing commercial real estate (“CRE”) mortgage loans and other commercial real estate-related debt investments. On July 31, 2020, our management contract was acquired from Exantas Capital Manager Inc., a subsidiary of C-III Capital Partners LLC, by ACRES Capital, LLC (the “Manager”), a subsidiary of ACRES Capital Corp. (collectively, “ACRES”), a private commercial real estate lender exclusively dedicated to nationwide middle market CRE lending with a focus on multifamily, student housing, hospitality, office and industrial in top United States (“U.S.”) markets (the “ACRES acquisition”). Our Manager draws upon the management team of ACRES and its collective investment experience to provide its services. Our objective is to provide our stockholders with total returns over time, including quarterly distributions and capital appreciation, while seeking to manage the risks associated with our investment strategies as well as to maximize long-term stockholder value by maintaining stability through our available liquidity and diversified CRE loan portfolio.
In connection with the ACRES acquisition:
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We entered into a Fourth Amended and Restated Management Agreement (the “Management Agreement”) which was amended and restated to (i) extend its term to July 21, 2023, (ii) allow for board designation rights that give the Manager the right to designate not less than two nominees for election to our board of directors (“Board”), (iii) provide for a termination fee to be payable to the Manager upon its termination of the Management Agreement due to our default in the performance of any material term, condition or covenant in the Management Agreement, (iv) provide for a minimum monthly base management fee through July 31, 2022 and (v) revise the computation of incentive compensation with respect to each fiscal quarter commencing with the quarter ended December 31, 2022.
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We entered into separate agreements with Massachusetts Mutual Life Insurance Company (“MassMutual”) and a fund managed by Oaktree Capital Management, L.P. (“Oaktree”) for new capital commitments aggregating up to $375 million. The asset-based revolving loan facility of up to $250.0 million can be used to finance our core CRE lending business and is not subject to mark-to-market provisions. The senior Note and Warrant Purchase Agreement (the “Note and Warrant Purchase Agreement”) of up to $125.0 million can be used for general corporate purposes. See further discussion of these commitments in “Liquidity and Capital Resources.”
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We entered into a $12.0 million promissory note (the “Promissory Note”) as lender with ACRES to partially fund the acquisition of our management contract.
An important aspect of the ACRES acquisition was that it delivered operational liquidity in order to substantially mitigate additional potential margin call risk, allowing us to focus on asset management within the existing portfolio and restart loan originations and underwriting. Additionally, our Manager expects to leverage the complementary nature of our lending platforms, its experience and its network of relationships to generate a CRE pipeline to improve and grow book value and earnings.
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In December 2019, a novel strain of coronavirus (“COVID-19”) was identified. The resulting spread of COVID-19 throughout the globe led the World Health Organization to designate COVID-19 as a pandemic and numerous countries, including the U.S., to declare national emergencies. Many countries have responded to the outbreak by instituting quarantines and restrictions on travel and limiting operations of non-essential offices and retail centers, which has resulted in the closure or remote operation of non-essential businesses and increased rates of unemployment. While certain countries around the world have eased restrictions and financial markets have stabilized to some degree, the pandemic continues to cause uncertainty surrounding its ultimate impact on the global economy, generally, and the CRE business in particular. We continue to actively and responsibly manage corporate liquidity and operations in light of the market disruptions caused by COVID-19. Additionally, nationwide restrictions placed on most businesses in response to COVID-19 are expected to cause significant cash flow disruptions across the economy that will likely impact our borrowers and their ability to stay current with their debt obligations in the near term. We have used and continue to expect to use a variety of legal and structural options to manage that risk effectively, including through forbearance and extension provisions or agreements. It is inherently difficult to accurately assess the impact of COVID-19 on our revenues, profitability and financial position due to uncertainty of the severity and duration of the pandemic. In response, in the near-term, we are focused on prudently retaining and managing sufficient liquidity. We, therefore, have not paid distributions on our common shares in 2020. We continuously monitor the effects of COVID-19 on our operations and financial position to ensure that we remain responsive and adaptable to the dynamic environment that has been created by the pandemic. For additional discussion with respect to the potential impact of COVID-19 on our liquidity and capital resources, see “Liquidity and Capital Resources.”
Historically, we maintained a portfolio of commercial mortgage-backed securities (“CMBS”), including senior and subordinated investment grade CMBS, below investment grade CMBS and unrated CMBS, that we primarily financed using short-term repurchase agreements. However, the COVID-19 pandemic produced material and previously unforeseeable liquidity shocks to the real estate credit markets that led to the receipt of substantial margin calls, and subsequently some default notices, from our CMBS repurchase agreement counterparties. In April 2020, we completed the sale of substantially all of our portfolio of CMBS and settlements were reached on all of our remaining CMBS-related obligations, which were paid in full in April 2020. The repayment of all of our CMBS repurchase agreements in April 2020 signifies that we have no further exposure to financings related to CMBS. We realized a loss of $180.3 million on the aforementioned disposition of our CMBS portfolio.
At December 31, 2020, we retained two unencumbered CMBS that previously had fair values below their cost bases with a collective fair value of $2.1 million for which we recognized an unrealized loss of $6.1 million in our consolidated statements of operations for the year ended December 31, 2020.
Our CRE loan portfolio, which had a $1.5 billion and $1.8 billion carrying value at December 31, 2020 and 2019, respectively, comprised:
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First mortgage loans, which we refer to as whole loans. These loans are typically secured by first liens on CRE property, including the following property types: office, multifamily, self-storage, retail, hotel, healthcare, student housing, manufactured housing, industrial and mixed-use. At December 31, 2020 and 2019, our whole loans had a carrying value of $1.5 billion and $1.8 billion, respectively, or 98.0% and 98.3%, respectively, of the CRE loan portfolio.
•
Mezzanine debt that is senior to borrower’s equity but is subordinated to other third-party debt. These loans are subordinated CRE loans, usually secured by a pledge of the borrower’s equity ownership in the entity that owns the property or by a second lien mortgage on the property. At December 31, 2020 and 2019, our mezzanine loans had a carrying value of $4.4 million and $4.7 million, respectively, or 0.3% of the CRE loan portfolio at each date.
•
Preferred equity investments that are subordinate to first mortgage loans and mezzanine debt. These investments may be subject to more credit risk than subordinated debt but provide the potential for higher returns upon a liquidation of the underlying property and are typically structured to provide some credit enhancement differentiating it from the common equity in such investments. At December 31, 2020 and 2019, our preferred equity investments had a carrying value of $26.0 million and $26.1 million, respectively, or 1.7% and 1.4% respectively of the CRE loan portfolio.
We generate our income primarily from the spread between the revenues we receive from our assets and the cost to finance our ownership of those assets, including corporate debt and, to a lesser extent, from hedging interest rate risks.
While the CRE whole loans included in the CRE loan portfolio are entirely composed of floating-rate loans benchmarked to the London Interbank Offered Rate (“LIBOR”), asset yields are protected through the use of LIBOR floors and minimum interest periods that typically range from 12 to 18 months at the time of a loan’s origination. In a lower interest rate environment, our LIBOR floors provide asset yield protection when LIBOR falls below an in-place LIBOR floor. In addition, our net investment returns are enhanced by a decline in the cost of our floating-rate liabilities that do not have LIBOR floors. At December 31, 2020, our $1.5 billion floating-rate CRE loan portfolio, at par, has a weighted average LIBOR floor of 1.88% and weighted average spread over LIBOR of 3.56%. We expect to see a meaningful benefit to interest income as the forward LIBOR curve projects to remain low in the near term in 2021.
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Our portfolio comprised loans with a diverse array of collateral types and locations. At December 31, 2020 and 2019, 83.3% and 81.6%, respectively, of our CRE loans were collateralized by multifamily, office, self-storage, manufactured housing and industrial properties, with the remaining 16.7% and 18.4%, respectively, collateralized by hotel and retail properties. These properties are located throughout the U.S., with one National Council of Real Estate Investment Fiduciaries (“NCREIF”) region in excess of 20% (Mountain at 21.4%) at December 31, 2020 and no individual region making up more than 20% of the total CRE loan portfolio at December 31, 2019.
In June 2020 we sold one CRE whole loan note for $17.4 million that resulted in a realized loss of $1.0 million during the year ended December 31, 2020.
Except for four loans (two of which were paid currently as of February 2021), all of our loans were current on debt service at December 31, 2020. Additionally, we have provided relief in the form of forbearance agreements, term extensions and other modifications on 25 loans during the year ended December 31, 2020. Thirteen of these loans were given forbearances, with a weighted average forbearance period of five months. Eighteen loans were extended by a weighted average of 10 months in exchange for $891,000 of extension fees, in an effort to manage credit risk that was created in connection with the effects of the COVID-19 pandemic.
Our CRE mezzanine loan and preferred equity investments earn interest at fixed rates and were current on debt service at December 31, 2020.
We use leverage to enhance our returns. The cost of borrowings to finance our investments is a significant part of our expenses. Our net interest income depends on our ability to control these expenses relative to our revenue. Our CRE loans may initially be financed with term facilities, such as CRE loan warehouse financing facilities, in anticipation of their ultimate securitization. We ultimately seek to finance our CRE loans through the use of non-recourse long-term, match-funded CRE debt securitizations.
In September 2020, with an improved liquidity profile, we repaid the outstanding balances on all of our CRE warehouse financing facilities, and in October 2020, we amended all three of our CRE loan warehouse financing facilities to revise a covenant definition to be in line with other market participants as well as, at our request, to reduce the maximum borrowing capacity from $400.0 million to $250.0 million on one warehouse financing facility as well as to extend the maturity of that same warehouse facility one year. At December 31, 2020 and 2019, we had an outstanding balance of $12.3 million and $544.9 million, respectively, on our CRE loan warehouse financing facilities, representing 0.94% and 29.1%, respectively, of total outstanding borrowings. We expect to utilize our CRE loan warehouse financing facilities to fund our loan origination pipeline in 2021 alongside the equity we will invest. We also expect to utilize CRE securitization financing alternatives as market conditions permit in 2021.
At December 31, 2020 and 2019, we had outstanding balances of $1.0 billion and $746.4 million, respectively, on CRE debt securitizations, or 78.8% and 39.9%, respectively, of total outstanding borrowings. In March 2020, we closed a CRE debt securitization that financed CRE loans of $522.6 million at a weighted average cost of LIBOR plus 1.43%. In September 2020, we closed a CRE debt securitization that financed $297.0 million of CRE loan commitments at a weighted average cost of LIBOR plus 3.13%. We anticipate that we will close CRE debt securitizations of between $500.0 million and $1.0 billion for the year ended December 31, 2021.
In September 2020, we liquidated our 2018 CRE debt securitization by refinancing loans with our senior secured financing facility obtained as a result of the ACRES acquisition. At December 31, 2020, we had an outstanding principal balance on our senior secured financing facility of $33.4 million. Also in conjunction with the ACRES acquisition, we issued $50.0 million in 12.00% senior unsecured notes due 2027 (“Senior Unsecured Notes due 2027”) and warrants to purchase 466,661 shares of our common stock to improve and stabilize our corporate liquidity.
In January 2020, we adopted updated accounting guidance that replaced the incurred loss approach with the current expected credit losses (“CECL”) model for the determination of our allowance for credit losses and write-offs on our investment securities available-for-sale. Upon adoption on January 1, 2020, we recorded an initial CECL reserve of approximately $4.5 million, of which $3.0 million, or $0.29 per share, was recorded as a charge to retained earnings. The estimated CECL reserve represented 0.25% of the aggregate outstanding principal balance of our $1.8 billion commercial loan portfolio at December 31, 2019. We reevaluate our CECL reserves quarterly, incorporating our current expectations of macroeconomic factors considered in the determination of our CECL reserves. At December 31, 2020, the CECL reserves on our CRE loan portfolio was $34.3 million or 2.21% of our $1.5 billion loan portfolio, which reflects weakened macroeconomic factors, including increased unemployment, declining CRE values and less liquidity in CRE capital markets since the adoption of CECL on January 1, 2020.
We historically used derivative financial instruments to hedge a portion of the interest rate risk associated with our borrowings. We generally sought to minimize interest rate risk with a strategy that is expected to result in the least amount of volatility under accounting principles generally accepted in the United States of America (“GAAP”) while still meeting our strategic economic objectives and maintaining adequate liquidity and flexibility. These hedging transactions may include interest rate swaps, collars, caps or floors, puts, calls and options.
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In April 2020 we terminated all interest rate hedges in conjunction with the disposition of our financed CMBS portfolio. At termination, we recognized a realized loss in equity of $11.8 million that will be amortized into interest expense over the remaining life of the debt. During the year ended December 31, 2020, we recognized amortization expense on these terminated contracts of $1.3 million.
We target originating transitional floating-rate CRE loans between $10.0 million and $80.0 million. In March 2020, due to the market disruptions caused by the COVID-19 pandemic, we halted loan originations to manage our liquidity. In conjunction with the capital commitments secured through the ACRES acquisition, we resumed originating floating-rate CRE loans in November 2020. During the year ended December 31, 2020, we originated 19 floating-rate CRE whole loans with total commitments of $287.5 million.
We anticipate that our CRE loan originations and other CRE-related investments for the year ended December 31, 2021 will be between $500.0 million and $1.0 billion.
Common stock book value was $20.57 per share at December 31, 2020, a $21.43 per share decrease from December 31, 2019 and reflects the effect of our one-for-three reverse stock split that was announced in February 2021.
Impact of COVID-19
As discussed in the “Overview” above, the impact of the COVID-19 pandemic in the U.S. and globally has, and will continue to, adversely impact us, our borrowers and their tenants, the properties securing our investments and the economy as a whole. The COVID-19 pandemic could have a continued and prolonged adverse impact on economic and market conditions and the fluidity of this situation precludes any prediction as to the ultimate adverse impact of the pandemic on economic and market conditions. While the discovery and initial distribution of vaccines has had a positive impact on projected macroeconomic indicators, the full extent and impact of the COVID-19 pandemic on companies continues to evolve rapidly and will depend on future developments, which are uncertain and cannot be predicted, including the duration and spread of the outbreak, the extension of quarantines and restrictions on travel, the further discovery of successful treatments and the ensuing reactions by consumers, companies, governmental entities and global markets. The impact of the pandemic has had, and we expect will continue to have, a long-term and material impact on our results of operations, financial condition and our liquidity and capital resources during the fiscal year 2020 and in future quarters. Further discussion of the potential impacts on our business from the COVID-19 pandemic is provided below in the section entitled “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K.
Results of Operations
Our net loss allocable to common shares for the year ended December 31, 2020 was $208.1 million, or $(19.33) per share-basic ($(19.33) per share-diluted), as compared to net income allocable to common shares of $25.6 million, or $2.45 per share-basic ($2.43 per share-diluted), for the year ended December 31, 2019.
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Net Interest Income
The following table analyzes the change in interest income and interest expense for the comparative years ended December 31, 2020 and 2019 by changes in volume and changes in rates. The changes attributable to the combined changes in volume and rate have been allocated proportionately, based on absolute values, to the changes due to volume and changes due to rates (dollars in thousands, except amounts in footnotes):
(1)
Percent change is calculated as the net change divided by the respective interest income or interest expense for the year ended December 31, 2019.
(2)
Includes decreases in fee income of approximately $1.2 million, $49,000 and $9,000 recognized on our floating-rate CRE whole loans, legacy CRE loan and CRE preferred equity investments, respectively, that were due to changes in volume.
(3)
Includes the change in interest income recognized on one legacy CRE loan with an amortized cost of $11.4 million and $11.5 million at December 31, 2020 and 2019, respectively, classified as a CRE loan on the consolidated balance sheet.
(4)
Includes a decrease from net accretion income of approximately $2.1 million that was due to changes in volume.
(5)
Includes decreases of net amortization expense of approximately $400,000, $330,000 and $279,000 on our securitized borrowings, CRE - term warehouse financing facilities and trust certificates - term repurchase facilities, respectively, and increases of approximately $258,000, $54,000 and $136,000 on our senior secured financing facility, convertible senior notes and Senior Unsecured Notes due 2027, respectively, that were due to changes in volume.
Net Change in Interest Income for the Comparative Years Ended December 31, 2020 and 2019:
Aggregate interest income decreased by $36.6 million for the comparative years ended December 31, 2020 and 2019. We attribute the change to the following:
CRE whole loans. The decrease of $17.1 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to decreases in the yields on floating-rate CRE whole loans, attributable to declines in the spreads on the originated CRE whole loans over the comparative periods and to a decrease in one-month LIBOR, the benchmark interest rate for our floating-rate CRE whole loans, over the comparative periods. The effect of the decrease in LIBOR over the comparative periods is mitigated by our LIBOR floors, which provide asset yield protection. At December 31, 2020, our floating-rate CRE whole loan portfolio had a weighted average LIBOR floor of 1.88%
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CRE preferred equity investments. The increase of $439,000 for the comparative years ended December 31, 2020 and 2019 was attributable to the closing of our June 2019 investment in a preferred equity interest with an outstanding principal balance of $6.5 million and an 11.00% interest rate at December 31, 2020.
Securities. The net decrease of $19.5 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the disposition of our entire CMBS portfolio as of April 2020, except for two CMBS securities retained with a total fair value of $2.1 million at December 31, 2020.
Net Change in Interest Expense for the Comparative Years Ended December 31, 2020 and 2019:
Aggregate interest expense decreased by $25.8 million for the comparative years ended December 31, 2020 and 2019. We attribute the change to the following:
Securitized borrowings. The total net decrease of $6.7 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to a decrease in one-month LIBOR, the benchmark interest rate for our securitized borrowings, over the comparative periods. The net rate decrease for the comparative years ended December 31, 2020 and 2019 was partially offset by an net increase in volume attributable to the issuances of Exantas Capital Corp. 2019-RSO7, Ltd. (“XAN 2019-RSO7”), Exantas Capital Corp. 2020-RSO8, Ltd. (“XAN 2020-RSO8”) and Exantas Capital Corp. 2020-RSO9, Ltd. (“XAN 2020-RSO9”), which closed in April 2019, March 2020 and September 2020, respectively, offset by the liquidations of Resource Capital Corp. 2017-CRE5, Ltd. (“RCC 2017-CRE5”) and Exantas Capital Corp. 2018-RSO6, Ltd. (“XAN 2018-RSO6”) in July 2019 and September 2020, respectively.
Unsecured junior subordinated debentures. The net decrease $785,000 for the comparative years ended December 31, 2020 and 2019 was attributable to a decrease in three-month LIBOR, the benchmark interest rate for our unsecured junior subordinated debentures, over the comparative periods.
Convertible senior notes. The net decrease of $1.6 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the payoff of our 8.00% convertible senior notes upon maturity in January 2020.
Senior Unsecured Notes due 2027. The increase of $2.7 million for the comparative years ended December 31, 2020 and 2019 was attributable to the execution and borrowings on of the Senior Unsecured Notes due 2027 in July 2020.
Senior secured financing facility. The increase of $2.0 million for the comparative years ended December 31, 2020 and 2019 was attributable to the execution and borrowings on the senior secured financing facility in July 2020.
CRE - term warehouse financing facilities. The decrease of $12.5 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to payoffs of our CRE term warehouse financing facilities in connection with the close of the senior secured financing facility, XAN 2020-RSO8 and XAN 2020-RSO9 and a decrease in the weighted average one-month LIBOR over the comparative periods.
Trust certificates - term repurchase facilities. The decrease of $1.9 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the repayment of the RSO Repo SPE Trust 2017 facility in July 2019.
CMBS - short-term repurchase agreements. The decrease of $8.5 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to our CMBS - short term agreements being paid off in full as of April 2020 due to the impact of the COVID-19 pandemic on real estate securities markets in March 2020. See “Senior Secured Financing Facility, Term Warehouse Financing Facilities and Repurchase Agreements” for additional information.
Hedging. The increase of $1.4 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to amortization expense on terminated interest rate swaps during the year ended December 31, 2020. In April 2020, in conjunction with the disposition of our CMBS portfolio financed with short-term repurchase agreements, we terminated all interest rate swap contracts hedging that portfolio. At termination, we realized a loss of $11.8 million. During the year ended December 31, 2020, we recorded net amortization expense, reported in interest expense on the consolidated statements of operations, of $1.3 million related to the terminated interest rate swaps.
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The following table presents the average net yield and average cost of funds for the years ended December 31, 2020 and 2019 (dollars in thousands, except amounts in footnotes):
(1)
Average net yield includes net amortization/accretion and fee income and is computed based on average amortized cost.
(2)
Includes fee income of approximately $6.6 million, $54,000 and $152,000 recognized on our floating-rate CRE whole loans, legacy CRE loan and our CRE preferred equity investments, respectively, for the year ended December 31, 2020 and approximately $7.8 million, $103,000 and $162,000 on our floating-rate CRE whole loans, legacy CRE loans and our CRE preferred equity investments, respectively, for the year ended December 31, 2019.
(3)
Includes net accretion income of approximately $616,000 and $2.7 million for the years ended December 31, 2020 and 2019, respectively, on our CMBS securities.
(4)
Includes amortization expense of approximately $7.9 million and $8.4 million for the years ended December 31, 2020 and 2019, respectively, on our interest-bearing liabilities collateralized by CRE whole loans.
(5)
Includes aggregated amortization expense of approximately $3.6 million for the years ended December 31, 2020 and 2019 on our convertible senior notes.
(6)
Includes amortization expense of approximately $136,000 for the year ended December 31, 2020 on our Senior Unsecured Notes due 2027.
(7)
Includes amortization expense of approximately $279,000 for the year ended December 31, 2019 on our trust certificates - term repurchase facilities.
(8)
Includes net amortization expense of approximately $1.3 million for the year ended December 31, 2020 and accretion income of $91,000 for the year ended December 31, 2019 on 22 and two terminated interest rate swap agreements, respectively, that were in net loss and gain positions, respectively, at the time of termination. The remaining losses and gains, reported in accumulated other comprehensive (loss) income on the consolidated balance sheets, will be accreted over the remaining life of the debt.
Operating Expenses
Year Ended December 31, 2020 as compared to the Year Ended December 31, 2019
The following table sets forth information relating to our operating expenses for the years presented (dollars in thousands):
Aggregate operating expenses increased by $33.0 million for the comparative years ended December 31, 2020 and 2019. We attribute the changes to the following:
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Management fees. The decrease of $2.9 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to a decrease in our base management fees during the year ended December 31, 2020. Our monthly base management fee was equal to 1/12th of the amount of our equity multiplied by 1.50% in accordance with our prior management agreement. In March 2020, our equity decreased in connection with the losses incurred on the disposition of our financed CMBS portfolio. Additionally, our management fees decreased due to incentive compensation of $606,000 that was incurred during the year ended December 31, 2019. No incentive compensation was payable during the year ended December 31, 2020. As of July 31, 2020, as part of the amended Management Agreement, the monthly base management fee was amended to be the greater of 1/12th of the amount of our equity multiplied by 1.50% or $442,000 through July 31, 2022.
Equity compensation. The increase of $924,000 for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the acceleration of all unvested stock awards at July 31, 2020 upon the close of the ACRES acquisition.
Real Estate operating expense. The increase of $298,000 for the comparative years ended December 31, 2020 and 2019 was attributable to expenses recorded on a real estate owned (“REO”) property delivered as collateral in a deed in lieu of foreclosure transaction in November 2020.
General and administrative. General and administrative expenses increased by $3.9 million for the comparative years ended December 31, 2020 and 2019. The following table summarizes the information relating to our general and administrative expenses for the years presented (dollars in thousands):
The increase in general and administrative expenses for the comparative years ended December 31, 2020 and 2019 was primarily attributable to (i) an increase in professional services in connection with legal fees and advisory fees for services rendered as part of the ACRES acquisition as well as legal fees incurred in 2020 primarily related to the settlement of our CMBS repurchase agreements and (ii) an increase in wages and benefits allocated to us by our Manager. The increase in professional services for the comparative periods was offset by an increase in professional services during the year ended December 31, 2019 in connection with expenses incurred on a non-consummated transaction.
Provision for credit losses, net. The increase of $30.8 million in provisions for credit losses for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the updated estimates of losses calculated in our CECL model. The CECL model, adopted on January 1, 2020, measures the allowance for credit losses using an expected credit losses approach, as compared to the incurred credit losses approach utilized during the year ended December 31, 2019. The CECL model projected significantly increased expected credit losses during the year ended December 31, 2020 in connection with the adverse market conditions caused by the COVID-19 pandemic.
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Other Income (Expense)
Year Ended December 31, 2020 as compared to Year Ended December 31, 2019
The following table sets forth information relating to our other expense for the years presented (dollars in thousands):
Aggregate other expense increased $190.1 million for the comparative years ended December 31, 2020 and 2019. We attribute the change to the following:
Net realized and unrealized (loss) gain on investment securities available-for-sale and loans and derivatives. The increase in losses of $186.6 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to a loss of $180.3 million on the disposition of our CMBS portfolio that was financed with our CMBS - short-term repurchase facilities during year ended December 31, 2020. Additionally, the increase was attributable to a loss of $6.1 million recorded to mark our two remaining investment securities available-for-sale to fair value during the year ended December 31, 2020.
Fair value adjustments on financial assets held for sale. The change of $4.1 million for the comparative years ended December 31, 2020 and 2019 was primarily attributable to charges of $8.8 million and $4.7 million, respectively, incurred on the remaining legacy CRE asset held for sale, which included protective advances to cover borrower operating losses of $2.7 million and $1.2 million, respectively. The remaining asset held for sale was sold in December 2020.
Gain on conversion of real estate. The gain of $1.6 million for the year ended December 31, 2020 and was attributable to the receipt of a deed in lieu of foreclosure on one CRE whole loan with an appraised value of $39.8 million, which was above our loan basis, in November 2020.
Other income. The decrease of $937,000 for the comparative years ended December 31, 2020 and 2019 was primarily attributable to the recovery of $647,000 of the reserve for the Pearlmark Mezzanine Realty Partners IV, L.P. (“Pearlmark Mezz”) indemnification during the year ended December 31, 2019.
Financial Condition
Summary
Our total assets were $1.7 billion at December 31, 2020 as compared to $2.5 billion at December 31, 2019. The decrease was primarily attributable to the disposition of our financed CMBS portfolio, completed in April 2020, in connection with the receipt of default notices from certain CMBS - short-term repurchase agreement counterparties (see “Senior Secured Financing Facility, Term Warehouse Financing Facilities and Repurchase Agreements”) and the payoffs and paydowns on our CRE whole loans as well as macroeconomic outlook and uncertainty caused by the COVID-19 pandemic.
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Investment Portfolio
The tables below summarize the amortized cost and net carrying amount of our investment portfolio, classified by asset type, at December 31, 2020 and 2019 as follows (dollars in thousands, except amounts in footnotes):
(1)
Net carrying amount includes an allowance for credit losses of $34.3 million and $1.5 million at December 31, 2020 and 2019, respectively.
(2)
Includes real estate related right of use asset of $5.6 million and intangible assets of $3.3 million at December 31, 2020.
(3)
Classified as other assets on the consolidated balance sheet.
(4)
There were no stated rates associated with these investments.
(5)
Excludes one asset classified as held for sale at December 31, 2019.
CRE loans. During the twelve months ended December 31, 2020, we originated $287.5 million of floating-rate CRE loan whole loan commitments (of which $24.4 million was unfunded loan commitments), funded $35.0 million of previously unfunded loan commitments and received $507.2 million in proceeds from loan payoffs, paydowns and a loan sale. In January 2021, we received an additional $4.3 million of proceeds from the collection of our principal paydown receivable balance.
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The following is a summary of our loans (dollars in thousands, except amounts in footnotes):
(1)
Amounts include unamortized loan origination fees of $5.7 million and $9.1 million and deferred amendment fees of $495,000 and $72,000 at December 31, 2020 and 2019, respectively. Additionally, the amounts include unamortized loan acquisition costs of $118,000 and $1.3 million at December 31, 2020 and 2019, respectively.
(2)
Maturity dates exclude contractual extension options, subject to the satisfaction of certain terms that may be available to the borrowers.
(3)
Maturity dates exclude three whole loans, with amortized costs of $39.7 million, and one whole loan, with an amortized cost of $11.5 million, in maturity default and performing with respect to debt service due in accordance with forbearance agreements at December 31, 2020 and 2019, respectively.
(4)
Maturity dates include two whole loans with original maturity dates in January 2021 that were granted one year extensions in January 2021.
(5)
Substantially all loans are pledged as collateral under various borrowings at December 31, 2020 and 2019.
(6)
Whole loans had $67.2 million and $98.0 million in unfunded loan commitments at December 31, 2020 and 2019, respectively. Preferred equity investments had $2.5 million and $3.0 million in unfunded commitments at December 31, 2020 and 2019, respectively. These unfunded loan commitments are advanced as the borrowers formally request additional funding, as permitted under the loan agreement, and any necessary approvals have been obtained.
(7)
The interest rate on our preferred equity investments pay at 8.00%. The remaining interest is deferred until maturity.
(8)
Beginning in April 2023, we have the right to unilaterally force the sale of the Prospect Hackensack JV LLC’s underlying property. Beginning in June 2022, we have the right to unilaterally force the sale of WC Newhall MM, LLC’s underlying property.
(9)
Our floating-rate CRE loan portfolio of $1.5 billion had a weighted-average one-month LIBOR floor of 1.88% at December 31, 2020.
At December 31, 2020, approximately 21.4%, 17.9% and 16.1% of our CRE loan portfolio was concentrated in the Mountain, Southwest and Southeast regions, respectively, based on carrying value, as defined by the NCREIF. At December 31, 2019, approximately 19.5%, 19.4% and 17.6% of our CRE loan portfolio was concentrated in the Mountain, Southwest and Southeast regions, respectively, based on carrying value. No single loan or investment represented more than 10% of our total assets and no single investment group generated over 10% of our total revenue.
CMBS. Beginning in the first quarter of 2020, the COVID-19 pandemic produced material and previously unforeseeable liquidity shocks to credit markets. As a result of the receipt of default notices with respect to some of our CMBS (see “Senior Secured Financing Facility, Term Warehouse Financing Facilities and Repurchase Agreements”) and the uncertainty caused by the COVID-19 pandemic, we disposed of our entire CMBS portfolio, except for two CMBS securities with an amortized cost and fair value of $2.1 million, as of December 31, 2020.
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The following table summarizes our CMBS investments earning coupon interest at fixed-rates or floating-rates at December 31, 2020 and 2019 (dollars in thousands, except amounts in the footnote):
(1)
Face value includes $25.9 million, with a total cost basis of $106,000, of CMBS that have been subject to other-than-temporarily-impairment charges at December 31, 2019.
Investments in unconsolidated entities. Our investments in unconsolidated entities at December 31, 2020 and 2019 comprised a 100% interest in the common shares of Resource Capital Trust I (“RCT I”) and RCC Trust II (“RCT II”), respectively, with a value of $1.5 million in the aggregate, or 3.0% of each trust. We record our investments in RCT I’s and RCT II’s common shares as investments in unconsolidated entities using the cost method, recording dividend income when declared by RCT I and RCT II. During years ended December 31, 2020 and 2019, we recorded dividends from the investments in RCT I’s and RCT II’s common shares, reported in other revenue on the consolidated statement of operations, of $77,000 and $100,000, respectively.
Financing Receivables
The following tables show the activity in the allowance for credit losses for the years ended December 31, 2020 and 2019 (in thousands, except amount in the footnote):
(1)
Our mezzanine loan and preferred equity investments were evaluated individually for impairment during the year ended December 31, 2019 and were determined to have no evidence of impairment.
(2)
Excludes the recovery of credit losses on one bank loan with no amortized cost or carrying value at December 31, 2020 and 2019 that received a payment of approximately $1,000 during the year ended December 31, 2019.
(3)
The allowance for credit losses included a realized loss of $997,000 that was charged to the allowance related to one CRE loan sale that occurred during the year ended December 31, 2020. There was no such charge off as of December 31, 2019.
The COVID-19 pandemic had a significant impact on the losses assumed in our CECL computations during the year ended December 31, 2020. CECL losses in the CRE loan portfolio were negatively impacted by higher expected unemployment and increased volatility in CRE asset pricing and liquidity.
During the year ended December 31, 2020, we individually evaluated a hotel loan in the Northeast region with a $37.9 million principal balance for which disclosure was deemed probable. In November 2020, as a result of discussions with the borrower, we received the deed in lieu of foreclosure on the property. In conjunction with receiving the deed in lieu of foreclosure, we obtained an updated appraisal that indicated an as-is appraised value of $39.8 million and consequently reversed the $8.0 million CECL allowance that was previously established for the loan that was based on the estimated sales value of the collateral, less estimated costs to sell.
Also at December 31, 2020, we individually evaluated an office loan in the North East Central region with a $19.9 million principal balance and a hotel loan in the Northeast region with a $14.0 million par balance for which foreclosure was determined to be probable. At December 31, 2020, we determined that these loans had CECL allowances of $1.9 million and $0, respectively, which was calculated as the difference between the as-is appraised values and the loans’ amortized costs.
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In June 2020, we sold one CRE whole loan note for $17.4 million, which resulted in a realized loss of $1.0 million recorded in the provision for credit losses during the year ended December 31, 2020.
Credit quality indicators
Commercial Real Estate Loans
CRE loans are collateralized by a diversified mix of real estate properties and are assessed for credit quality based on the collective evaluation of several factors, including but not limited to: collateral performance relative to underwritten plan, time since origination, current implied and/or re-underwritten loan-to-collateral value (“LTV”) ratios, loan structure and exit plan. Depending on the loan’s performance against these various factors, loans are rated on a scale from 1 to 5, with loans rated 1 representing loans with the highest credit quality and loans rated 5 representing the loans with the lowest credit quality. The factors evaluated provide general criteria to monitor credit migration in our loan portfolio; as such, a loan’s rating may improve or worsen, depending on new information received.
The criteria set forth below should be used as general guidelines and, therefore, not every loan will have all of the characteristics described in each category below.
Risk Rating
Risk Characteristics
• Property performance has surpassed underwritten expectations.
• Occupancy is stabilized, the property has had a history of consistently high occupancy, and the property has a diverse and high quality tenant mix.
• Property performance is consistent with underwritten expectations and covenants and performance criteria are being met or exceeded.
• Occupancy is stabilized, near stabilized or is on track with underwriting.
• Property performance lags behind underwritten expectations.
• Occupancy is not stabilized and the property has some tenancy rollover.
• Property performance significantly lags behind underwritten expectations. Performance criteria and loan covenants have required occasional waivers.
• Occupancy is not stabilized and the property has a large amount of tenancy rollover.
• Property performance is significantly worse than underwritten expectations. The loan is not in compliance with loan covenants and performance criteria and may be in default. Expected sale proceeds would not be sufficient to pay off the loan at maturity.
• The property has a material vacancy rate and significant rollover of remaining tenants.
• An updated appraisal is required upon designation and updated on an as-needed basis.
All CRE loans are evaluated for any credit deterioration by debt asset management and certain finance personnel on at least a quarterly basis. Mezzanine loans and preferred equity investments may experience greater credit risks due to their nature as subordinated investments.
For the purpose of calculating the quarterly provision for credit losses under CECL, we pool CRE loans based on the underlying collateral property type and utilize a probability of default and loss given default methodology for approximately one year after which we immediately revert to a historical mean loss ratio. In order to calculate the historical mean loss ratio, we utilize our full, 14 year underwriting history in the determination of historical losses, along with the market loss history from a selected population from an engaged third-party provider’s database that were similar to our loan types, loan sizes, durations, interest rate structure and general LTV profiles.
Prior to the implementation of CECL, whole loans were first individually evaluated for impairment; and to the extent not deemed impaired, a general reserve was established. The allowance for credit loss was computed as (i) 1.5% of the aggregate face values of loans rated as a 3, plus (ii) 5.0% of the aggregate face values of loans rated as a 4, plus (iii) specific allowances measured and determined on loans individually evaluated, which were loans rated as a 5. While the overall risk rating was generally not the sole factor used in determining whether a loan was impaired, a loan with a higher overall risk rating would tend to have more adverse indicators of impairment, and therefore would be more likely to experience a credit loss.
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Credit risk profiles of CRE loans, at amortized cost, were as follows (in thousands, except amounts in footnotes):
(1)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019, respectively.
(2)
Our mezzanine loan and preferred equity investments were evaluated individually for impairment at December 31, 2019.
Credit risk profiles of CRE loans by origination year at amortized cost were as follows (in thousands):
(1)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019.
(2)
Acquired CRE whole loans are grouped within each loan’s year of issuance.
In November 2019, we foreclosed on our remaining legacy CRE loan included in assets held for sale and obtained ownership of the underlying property, which remained classified as an asset held for sale on the consolidated balance sheets recorded at the lower of cost or fair market value. An appraisal was received on the property in February 2020 and concluded its fair value, less estimated costs to sell, was $16.5 million, the effect of which was recorded as of December 31, 2019. In the third quarter of 2020, we received a new offer of $11.0 million on the property. Net of approximately $715,000 of estimated costs to sell, the asset was valued at $10.3 million. The CRE asset held for sale was sold in December 2020 for proceeds of $10.3 million.
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During the years ended December 31, 2020 and 2019, we incurred fair value adjustments on the remaining CRE asset held for sale to reduce the carrying value of $8.8 million and $4.7 million, respectively, which included protective advances to cover borrower operating losses of $2.7 million and $1.2 million, respectively, recorded in fair value adjustments on financial assets held for sale on the consolidated statements of operations. The adjustments during the year ended December 31, 2020 included fair value charges of $6.2 million in connection with the offers received and the subsequent sale of the asset.
At December 31, 2020 and 2019, we had one mezzanine loan included in assets held for sale that had no fair value.
During the year ended December 31, 2020, we recorded an increase in the reserve of $29.8 million. The COVID-19 pandemic had a significant impact on the losses assumed in our CECL computations during year ended December 31, 2020. CECL losses in the CRE loan portfolio were negatively impacted by higher expected unemployment and increased volatility in CRE asset pricing and liquidity. During the year ended December 31, 2019, we recorded a increase in the reserve of $59,000, which was primarily attributable to two loans that migrated from a risk rating of 2 to a risk rating of 3, in which performance lagged behind underwritten expectations, and partially offset by two loans risk rated as a 3 that repaid and loan paydowns on one loan risk rated as a 3 and one loan risk rated as a 4.
Loan Portfolios Aging Analysis
The following table presents the CRE loan portfolio aging analysis as of the dates indicated for CRE loans, at amortized cost and a legacy CRE loan held for sale at the lower of cost or fair value (in thousands, except amounts in footnotes):
(1)
Includes one whole loan, with an amortized cost of $11.4 million and $11.5 million, in maturity default at December 31, 2020 and 2019, respectively. The loan is performing with respect to debt service due in accordance with a forbearance agreement at December 31, 2020 and 2019. During the years ended December 31, 2020 and 2019, we recognized interest income of $670,000 and $747,000, respectively, on this whole loan.
(2)
Includes two whole loans that entered technical default in December 2020, with total amortized costs of $28.3 million at December 31, 2020.
(3)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019, respectively.
At December 31, 2020 and December 31, 2019, we had three and one CRE loans, respectively, in maturity default, including two CRE loans that entered maturity default in the fourth quarter of 2020, with total amortized costs of $39.7 million and $11.5 million, respectively.
In the fourth quarter of 2020, the sponsor of our $6.5 million preferred equity investment in a self-storage CRE property located in Southern California did not make its October and November senior loan debt service payments constituting an event of default under the related senior loan documents. As of December 31, 2020, we were notified that the senior loan debt service was brought current.
Troubled-Debt Restructurings (“TDRs”)
The following table summarizes TDRs during the year ended December 31, 2020 (dollars in thousands):
(1)
In November 2020, we received the deed in lieu of foreclosure on the collateral property on one loan that underwent a troubled debt restructuring in the third quarter 2020.
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During the year ended December 31, 2020, we entered into 18 extension agreements that had a weighted average period of 10 months and 13 forbearance agreements that had a weighted average period of five months. As of December 31, 2020, 25 borrowers received payment timing relief in connection with these agreements. Three borrowers with formerly forborne interest are now current and two borrowers continue to perform in accordance with their forbearance agreements at December 31, 2020. Two formerly forborne borrowers and one borrower performing in accordance with a forbearance agreement were in maturity default at December 31, 2020. Except as previously disclosed, no other loan modifications during the year ended December 31, 2020 resulted in TDRs.
Restricted Cash
At December 31, 2020, we had restricted cash of $38.4 million, which consisted of $38.4 million held within our six consolidated securitization entities and $33,000 held in various reserve accounts. At December 31, 2019, we had restricted cash of $14.5 million, which consisted of $13.9 million of restricted cash held as margin, $532,000 held within three of our five consolidated securitizations and $22,000 held in various reserve accounts. The increase of $23.9 million was primarily attributable to an increase in the restricted cash outstanding at our consolidated securitization entities, including a future fundings advance reserve account at XAN 2020-RSO9 of $18.6 million, offset by cash paid for settlements on our CMBS portfolio and fundings made on existing commitments on our CRE portfolio.
Accrued Interest Receivable
The following table summarizes our accrued interest receivable at December 31, 2020 and 2019 (in thousands):
The $670,000 decrease in accrued interest receivable was primarily attributable to the decrease of $1.1 million in accrued interest receivable from securities attributable to the disposition of our CMBS portfolio, offset by an increase of $564,000 in accrued interest receivable from loans, which was primarily attributable to loans that were operating in accordance with forbearance agreements during the year ended December 31, 2020.
Other Assets
The following table summarizes our other assets at December 31, 2020 and 2019 (in thousands):
The increase of $5.5 million in other assets was primarily attributable to the origination of two fixed-rate CRE whole loans during the year ended December 31, 2020 with a total carrying value of $4.8 million at December 31, 2020. The increase in other assets was also attributable to a $688,000 increase in other receivables, resulting from an increase in fee income receivable, and a $181,000 increase in unsettled trades receivable, resulting from the repurchase of $181,000 of our common stock which settled in January 2021. The increase in other assets was offset by a $267,000 decrease in other prepaid expenses, primarily attributable to August 2019 expenses incurred on a legacy CRE loan held for sale.
Deferred Tax Assets
At December 31, 2020 and 2019, our net deferred tax asset was zero, resulting from a full valuation allowance of $21.2 million and $9.9 million, respectively, on our gross deferred tax asset as we believed it was more likely than not that some or all of the deferred tax assets would not be realized. We will continue to evaluate our ability to realize the tax benefits associated with deferred tax assets by analyzing forecasted taxable income using both historical and projected future operating results, the reversal of existing temporary differences, taxable income in prior carry back years (if permitted) and the availability of tax planning strategies.
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Core and Non-Core Asset Classes
Our investment strategy targets the following core asset class:
CRE/Core Asset Class
Principal Investments
Commercial real estate-related assets
●
Floating and fixed-rate first mortgage loans, which we refer to as whole loans;
●
First priority interests in first mortgage loans, which we refer to as A-notes;
●
Subordinated interests in first mortgage loans, which we refer to as B-notes;
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Mezzanine debt related to CRE that is senior to the borrower’s equity position but subordinated to other third-party debt;
●
Preferred equity investments related to CRE that are subordinate to first mortgage loans and are not collateralized by the property underlying the investment;
●
CMBS; and
●
CRE equity investments.
In November 2016, we received approval from our Board to execute the plan to focus our strategy on CRE debt investments (the “Plan”). The Plan contemplated disposing of certain legacy CRE debt investments, exiting underperforming non-core asset classes and establishing a dividend policy based on sustainable earnings. Legacy CRE loans are loans underwritten prior to 2010. In December 2020, we sold our last remaining CRE asset held for sale. The non-core asset classes in which we had historically invested are described below:
Non-Core Asset Classes
Principal Investments
Residential real estate-related assets
●
Residential mortgage loans; and
●
Residential mortgage-backed securities, which comprise our available-for-sale portfolio.
Commercial finance assets
●
Middle market secured corporate loans and preferred equity investments;
●
Asset-backed securities, backed by senior secured corporate loans;
●
Debt tranches of collateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”), and sometimes, collectively, as CDOs;
●
Structured note investments, which comprise our trading securities portfolio;
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Syndicated corporate loans; and
●
Preferred equity investment in a commercial leasing enterprise that originates and holds small- and middle-ticket commercial direct financing leases and notes.
Derivative Instruments
A significant market risk to us is interest rate risk. 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. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of our interest-earning assets and our ability to realize gains from the sale of these assets. A decline in the value of our interest-earning assets pledged as collateral for borrowings could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.
Historically, we have sought to manage the extent to which net income changes as a fluctuation of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. We have sought to mitigate the potential impact on net income (loss) of adverse fluctuations in interest rates incurred on our borrowings by entering into hedging agreements.
Historically, we have classified our interest rate hedges as cash flow hedges, which are hedges that eliminate the risk of changes in the cash flows of a financial asset or liability. We recorded changes in fair value of derivatives designated and effective as cash flow hedges in accumulated other comprehensive income (loss), and recorded changes in fair value of derivatives designated and ineffective as cash flow hedges in earnings.
Historically, we have sought to mitigate the market price risk in connection with our fixed-rate CRE whole loans by entering into interest rate swap contracts in which we pay a fixed rate of interest in exchange for a variable rate benchmark, usually three-month LIBOR. Unrealized gains and losses on the value of these swap contracts were recorded in other income on the consolidated statements of operations.
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The following tables present the fair value of our derivative financial instruments as well as their classification on our consolidated balance sheets and on the consolidated statements of operations for the years presented:
(1)
Interest rate swap contracts are accounted for as cash flow hedges.
(1)
Negative values indicate a decrease to the associated consolidated statements of operations line items.
We had 19 interest rate swap contracts at December 31, 2019. We had no interest rate swap contracts at December 31, 2020.
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Senior Secured Financing Facility, Term Warehouse Financing Facilities and Repurchase Agreements
Borrowings under our senior secured financing facility, term warehouse financing facilities and repurchase agreements are guaranteed by us or one or more of our subsidiaries. The following table sets forth certain information with respect to our senior secured financing and term warehouse financing facilities and repurchase agreements (dollars in thousands, except amounts in footnotes):
(1)
Includes $4.0 million of deferred debt issuance costs at December 31, 2020 and no deferred debt issuance costs at December 31, 2019.
(2)
Outstanding borrowings includes accrued interest payable.
(3)
Includes $607,000 of deferred debt issuance costs at December 31, 2019.
(4)
Includes $817,000 of deferred debt issuance costs at December 31, 2019.
(5)
Includes $1.3 million and $1.3 million of deferred debt issuance costs at December 31, 2020 and 2019, respectively, which includes $678,000 of deferred debt issuance costs at December 31, 2020 from other term warehouse financing facilities with no balance.
We were in compliance with all covenants in the respective agreements at December 31, 2020 and 2019.
Senior Secured Financing Facility
On July 31, 2020, our indirect, wholly owned subsidiary (“Holdings”), along with its direct wholly owned subsidiary (the “Borrower”), entered into a $250.0 million Loan and Servicing Agreement (the “MassMutual Loan Agreement”) with MassMutual and the other lenders party thereto (the “Lenders”). The asset-based revolving loan facility (the “MassMutual Facility”) provided under the MassMutual Loan Agreement will be used to finance our core CRE lending business. The MassMutual Facility has an interest rate of 5.75% per annum payable monthly. The MassMutual Facility matures on July 31, 2027. We paid a commitment fee as well as other reasonable closing costs. The loans under the MassMutual Facility are available for drawing during the first two years of the MassMutual Facility (the “Availability Period”). During the Availability Period, an unused commitment fee of 0.50% per annum (payable monthly) on unused commitments under the MassMutual Loan Agreement is payable for each day on which less than 75% of the total commitment is drawn.
Pursuant to the MassMutual Loan Agreement, the Borrower’s obligations under the MassMutual Loan Agreement are secured by the Borrower’s assets and Holdings’ equity interests in the Borrower, including all distributions, proceeds and profits from Holdings’ interests in the Borrower.
In September 2020, the MassMutual Loan Agreement was amended pursuant to which (i) the initial portfolio assets were revised and an agreed advance rate for each initial portfolio asset (each, an “Initial Portfolio Asset Advance Rate”) was set, and (ii) the revolving loan facility under the MassMutual Loan Agreement was amended to require the initial lender (currently MassMutual) to provide a specific advance rate for any future eligible portfolio assets and to limit the aggregate total amount of advances outstanding at any time to both the total facility amount and, in lieu of a 55% LTV, a borrowing base as of any required date of determination equal to the sum of, in each case, the product of the advance rate for such eligible portfolio asset (including in respect of the initial portfolio assets, the applicable Initial Portfolio Asset Advance Rate therefor) and the then determined value of such eligible portfolio asset.
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In connection with the MassMutual Loan Agreement, we entered into a Guaranty (the “MassMutual Guaranty”) among ourselves, Exantas Real Estate Funding 2018-RSO6 Investor, LLC (“RSO6”), Exantas Real Estate Funding 2019-RSO7 Investor, LLC (“RSO7”), and Exantas Real Estate Funding 2020-RSO8 Investor, LLC (collectively with RSO6 and RSO7, the “Additional Subsidiaries”), each our indirect, wholly owned subsidiary, in favor of the secured parties under the MassMutual Loan Agreement. Pursuant to the MassMutual Guaranty, we fully guaranteed all payments and performance of Holdings and the Borrower under the MassMutual Loan Agreement. Additionally, the Additional Subsidiaries and we made certain representations and warranties and agreed to not incur debt or liens, each subject to certain exceptions, and agreed to provide the Lenders with certain information.
The MassMutual Loan Agreement contains events of default, subject to certain materiality thresholds and grace periods, customary for this type of financing arrangement. The remedies for such events of default are also customary for this type of transaction.
CRE - Term Warehouse Financing Facilities
In July 2018, our wholly-owned subsidiary entered into an amended and restated master repurchase agreement (the “2018 Facility”), originally executed in February 2012, with Wells Fargo Bank, N.A. (“Wells Fargo”) to finance the origination of CRE loans. In May 2020, Wells Fargo revised the minimum equity financial covenant required of us as of March 31, 2020 and provided a framework to avoid credit-based markdowns for approximately four months, ending September 4, 2020. In July 2020 and September 2020, the maturity date of the 2018 Facility was extended to September 3, 2020 and October 3, 2020, respectively. In October 2020, the 2018 Facility was amended, at our request, to reduce the 2018 Facility’s maximum amount from $400.0 million to $250.0 million, extend the funding expiration date and revise covenant definitions so that credit losses are determined in accordance with a risk rating-based methodology. In connection with the amendment to the 2018 Facility, we exercised the first of three options to extend the termination date for a one year period thereby extending the maturity date to October 2, 2021. The 2018 Facility charges interest rates of one-month LIBOR plus spreads ranging from 1.75% to 2.50%.
In April 2018, an indirect wholly-owned subsidiary entered into a master repurchase agreement (the “Barclays Facility”) with Barclays Bank PLC (“Barclays”) to finance the origination of CRE loans. In connection with the Barclays Facility, we entered into a guaranty agreement (the “Barclays Guaranty”) pursuant to which we fully guaranteed all payments and performance under the Barclays Facility. In May 2020, we entered into an amendment to the Barclays Guaranty that revised its minimum equity financial covenant as of March 1, 2020. Barclays also provided a framework to avoid credit-based markdowns for approximately four months, ending August 31, 2020. In October 2020, we entered into an amendment to the Barclays Guaranty that revised a covenant definition to be in line with other market participants so that credit losses are determined in accordance with a risk rating-based methodology. The Barclays Facility has a maximum facility amount of $250.0 million, charges interest of one-month LIBOR plus a spread between 2.00% and 2.50% and matures in April 2021, subject to certain one-year extension options in accordance with the facility’s terms. In March 2021, we amended the Barclay’s Facility to extend the revolving period through October 2021.
In October 2018, an indirect wholly-owned subsidiary entered into a master repurchase agreement (the “JPMorgan Chase Facility”) with JPMorgan Chase Bank, N.A. to finance the origination of CRE loans. In connection with the JPMorgan Chase Facility, we entered into a guarantee agreement (the “JPMorgan Chase Guarantee”) pursuant to which we fully guaranteed all payments and performance under the JPMorgan Chase Facility. In May 2020, we entered into an amendment to the JPMorgan Chase Guarantee that revised its minimum equity financial covenant as of February 29, 2020. In October 2020, we entered into an amendment to the JPMorgan Chase Guarantee that revised a covenant definition so that credit losses are determined in accordance with a risk rating-based methodology. The JPMorgan Chase Facility has a maximum facility amount of $250.0 million, charges interest of one-month LIBOR plus a spread between 2.00% and 2.25% and matures in October 2021, subject to two one-year extension options in accordance with the facility’s terms.
Trust Certificates - Term Repurchase Facility
In September 2017, a wholly-owned subsidiary entered into a repurchase and securities agreement (the “2017 Term Repurchase Trust Facility”) with RSO Repo SPE Trust 2017, a structure that provides financing under a structured sale of trust certificates to qualified institutional buyers through an offering led by Wells Fargo Securities. In July 2019, we paid off the outstanding balance of the 2017 Term Repurchase Trust Facility in connection with the redemption of RCC 2017-CRE5.
CMBS - Short-Term Repurchase Agreements
The COVID-19 pandemic produced material and previously unforeseeable liquidity shocks in credit markets causing significant declines in the pricing of our investment securities available-for-sale that were collateral for our CMBS short-term repurchase facilities. As a result, in March 2020, we received written notices from RBC Capital Markets, LLC, RBC (Barbados) Trading Bank Corporation and Deutsche Bank Securities Inc. alleging that events of default had occurred under our associated repurchase agreements as a result of not meeting certain margin calls. These notices were subsequently either withdrawn or rescinded. We had no outstanding balances on our CMBS - short-term repurchase agreements at December 31, 2020.
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Securitizations
RCC 2017-CRE5
In July 2017, we closed RCC 2017-CRE5, a $376.7 million CRE securitization transaction that provided financing for transitional CRE loans. In May 2019, we paid off all of the outstanding third-party owned senior notes from the payoff proceeds of certain of the securitization’s assets. In July 2019, we exercised the optional redemption feature of the securitization.
XAN 2018-RSO6
In June 2018, we closed XAN 2018-RSO6, a $514.2 million CRE securitization transaction that provided financing for transitional CRE loans. In September 2020, we executed the optional liquidation of XAN 2018-RSO6, and all of the outstanding senior notes were paid off from the sales proceeds of certain of the securitization’s assets.
XAN 2019-RSO7
In April 2019, we closed XAN 2019-RSO7, a $687.2 million CRE securitization transaction that provided financing for transitional CRE loans. XAN 2019-RSO7 issued a total of approximately $585.8 million of senior notes at par to unrelated investors. A subsidiary of ACRES Realty Funding, Inc. (“ACRES RF”), formerly RCC Real Estate, Inc., purchased 20.4% of the Class D senior notes and 100% of the Class E and Class F notes. In addition, a subsidiary of ACRES RF purchased an equity interest representing 100% of the outstanding preference shares. All of the notes issued mature in April 2036, although we have the right to call the notes any time after May 2021 until maturity.
XAN 2020-RSO8
In March 2020, we closed XAN 2020-RSO8, a $522.6 million CRE debt securitization transaction that provided financing for CRE loans. XAN 2020-RSO8 issued a total of $435.7 million of non-recourse, floating-rate notes at par, of which ACRES RF purchased 100% of the Class D and Class E notes. Our investments in the Class D and Class E notes were financed by CMBS short-term repurchase agreements and were sold in conjunction with the disposition of our CMBS portfolio in April 2020. Additionally, ACRES RF purchased 100% of the Class F and Class G notes and a subsidiary of ACRES RF purchased 100% of the outstanding preference shares. The notes purchased by ACRES RF are subordinated in right of payment to all other senior notes issued by XAN 2020-RSO8, but are senior in right of payment to the preference shares. The preference shares are subordinated in right of payment to all other securities issued by XAN 2020-RSO8. All of the notes issued mature in March 2035, although we have the right to call the notes any time after March 2022.
XAN 2020-RSO9
In September 2020, we closed XAN 2020-RSO9, a $297.0 million CRE debt securitization transaction that provided financing for CRE loans. XAN 2020-RSO9 issued a total of $245.8 million of non-recourse, floating-rate notes at par. Additionally, ACRES RF retained 100% of the Class E and Class F notes and a subsidiary of ACRES RF retained 100% of the outstanding preference shares. The notes purchased by ACRES RF are subordinated in right of payment to all other senior notes issued by XAN 2020-RSO9, but are senior in right of payment to the preference shares. The preference shares are subordinated in right of payment to all other securities issued by XAN 2020-RSO9. All of the notes issued mature in April 2037, although we have the right to call the notes any time after September 2022.
At December 31, 2020, we retain equity in the following securitizations (in thousands):
(1)
The designated principal reinvestment period is the period in which principal repayments can be utilized to purchase loans held outside of the respective securitization that represent the funded commitments of existing collateral in the respective securitization that were not funded as of the date the respective securitization was closed.
(2)
A designated principal reinvestment period is excluded from the terms of XAN 2020-RSO9’s indenture. XAN 2020-RSO9 includes a future advances reserve account of $18.6 million at December 31, 2020 to fund unfunded commitments, which is reported in restricted cash on the consolidated balance sheet.
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Corporate Debt
4.50% Convertible Senior Notes and 8.00% Convertible Senior Notes
We issued $100.0 million aggregate principal of our 8.00% Convertible Senior Notes and $143.8 million aggregate principal of our 4.50% convertible senior notes due 2022 (“4.50% Convertible Senior Notes”) in January 2015 and August 2017, respectively (together, the “Convertible Senior Notes”). In conjunction with the issuance of our 4.50% Convertible Senior Notes, we extinguished $78.8 million aggregate principal of our 8.00% Convertible Senior Notes. In January 2020, the remaining 8.00% Convertible Senior Notes were paid off upon maturity.
The following table summarizes the Convertible Senior Notes at December 31, 2020 (dollars in thousands, except the conversion prices and amounts in the footnotes):
(1)
Includes the amortization of the market discounts and deferred debt issuance costs, if any, for the 4.50% Convertible Senior Notes recorded in interest expense on the consolidated statements of operations.
(2)
During the years ended December 31, 2020 and 2019 the effective interest rate for the 4.50% Convertible Senior Notes was 7.43%.
(3)
Represents the number of shares of common stock per $1,000 principal amount of the 4.50% Convertible Senior Notes’ principal outstanding, subject to adjustment as provided in the Third Supplemental Indenture (the “4.50% Convertible Senior Notes Indenture”).
(4)
The conversion rate and conversion price of the 4.50% Convertible Senior Notes at December 31, 2020 are adjusted to reflect quarterly cash dividends in excess of a $0.30 dividend threshold, as defined in the 4.50% Convertible Senior Notes Indenture.
The 4.50% Convertible Senior Notes are convertible at the option of the holder at any time up until one business day before the maturity date and may be settled in cash, our common stock or a combination of cash and our common stock, at our election. We may not redeem the 4.50% Convertible Senior Notes prior to maturity. The closing price of our common stock was $11.97 on December 31, 2020, which did not exceed the conversion price of our 4.50% Convertible Senior Notes at December 31, 2020.
Unsecured Junior Subordinated Debentures
During 2006, we formed RCT I and RCT II for the sole purpose of issuing and selling capital securities representing preferred beneficial interests. RCT I and RCT II are not consolidated into our consolidated financial statements because we are not deemed to be the primary beneficiary of these entities. In connection with the issuance and sale of the capital securities, we issued junior subordinated debentures to RCT I and RCT II of $25.8 million each, representing our maximum exposure to loss. The debt issuance costs associated with the junior subordinated debentures for RCT I and RCT II were included in borrowings and were amortized into interest expense on the consolidated statements of operations using the effective yield method over a ten year period.
There were no unamortized debt issuance costs associated with the junior subordinated debentures for RCT I and RCT II outstanding at December 31, 2020 and 2019. The interest rates for RCT I and RCT II, at December 31, 2020, were 4.19% and 4.16%, respectively. The interest rates for RCT I and RCT II, at December 31, 2019, were 5.91% and 5.89%, respectively.
The rights of holders of common securities of RCT I and RCT II are subordinate to the rights of the holders of capital securities only in the event of a default; otherwise, the common securities’ economic and voting rights are pari passu with the capital securities. The capital and common securities of RCT I and RCT II are subject to mandatory redemption upon the maturity or call of the junior subordinated debentures held by each. Unless earlier dissolved, RCT I will dissolve in May 2041 and RCT II will dissolve in September 2041. The junior subordinated debentures are the sole assets of RCT I and RCT II, which mature in June 2036 and October 2036, respectively, and may currently be called at par.
Senior Unsecured Notes
12.00% Senior Unsecured Notes Due 2027
On July 31, 2020, we entered into the Note and Warrant Purchase Agreement with Oaktree and MassMutual pursuant to which we may issue to Oaktree and MassMutual from time to time up to $125.0 million aggregate principal amount of Senior Unsecured Notes due 2027. The Senior Unsecured Notes due 2027 have an annual interest rate of 12.00%, payable up to 3.25% (at our election) as pay-in-kind interest and the remainder as cash interest. On July 31, 2020, we issued to Oaktree $42.0 million aggregate principal amount of the Senior Unsecured Notes due 2027. In addition, on July 31, 2020, we issued to MassMutual $8.0 million aggregate principal amount of the Senior Unsecured Notes due 2027. We recorded a discount of $3.1 million (the offset of which was recorded in additional paid-in capital) on the Senior Unsecured Notes due 2027 that reflects the difference between the proceeds received less the fair value of the notes as if they were issued without the detachable warrants. The market discounts and deferred debt issuance costs are amortized into interest expense on the consolidated statements of operation on an effective interest basis over the period ending in July 2027. The effective interest rate is 13.65%. At any time and from time to time prior to January 31, 2022, we may elect to issue to Oaktree and MassMutual up to $75.0 million aggregate principal amount of additional Senior Unsecured Notes due 2027.
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The Note and Warrant Purchase Agreement contains events of default, subject to certain materiality thresholds and grace periods.
Stockholders’ Equity
Total stockholders’ equity at December 31, 2020 was $334.4 million and gave effect to $10.0 million of net unrealized losses on our cash flow hedges, shown as a component of accumulated other comprehensive income (loss). Stockholders’ equity at December 31, 2019 was $556.4 million and gave effect to $4.0 million of unrealized gains on our cash flow hedges and $5.8 million of net unrealized losses on our available-for-sale portfolio, shown as a component of accumulated other comprehensive income (loss). The decrease in stockholders’ equity during the year ended December 31, 2020 was primarily attributable to a decrease in retained earnings in connection with an increase in net losses, primarily attributable to the losses incurred on the disposition of our financed CMBS portfolio.
Balance Sheet - Book Value Reconciliation
The following table rolls forward our common stock book value for the three months and year ended December 31, 2020 (in thousands, except per share data amounts in footnotes):
(1)
Per share calculations and share amounts in the above table and the following tabular footnotes retrospectively reflect the three-for-one reverse stock split effective February 16, 2021.
(2)
Per share calculations exclude unvested restricted stock, as disclosed on the consolidated balance sheet, of 11,610, 11,610 and 140,320 shares at December 31, 2020, September 30, 2020 and December 31, 2019, respectively, and include warrants to purchase up to 466,661 shares of common stock at December 31, 2020. The denominator for the calculation is 10,617,340, 11,152,831 and 10,486,544 at December 31, 2020, September 30, 2020, and December 31, 2019, respectively.
(3)
The per share amounts are calculated with the denominator referenced in footnote (2) at December 31, 2020. We calculated net income per common share-diluted of $1.95 and net losses per common share-diluted of $19.33 using the weighted average diluted shares outstanding during the three and twelve months ended December 31, 2020.
(4)
We issued warrants to purchase an aggregate of 466,661 shares of common stock to Oaktree and MassMutual in connection with the issuance of the Senior Unsecured Notes due 2027. Upon issuance, the warrants were fair valued and recorded as a discount to the outstanding borrowings, offset in additional paid-in capital.
(5)
Our Board authorized and approved the continued use of the share repurchase program to repurchase up to $20.0 million of the currently outstanding common stock through June 30, 2021 or until the authorized $20.0 million is fully deployed. We purchased 535,485 shares for $5.4 million through December 31, 2020
(6)
We calculated common stock book value as total stockholders’ equity of $334.4 million less preferred stock equity of $116.0 million at December 31, 2020.
Management Agreement Equity
Our monthly base management fee, as defined in our Management Agreement, is equal to the greater of (i) 1/12th of the amount of our equity multiplied by 1.50% or (ii) $442,000 through July 31, 2022 and is calculated and paid monthly in arrears.
The following table summarizes the calculation of equity, as defined in the Management Agreement (in thousands):
(1)
Deducts underwriting discounts and commissions and other expenses and costs relating to such issuances.
(2)
Excludes non-cash equity compensation expense incurred to date.
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Core Earnings
Core Earnings is a non-GAAP financial measure that we use to evaluate our operating performance.
Core Earnings exclude the effects of certain transactions and adjustments in accordance with GAAP that we believe are not necessarily indicative of our current CRE loan portfolio and other CRE-related investments and operations. Core Earnings exclude income (loss) from all non-core assets such as commercial finance, middle market lending, residential mortgage lending, certain legacy CRE assets and other non-CRE assets designated as assets held for sale at the initial measurement date of December 31, 2016.
Core Earnings, for reporting purposes, is defined as GAAP net income (loss) allocable to common shares, excluding (i) non-cash equity compensation expense, (ii) unrealized gains and losses, (iii) non-cash provisions for credit losses, (iv) non-cash impairments on securities, (v) non-cash amortization of discounts or premiums associated with borrowings, (vi) net income or loss from a limited partnership interest owned at the initial measurement date, (vii) net income or loss from non-core assets, (1)(2) (viii) real estate depreciation and amortization, (ix) foreign currency gains or losses and (x) income or loss from discontinued operations. Core Earnings may also be adjusted periodically to exclude certain one-time events pursuant to changes in GAAP and certain non-cash items.
Although pursuant to the Management Agreement we calculate incentive compensation using Core Earnings that exclude incentive compensation payable to our Manager, we include incentive compensation payable to our Manager in calculating Core Earnings for reporting purposes.
The following table provides a reconciliation from GAAP net income (loss) allocable to common shares to Core Earnings allocable to common shares for the periods presented (dollars in thousands, except amounts in the footnotes):
(1)
Substantially comprises unrealized losses on two unencumbered CMBS investments of $6.1 million at December 31, 2020.
(2)
Income tax expense (benefit) from non-core investments and net realized gain on non-core assets are components of net income or loss from non-core assets.
(3)
Non-core assets are investments and securities owned by us at the initial measurement date in (i) commercial finance, (ii) middle market lending, (iii) residential mortgage lending, (iv) legacy CRE assets designated as held for sale and (v) other non-CRE assets included in assets held for sale.
Core Earnings in accordance with the Management Agreement, which excludes incentive compensation payable, was $3.0 million, or $0.28 per common share outstanding, for the three months ended December 31, 2020. There was no incentive compensation payable for the three months ended December 31, 2020.
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Incentive Compensation Hurdle
In accordance with the Management Agreement, incentive compensation is earned by our Manager when our Core Earnings per common share (as defined in the Management Agreement) for such quarter exceeds an amount equal to: (1) the weighted average of (a) book value (as defined in the Management Agreement) as of the end of such quarter divided by 10,293,783 shares and (b) the price per share (including the conversion price, if applicable) paid for common shares in each offering (or issuance, upon the conversion of convertible securities) by us subsequent to September 30, 2017, in each case at the time of issuance, multiplied by (2) the greater of (a) 1.75% and (b) 0.4375% plus one-fourth of the ten year treasury rate, as defined in the Management Agreement, for such quarter (the “Incentive Compensation Hurdle”).
For the three months ended December 31, 2020, our Core Earnings, as defined in the Management Agreement, did not exceed the Incentive Compensation Hurdle.
Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to pay dividends, fund investments, repay borrowings and provide for other general business needs, including payment of our base management fee and incentive compensation. Our ability to meet our on-going liquidity needs is subject to our ability to generate cash from operating activities and our ability to maintain and/or obtain additional debt financing and equity capital together with the funds referred to below.
On July 31, 2020, in conjunction with the ACRES acquisition, we secured new capital commitments of up to $375.0 million through the execution of the senior secured financing facility and the Senior Unsecured Notes due 2027. The senior secured financing facility has an interest rate of 5.75% and advance rates determined by property type with credit specific adjustments. Additionally, the senior secured financing facility has a two-year revolving period followed by a five-year term period and was utilized to repay our term warehouse financing facilities and repurchase agreements and is not subject to mark-to-market adjustments. The Senior Unsecured Notes due 2027 have an interest rate of 12.00% and can be used for general corporate purposes. The Senior Unsecured Notes due 2027 also give Oaktree and MassMutual warrants to purchase an aggregate of up to 1.2 million shares of our common stock at an exercise price of $0.03 per share. We issued $50.0 million of the Senior Unsecured Notes and issued warrants to purchase 466,661 shares of our common stock at the closing of the ACRES acquisition to Oaktree and MassMutual in the aggregate. We expect these proceeds will provide balance sheet flexibility as well as enhance our liquidity position. A total of $75.0 million remains issuable under the Senior Unsecured Notes due 2027 at December 31, 2020 from which we may draw, at our election, prior to January 31, 2022.
Also, in conjunction with the closing of the ACRES acquisition, we provided a $12.0 million loan to ACRES Capital Corp., the parent of our Manager, as evidenced by the Promissory Note. The note bears interest at 3.00% per annum, payable monthly, and matures in six years, subject to two one-year extensions, at ACRES Capital Corp.’s option, and amortizes at a rate of $25,000 per month.
During the year ended December 31, 2020, our principal sources of liquidity were: (i) proceeds of $128.5 million of financing sourced from our senior secured financing facility, (ii) net proceeds of $99.5 million from our CRE - term warehouse financing facilities, (iii) net proceeds of $89.1 million from repayments on our CRE loan portfolio, (iv) proceeds of $50.0 million from the issuance of the Senior Unsecured Notes due 2027, (v) net proceeds of $47.3 million from the close of XAN 2020-RSO8 and XAN 2020-RSO9, (vi) net proceeds of $27.7 million from the sales of one CRE whole loan and one CRE asset held for sale, and (vii) proceeds of $21.4 million from our CRE securitizations that used principal paydowns to invest in CRE loan future funding commitments. These sources of liquidity, offset by the liquidation of XAN 2018-RSO6, paydowns on our CRE term warehouse facilities, elective paydowns on our senior secured financing facility, pay off of our 8.00% Convertible Senior Notes, margin calls received, net settlements on CMBS repurchase agreements, deployments in CRE debt investments, repurchases of common stock, distributions on our common and preferred stock and ongoing operating expenses, substantially resulted in the $29.4 million of unrestricted cash we held at December 31, 2020.
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We utilize a variety of financing arrangements to finance certain assets. We generally utilize the following three types of financing arrangements:
1.
Senior Secured Financing Facility: Our senior secured financing facility allows us to borrow against loans that we own. During an initial revolving period, additional loans may be financed on the senior secured financing facility. After the revolving period, the senior secured financing facility transitions to a term period over the remaining life of the facility. We pay a fixed rate of interest on the senior secured financing facility as well as an unfunded commitment fee when the facility has borrowings below a certain threshold as a percentage of the total commitment.
2.
Term Warehouse Financing Facilities (CRE loans) and Short-Term Repurchase Agreements (CMBS): Term warehouse financing facilities and short-term repurchase agreements effectively allow us to borrow against loans and securities, respectively, that we own. Under these agreements, we transfer loans and securities to a counterparty and agree to purchase the same loans and securities from the counterparty at a price equal to the transfer price plus interest. The counterparty retains the sole discretion over both whether to purchase the loan or security from us and, subject to certain conditions, the collateral value of such loan or security for purposes of determining whether we are required to pay margin to the counterparty. Generally, if the lender determines (subject to certain conditions) that the value of the collateral in a repurchase transaction has decreased by more than a defined minimum amount, we would be required to repay any amounts borrowed in excess of the product of (i) the revised collateral or market value multiplied by (ii) the applicable advance rate. During the term of these agreements, we receive the principal and interest on the related loans and securities and pay interest to the counterparty.
3.
Securitizations: We seek non-recourse long-term financing from securitizations of our investments in CRE loans. The securitizations generally involve a senior portion of our loan but may involve the entire loan. Securitization generally involves transferring notes to a special purpose vehicle (or the issuing entity), which then issues one or more classes of non-recourse notes pursuant to the terms of an indenture. The notes are secured by the pool of assets. In exchange for the transfer of assets to the issuing entity, we receive cash proceeds from the sale of non-recourse notes. Securitizations of our portfolio investments might magnify our exposure to losses on those portfolio investments because the retained subordinate interest in any particular overall loan would be subordinate to the loan components sold and we would, therefore, absorb all losses sustained with respect to the overall loan before the owners of the senior notes experience any losses with respect to the loan in question.
As discussed in “Overview,” the impact of the COVID-19 pandemic produced material and previously unforeseeable liquidity shocks to global financial markets that resulted in substantial margin calls to us by our CMBS repurchase lenders and led to the ultimate disposition of our financed CMBS portfolio to satisfy our outstanding obligations with those lenders. In April 2020, the outstanding CMBS short-term repurchase agreement liability of $175.9 million was repaid in full. As such, we have no further exposure to losses related to CMBS repurchase agreements.
We were in compliance with all of our covenants at December 31, 2020 in accordance with the terms provided in agreements with our lenders that reduced our minimum equity requirements.
We are continuing to monitor the COVID-19 pandemic and its impact on us, the borrowers underlying our commercial real estate-related loans (and their tenants), our financing sources, and the economy as a whole. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain, rapidly changing and difficult to predict, the pandemic’s impact on our operations and liquidity remains uncertain and difficult to predict. Further discussion of the potential impacts on us from the COVID-19 pandemic is provided in the section entitled “Risk Factors-Impact of Current Economic Conditions” in Part I, Item 1A of this Annual Report on Form 10-K.
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At December 31, 2020, we had a senior secured financing facility and term warehouse financing facilities as summarized below (in thousands, except amounts in footnotes):
(1)
Facility principal outstanding excludes deferred debt issuance costs of $4.0 million at December 31, 2020.
(2)
Facilities principal outstanding excludes accrued interest payable of $16,000 and deferred debt issuance costs and discounts of $1.3 million at December 31, 2020.
The following table summarizes the average principal outstanding on our senior secured financing facility, term warehouse financing facilities and short-term repurchase agreements during the three months ended December 31, 2020 and 2019 and the principal outstanding on our senior secured financing facility, term warehouse financing facilities and short-term repurchase agreements at December 31, 2020 and 2019 (in thousands, except amounts in footnotes):
(1)
Excludes accrued interest payable on the senior secured financing facility collateralized by CRE loans of $75,000 and deferred debt issuance costs of $4.0 million at December 31, 2020.
(2)
Excludes accrued interest payable on term warehouse financing facilities collateralized by CRE loans of $16,000 and $810,000 and deferred debt issuance costs and discounts of $1.3 million and $2.7 million at December 31, 2020 and 2019, respectively.
(3)
Excludes accrued interest payable on repurchase agreements collateralized by CMBS of $470,000 at December 31, 2019.
The following table summarizes the maximum month-end principal outstanding on our senior secured financing facility, term warehouse financing facilities and short-term repurchase agreements during the periods presented (in thousands):
(1)
Increases in the maximum month-end outstanding principal balances for the periods presented resulted from the originations and acquisitions of CRE loans and CMBS.
During the year ended December 31, 2019, our principal sources of liquidity were proceeds of: (i) $863.5 million (net) from financing sourced from our CRE - term warehouse financing facilities and CMBS - short-term repurchase agreement proceeds, (ii) $123.4 million from net repayments on our CRE loan portfolio, (iii) $46.3 million from our CRE securitizations that used repaid principal to invest in CRE loan future funding commitments and (iv) $31.5 million from the close of XAN 2019-RSO7. These sources of liquidity, offset by our deployments in CRE debt investments, distributions on our common and preferred stock and operating expenses, substantially resulted in the $80.0 million of unrestricted cash we held at December 31, 2019.
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Historically, we financed the acquisition of our investments through CDOs and securitizations that essentially match the maturity and repricing dates of these financing vehicles with the maturities and repricing dates of our investments. In the past, we have derived substantial operating cash from our equity investments in our CDOs and securitizations, which will cease if the CDOs and securitizations fail to meet certain tests. Through December 31, 2020, we did not experience difficulty in maintaining our existing CDO and securitization financing and passed all of the critical tests required by these financings.
The following table sets forth the distributions received by us and coverage test summaries for our active securitizations at the periods presented (in thousands, except amount in footnotes):
(1)
Overcollateralization cushion represents the amount by which the collateral held by the securitization issuer exceeds the minimum amount required.
(2)
The designated principal reinvestment period for XAN 2019-RSO7 and XAN 2020-RSO8 is the period in which principal repayments can be utilized to purchase loans held outside of the respective securitization that represent the funded commitments of existing collateral in the respective securitization that were not funded as of the date the respective securitization was closed. Additionally, the indenture for each securitization does not contain any interest coverage test provisions.
(3)
XAN 2020-RSO9 includes a future advances reserve account, which had a balance of $18.6 million at December 31, 2020, to fund commitments that were not funded as of the closing date. Additionally, the indenture does not contain any interest coverage test provisions.
The following table sets forth the distributions made by and liquidation details for our liquidated securitizations for the periods presented (in thousands):
(1)
The remaining assets at the liquidation date were distributed to us in exchange for our notes owned and preference shares in the respective securitization.
(2)
Whitney CLO I, Ltd. was substantially liquidated in September 2013.
(3)
Apidos CDO I, Ltd. was substantially liquidated in October 2014.
At February 28, 2021 our liquidity consisted of $37.2 million of unrestricted cash and cash equivalents, $78.1 million of unlevered financeable CRE loans and $75.0 million of availability under the Oaktree and MassMutual Senior Unsecured Notes due 2027.
Our leverage ratio, defined as the ratio of borrowings to stockholders’ equity, may vary as a result of the various funding strategies we use. At December 31, 2020 and 2019, our leverage ratio under GAAP was 3.9 and 3.4 times, respectively. The leverage ratio increase through December 31, 2020, was primarily attributable to a net decrease in stockholder’s equity due to the disposition of our financed CMBS portfolio combined with increases in our CECL allowance for credit losses offset by a net decrease in borrowings outstanding.
Distributions
We did not pay distributions on our common shares during the year ended December 31, 2020 as we were focused on prudently retaining and managing sufficient excess liquidity in connection with the economic impact of the COVID-19 pandemic. As we continue to take steps necessary to stabilize our financial condition and capital position in light of the COVID-19 pandemic, our Board will establish a plan for the prudent resumption of the payment of common share distributions. We intend to continue to make regular quarterly distributions to holders of our preferred stock.
U.S. federal income tax law generally requires that a REIT distribute at least 90% of its REIT taxable income annually, determined without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating and debt service requirements on our repurchase agreements and other debt payable. If our cash available for distribution is less than our taxable income, we could be required to sell assets or borrow funds to make cash distributions, or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.
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Contractual Obligations and Commitments
(1)
Contractual commitments exclude $22.3 million and $23.0 million of estimated interest expense payable through maturity, in June 2036 and October 2036, respectively, on our trust preferred securities.
(2)
Contractual commitments exclude $10.6 million of interest expense payable through maturity, in August 2022, on our 4.50% Convertible Senior Notes.
(3)
Contractual commitments exclude $39.5 million of interest expense payable through maturity, in July 2027, on our Senior Unsecured Notes due 2027.
(4)
Contractual commitments exclude $75,000 of accrued interest payable at December 31, 2020 on our senior secured financing facility.
(5)
Contractual commitments include $16,000 of accrued interest payable at December 31, 2020 on our term warehouse financing facilities.
(6)
Unfunded commitments on our originated CRE whole loans generally fall into two categories: (i) pre-approved capital improvement projects and (ii) new or additional construction costs subject, in each case, to the borrower meeting specified criteria. Upon completion of the improvements or construction, we would receive additional interest income on the advanced amount. At December 31, 2020, we had unfunded commitments on 51 CRE whole loans and one CRE preferred equity investment. At December 31, 2020, XAN 2020-RSO9 includes a future advances reserve account of $18.6 million to fund unfunded commitments.
(7)
Base management fees presented are based on an estimate of base management fees payable to our Manager over the next 12 months. As of July 31, 2020, the minimum base management fee is $442,000 per month under the terms of the Management Agreement. Our Management Agreement also provides for an incentive compensation arrangement that is based on operating performance. The incentive compensation is not a fixed and determinable amount, and therefore it is not included in this table.
Off-Balance Sheet Arrangements
General
At December 31, 2020, we did not maintain any relationships with unconsolidated entities or financial partnerships that were established for the purpose of facilitating off-balance sheet arrangements or contractually narrow or limited purposes, although we do have interests in unconsolidated entities not established for those purposes. Except as set forth below, at December 31, 2020, we had not guaranteed obligations of any unconsolidated entities or entered into any commitment or letter of intent to provide additional funding to any such entities.
Unfunded CRE Loan Commitments
In the ordinary course of business, we make commitments to borrowers whose loans are in our CRE loan portfolio to provide additional loan funding in the future. Disbursement of funds pursuant to these commitments is subject to the borrower meeting pre-specified criteria. These commitments are subject to the same underwriting requirements and ongoing portfolio maintenance as are the on-balance sheet financial investments that we hold. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Whole loans had $67.2 million and $98.0 million in unfunded loan commitments at December 31, 2020 and 2019, respectively. Preferred equity investments had $2.5 million and $3.0 million in unfunded investment commitments at December 31, 2020 and 2019, respectively.
Guarantees and Indemnifications
In the ordinary course of business, we may provide guarantees and indemnifications that contingently obligate us to make payments to the guaranteed or indemnified party based on changes in the value of an asset, liability or equity security of the guaranteed or indemnified party. As such, we may be obligated to make payments to a guaranteed party based on another entity’s failure to perform or achieve specified performance criteria, or we may have an indirect guarantee of the indebtedness of others.
As part of our May 2017 sale of our equity interest in Pearlmark Mezz, we entered into an indemnification agreement whereby we indemnified the purchaser against realized losses of up to $4.3 million on one mezzanine loan until its final maturity date in 2020. As a result of the indemnified party’s partial sale of the mezzanine loan, our maximum exposure was reduced to $536,000 in 2019. In October 2020, the mezzanine loan paid off its balance to the indemnified party, resulting in the extinguishment of our liability. During the years ended December 31, 2020 and 2019, we recorded a reversal of our reserve for probable losses of $56,000 and $647,000, respectively. At December 31, 2019, we had a contingent liability, reported in accounts payable and other liabilities on our consolidated balance sheet, of $56,000 outstanding as a reserve for probable losses on the indemnification.
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Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared by management in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires that we make estimates and assumptions that may affect the value of our assets or liabilities and disclosure of contingent assets and liabilities at the date of our financial statements, and our financial results. We believe that certain of our policies are critical because they require us to make difficult, subjective and complex judgments about matters that are inherently uncertain. The critical policies summarized below relate to valuation of investment securities, accounting for derivative financial instruments and hedging activities, income taxes, allowance for credit losses and variable interest entities (“VIEs”). We have reviewed these accounting policies with our Board and believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time made based upon information available to us at the time.
Allowance for Credit Losses
We maintain an allowance for credit loss on our loans held for investment. CRE loans that are held for investment are carried at cost, net of unamortized acquisition premiums or discounts, loan fees and origination costs as applicable. Effective January 1, 2020, we determine our allowance for credit losses, consistent with GAAP, by measuring the CECL on the loan portfolio on a quarterly basis. We utilize a probability of default and loss given default methodology over a reasonable and supportable forecast period after which it reverts to its historical mean loss ratio, utilizing a blended approach sourced from its own historical losses and the market losses from an engaged third party’s database, to be applied for the remaining estimable period. The CECL model requires us to make significant judgements, including: (i) the selection of a reasonable and supportable forecast period, (ii) the selection of appropriate macroeconomic forecast scenarios, (iii) projections for the amounts and timing of future fundings of committed balances and prepayments on CRE investments, (iv) the determination of the risk characteristics in which to pool financial assets, and (v) the appropriate historical loss data to use in the model. Unfunded commitments are not considered in the CECL reserve if they are unconditionally cancellable by us.
We measure the loan portfolio’s credit losses by grouping loans based on similar risk characteristics under CECL, which is typically based on the loan’s collateral type. We regularly evaluate the risk characteristics of our loan portfolio to determine whether a different pooling methodology is more accurate. Further, if we determine that foreclosure of a loan’s collateral is probable or repayment of the loan is expected through sale or operation of the collateral and the borrower is experiencing financial difficulty, expected credit losses are measured as the difference between the current fair value of the collateral and the amortized cost of the loan. Fair value may be determined based on (i) the present value of estimated cash flows; (ii) the market price, if available; or (iii) the fair value of the collateral less estimated disposition costs.
While a loan exhibiting credit quality deterioration may remain on accrual status, the loan is placed on non-accrual status at such time as (i) management believes that scheduled debt service payments will not be met within the coming 12 months; (ii) the loan becomes 90 days past due; (iii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the credit deterioration; or (iv) the net realizable value of the loan’s underlying collateral approximates our carrying value for such loan. While on non-accrual status, we recognize interest income only when an actual payment is received if a credit analysis supports the borrower’s principal repayment capacity. When a loan is placed on non-accrual, previously accrued interest is reversed from interest income.
We utilize the contractual life of our loans to estimate the period over which we measure expected credit losses. Estimates for prepayments and extensions are incorporated into the inputs for our CECL model. Modifications to loan terms, such as a modification in connection with a TDR, where a concession is granted to a borrower experiencing financial difficulty, may result in the extension of the loan’s life and an increase in the allowance for credit losses. In March 2020, the Financial Accounting Standards Board (“FASB”) concurred with a joint statement of federal and state banking regulators that eased the requirements to classify a modification as a TDR if the modification was granted in connection with the effects of the COVID-19 pandemic. The measurement of the impact of TDRs on the expected credit losses occurs when a TDR is reasonably expected. If the concession granted on a TDR can only be captured through a discounted cash flow analysis, then we will individually assess the loan for expected credit losses using the discounted cash flow method.
In order to calculate the historical mean loss ratio applied to the loan portfolio, we utilize historical losses from our full underwriting history, along with the market loss history of a selected population of loans from a third party’s database that are similar to our loan types, loan sizes, durations, interest rate structure and general LTV profiles. We may make adjustments to the historical loss history for qualitative or environmental factors if we believe there is evidence that the estimate for expected credit losses should be increased or decreased.
We record write-offs against the allowance for credit losses if we deem that all or a portion of a loan’s balance is uncollectible. If we receive cash in excess of some or all of the amounts we previously wrote off, we record a recovery to increase the allowance for credit losses.
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As part of the evaluation of the loan portfolio, we assess the performance of each loan and assigns a risk rating based on the collective evaluation of several factors, including but not limited to: collateral performance relative to underwritten plan, time since origination, current implied and/or re-underwritten LTV ratios, risk inherent in the loan structure and exit plan. Loans are rated “1” through “5,” from less risk to greatest risk, in connection with this review.
Prior to the implementation of CECL, we calculated its allowance for credit losses through the calculation of general and specific reserves. The general reserve, established for loans not determined to be impaired individually, was based on our loan risk ratings. We recorded a general reserve equal to 1.5% of the aggregate face values of loans with a risk rating of “3,” plus 5.0% of the aggregate face values of loans with a risk rating of “4.” Loans with a risk rating of “5” were individually measured for impairment to be included in a specific reserve on a quarterly basis.
We considered a loan to be impaired if at least one of two conditions exists. The first condition was if, based on our evaluation as part of the loan risk rating process, management believed that a loss event had occurred that made it probable that we would be unable to collect all amounts due according to the contractual terms of the loan agreement. The second condition was that the loan was deemed to be a TDR. These TDRs may not have had an associated specific credit loss allowance if the principal and interest amount was considered recoverable based on market conditions, appraisals of the underlying collateral, expected collateral performance and/or guarantees made by the borrowers.
When a loan was impaired under either of these two conditions, the allowance for credit losses was increased by the amount of the excess of the amortized cost basis of the loan over its fair value. When a loan, or a portion thereof, was considered uncollectible and pursuit of collection was not warranted, we recorded a charge-off or write-down of the loan against the allowance for credit losses.
Investment in Real Estate
Acquired investments in real estate assets are recorded initially at fair value in accordance with U.S. GAAP. We allocate the purchase price of our acquired assets and assumed liabilities based on the relative fair values of the assets acquired and liabilities assumed.
Investments in real estate are carried net of accumulated depreciation. We depreciate real property and furniture, fixtures, and equipment using the straight-line method over the estimated useful lives of the assets. We amortize any acquired intangible assets, including but not limited to franchise agreement and customer list assets, using the straight-line method over the estimated useful lives of the intangible assets. We amortize the value allocated to lease right of use assets and related in-place lease liabilities, when determined to be operating leases, using the straight-line method over the remaining lease term. The value allocated to any associated above or below market lease intangible asset or liability is amortized to lease expense over the remaining lease term.
Ordinary repairs and maintenance are expensed as incurred. Costs related to the improvement of the real property are capitalized and depreciated over their useful lives.
We depreciate investments in real estate and amortize intangible assets over the estimated useful lives of the assets as follows:
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Revenue Recognition
Interest income from our loan portfolio is recognized over the life of each loan using the effective interest method and is recorded on the accrual basis. Premiums and discounts are amortized or accreted into income using the effective yield method. If a loan with a premium or discount is prepaid, we immediately recognize the unamortized portion as a decrease or increase to interest income. In addition, we defer loan origination and extension fees and loan origination costs and recognize them over the life of the related loan against interest income using the straight-line method, which approximates the effective yield method. Income recognition is suspended for loans at the earlier of the date at which payments become 90 days past due or when, in our opinion, a full recovery of principal and income becomes doubtful. When the ultimate collectability of the principal is in doubt, all payments received are applied to principal under the cost recovery method. When the ultimate collectability of the principal is not in doubt, contractual interest is recorded as interest income when received, under the cash method, until an accrual is resumed when the loan becomes contractually current and performance is demonstrated to be resumed.
Variable Interest Entities
We consolidate entities that are VIEs where we have determined that we are the primary beneficiary of such entities. Once it is determined that we hold a variable interest in a VIE, management performs a qualitative analysis to determine (i) if we have the power to direct the matters that most significantly impact the VIE’s financial performance; and (ii) if we have the obligation to absorb the losses of the VIE that could potentially be significant to the VIE or the right to receive the benefits of the VIE that could potentially be significant to the VIE. If our variable interest possesses both of these characteristics, we are deemed to be the primary beneficiary and would be required to consolidate the VIE. This assessment must be done on an ongoing basis.
At December 31, 2020, we determined that we are the primary beneficiary of six VIEs that are consolidated.
Recent Accounting Pronouncements
Accounting Standards Adopted in 2020
In June 2016, the FASB issued guidance that changes how credit losses for most financial assets and certain other instruments that are measured at fair value through net income are determined. The new guidance replaced the incurred loss approach with a CECL model for instruments measured at amortized cost. For available-for-sale debt securities, the guidance requires recording allowances rather than reducing the carrying amount, as we were previously under the other-than-temporary impairment model. It also simplifies the accounting model for debt securities and loans with evidence of credit quality deterioration.
On January 1, 2020, we adopted the above-mentioned accounting guidance and recorded an initial CECL allowance of approximately $4.5 million, of which $3.0 million, or $0.29 per share, was recorded as a charge to retained earnings on such date. The estimated CECL reserve represented 0.25% of the aggregate outstanding principal balance of our $1.8 billion commercial loan portfolio at December 31, 2019. During the year ended December 31, 2020, we recorded an additional CECL reserve of $29.8 million for a total CECL reserve of $34.3 million, or 2.21% of the aggregate outstanding principal balance of our $1.5 billion commercial loan portfolio at December 31, 2020.
In August 2018, the FASB issued guidance to modify the fair value measurement disclosure requirements, including: disclosures on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, the policy for timing of transfers between levels and the narrative description of measurement uncertainty. Adoption did not have a material impact on our consolidated financial statements.
Accounting Standards to be Adopted in Future Periods
In March 2020, the FASB issued guidance that provides optional expedients and exceptions to GAAP requirements for modifications on debt instruments, leases, derivatives and other contracts, related to the expected market transition from the LIBOR, and certain other floating-rate benchmark indices to alternative reference rates. The guidance generally considers contract modifications related to reference rate reform to be an event that does not require contract remeasurement at the modification date nor a reassessment of a previous accounting determination. The guidance is optional and may be elected over time, through December 31, 2022, as reference rate reform activities occur. We are in the process of evaluating the impact of this guidance.
In August 2020, the FASB issued guidance that removes certain separation models for convertible debt instruments and convertible preferred stock that require the separation into a debt component and an equity or derivative component. Consequently, a convertible debt instrument will be accounted for as a single liability measured at its amortized cost, as long as no other features require bifurcation and recognition as derivatives and the convertible instrument are not issued with substantial premiums accounted for as paid-in capital. By removing those separation models, the interest rate of convertible debt instruments typically will be closer to the coupon interest rate. The guidance also revises the derivative scope exception for contracts in an entity’s own equity and improves the consistency of EPS calculations. The guidance is effective for larger public business entities’ annual periods, and interim periods therein, beginning after December 15, 2021 and for smaller reporting entities after December 15, 2023. Early application is permitted for fiscal years beginning after December 15, 2020. We are in the process of evaluating the impact of this guidance.
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Inflation
Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our consolidated financial statements are prepared in accordance with GAAP and our distributions are determined by our Board based primarily on our maintaining our REIT qualification; in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation.
ITEM 7A.
ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At December 31, 2020, the primary component of our market risk was credit risk, counterparty risk, financing risk and interest rate risk, as described below. While we do not seek to avoid risk completely, we do seek to assume risk that can be quantified from historical experience, to actively manage that risk, to earn sufficient compensation to justify assuming that risk and to maintain capital levels consistent with the risk we undertake or to which we are exposed.
Credit Risks
Our loans and investments are subject to credit risk. The performance and value of our loans and investments depend upon the sponsors’ ability to operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due to us. To monitor this risk, ACRES Capital, LLC’s asset management team reviews our investment portfolios and in certain instances is in regular contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary.
In addition, we are exposed to the risks generally associated with the commercial real estate (“CRE”) market, including variances in occupancy rates, capitalization rates, absorption rates, and other macroeconomic factors beyond our control. We seek to manage these risks through our underwriting and asset management processes.
The COVID-19 pandemic has significantly impacted the CRE markets, causing reduced occupancy, requests from tenants for rent deferral or abatement, and delays in construction and development projects currently planned or underway. Our portfolio includes loans collateralized by multifamily, hotel, retail and other property types that are particularly negatively impacted by the pandemic. Approximately 56.3% of our portfolio is in multifamily properties. Residents that experience deteriorating financial conditions as a result of the pandemic may be unwilling or unable to pay rent in full on a timely basis. Furthermore, numerous state, local and federal regulations have also imposed restrictions at present on the borrower’s ability to enforce residents’ contractual lease obligations, and this will affect their ability to collect rent or enforce remedies for the failure to pay rent. Approximately 11.8% of our portfolio is in hotel properties. While many restrictions on hotels have eased, the industry is still experiencing a significant reduction of operations resulting a decline in group, business and leisure travel. Travelers may continue to be wary to travel despite the easing of restrictions because of concerns of risk of contagion or curtailment of leisure travel due to the economic recession. Approximately 4.9% of our portfolio is in retail properties. While government restrictions effecting retail have eased, complete or partial closure of many retail properties have resulted from tenant action. The reduced economic activity severely impacts the tenants’ businesses, financial condition and liquidity and may result in the tenants being unwilling or unable to meet their obligations to the borrower in part or in full.
These negative conditions may persist into the future and impair our borrowers’ ability to comply with the terms under our loan agreements. We maintain a robust asset management relationship with our borrowers and have utilized these relationships to address the potential impacts of the COVID-19 pandemic on our loans secured by properties experiencing cash flow pressure. While we believe the principal amounts of our loans are generally adequately protected by underlying collateral value, there is a risk that we will not realize the entire principal value of certain investments. In order to mitigate that risk, we have proactively engaged with our borrowers, particularly with those with near-term maturities, in order to maximize recovery.
Counterparty Risk
The nature of our business requires us to hold our cash and cash equivalents and obtain financing from with various financial institutions. This exposes us to the risk that these financial institutions may not fulfill their obligations to us under these various contractual arrangements. We mitigate this exposure by depositing our cash and cash equivalents and entering into financing agreements with high credit-quality institutions.
Financing Risk
We finance our target assets using our CRE debt securitizations, a senior secured financing facility, warehouse financing facilities and short-term repurchase agreements. Over time, as market conditions change, we may use other forms of leverage in addition to these methods of financing. Weakness or volatility in the financial markets, the CRE and mortgage markets or the economy generally, such as through the impact of the COVID-19 pandemic, could adversely affect one or more of our lenders or potential lenders and could cause one or more of our lenders or potential lenders to be unwilling or unable to provide us with financing, or to decrease the amount of our available financing, or to increase the costs of that financing.
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Interest Rate Risk
Our business model is such that rising interest rates will increase our net income, while declining interest rates will decrease net income, subject to the impact of interest rate floors. As of December 31, 2020, 98% of our CRE loan portfolio by par value earned a floating rate of interest and were financed with liabilities that both pay interest at floating rates and that are fixed. Floating-rate loans financed with fixed rate liabilities have a negative correlation with declining interest rates to the extent of our financing. The remaining approximate 2% of our CRE loan portfolio by par value earned a fixed rate of interest and were either not financed or financed with liabilities that pay interest at floating rates. Fixed rate loans financed with floating rate liabilities have a negative correlation with rising interest rates to the extent of our financing. To the extent that interest rate floors on our floating-rate CRE loans are in the money, our net interest will have a negative correlation with rising interest rates to the extent of those interest rate floors. Our floating-rate loan portfolio of $1.5 billion has a weighted-average one-month LIBOR floor of 1.88% at December 31, 2020. Additionally, all interest rate floors on our CRE loan portfolio were in the money at December 31, 2020.
The following table estimates the hypothetical impact on our net interest income assuming an immediate increase or decrease of 100 basis points in the applicable interest rate benchmark (in thousands, except per share data):
(1)
Includes our floating-rate CRE loans at December 31, 2020.
(2)
Includes amounts outstanding on our securitizations, CRE term warehouse financing facilities, senior secured financing facility and unsecured junior subordinated debentures.
(3)
Certain of our floating rate loans are subject to a LIBOR floor.
(4)
Decrease in rates assumes the applicable benchmark rate does not fall below 0%.
Risk Management
To the extent consistent with maintaining our status as a REIT, we seek to manage our interest rate risk exposure to protect our variable rate debt against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:
•
monitoring and adjusting, if necessary, the reset index and interest rate related to our borrowings; and
•
attempting to structure our borrowing agreements for our commercial mortgage-backed securities to have a range of different maturities, terms, amortizations and interest rate adjustment periods.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
ACRES Commercial Realty Corp.
Opinion on the financial statements
We have audited the accompanying consolidated balance sheets of ACRES Commercial Realty Corp. (a Maryland corporation) and subsidiaries (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income (loss), changes in equity, and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedules included under Item 15(a) (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and our report dated March 11, 2021 expressed an unqualified opinion.
Change in accounting principle
As discussed in Note 2 to the financial statements, the Company has changed its method of accounting for credit losses in the year ended December 31, 2020 due to adoption of Accounting Standard Update, or ASU, 2016-13 “Financial Instruments - Credit Losses - Measurement of Credit Losses on Financial Instruments (Topic 326).”
Basis for opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical audit matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Allowance for credit losses on loans
As described in Note 2 and Note 7 to the financial statements, and in accordance with Accounting Standard Codification (ASC) 326, Financial Instruments - Credit Losses, the Company utilizes a current expected credit loss approach to determine the allowance for credit losses. The Company measures expected credit losses on loans on a pooled basis based on shared risk characteristics. To estimate the allowance for credit losses on pooled loans, the Company utilizes a probability of default and loss given default methodology, which incorporates individual loan characteristics, historical loss experience and forecasted economic data from a third party that is sensitive to management’s selection of economic recovery scenarios. We identified the allowance for credit losses as a critical audit matter.
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The principal considerations for our determination that the allowance for credit losses is a critical audit matter are that management is required to make significant judgments in selecting and weighing economic recovery scenarios and in evaluating whether, for individual commercial real estate (CRE) loans, factors are present that require the adjustment of loan specific characteristics used in the allowance for credit losses. These conclusions require significant auditor judgment in obtaining sufficient appropriate audit evidence related to these management determinations.
Our audit procedures related to the allowance for credit losses included the following, among others:
•
We tested the design and operating effectiveness of management’s review controls over the allowance for credit losses, which included controls related to the selection and weighing of various economic scenarios, and the identification and evaluation of loans where property performance lagged behind underwritten plans.
•
We assessed the appropriateness and weighting of the various economic scenarios selected by management.
•
We inspected a sample of CRE loan files to assess management’s processes for identifying individual CRE loans where property performance lagged behind underwritten plans and, for each such loan identified, evaluating whether factors are present that require adjustment to loan specific characteristics used in the allowance for credit losses.
•
For CRE loans which required an update to loan specific characteristics used in the allowance for credit losses, we assessed the appropriateness of loan-specific or collateral-specific characteristics, which involved the assistance of professionals with specialized skill and knowledge.
Estimation of fair value of assets received in satisfaction of CRE whole loan
As described in Note 18 to the financial statements, in November 2020, the Company received the deed in lieu of foreclosure for a hotel property in full satisfaction of an outstanding $38.0 million CRE whole loan. The Company recorded the hotel property at its fair value, $39.8 million, upon receipt of the deed. The fair value was determined by the Company with assistance from third party appraiser, which utilized an income approach that involved projections of expected cash flows and the application of certain subjective inputs including the discount rate and overall capitalization rate. We identified the valuation of the hotel property as a critical audit matter.
The principal consideration for our determination that the valuation of the hotel property is a critical audit matter is that management, with the assistance of a third party appraiser, made significant judgements about cash flow projections and the discount rate and overall capitalization rate, which are subjective inputs into the fair value estimate of the hotel property. Significant management judgments and estimates utilized to determine the fair value of the hotel property are subject to estimation uncertainty and require significant auditor subjectivity in evaluating the reasonableness of those judgments and estimates.
Our audit procedures related to the valuation of the hotel property included the following, among others:
•
We tested the design and operating effectiveness of controls over the estimation of the fair value of the assets acquired, including management review controls over the appropriateness of the valuation method, the cash flow projections, discount rate and overall capitalization rate utilized by the third party appraiser to determine the fair value of the hotel property.
•
We assessed the appropriateness of the valuation method, the cash flow projections, and the discount rate and overall capitalization rate utilized by the appraiser, which involved the assistance of professionals with specialized skill and knowledge.
/s/ GRANT THORNTON LLP
We have served as the Company’s auditor since 2005.
Philadelphia, Pennsylvania
March 11, 2021
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - (Continued)
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2020, 2019 AND 2018
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2020, 2019 AND 2018 - (Continued)
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2020, 2019 AND 2018 - (Continued)
(in thousands, except share and per share data)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
(in thousands)
The accompanying notes are an integral part of these statements
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2020
NOTE 1 - ORGANIZATION
ACRES Commercial Realty Corp., a Maryland corporation, along with its subsidiaries (collectively, the “Company”)(formerly known as Exantas Capital Corp.) is a real estate investment trust (“REIT”) that is primarily focused on originating, holding and managing commercial real estate (“CRE”) mortgage loans and other commercial real estate-related debt investments. On July 31, 2020, the Company’s management contract was acquired from Exantas Capital Manager Inc. (the “Prior Manager”), a subsidiary of C-III Capital Partners LLC (“C-III”), by ACRES Capital, LLC (the “Manager”), a subsidiary of ACRES Capital Corp. (collectively, “ACRES”), a private commercial real estate lender exclusively dedicated to nationwide middle market CRE lending with a focus on multifamily, student housing, hospitality, office and industrial property in top United States (“U.S.”) markets (the “ACRES acquisition”). In conjunction with the ACRES acquisition, the Company secured new capital commitments for up to $375.0 million and entered into a promissory note (the “Promissory Note”) as lender with ACRES Capital Corp., as disclosed in Note 11 and Note 17, respectively.
The Company has qualified, and expects to qualify in the current fiscal year, as a REIT.
The Company conducts its operations through the use of subsidiaries that it consolidates into its financial statements. The Company’s core assets are consolidated through its investment in ACRES Realty Funding, Inc. (“ACRES RF”), formerly RCC Real Estate, Inc., a wholly-owned subsidiary that holds CRE loans, CRE-related securities and retained investment securities in CRE securitizations, which are consolidated as VIEs, as discussed in Note 3, and special purpose entities.
Reverse Stock Split
Effective February 16, 2021 the Company completed a one-for-three reverse stock split of its outstanding common stock. The accompanying financial statements and notes to the financial statements give retroactive effect to the reverse stock split for all periods presented. In addition, the Company adopted articles of amendment to its certificate of incorporation, which provided that there was no change in the Company’s authorized capital stock and the par value of the Company’s common stock would remain $0.001 immediately after effect is given for the reverse stock split. No fractional shares were issued in connection with the reverse stock split. Stockholders who otherwise held fractional shares of the Company’s common stock as a result of the reverse stock split received a cash payment in lieu of such fractional shares.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S. (“GAAP”). The consolidated financial statements include the accounts of the Company, majority-owned or controlled subsidiaries and VIEs for which the Company is considered the primary beneficiary. All inter-company transactions and balances have been eliminated in consolidation.
Variable Interest Entities
A VIE is defined as an entity in which equity investors (i) do not have a controlling financial interest and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A VIE is required to be consolidated by its primary beneficiary, which is defined as the party that (a) has the power to control the activities that most significantly impact the VIE’s economic performance and (b) has the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.
The Company considers the following criteria in determining whether an entity is a VIE:
1.
The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including the equity holders.
2.
The equity investors lack one or more of the following essential characteristics of a controlling financial interest.
a.
The direct ability to make decisions about the entity’s activities through voting rights or similar rights.
b.
The obligation to absorb the expected losses of the entity.
c.
The right to receive the expected residual returns of the entity. The equity investors have voting rights that are not proportionate to their economic interests, and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
In determining whether the Company is the primary beneficiary of a VIE, the Company reviews governing contracts, formation documents and any other contractual arrangements for any relevant terms and determines the activities that have the most significant impact on the VIE and who has the power to direct those activities. The Company also looks for kick-out rights, protective rights and participating rights as well as any financial or other support provided to the VIE and the reason for that support, and the terms of any explicit or implicit arrangements that may require the Company to provide future support. The Company then makes a determination based on its power to direct the most significant activities of the VIE and/or a financial interest that is potentially significant. In instances when a VIE is owned by both the Company and related parties, the Company considers whether there is a single party in the related party group that meets both the power and losses or benefits criteria on its own as though no related party relationship existed. If one party within the related party group meets both these criteria, such reporting entity is the primary beneficiary of the VIE and no further analysis is needed. If no party within the related party group on its own meets both the power and losses or benefits criteria, but the related party group as a whole meets these two criteria, the determination of primary beneficiary within the related party group is based upon an analysis of the facts and circumstances with the objective of determining which party is most closely associated with the VIE. Determining the primary beneficiary requires significant judgment. The Company continuously analyzes entities in which it holds variable interests, including when there is a reconsideration event, to determine whether such entities are VIEs and whether such potential VIEs should be consolidated or deconsolidated.
Voting Interest Entities
A voting interest entity is an entity in which the total equity investment at risk is sufficient to enable it to finance its activities independently and the equity holders have the power to direct the activities of the entity that most significantly impact its economic performance, the obligation to absorb the losses of the entity and the right to receive the residual returns of the entity. The usual condition for a controlling financial interest in a voting interest entity is ownership of a majority voting interest. If the Company has a majority voting interest in a voting interest entity, the entity will generally be consolidated. The Company does not consolidate a voting interest entity if there are substantive participating rights by other parties and/or kick-out rights by a single party or through a simple majority vote.
The Company performs on-going reassessments of whether entities previously evaluated under the voting interest framework have become VIEs, based on certain events, and therefore subject to the VIE consolidation framework.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the financial results. Actual results could differ from those estimates. Estimates affecting the accompanying consolidated financial statements include but are not limited to the net realizable and fair values of the Company’s investments and derivatives, the estimated useful lives used to calculate depreciation, the expected lives over which to amortize premiums and accrete discounts, provisions for expected credit losses and the disclosure of contingent liabilities.
In December 2019, a novel strain of coronavirus (“COVID-19”) was identified. The resulting global proliferation of the virus led the World Health Organization to designate COVID-19 as a pandemic and numerous countries, including the U.S., to declare national emergencies. Many countries have responded to the outbreak by instituting quarantines and restrictions on travel, which have resulted in the closure or remote operation of non-essential businesses. Such actions have produced material and previously unforeseeable shocks to global markets, disruptions to global supply chains and adversity to many industries and economies as whole. While certain countries around the world have eased restrictions and financial markets have stabilized to some degree, the pandemic continues to plague the overall U.S. economy and cause uncertainty surrounding the ultimate impact on the global economy generally, and the CRE business in particular, that make estimates and assumptions as of December 31, 2020 inherently less certain than they would be absent the current and potential impacts of COVID-19. The Company believes the estimates and assumptions underlying the consolidated financial statements are reasonable and supportable based on the information available at December 31, 2020. Actual results may ultimately differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and all highly liquid investments with original maturities of three months or less at the time of purchase. At December 31, 2020 and 2019, approximately $27.3 million and $77.6 million, respectively, of the reported cash balances exceeded the Federal Deposit Insurance Corporation and Securities Investor Protection Corporation deposit insurance limits of $250,000 per respective depository or brokerage institution. However, all of the Company’s cash deposits are held at multiple, established financial institutions, in multiple accounts associated with its parent and respective consolidated subsidiaries, to minimize credit risk exposure.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Restricted cash includes required account balance minimums primarily for the Company’s CRE debt securitizations and derivative instruments as well as cash held in the syndicated corporate loan collateralized debt obligations (“CDOs”).
The following table provides a reconciliation of cash, cash equivalents and restricted cash on the consolidated balance sheets to the total amount shown on the consolidated statements of cash flows (in thousands):
Investment in Unconsolidated Entities
The Company’s non-controlling investments in unconsolidated entities are included in investments in unconsolidated entities on the consolidated balance sheets and may be accounted for under the equity method or the cost method.
Under the equity method, capital contributions, distributions, profits and losses of the entities are allocated in accordance with the terms of the entities’ operating agreements. Such allocations may differ from the stated percentage interests, if any, as a result of preferred returns and allocation formulas as described in the entities’ operating agreements. For non-controlling investments in unconsolidated entities qualifying for equity method treatment with substantive profit-sharing arrangements, the hypothetical liquidation at book value (“HLBV”) method may be used for recognizing earnings. Under the HLBV method, earnings are calculated and recognized based on the change in how the unconsolidated entity would allocate and distribute its cash if it were to liquidate the carrying value of its assets and liabilities on the beginning and end dates of the earnings period; excluding contributions made or distributions received.
The Company may account for an investment that does not qualify for equity method accounting using the cost method. Under the cost method, the Company records dividend income when declared to the extent it is not considered a return of capital, which is recorded as a reduction of the cost of the investment.
Investment Securities
The Company classifies its investment securities portfolio as trading or available-for-sale. The Company, from time to time, may sell any of its investments due to changes in market conditions or in accordance with its investment strategy.
The Company reports its investment securities available-for-sale and historically has reported its investment securities, trading at fair value. To determine fair value, the Company uses an independent third-party valuation firm utilizing data available in the market as well as appropriate prepayment, default and recovery rates. The Company evaluates the reasonableness of the valuation it receives by using a dealer quote, bid, or internal model. If there is a material difference between the value indicated by the third-party valuation firm and the dealer quote, bid or internal model, the Company will evaluate the difference, which could result in an updated valuation from the third-party or a revised dealer quote. Based on a prioritization of inputs used in the valuation of each position, the Company categorizes these investments as either Level 2 or Level 3 in the fair value hierarchy. Historically, any changes in fair value of the Company’s investment securities, trading were recorded on the Company’s consolidated statements of operations as net realized and unrealized gain (loss) on investment securities, trading. Any changes in fair value of the Company’s investment securities available-for-sale are recorded on the Company’s consolidated balance sheets as a component of accumulated other comprehensive income (loss) in stockholders’ equity.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
On a quarterly basis, the Company evaluates available-for-sale securities with fair values below their amortized cost bases to determine the estimate of expected credit losses. Evidence of the need for an allowance for credit losses will be based on consideration of several factors, including (i) if the Company intends to sell the security, (ii) if it is more likely than not that the Company will be required to sell the security before recovering its cost, or (iii) whether a portion of the unrealized loss is a result of credit losses or other market factors. A credit loss will have occurred if the present value of cash flows expected to be collected from the debt security is less than the amortized cost basis. If the Company intends to sell a debt security with a fair value below the amortized cost basis or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, a write-off is recognized in earnings through a charge to the amortized cost of the security and equal to the entire difference between fair value and amortized cost. If a credit loss exists, but the Company does not intend nor is it more likely than not that it will be required to sell before recovery, the loss will be separated into (i) the estimated amount relating to the credit loss and (ii) the amount relating to all other factors. Only the estimated credit loss amount is recognized in earnings through an increase to the allowance for credit losses, with the remainder of the loss recognized in other comprehensive income. If the Company uses a discounted cash flow approach to estimate expected credit losses, changes in the present value attributable to the passage of time are recorded in the provision for credit losses. Estimating cash flows and determining whether there are credit losses require management to exercise judgment and to make significant assumptions, including, but not limited to, assumptions regarding estimated prepayments, loss assumptions and assumptions regarding changes in interest rates. As a result, actual losses, and the timing of income recognized on these securities, could differ from reported amounts.
Investment security transactions are recorded on the trade date. Realized gains and losses on investment securities are determined on the specific identification method.
Investment Security Interest Income Recognition
Interest income on the Company’s mortgage-backed securities (“MBS”) and other asset-backed securities (“ABS”) is accrued using the effective yield method based on the actual coupon rate and the outstanding principal amount of the underlying mortgages or other assets. Premiums and discounts are amortized or accreted into interest income over the expected lives of the securities also using the effective yield method, adjusted for the effects of estimated prepayments. For an investment purchased at par, the effective yield is the contractual interest rate on the investment. If the investment is purchased at a discount or at a premium, the effective yield is computed based on the contractual interest rate increased for the accretion of a purchase discount or decreased for the amortization of a purchase premium. The effective yield method requires the Company to make estimates of future prepayment rates for its investments that can be contractually prepaid before their contractual maturity date so that the purchase discount can be accreted, or the purchase premium can be amortized, over the estimated remaining life of the investment. The prepayment estimates that the Company uses directly impact the estimated remaining lives of its investments. Actual prepayment estimates are reviewed at each quarter end or more frequently if the Company becomes aware of any material information that would lead it to believe that an adjustment is necessary. For MBS and other ABS that are not of high credit quality or that can be prepaid in such a way that the Company would not recover substantially all of its initial investment, changes in the original or most recent cash flow projections may result in a prospective change in interest income recognized. For MBS and other ABS that are of high credit quality, changes in the original or most recent cash flow projections may result in an immediate cumulative adjustment in interest income recognized.
The Company records interest receivable on its available-for-sale debt securities in accrued interest receivable on its consolidated balance sheets. The Company analyzes the interest receivable balances on a timely basis, or at least quarterly, to determine if they are uncollectible. If an interest receivable balance is deemed uncollectible, then the Company writes off the balance of the interest receivable through a reversal of interest income.
Loans
The Company acquires loans through direct origination and occasionally through purchases from third-parties and had historically acquired corporate leveraged loans in the secondary market and through syndications of newly originated loans. Loans are held for investment; therefore, the Company initially records loans at the amount funded for originated loans or at the acquisition price for loans purchased, and subsequently, accounts for them based on their outstanding principal plus or minus unamortized premiums or discounts. The Company may sell a loan held for investment where the credit fundamentals underlying a particular loan have changed in such a manner that the Company’s expected return on investment may decrease. Once the determination has been made by the Company that it no longer will hold the loan for investment, the Company identifies these loans as loans held for sale. Any credit-related write-off considerations prior to the transfer of the loan to loans held for sale are accounted for through the allowance for credit losses on the Company’s consolidated balance sheets.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The Company reports its loans held for sale at the lower of amortized cost or fair value. To determine fair value, the Company primarily uses appraisals obtained from third-parties as a practical expedient. Key assumptions used in those appraisals are reviewed by the Company. If there is a material difference between the value provided by the appraiser and information used by the Company to validate the appraisal, the Company will evaluate the difference with the appraiser, which could result in an updated appraisal. The Company may also use the present value of estimated cash flows, market price, if available, or other determinants of the fair value of the collateral less estimated disposition costs. Any determined changes in the fair value of loans held for sale are recorded in fair value adjustments on financial assets held for sale on the Company’s consolidated statements of operations. Based on a prioritization of inputs used in the valuation of each position, the Company categorizes these investments as either Level 2 or Level 3 in the fair value hierarchy.
Loan Interest Income Recognition
Interest income on loans includes interest at stated rates adjusted for amortization or accretion of premiums and discounts based on the contractual payment terms of the loan. Premiums and discounts are amortized or accreted into income using the effective yield method. If a loan with a premium or discount is prepaid, the Company immediately recognizes the unamortized portion as a decrease or increase to interest income. In addition, the Company defers loan origination and extension fees and loan origination costs and recognizes them over the life of the related loan against interest income using the straight line method, which approximates the effective yield method. Income recognition is suspended for loans at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of principal and income becomes doubtful. When the ultimate collectability of the principal is in doubt, all payments received are applied to principal under the cost recovery method. On the other hand, when the ultimate collectability of the principal is not in doubt, contractual interest is recorded as interest income when received, under the cash method, until an accrual is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. A loan is written off when it is no longer realizable and/or legally discharged.
The Company records interest receivable on its loans in accrued interest receivable on its consolidated balance sheets. The Company analyzes the interest receivable balances on a timely basis, or at least quarterly, to determine if they are uncollectible. If an interest receivable balance is deemed uncollectible, then the Company writes off the balance of the interest receivable through a reversal of interest income.
Preferred Equity Investment
Preferred equity investments, which are subordinate to any loans but senior to common equity, depending on the investment’s characteristics, may be accounted for as real estate, joint ventures or as mortgage loans. The Company’s preferred equity investments are accounted for as CRE loans held for investment, are carried at cost, net of unamortized loan fees and origination costs, and are included within CRE loans on the Company’s consolidated balance sheets. The Company accretes or amortizes any discounts or premiums over the life of the related loan utilizing the effective interest method. Interest and fees are recognized as income subject to recoverability, which is substantiated by obtaining annual appraisals on the underlying property.
Allowance for Credit Losses
The Company maintains an allowance for credit loss on its loans held for investment. Effective January 1, 2020, the Company determines its allowance for credit losses by measuring the current expected credit losses (“CECL”) on the loan portfolio on a quarterly basis. The Company utilizes a probability of default and loss given default methodology together with collateral-specific data for each loan over a reasonable and supportable forecast period after which it reverts to its historical mean loss ratio, utilizing a blended approach sourced from its own historical losses and the market losses from an engaged third party’s database, to be applied for the remaining estimable period. The CECL model requires the Company to make significant judgements, including: (i) the selection of a reasonable and supportable forecast period, (ii) the selection of appropriate macroeconomic forecast scenarios, (iii) projections for the amounts and timing of future fundings of committed balances and prepayments on CRE investments, (iv) the determination of the risk characteristics in which to pool financial assets, and (v) the appropriate historical loss data to use in the model. Unfunded commitments are not considered in the CECL reserve if they are unconditionally cancellable by the Company.
The Company measures the loan portfolio’s credit losses by grouping loans based on similar risk characteristics under CECL, which is typically based on the loan’s collateral type. The Company regularly evaluates the risk characteristics of its loan portfolio to determine whether a different pooling methodology is more accurate. Further, if the Company determines that foreclosure of a loan’s collateral is probable or repayment of the loan is expected through sale or operation of the collateral and the borrower is experiencing financial difficulty, expected credit losses are measured as the difference between the current fair value of the collateral and the amortized cost of the loan. Fair value may be determined based on (i) the present value of estimated cash flows; (ii) the market price, if available; or (iii) the fair value of the collateral less estimated disposition costs.
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DECEMBER 31, 2020
While a loan exhibiting credit quality deterioration may remain on accrual status, the loan is placed on non-accrual status at such time as (i) management believes that scheduled debt service payments will not be met within the coming 12 months; (ii) the loan becomes 90 days past due; (iii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the credit deterioration; or (iv) the net realizable value of the loan’s underlying collateral approximates the Company’s carrying value for such loan. While on non-accrual status, the Company recognizes interest income only when an actual payment is received if a credit analysis supports the borrower’s principal repayment capacity. When a loan is placed on non-accrual, previously accrued interest is reversed from interest income.
The Company utilizes the contractual life of its loans to estimate the period over which it measures expected credit losses. Estimates for prepayments and extensions are incorporated into the inputs for the Company’s CECL model. Modifications to loan terms, such as a modification in connection with a troubled debt restructuring (“TDR”), where a concession is granted to a borrower experiencing financial difficulty, may result in the extension of the loan’s life and an increase in the allowance for credit losses. In March 2020, the Financial Accounting Standards Board (“FASB”) concurred with a joint statement of federal and state banking regulators that eased the requirements to classify a modification as a TDR if the modification was granted in connection with the effects of the COVID-19 pandemic. If the concession granted on a TDR can only be captured through a discounted cash flow analysis, then the Company will individually assess the loan for expected credit losses using the discounted cash flow method.
In order to calculate the historical mean loss ratio applied to the loan portfolio, the Company utilizes historical losses from its full underwriting history, along with the market loss history of a selected population of loans from a third party’s database that are similar to the Company’s loan types, loan sizes, durations, interest rate structure and general loan-to-collateral value (“LTV”) profiles. The Company may make adjustments to the historical loss history for qualitative or environmental factors if it believes there is evidence that the estimate for expected credit losses should be increased or decreased.
The Company records write-offs against the allowance for credit losses if it deems that all or a portion of a loan’s balance is uncollectible. If the Company receives cash in excess of some or all of the amounts it previously wrote off, it records the recovery by increasing the allowance for credit losses.
As part of the evaluation of the loan portfolio, the Company assesses the performance of each loan and assigns a risk rating based on the collective evaluation of several factors, including but not limited to: collateral performance relative to underwritten plan, time since origination, current implied and/or re-underwritten LTV ratios, risk inherent in the loan structure and exit plan. Loans are rated “1” through “5,” from less risk to greatest risk, in connection with this review.
Prior to the implementation of CECL, the Company calculated its allowance for credit losses through the calculation of general and specific reserves. The general reserve, established for loans not determined to be impaired individually, was based on the Company’s loan risk ratings. The Company recorded a general reserve equal to 1.5% of the aggregate face values of loans with a risk rating of “3,” plus 5.0% of the aggregate face values of loans with a risk rating of “4.” Loans with a risk rating of “5” were individually measured for impairment to be included in a specific reserve on a quarterly basis.
The Company considered a loan to be impaired if at least one of two conditions exists. The first condition was if, based on the Company’s evaluation as part of the loan risk rating process, management believed that a loss event had occurred that made it probable that the Company would be unable to collect all amounts due according to the contractual terms of the loan agreement. The second condition was that the loan was deemed to be a TDR. These TDRs may not have had an associated specific credit loss allowance if the principal and interest amount was considered recoverable based on market conditions, appraisals of the underlying collateral, expected collateral performance and/or guarantees made by the borrowers.
When a loan was impaired under either of these two conditions, the allowance for credit losses was increased by the amount of the excess of the amortized cost basis of the loan over its fair value. When a loan, or a portion thereof, was considered uncollectible and pursuit of collection was not warranted, the Company recorded a charge-off or write-down of the loan against the allowance for credit losses.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Investment in Real Estate
Acquired investments in real estate assets are recorded initially at fair value in accordance with U.S. GAAP. The Company allocates the purchase price of its acquired assets and assumed liabilities based on the relative fair values of the assets acquired and liabilities assumed.
Investments in real estate are carried net of accumulated depreciation. The Company depreciates real property and furniture, fixtures, and equipment using the straight-line method over the estimated useful lives of the assets. The Company amortizes any acquired intangible assets, including but not limited to franchise agreement and customer list assets, using the straight-line method over the estimated useful lives of the intangible assets. The Company amortizes the value allocated to lease right of use assets and related in-place lease liabilities, when determined to be operating leases, using the straight-line method over the remaining lease term. The value allocated to any associated above or below market lease intangible asset or liability is amortized to lease expense over the remaining lease term.
Ordinary repairs and maintenance are expensed as incurred. Costs related to the improvement of the real property are capitalized and depreciated over their useful lives.
The Company depreciates investments in real estate and amortizes intangible assets over the estimated useful lives of the assets as follows:
Assets and Liabilities Held for Sale
The Company classifies long-lived assets or a disposal group to be sold as held for sale in the period in which all of the following criteria are met:
•
management, having the authority to approve the action, commits to a plan to sell the asset or the disposal group;
•
the asset or disposal group is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets;
•
an active program to locate a buyer and other actions required to complete the plan to sell the asset or disposal group have been initiated;
•
the sale of the asset or disposal group is probable, and transfer of the asset or disposal group is expected to qualify for recognition as a completed sale within one year, except if events or circumstances beyond the Company’s control extend the period of time required to sell the asset or disposal group beyond one year;
•
the asset or disposal group is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and
•
actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
A long-lived asset or disposal group that is classified as held for sale is initially measured at the lower of its cost or fair value less any costs to sell. Any loss resulting from the transfer of long-lived assets or disposal groups to assets held for sale is recognized in the period in which the held for sale criteria are met. Legacy CRE loans included as assets held for sale were measured at the lower of cost or fair value on the date the legacy CRE loans were transferred to assets held for sale. Any specific loan loss reserves for legacy CRE loans transferred to assets held for sale were measured and charged off on the date of transfer, establishing a new cost basis for the loans.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The fair values of assets held for sale are assessed each reporting period and changes in such fair values are reported as an adjustment to the carrying value of the asset or disposal group with an offset to fair value adjustments on financial assets held for sale on the Company’s consolidated statements of operations, to the extent that any subsequent changes in fair value do not exceed the cost basis of the asset or disposal group.
Additionally, upon determining that a long-lived asset or disposal group meets the criteria to be classified as held for sale, the Company reports the assets and liabilities of the disposal group, if material, in the line items assets or liabilities held for sale, respectively, on the consolidated balance sheets.
Discontinued Operations
The results of operations of a component or a group of components of the Company that either has been disposed of or is classified as held for sale is reported in discontinued operations if the disposal represents a strategic shift that has or will have a major effect on the Company’s operations and financial results.
Comprehensive Income (Loss)
Comprehensive income (loss) for the Company includes net income and the change in net unrealized gains (losses) on available-for-sale securities and derivative instruments used to hedge exposure to interest rate fluctuations.
Income Taxes
The Company operates in such a manner as to qualify as a REIT under the provisions of the Internal Revenue Code of 1986, as amended (the “Code”); therefore, applicable REIT taxable income is included in the taxable income of its shareholders, to the extent distributed by the Company. To maintain REIT status for federal income tax purposes, the Company is generally required to distribute at least 90% of its REIT taxable income to its shareholders as well as comply with certain other qualification requirements as defined under the Code. As a REIT, the Company is not subject to federal corporate income tax to the extent that it distributes 100% of its REIT taxable income each year.
Taxable income, from non-REIT activities managed through the Company’s taxable REIT subsidiaries (“TRSs”), is subject to federal, state and local income taxes. The Company’s TRS’ income taxes are accounted for under the asset and liability method. Under the asset and liability method, deferred income taxes are recognized for the temporary differences between the financial reporting basis and tax basis of assets and liabilities. The Company evaluates the realizability of its deferred tax assets and liabilities and recognizes a valuation allowance if, based on available evidence, it is more likely than not that some or all of its deferred tax assets will not be realized. In evaluating the realizability of the deferred tax asset or liability, the Company will consider the expected future taxable income, existing and projected book to tax differences as well as tax planning strategies. This analysis is inherently subjective, as it is based on forecasted earning and business and economic activity. Changes in estimates of deferred tax asset realizability, if any, are included in income tax (expense) benefit on the consolidated statements of operations.
In addition, several of the Company’s foreign TRSs, are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands. Despite their status as TRSs, they generally will not be subject to corporate tax on their earnings and no provision for income taxes is required. However, because they are either controlled foreign corporations or passive foreign investment companies (in which the Company has made a Qualified Electing Fund election), the Company will generally be required to include its share of current taxable income from the foreign TRSs in its calculation of REIT taxable income.
The Company accounts for taxes assessed by a governmental authority that is directly imposed on a revenue-producing transaction (e.g., sales, use, value added) on a net (excluded from revenue) basis.
The Company established a full valuation allowance against its net deferred tax asset of approximately $62.9 million (tax effected $21.2 million) at December 31, 2020 as the Company believed it was more likely than not that all of the deferred tax assets would not be realized. This assessment was based on the Company’s cumulative historical losses and uncertainties as to the amount of taxable income that would be generated in future years in its TRSs.
The Company evaluates and recognizes tax positions only if it is more likely than not that the position will be sustained upon examination by the appropriate taxing authority. A tax position that meets this threshold is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies any tax penalties as other operating expenses and any interest as interest expense. The Company does not have any unrecognized tax benefits that would affect the Company’s financial position.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Stock Based Compensation
Issuances of restricted stock and options are initially measured at fair value on the grant date and expensed monthly on a straight-line basis over the service period to equity compensation expense on the consolidated statements of operations, with a corresponding entry to additional paid-in capital on the consolidated balance sheets. Effective January 1, 2019, in accordance with updated guidance under GAAP, the fair value of all unvested issuances of restricted stock and options is not remeasured after the initial grant date. Previously, the Company adjusted unvested issuances of restricted stock and options to the Manager and to non-employees quarterly to reflect changes in fair value.
Net Income (Loss) Per Share
The Company calculates basic income per share by dividing net income for the period by the weighted average number of shares of its common stock, including vested restricted stock and participating securities, outstanding for that period. Diluted income per share takes into account the effect of dilutive investments, such as stock options, unvested restricted stock and convertible notes, but uses the treasury stock method or average share price for the period in determining the number of incremental shares that are to be added to the weighted average number of shares outstanding.
Derivative Instruments
The Company’s policies permit it to enter into derivative contracts, including interest rate swaps and interest rate caps, to add stability to its interest expense and to manage its exposure to interest rate movements or other identified risks. The Company has designated these transactions as cash flow hedges. The contracts or hedge instruments are evaluated at inception and at subsequent consolidated balance sheet dates to determine if they qualify for hedge accounting, which requires that the Company recognize all derivatives on the consolidated balance sheets at fair value. The Company records changes in the estimated fair value of the derivative in other comprehensive income to the extent that it is effective. Any ineffective portion of a derivative’s change in fair value is immediately recognized in earnings.
Derivative assets and liabilities, are reported at fair value, and are valued by a third-party pricing agent using an income approach with models that use, as their primary inputs, readily observable market parameters. This valuation process considers factors including interest rate yield curves, time value, credit factors and volatility factors. Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy (See the discussion of the Fair Value Measurements policy that follows in the next section), the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by the Company and its counterparties. The Company assesses the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and, if material, categorizes those derivatives within Level 3 of the fair value hierarchy.
Fair Value Measurements
In analyzing the fair value of its investments accounted for on a fair value basis, the Company uses the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company determines fair value based on quoted prices when available or, if quoted prices are not available, through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment. The hierarchy defines three levels of inputs that may be used to measure fair value:
Level 1 - Quoted prices for identical instruments in active markets.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value inputs are observable.
Level 3 - Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable, for example, when there is little or no market activity for an investment at the end of the period, unobservable inputs may be used.
The level in the fair value hierarchy within which a fair value measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter; depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. Transfers between levels are determined by the Company at the end of the reporting period. However, the Company expects that changes in classifications between levels will be rare.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Recent Accounting Standards
Accounting Standards Adopted in 2020
In June 2016, the FASB issued guidance that changed how credit losses for most financial assets and certain other instruments that are measured at fair value through net income are determined. The new guidance replaced the incurred loss approach with a CECL model for instruments measured at amortized cost. For available-for-sale debt securities, the guidance requires recording allowances rather than reducing the carrying amount, as the Company was previously under the other-than-temporary impairment model. It also simplifies the accounting model for debt securities and loans with evidence of credit quality deterioration.
On January 1, 2020, the Company adopted the above-mentioned accounting guidance and recorded an initial CECL allowance of approximately $4.5 million, of which $3.0 million was recorded as a charge to retained earnings on such date. The estimated CECL reserve represented 0.25% of the aggregate outstanding principal balance of the Company’s $1.8 billion commercial loan portfolio at December 31, 2019. During the year ended December 31, 2020, the Company recorded an additional CECL reserve of $30.8 million for a total CECL reserve of $34.3 million, or 2.21% of the aggregate outstanding principal balance of the Company’s $1.5 billion commercial loan portfolio at December 31, 2020. The Company’s updated accounting policies in connection with this guidance are referenced above in the “Investment Securities,” “Investment Security Interest Income Recognition,” “Loans,” “Loan Interest Income Recognition,” and “Allowance for Credit Losses” sections. See Note 6 for additional disclosures in connection with the updated guidance.
In August 2018, the FASB issued guidance to modify the fair value measurement disclosure requirements, including: disclosures on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, the policy for timing of transfers between levels and the narrative description of measurement uncertainty. Adoption did not have a material impact on the Company’s consolidated financial statements.
Accounting Standards to be Adopted in Future Periods
In March 2020, the FASB issued guidance that provides optional expedients and exceptions to GAAP requirements for modifications on debt instruments, leases, derivatives and other contracts, related to the expected market transition from the London Interbank Offered Rate (“LIBOR”), and certain other floating-rate benchmark indices to alternative reference rates. The guidance generally considers contract modifications related to reference rate reform to be an event that does not require contract remeasurement at the modification date nor a reassessment of a previous accounting determination. The guidance is optional and may be elected over time, through December 31, 2022, as reference rate reform activities occur. The Company is in the process of evaluating the impact of this guidance.
In August 2020, the FASB issued guidance that removes certain separation models for convertible debt instruments and convertible preferred stock that require the separation into a debt component and an equity or derivative component. Consequently, a convertible debt instrument will be accounted for as a single liability measured at its amortized cost, as long as no other features require bifurcation and recognition as derivatives and the convertible instrument are not issued with substantial premiums accounted for as paid-in capital. By removing those separation models, the interest rate of convertible debt instruments typically will be closer to the coupon interest rate. The guidance also revises the derivative scope exception for contracts in an entity’s own equity and improves the consistency of EPS calculations. The guidance is effective for larger public business entities’ annual periods, and interim periods therein, beginning after December 15, 2021 and for smaller reporting entities after December 15, 2023. Early application is permitted for fiscal years beginning after December 15, 2020. The Company is in the process of evaluating the impact of this guidance.
NOTE 3 - VARIABLE INTEREST ENTITIES
The Company has evaluated its securities, loans, investments in unconsolidated entities, liabilities to subsidiary trusts issuing preferred securities (consisting of unsecured junior subordinated notes), securitizations, guarantees and other financial contracts in order to determine if they are variable interests in VIEs. The Company regularly monitors these legal interests and contracts and, to the extent it has determined that it has a variable interest, analyzes the related entity for potential consolidation.
Consolidated VIEs (the Company is the primary beneficiary)
Based on management’s analysis, the Company was the primary beneficiary of six and five VIEs at December 31, 2020 and 2019, respectively (for each period, collectively, the “Consolidated VIEs”).
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The Consolidated VIEs are CRE securitizations, CDOs and CLOs that were formed on behalf of the Company to invest in real estate-related securities, commercial mortgage-backed securities (“CMBS”), syndicated corporate loans, corporate bonds and ABS and were financed by the issuance of debt securities. By financing these assets with long-term borrowings through the issuance of debt securities, the Company seeks to generate attractive risk-adjusted equity returns and to match the term of its assets and liabilities. The primary beneficiary determination for each of these VIEs was made at each VIE’s inception and is continually assessed.
The Company has exposure to losses on its securitizations to the extent of its investments in the subordinated debt and preferred equity of each securitization. The Company is entitled to receive payments of principal and interest on the debt securities it holds and, to the extent revenues exceed debt service requirements and other expenses of the securitizations, distributions with respect to its preferred equity interests. As a result of consolidation, the debt and equity interests the Company holds in these securitizations have been eliminated, and the Company’s consolidated balance sheets reflect the assets held, debt issued by the securitizations to third parties and any accrued payables to third parties. The Company’s operating results and cash flows include the gross amounts related to the securitizations’ assets and liabilities as opposed to the Company’s net economic interests in the securitizations. Assets and liabilities related to the securitizations are disclosed, in the aggregate, on the Company’s consolidated balance sheets. For a discussion of the debt issued through the securitizations see Note 11.
Creditors of the Company’s Consolidated VIEs have no recourse to the general credit of the Company, nor to each other. During the years ended December 31, 2020, 2019 and 2018, the Company did not provide any financial support to any of its VIEs nor does it have any requirement to do so, although it may choose to do so in the future to maximize future cash flows on such investments by the Company. There are no explicit arrangements that obligate the Company to provide financial support to any of its Consolidated VIEs.
The following table shows the classification and carrying values of assets and liabilities of the Company’s Consolidated VIEs at December 31, 2020 (in thousands):
(1)
Excludes allowance for credit losses.
(2)
Assets of each of the Consolidated VIEs may only be used to settle the obligations of each respective VIE.
Unconsolidated VIEs (the Company is not the primary beneficiary, but has a variable interest)
Based on management’s analysis, the Company is not the primary beneficiary of the VIEs discussed below since it does not have both (i) the power to direct the activities that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb the losses of the VIE or the right to receive the benefits from the VIE, which could be significant to the VIE. Accordingly, the following VIEs are not consolidated in the Company’s financial statements at December 31, 2020. The Company continuously reassesses whether it is deemed to be the primary beneficiary of its unconsolidated VIEs. The Company’s maximum exposure to risk for each of these unconsolidated VIEs is set forth in the “Maximum Exposure to Loss” column in the table below.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Unsecured Junior Subordinated Debentures
The Company has a 100% interest in the common shares of Resource Capital Trust I (“RCT I”) and RCC Trust II (“RCT II”), respectively, with a value of $1.5 million in the aggregate, or 3.0% of each trust, at December 31, 2020. RCT I and RCT II were formed for the purposes of providing debt financing to the Company. The Company completed a qualitative analysis to determine whether or not it is the primary beneficiary of each of the trusts and determined that it was not the primary beneficiary of either trust because it does not have the power to direct the activities most significant to the trusts, which include the collection of principal and interest through servicing rights. Accordingly, neither trust is consolidated into the Company’s consolidated financial statements.
The Company records its investments in RCT I and RCT II’s common shares of $774,000 each as investments in unconsolidated entities using the cost method, recording dividend income when declared by RCT I and RCT II. The trusts each hold subordinated debentures, for which the Company is the obligor, in the amount of $25.8 million for each of RCT I and RCT II. The debentures were funded by the issuance of trust preferred securities of RCT I and RCT II.
Wells Fargo Commercial Mortgage Trust 2017-C40
In October 2017, the Company purchased 95% of the Class E, F, G, H and J certificates of Wells Fargo Commercial Mortgage Trust 2017-C40 (“C40”), a B-piece investment in a Wells Fargo Commercial Mortgage Securities, Inc., private-label, $705.4 million securitization. C-III Asset Management LLC (“C3AM”), a former related party, is the special servicer of C40. As of December 31, 2020, the Company continued to hold investments in the H and J certificates of C40. The Company determined that although its investment in C40 represented a variable interest, its investment did not provide the Company with a controlling financial interest. The Company accounts for its various investments in C40 as investment securities available-for-sale on its consolidated financial statements.
Prospect Hackensack JV LLC
In March 2018, the Company invested $19.2 million in the preferred equity of Prospect Hackensack JV LLC (“Prospect Hackensack”), a joint venture between the Company and an unrelated third party (“Managing Member”). Prospect Hackensack was formed for the purpose of acquiring and operating a multifamily CRE property. The Managing Member manages the daily operations of the property. The Company determined that although its investment in Prospect Hackensack represented a variable interest, its investment did not provide the Company with a controlling financial interest. The Company accounts for its investment in Prospect Hackensack’s preferred equity as a CRE loan on its consolidated financial statements.
WC Newhall MM, LLC
In June 2019, the Company invested $5.5 million in the preferred equity of WC Newhall MM, LLC (“Santa Clarita”), a joint venture between the Company and two unrelated third parties (“Sponsor Members”). Santa Clarita was formed for the purpose of refinancing a self-storage CRE property. The Sponsor Members manage the daily operations of the property. The Company determined that although its investment in Santa Clarita represented a variable interest, its investment did not provide the Company with a controlling financial interest. The Company accounts for its investment in Santa Clarita’s preferred equity as a CRE loan on its consolidated financial statements.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following table shows the classification, carrying value and maximum exposure to loss with respect to the Company’s unconsolidated VIEs at December 31, 2020 (in thousands):
(1)
The carrying values exclude the allowance for credit losses.
(2)
The Company’s investment in C40 is carried at fair value and its maximum exposure to loss is the amortized cost of the investment.
At December 31, 2020, there were no explicit arrangements or implicit variable interests that could require the Company to provide financial support to any of its unconsolidated VIEs.
NOTE 4 - SUPPLEMENTAL CASH FLOW INFORMATION
The following table summarizes the Company’s supplemental disclosure of cash flow information (in thousands):
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 5 - RESTRICTED CASH
The following table summarizes the Company’s restricted cash (in thousands):
NOTE 6 - LOANS
The following is a summary of the Company’s loans (dollars in thousands, except amounts in footnotes):
(1)
Amounts include unamortized loan origination fees of $5.7 million and $9.1 million and deferred amendment fees of $495,000 and $72,000 at December 31, 2020 and 2019, respectively. Additionally, the amounts include unamortized loan acquisition costs of $118,000 and $1.3 million at December 31, 2020 and 2019, respectively.
(2)
Maturity dates exclude contractual extension options, subject to the satisfaction of certain terms, that may be available to the borrowers.
(3)
Maturity dates exclude three whole loans, with amortized costs of $39.7 million, and one whole loan, with an amortized cost of $11.5 million, in maturity default at December 31, 2020 and 2019, respectively.
(4)
Maturity dates include two whole loans with original maturity dates in January 2021 that were granted one year extensions in January 2021.
(5)
Substantially all loans are pledged as collateral under various borrowings at December 31, 2020 and 2019.
(6)
Whole loans had $67.2 million and $98.0 million in unfunded loan commitments at December 31, 2020 and 2019, respectively. Preferred equity investments had $2.5 million and $3.0 million in unfunded commitments at December 31, 2020 and 2019, respectively. These unfunded loan commitments are advanced as the borrowers formally request additional funding and meet certain benchmarks, as permitted under the loan agreement, and any necessary approvals have been obtained.
(7)
The interest rate on the Company’s preferred equity investments each pay at 8.00%. The remaining interest is deferred until maturity.
(8)
Beginning in April 2023, the Company has the right to unilaterally force the sale of the Prospect Hackensack’s underlying property. Beginning in June 2022, the Company has the right to unilaterally force the sale of Santa Clarita’s underlying property.
(9)
The Company’s floating-rate CRE loan portfolio of $1.5 billion had a weighted-average one-month LIBOR floor of 1.88% at December 31, 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following is a summary of the contractual maturities of the Company’s CRE loans held for investment, at amortized cost (in thousands, except amounts in the footnotes):
(1)
Maturity dates exclude three whole loans, with amortized costs of $39.7 million, and one whole loan, with an amortized cost of $11.5 million, in maturity default at December 31, 2020 and 2019, respectively.
(2)
At December 31, 2020, the amortized costs of the CRE whole loans, summarized by contractual maturity assuming full exercise of the extension options, were $112.4 million, $125.1 million and $1.3 billion in 2021, 2022 and 2023 and thereafter, respectively. At December 31, 2019, the amortized costs of the CRE whole loans, summarized by contractual maturity assuming full exercise of the extension options, were $105.5 million, $68.0 million and $1.6 billion in 2020, 2021 and 2022 and thereafter, respectively.
At December 31, 2020, approximately 21.4%, 17.9% and 16.1% of the Company’s CRE loan portfolio was concentrated in the Mountain, Southwest and Southeast regions, respectively, based on carrying value, as defined by the National Council of Real Estate Investment Fiduciaries. At December 31, 2019, approximately 19.5%, 19.4% and 17.6% of the Company’s CRE loan portfolio was concentrated in the Mountain, Southwest and Southeast regions, respectively, based on carrying value.
Principal Paydowns Receivable
Principal paydowns receivable represents loan principal payments that have been received by the Company’s servicers and trustees but have not been remitted to the Company. At December 31, 2020, the Company had $4.3 million of loan principal paydowns receivable, all of which was received in cash by the Company during January 2021. At December 31, 2019, the Company had $19.5 million of loan principal paydowns receivable, all of which was received by the Company during January 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 7 - FINANCING RECEIVABLES
The following tables show the activity in the allowance for credit losses for the years ended December 31, 2020 and 2019 and the allowance for credit losses and recorded investments in loans at December 31, 2020 and 2019 (in thousands, except amount in the footnotes):
(1)
The Company’s mezzanine loan and preferred equity investments were evaluated individually for impairment during the year ended December 31, 2019 and were determined to have no evidence of impairment.
(2)
Excludes the recovery of credit losses on one bank loan with no amortized cost or carrying value at December 31, 2020 and 2019 that received a payment of approximately $1,000 during the year ended December 31, 2019.
(3)
The allowance for credit losses included a realized loss of $997,000 that was charged to the allowance related to one CRE loan sale that occurred during the year ended December 31, 2020. There was no such charge off as of December 31, 2019.
During the year ended December 31, 2020, expected losses in the portfolio were negatively impacted by higher than expected unemployment and increased volatility in CRE asset pricing and liquidity in connection with the COVID-19 pandemic.
During the year ended December 31, 2020, the Company individually evaluated a hotel loan in the Northeast region with a $37.9 million principal balance for which foreclosure was determined to be probable. In November 2020, as a result of discussions with the borrower, the Company received the deed in lieu of foreclosure on the property. In conjunction with receiving the deed in lieu of foreclosure, the Company obtained an updated appraisal that indicated an as-is appraised value of $39.8 million (See Note 8) and consequently reversed the $8.0 million CECL allowance that was previously established for the loan that was based on the estimated sales value of the collateral, less estimated costs to sell.
Also at December 31, 2020, the Company individually evaluated a loan on an office property in the North East Central region with a $19.9 million principal balance and a hotel loan in the Northeast region with a $14.0 million par balance for which foreclosure was determined to be probable. The Company determined that these loans had CECL allowances of $1.9 million and $0, respectively, calculated as the difference between the as-is appraised values and the loans’ amortized costs.
In June 2020, the Company sold one CRE whole loan note for $17.4 million, which resulted in a realized loss of $1.0 million recorded in the provision for credit losses during the year ended December 31, 2020.
Credit quality indicators
Commercial Real Estate Loans
CRE loans are collateralized by a diversified mix of real estate properties and are assessed for credit quality based on the collective evaluation of several factors, including but not limited to: collateral performance relative to underwritten plan, time since origination, current implied and/or re-underwritten LTV ratios, loan structure and exit plan. Depending on the loan’s performance against these various factors, loans are rated on a scale from 1 to 5, with loans rated 1 representing loans with the highest credit quality and loans rated 5 representing loans with the lowest credit quality. The factors evaluated provide general criteria to monitor credit migration in the Company’s loan portfolio; as such, a loan’s rating may improve or worsen, depending on new information received.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The criteria set forth below should be used as general guidelines and, therefore, not every loan will have all of the characteristics described in each category below.
Risk Rating
Risk Characteristics
• Property performance has surpassed underwritten expectations.
• Occupancy is stabilized, the property has had a history of consistently high occupancy, and the property has a diverse and high quality tenant mix.
• Property performance is consistent with underwritten expectations and covenants and performance criteria are being met or exceeded.
• Occupancy is stabilized, near stabilized or is on track with underwriting.
• Property performance lags behind underwritten expectations.
• Occupancy is not stabilized and the property has some tenancy rollover.
• Property performance significantly lags behind underwritten expectations. Performance criteria and loan covenants have required occasional waivers.
• Occupancy is not stabilized and the property has a large amount of tenancy rollover.
• Property performance is significantly worse than underwritten expectations. The loan is not in compliance with loan covenants and performance criteria and may be in default. Expected sale proceeds would not be sufficient to pay off the loan at maturity.
• The property has a material vacancy rate and significant rollover of remaining tenants.
• An updated appraisal is required upon designation and updated on an as-needed basis.
All CRE loans are evaluated for any credit deterioration by debt asset management and certain finance personnel on at least a quarterly basis. Mezzanine loans and preferred equity investments may experience greater credit risks due to their nature as subordinated investments.
For the purpose of calculating the quarterly provision for credit losses under CECL, the Company pools CRE loans based on the underlying collateral property type and utilizes a probability of default and loss given default methodology for approximately one year after which it immediately reverts to a historical mean loss ratio.
Credit risk profiles of CRE loans at amortized cost were as follows (in thousands, except amounts in footnotes):
(1)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019, respectively.
(2)
The Company’s mezzanine loan and preferred equity investments were evaluated individually for impairment at December 31, 2019.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Credit risk profiles of CRE loans by origination year at amortized cost were as follows (in thousands, except amounts in footnotes):
(1)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019, respectively.
(2)
Acquired CRE whole loans are grouped within each loan’s year of issuance.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Loan Portfolios Aging Analysis
The following table presents the CRE loan portfolio aging analysis as of the dates indicated for CRE loans at amortized cost (in thousands, except amounts in footnotes):
(1)
Includes one whole loan, with an amortized cost of $11.4 million and $11.5 million, that was in maturity default at December 31, 2020 and 2019, respectively. The loan is performing with respect to debt service at December 31, 2020 and 2019. During the years ended December 31, 2020, 2019 and 2018, the Company recognized interest income of $670,000, $747,000 and $621,000, respectively, on this whole loan.
(2)
Includes two whole loans that entered maturity default in December 2020, with total amortized costs of $28.3 million at December 31, 2020.
(3)
The total amortized cost of CRE loans excluded accrued interest receivable of $7.3 million and $6.7 million at December 31, 2020 and 2019, respectively.
At December 31, 2020 and 2019, the Company had three and one CRE loans, respectively, in maturity default with total amortized costs of $39.7 million and $11.5 million, respectively.
In the fourth quarter of 2020, the sponsor of the Company’s $6.5 million preferred equity investment in a self-storage CRE property located in Southern California did not make its October and November senior loan debt service payments constituting an event of default under the related senior loan documents. As of December 31, 2020, the Company was notified that the senior loan debt service was brought current.
Troubled-Debt Restructurings
The following table summarizes TDRs during the year ended December 31, 2020 (dollars in thousands):
(1)
In November 2020, the Company received the deed in lieu of foreclosure on one loan that underwent a troubled debt restructuring in the third quarter 2020 (See Note 8).
During the year ended December 31, 2020, the Company entered into 18 extension agreements that had a weighted average period of 10 months and 13 forbearance agreements that had a weighted average period of five months. As of December 31, 2020, 25 borrowers received payment timing relief in connection with these agreements. Three borrowers with formerly forborne interest are now current and two borrowers continue to perform in accordance with their forbearance agreements at December 31, 2020. Two formerly forborne borrowers and one borrower performing in accordance with a forbearance agreement were in maturity default at December 31, 2020. Except as previously disclosed, no other loan modifications during the year ended December 31, 2020 resulted in TDRs.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 8 - INVESTMENT IN REAL ESTATE AND OTHER ACQUIRED ASSETS AND ASSUMED LIABILITIES
In November 2020, the Company received the deed in lieu of foreclosure on a hotel property that formerly collateralized a $38.0 million CRE whole loan. The Company determined that the acquisition of the hotel property should be accounted for as an asset acquisition. The Company obtained third-party valuations of the acquired assets and assumed liabilities. The fair value of the total net assets acquired was $39.8 million, which resulted in the recognition of a $1.6 million gain on conversion recorded on the Company’s consolidated statements of operations.
The following table summarizes the acquisition date value of the acquired assets and liabilities (in thousands):
(1)
Right of use assets include a right of use asset associated with an acquired ground lease of $3.1 million accounted for as an operating lease and a below-market lease intangible asset of $2.5 million at December 31, 2020.
(2)
Intangible assets include a franchise agreement intangible of $2.8 million and a customer list intangible asset of $477,000 at December 31, 2020.
The following table summarizes the book value of the Company’s investments in real estate and related intangible assets (in thousands, except amounts in the footnotes):
(1)
Includes approximately $5,000 of furniture and fixtures purchased for the property subsequent to the date of acquisition, in December 2020.
(2)
Right of use assets include a right of use asset associated with an acquired ground lease of $3.1 million accounted for as an operating lease and a below-market lease intangible asset of $2.5 million at December 31, 2020.
(3)
Intangible assets include a franchise agreement intangible of $2.8 million and a customer list intangible asset of $477,000 at December 31, 2020.
The right of use assets and lease liabilities comprised a ground lease acquired, determined to be an operating lease. The lease payments consist of air rights rent, retail rent and parking rent, the amounts of which are specifically determined in the executed lease agreement and subsequently increased based on the increase of the consumer price index over a specified amount of periods. The Company recorded approximately $6,000 of offsetting amortization and accretion on its right of use assets and lease liabilities during the year ended December 31, 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
During the year ended December 31, 2020, the Company recorded amortization expense of approximately $47,000 on its intangible assets. The Company expects to record amortization expense of $375,000, $375,000, $355,000, $210,000 and $210,000 during the 2021, 2022, 2023, 2024 and 2025 fiscal years, respectively, on its intangible assets.
NOTE 9 - INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The following table summarizes the Company’s investment securities available-for-sale, including those pledged as collateral (in thousands, except amounts in the footnote):
(1)
The amortized cost of CMBS excluded accrued interest receivable of $56,000 and $1.1 million at December 31, 2020 and 2019, respectively.
(2)
At December 31, 2019, investment securities available-for-sale with fair values of $466.9 million were pledged as collateral under related financings. There were no investment securities available-for-sale pledged as collateral at December 31, 2020.
Beginning in the first quarter of 2020, the COVID-19 pandemic produced material and previously unforeseeable liquidity shocks to credit markets. This resulted in significant declines in the pricing of the Company’s investment securities available-for-sale, which triggered substantial margin calls by its counterparties and, in certain cases, formal notices of events of default, all of which were withdrawn or rescinded as of April 19, 2020 (see Note 11). As a result of these circumstances and the uncertainty caused by the COVID-19 pandemic, substantially all of the Company’s remaining CMBS available-for-sale were sold as of April 2020.
During the year ended December 31, 2020, the Company incurred losses of $186.4 million on its CMBS portfolio, including realized losses of $180.3 million in connection with the sale of 67 CMBS, with total amortized cost of $401.3 million. The remaining unrealized losses of $6.1 million, were recorded on two securities that previously had fair values below the amortized cost bases and expected to be sold prior to the recovery of their cost bases with an offsetting charge directly to the amortized cost bases of the securities. Write-offs on these two securities are being recognized in earnings.
During the twelve months ended December 31, 2019, the Company sold one CMBS position resulting in proceeds of $638,000 and a realized gain of $4,000.
Prior to the adoption of the CECL standard on January 1, 2020, the Company measured its investment securities available-for-sale for other-than-temporary impairment. The Company recognized no other-than-temporary impairments on the investment securities available-for-sale during the year ended December 31, 2019.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 10 - INVESTMENTS IN UNCONSOLIDATED ENTITIES
The following table summarizes the Company’s investments in unconsolidated entities at December 31, 2020 and 2019 and equity in earnings of unconsolidated entities for the years ended December 31, 2020, 2019 and 2018 (dollars in thousands, except amount in the footnotes):
(1)
In December 2018, Pelium Capital Partners, L.P. was fully liquidated.
(2)
In December 2018, RCM Global LLC was fully liquidated.
(3)
The Company’s investment in LEAF Commercial Capital, Inc. (“LCC”) liquidated in July 2017 as a result of the sale of LCC. Earnings for the year ended December 31, 2018 were related to the receipt of a distribution of funds formerly held in escrow accounts established as part of the sale.
(4)
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
During the years ended December 31, 2020, 2019 and 2018, dividends from the investments in RCT I and RCT II’s common shares were recorded in other revenue. See Note 11 for the disclosures on the associated unsecured junior subordinated debentures.
NOTE 11 - BORROWINGS
The Company historically has financed the acquisition of its investments, including investment securities and loans, through the use of secured and unsecured borrowings in the form of securitized notes, repurchase agreements, secured term warehouse financing facilities, a senior secured financing facility, senior unsecured notes, convertible senior notes and trust preferred securities issuances. Certain information with respect to the Company’s borrowings is summarized in the following table (dollars in thousands, except amounts in footnotes):
(1)
Principal outstanding includes accrued interest payable of $16,000 and $810,000 at December 31, 2020 and 2019, respectively.
(2)
Principal outstanding includes accrued interest payable of $470,000 and at December 31, 2019.
Securitizations
The following table sets forth certain information with respect to the Company’s consolidated securitizations at December 31, 2020 (in thousands):
(1)
The designated principal reinvestment period is the period in which principal repayments can be utilized to purchase loans held outside of the respective securitization that represent the funded commitments of existing collateral in the respective securitization that were not funded as of the date the respective securitization was closed.
(2)
A designated principal reinvestment period is excluded from the terms of Exantas Capital Corp. 2020-RSO9, Ltd.’s (“XAN 2020-RSO9”) indenture. XAN 2020-RSO9 includes a future advances reserve account of $18.6 million at December 31, 2020 to fund unfunded commitments, which is reported in restricted cash on the consolidated balance sheet.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The investments held by the Company’s securitizations collateralize the securitizations’ borrowings and, as a result, are not available to the Company, its creditors, or stockholders. All senior notes of the securitizations held by the Company at December 31, 2020 and 2019 were eliminated in consolidation.
RCC 2017-CRE5
In July 2017, the Company closed Resource Capital Corp. 2017-CRE5, Ltd. (“RCC 2017-CRE5”), a $376.7 million CRE securitization transaction that provided financing for transitional CRE loans. In May 2019, the Company paid off all of the outstanding third-party owned senior notes from the payoff proceeds of certain of the securitization’s assets. In July 2019, the Company exercised the optional redemption feature of the securitization.
XAN 2018-RSO6
In June 2018, the Company closed Exantas Capital Corp. 2018-RSO6, Ltd. (“XAN 2018-RSO6”), a $514.2 million CRE securitization transaction that provided financing for transitional CRE loans. In September 2020, the Company executed the optional liquidation of XAN 2018-RSO6, and all of the outstanding senior notes were paid off from the sales proceeds of certain of the securitization’s assets.
XAN 2019-RSO7
In April 2019, the Company closed Exantas Capital Corp. 2019-RSO7, Ltd. (“XAN 2019-RSO7”), a $687.2 million CRE debt securitization transaction that provided financing for CRE loans. XAN 2019-RSO7 issued a total of $585.8 million of non-recourse, floating-rate notes at par, of which ACRES RF purchased $10.0 million, or approximately 20.4%, of the Class D notes. Additionally, ACRES RF purchased 100% of the Class E and Class F notes and a subsidiary of ACRES RF purchased 100% of the outstanding preference shares. The notes purchased by ACRES RF are subordinated in right of payment to all other senior notes issued by XAN 2019-RSO7, but are senior in right of payment to the preference shares. The preference shares are subordinated in right of payment to all other securities issued by XAN 2019-RSO7.
At closing, the senior notes issued to investors consisted of the following classes: (i) $390.0 million of Class A notes bearing interest at one-month LIBOR plus 1.00%, increasing to 1.25% in April 2024; (ii) $70.4 million of Class A-S notes bearing interest at one-month LIBOR plus 1.50%, increasing to 1.75% in April 2024; (iii) $33.5 million of Class B notes bearing interest at one-month LIBOR plus 1.70%, increasing to 2.20% in May 2024; (iv) $42.9 million of Class C notes bearing interest at one-month LIBOR plus 2.05%, increasing to 2.55% in June 2024; and (v) $49.0 million of Class D notes bearing interest at one-month LIBOR plus 2.70% increasing to 3.20% in July 2024.
All of the notes issued mature in April 2036, although the Company has the right to call the notes any time after May 2021. Principal repayments received, after closing and ending in April 2022, may be used to purchase funding participations with respect to existing collateral held outside of the securitization.
XAN 2020-RSO8
In March 2020, the Company closed Exantas Capital Corp. 2020-RSO8, Ltd. (“XAN 2020-RSO8”), a $522.6 million CRE debt securitization transaction that provided financing for CRE loans. XAN 2020-RSO8 issued a total of $435.7 million of non-recourse, floating-rate notes at par, of which ACRES RF purchased 100% of the Class D and Class E notes. The Company’s investments in the Class D and Class E notes were financed by CMBS short-term repurchase agreements and were sold in conjunction with the disposition of the Company’s CMBS portfolio in April 2020 (See Note 9). Additionally, ACRES RF purchased 100% of the Class F and Class G notes and a subsidiary of ACRES RF purchased 100% of the outstanding preference shares. The notes purchased by ACRES RF are subordinated in right of payment to all other senior notes issued by XAN 2020-RSO8, but are senior in right of payment to the preference shares. The preference shares are subordinated in right of payment to all other securities issued by XAN 2020-RSO8.
At closing, the senior notes issued to investors consisted of the following classes: (i) $295.3 million of Class A notes bearing interest at one-month LIBOR plus 1.15%, increasing to 1.40% in November 2024; (ii) $39.2 million of Class A-S notes bearing interest at one-month LIBOR plus 1.45%, increasing to 1.70% in December 2024; (iii) $26.1 million of Class B notes bearing interest at one-month LIBOR plus 1.75%, increasing to 2.25% in January 2025; (iv) $32.7 million of Class C notes bearing interest at one-month LIBOR plus 2.15%, increasing to 2.65% in January 2025; (v) $26.1 million of Class D notes bearing interest at one-month LIBOR plus 2.50%, increasing to 3.00% in February 2025; and (vi) $16.3 million of Class E notes bearing interest at one-month LIBOR plus 2.80%, increasing to 3.30% in February 2025.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
All of the notes issued mature in March 2035, although the Company has the right to call the notes any time after March 2022. Principal repayments received, after closing and ending in March 2023, may be used to purchase funding participations with respect to existing collateral held outside of the securitization.
XAN 2020-RSO9
In September 2020, the Company closed XAN 2020-RSO9, a $297.0 million CRE debt securitization transaction that provided financing for CRE loans. XAN 2020-RSO9 issued a total of $245.8 million of non-recourse, floating-rate notes to third parties at par. Additionally, ACRES RF retained 100% of the Class E and Class F notes and a subsidiary of ACRES RF retained 100% of the outstanding preference shares. The notes purchased by ACRES RF are subordinated in right of payment to all other senior notes issued by XAN 2020-RSO9, but are senior in right of payment to the preference shares. The preference shares are subordinated in right of payment to all other securities issued by XAN 2020-RSO9.
At closing, the senior notes issued to investors consisted of the following classes: (i) $158.9 million of Class A notes bearing interest at one-month LIBOR plus 2.50%, increasing to 2.75% in June 2024; (ii) $26.7 million of Class A-S notes bearing interest at one-month LIBOR plus 3.50%, increasing to 3.75% in July 2025; (iii) $16.7 million of Class B notes bearing interest at one-month LIBOR plus 3.90%, increasing to 4.40% in July 2025; (iv) $20.8 million of Class C notes bearing interest at one-month LIBOR plus 4.25%, increasing to 4.75% in August 2025; and (v) $22.7 million of Class D notes bearing interest at one-month LIBOR plus 5.50%, increasing to 6.00% in August 2025.
All of the notes issued mature in April 2037, although the Company has the right to call the notes any time after September 2022.
Corporate Debt
Unsecured Junior Subordinated Debentures
During 2006, the Company formed RCT I and RCT II for the sole purpose of issuing and selling capital securities representing preferred beneficial interests. RCT I and RCT II are not consolidated into the Company’s consolidated financial statements because the Company is not deemed to be the primary beneficiary of these entities. In connection with the issuance and sale of the capital securities, the Company issued junior subordinated debentures to RCT I and RCT II of $25.8 million each, representing the Company’s maximum exposure to loss. The debt issuance costs associated with the junior subordinated debentures for RCT I and RCT II were included in borrowings and were amortized into interest expense on the consolidated statements of operations using the effective yield method over a ten year period.
There were no unamortized debt issuance costs associated with the junior subordinated debentures for RCT I and RCT II outstanding at December 31, 2020 and 2019. The interest rates for RCT I and RCT II, at December 31, 2020, were 4.19% and 4.16%, respectively. The interest rates for RCT I and RCT II, at December 31, 2019, were 5.91% and 5.89%, respectively.
The rights of holders of common securities of RCT I and RCT II are subordinate to the rights of the holders of capital securities only in the event of a default; otherwise, the common securities’ economic and voting rights are pari passu with the capital securities. The capital and common securities of RCT I and RCT II are subject to mandatory redemption upon the maturity or call of the junior subordinated debentures held by each. Unless earlier dissolved, RCT I will dissolve in May 2041 and RCT II will dissolve in September 2041. The junior subordinated debentures are the sole assets of RCT I and RCT II, which mature in June 2036 and October 2036, respectively, and may currently be called at par.
4.50% Convertible Senior Notes and 8.00% Convertible Senior Notes
The Company issued $100.0 million aggregate principal of its 8.00% convertible senior notes due 2020 (“8.00% Convertible Senior Notes”) and $143.8 million aggregate principal of its 4.50% convertible senior notes due 2022 (“4.50% Convertible Senior Notes”) in January 2015 and August 2017, respectively. In conjunction with the issuance of the 4.50% Convertible Senior Notes, the Company extinguished $78.8 million aggregate principal of its 8.00% Convertible Senior Notes. In January 2020, the 8.00% Convertible Senior Notes were paid off upon maturity.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following table summarizes the 4.50% Convertible Senior Notes at December 31, 2020 (dollars in thousands, except the conversion prices and amounts in the footnotes):
(1)
Includes the amortization of the market discounts and deferred debt issuance costs, if any, for the 4.50% Convertible Senior Notes recorded in interest expense on the consolidated statements of operations.
(2)
During the years ended December 31, 2020 and 2019 the effective interest rate for the 4.50% Convertible Senior Notes was 7.43%.
(3)
Represents the number of shares of common stock per $1,000 principal amount of the 4.50% Convertible Senior Notes’ principal outstanding, subject to adjustment as provided in the Third Supplemental Indenture (the “4.50% Convertible Senior Notes Indenture”).
(4)
The conversion rate and conversion price of the 4.50% Convertible Senior Notes at December 31, 2020 are adjusted to reflect quarterly cash dividends in excess of a $0.30 dividend threshold, as defined in the 4.50% Convertible Senior Notes Indenture.
The 4.50% Convertible Senior Notes are convertible at the option of the holder at any time up until one business day before the maturity date and may be settled in cash, the Company’s common stock or a combination of cash and the Company’s common stock, at the Company’s election. The Company may not redeem the 4.50% Convertible Senior Notes prior to maturity. The closing price of the Company’s common stock was $11.97 on December 31, 2020, which did not exceed the conversion price of its 4.50% Convertible Senior Notes at December 31, 2020.
Senior Unsecured Notes
12.00% Senior Unsecured Notes Due 2027
On July 31, 2020, the Company entered into a Note and Warrant Purchase Agreement (the “Note and Warrant Purchase Agreement”) with Oaktree Capital Management, L.P. (“Oaktree”) and Massachusetts Mutual Life Insurance Company (“MassMutual”) pursuant to which the Company may issue to Oaktree and MassMutual from time to time up to $125.0 million aggregate principal amount of 12.00% senior unsecured notes due 2027 (the “Senior Unsecured Notes due 2027”). The Senior Unsecured Notes due 2027 have an annual interest rate of 12.00%, payable up to 3.25% (at the election of the Company) as pay-in-kind interest and the remainder as cash interest. On July 31, 2020, the Company issued to Oaktree $42.0 million aggregate principal amount of the Senior Unsecured Notes due 2027. In addition, on July 31, 2020, the Company issued to MassMutual $8.0 million aggregate principal amount of the Senior Unsecured Notes due 2027. The Company recorded a discount of $3.1 million (the offset of which was recorded in additional paid-in capital) on the Senior Unsecured Notes due 2027 that reflects the difference between the proceeds received less the fair value of the notes as if they were issued without the detachable warrants. The market discounts and deferred debt issuance costs are amortized into interest expense on the consolidated statements of operations on an effective interest basis over the period ending in July 2027. The effective interest rate is 13.65%. At any time and from time to time prior to January 31, 2022, the Company may elect to issue to Oaktree and MassMutual up to $75.0 million aggregate principal amount of additional Senior Unsecured Notes due 2027.
The Note and Warrant Purchase Agreement contains events of default, subject to certain materiality thresholds and grace periods.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Senior Secured Financing Facility, Term Warehouse Financing Facilities and Repurchase Agreements
Borrowings under the Company’s senior secured financing facility, term warehouse facilities and repurchase agreements are guaranteed by the Company or one or more of its subsidiaries. The following table sets forth certain information with respect to the Company’s senior secured financing facility, term warehouse facilities and repurchase agreements (dollars in thousands, except amounts in footnotes):
(1)
Includes $4.0 million of deferred debt issuance costs at December 31, 2020 on the senior secured financing facility.
(2)
Outstanding borrowings include accrued interest payable.
(3)
Includes $607,000 of deferred debt issuance costs at December 31, 2019.
(4)
Includes $817,000 of deferred debt issuance costs at December 31, 2019.
(5)
Includes $1.3 million and $1.3 million of deferred debt issuance costs at December 31, 2020 and 2019, respectively, which includes $678,000 of deferred debt issuance costs at December 31, 2020 from other term warehouse financing facilities with no balance.
The following table shows information about the amount at risk under the warehouse financing facilities (dollars in thousands):
(1)
Equal to the total of the estimated fair value of securities or loans sold and accrued interest receivable, minus the total of the warehouse financing agreement liabilities and accrued interest payable.
The Company was in compliance with all financial covenants in each of the respective agreements at December 31, 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Senior Secured Financing Facility
On July 31, 2020, an indirect, wholly owned subsidiary (“Holdings”), along with its direct wholly owned subsidiary (the “Borrower”), of the Company entered into a $250.0 million Loan and Servicing Agreement (the “MassMutual Loan Agreement”) with MassMutual and the other lenders party thereto (the “Lenders”). The asset-based revolving loan facility (the “MassMutual Facility”) provided under the MassMutual Loan Agreement will be used to finance the Company’s core CRE lending business. The MassMutual Facility has an interest rate of 5.75% per annum payable monthly. The MassMutual Facility matures on July 31, 2027. The Company paid a commitment fee as well as other reasonable closing costs. The loans under the MassMutual Facility are available for drawing during the first two years of the MassMutual Facility (the “Availability Period”). During the Availability Period, an unused commitment fee of 0.50% per annum (payable monthly) on unused commitments under the MassMutual Loan Agreement is payable for each day on which less than 75% of the total commitment is drawn.
Pursuant to the MassMutual Loan Agreement, the Borrower’s obligations under the MassMutual Loan Agreement are secured by the Borrower’s assets and Holdings’ equity interests in the Borrower, including all distributions, proceeds and profits from Holdings’ interests in the Borrower.
In September 2020, the MassMutual Loan Agreement was amended pursuant to which (i) the initial portfolio assets were revised and an agreed advance rate for each initial portfolio asset (each, an “Initial Portfolio Asset Advance Rate”) was set, and (ii) the revolving loan facility under the MassMutual Loan Agreement was amended to require the initial lender (currently MassMutual) to provide a specific advance rate for any future eligible portfolio assets and to limit the aggregate total amount of advances outstanding at any time to both the total facility amount and, in lieu of a 55% LTV, a borrowing base as of any required date of determination equal to the sum of, in each case, the product of the advance rate for such eligible portfolio asset (including in respect of the initial portfolio assets, the applicable Initial Portfolio Asset Advance Rate therefor) and the then determined value of such eligible portfolio asset.
In connection with the MassMutual Loan Agreement, the Company entered into a Guaranty (the “MassMutual Guaranty”) among the Company, Exantas Real Estate Funding 2018-RSO6 Investor, LLC (“RSO6”), Exantas Real Estate Funding 2019-RSO7 Investor, LLC (“RSO7”), and Exantas Real Estate Funding 2020-RSO8 Investor, LLC (collectively with RSO6 and RSO7, the “Additional Subsidiaries”), each an indirect, wholly owned subsidiary of the Company, in favor of the secured parties under the MassMutual Loan Agreement. Pursuant to the MassMutual Guaranty, the Company fully guaranteed all payments and performance of Holdings and the Borrower under the MassMutual Loan Agreement. Additionally, the Company and the Additional Subsidiaries made certain representations and warranties and agreed to not incur debt or liens, each subject to certain exceptions, and agreed to provide the Lenders with certain information.
The MassMutual Loan Agreement contains events of default, subject to certain materiality thresholds and grace periods, customary for this type of financing arrangement. The remedies for such events of default are also customary for this type of transaction.
CRE - Term Warehouse Financing Facilities
In February 2012, a wholly-owned subsidiary entered into a master repurchase and securities agreement (the “2012 Facility”) with Wells Fargo Bank, N.A. (“Wells Fargo”) to finance the origination of CRE loans. In July 2018, the subsidiary entered into an amended and restated master repurchase agreement (the “2018 Facility”), in exchange for an extension fee and other reasonable costs, that maintained the $400.0 million maximum facility amount and extended the term of the facility to July 2020 with three one-year extension options exercisable at the Company’s discretion. In May 2019, the Company executed an amendment of the 2018 Facility, amending certain terms to add an available loan servicer and to update references in connection with an amended fee letter. In May 2020, Wells Fargo revised the minimum equity financial covenant required of the Company as of March 31, 2020 and provided a framework to avoid credit-based markdowns for approximately four months, ending September 4, 2020. In July 2020 and September 2020, the maturity date of the 2018 Facility was extended to September 3, 2020 and October 3, 2020, respectively. In October 2020, the 2018 Facility was amended, at the Company’s request, to reduce the 2018 Facility’s maximum amount from $400.0 million to $250.0 million, extend the funding expiration date and revise covenant definitions so that credit losses are determined in accordance with a risk rating-based methodology. In connection with the amendment of the 2018 Facility, the Company exercised the first of three options to extend the termination date for a one year period thereby extending the maturity date to October 2, 2021. The 2018 Facility charges interest rates of one-month LIBOR plus spreads from 1.75% to 2.50%.
The 2018 Facility, consistent with the 2012 Facility, contains customary events of default. The remedies for such events of default are also customary for this type of transaction and include the acceleration of all obligations of the Company to repay the purchase price for purchased assets.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The 2018 Facility, consistent with the 2012 Facility, also contains margin call provisions relating to a decline in the market value of a security. Under these circumstances, Wells Fargo may require the Company to transfer cash in an amount sufficient to eliminate any margin deficit resulting from such a decline.
Consistent with the guaranty agreement dated February 2012, the Company continues to guarantee the payment and performance of its subsidiaries’ obligations to the lender through an amended and restated guaranty agreement dated in July 2018 (the “2018 Guaranty”), including all reasonable expenses that are incurred by the lender in connection with the enforcement of the 2018 Facility. The 2018 Guaranty includes covenants that, among other requirements, stipulate certain thresholds, including: required liquidity, required capital, total indebtedness to total equity, EBITDA to interest expense and total indebtedness.
In April 2018, the Company’s indirect wholly-owned subsidiary entered into a master repurchase agreement (the “Barclays Facility”) with Barclays Bank PLC (“Barclays”) to finance the origination of CRE loans. In connection with the Barclays Facility, the Company entered into a guaranty agreement (the “Barclays Guaranty”) pursuant to which the Company fully guaranteed all payments and performance under the Barclays Facility. In May 2020, the Company entered into an amendment to the Barclays Guaranty that revised its minimum equity financial covenant as of March 1, 2020. Barclays also provided a framework to avoid credit-based markdowns for approximately four months, ending August 31, 2020. In October 2020, the Company entered into an amendment to the Barclays Guaranty that revised a covenant definition so that credit losses are determined in accordance with a risk rating-based methodology. The Barclays Facility has a maximum facility amount of $250.0 million, charges interest of one-month LIBOR plus a spread between 2.00% and 2.50% and matures in April 2021, subject to certain one-year extension options in accordance with the facility’s terms. In March 2021, the Company amended the Barclays Facility to extend the revolving period through October 2021.
The Barclays Facility contains margin call provisions that provide Barclays with certain rights when there has been a decline in the value of purchased assets. Under these circumstances, Barclays may require the Company to transfer cash in an amount necessary to eliminate such margin deficit or repurchase the asset that resulted in the margin call.
In connection with the Barclays Facility, the Company fully guaranteed all payments and performance under the Barclays Facility pursuant to a guaranty agreement (the “Barclays Guaranty”). The Barclays Guaranty includes certain financial covenants required of the Company, including required liquidity, required capital, ratios of total indebtedness to equity and EBITDA requirements. Also, ACRES RF, the direct owner of the wholly-owned subsidiary borrower, executed a pledge and security agreement with Barclays whereby it agreed to pledge and grant to Barclays a continuing security interest in any and all of its right, title and interest in and to the wholly-owned subsidiary, including all distributions, proceeds, payments, income and profits from its interests in the wholly-owned subsidiary.
The Barclays Facility contains events of default, subject to certain materiality thresholds and grace periods, customary for this type of financing arrangement. The remedies for such events of default are also customary for this type of transaction and include the acceleration of the principal amount outstanding under the Barclay Facility and the liquidation by Barclays of purchased assets then subject to the Barclays Facility.
In October 2018, an indirect wholly-owned subsidiary of the Company entered into a master repurchase agreement (the “JPMorgan Chase Facility”) with JPMorgan Chase Bank, N.A. (“JPMorgan Chase”) to finance the origination of CRE loans. In connection with the JPMorgan Chase Facility, the Company entered into a guarantee agreement (the “JPMorgan Chase Guarantee”) pursuant to which the Company fully guaranteed all payments and performance under the JPMorgan Chase Facility. In May 2020, the Company entered into an amendment to the JPMorgan Chase Guarantee that revised its minimum equity financial covenant as of February 29, 2020. In October 2020, the Company entered into an amendment to the JPMorgan Chase Guarantee that revised a covenant definition so that credit losses are determined in accordance with a risk rating-based methodology. The JPMorgan Chase Facility has a maximum facility amount of $250.0 million, generally charges interest of one-month LIBOR plus a spread between 2.00% and 2.25% and matures in October 2021, subject to two one-year extension options in accordance with the facility’s terms.
The JPMorgan Chase Facility contains margin call provisions that provide JPMorgan Chase with certain rights if the value of purchased assets declines. Under these circumstances, JPMorgan Chase may require the Company to transfer cash in an amount necessary to eliminate such margin deficit or repurchase the asset(s) that resulted in the margin call.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
In connection with the JPMorgan Chase Facility, the Company guaranteed the payment and performance under the JPMorgan Chase Facility pursuant to a guarantee agreement (the “JPMorgan Chase Guarantee”) subject to a limit of 25% of the then currently unpaid aggregate repurchase price of all purchased assets. The JPMorgan Chase Guarantee includes certain financial covenants required of the Company, including required liquidity, required capital, ratios of total indebtedness to equity and EBITDA requirements. Also, ACRES RF, the direct owner of the wholly-owned subsidiary borrower, executed a pledge agreement with JPMorgan Chase pursuant to which it pledged and granted to JPMorgan Chase a continuing security interest in any and all of its right, title and interest in and to the wholly-owned subsidiary, including all distributions, proceeds, payments, income and profits from its interests in the wholly-owned subsidiary.
The JPMorgan Chase Facility specifies events of default, subject to certain materiality thresholds and grace periods, customary for this type of financing arrangement. The remedies for such events of default are also customary for this type of financing arrangement and include the acceleration of the principal amount outstanding under the JPMorgan Chase Facility and the liquidation by JPMorgan Chase of purchased assets then subject to the JPMorgan Chase Facility.
Trust Certificates - Term Repurchase Facilities
In September 2017, a subsidiary entered into a repurchase and securities agreement (the “2017 Term Repurchase Trust Facility”) with RSO Repo SPE Trust 2017, a structure that provides financing under a structured sale of trust certificates to qualified institutional buyers through an offering led by Wells Fargo Securities. In July 2019, the Company paid off the outstanding balance of the 2017 Term Repurchase Trust Facility in connection with the redemption of RCC 2017-CRE5.
CMBS - Short-Term Repurchase Agreements
The COVID-19 pandemic produced material and previously unforeseeable liquidity shocks in credit markets causing significant declines in the pricing of the Company’s investment securities available-for-sale that were collateral for the Company’s CMBS short-term repurchase facilities (see Note 9). As a result, in March 2020, the Company received written notices from RBC Capital Markets, LLC, RBC (Barbados) Trading Bank Corporation and Deutsche Bank Securities Inc. alleging that events of default had occurred under the Company’s associated repurchase agreements as a result of not meeting certain margin calls. These notices were subsequently either withdrawn or rescinded. The Company had no outstanding balances on its CMBS - short-term repurchase agreements at December 31, 2020.
Contractual maturity dates of the Company’s borrowings’ principal outstanding by category and year are presented in the table below (in thousands):
(1)
Includes accrued interest payable in the balances of principal outstanding.
NOTE 12 - SHARE ISSUANCE AND REPURCHASE
On or after July 30, 2024, the Company may, at its option, redeem its 8.625% Fixed-to-Floating Series C Cumulative Redeemable Preferred Stock (“Series C Preferred Stock”), in whole or in part, at any time and from time to time, for cash at $25.00 per share, plus accrued and unpaid dividends, if any, to the redemption date. Effective July 30, 2024 and thereafter, the Company will pay cumulative distributions on the Series C Preferred Stock at a floating rate equal to three-month LIBOR plus a spread of 5.927% per annum based on the $25.00 liquidation preference, provided that such floating rate shall not be less than the initial rate of 8.625% at any date of determination.
At December 31, 2020, the Company had 4.8 million shares of Series C Preferred Stock outstanding, with a weighted average offering price, excluding offering costs, of $25.00.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
In March 2016, the Board approved a securities repurchase plan and in November 2020, the Board reauthorized and approved the continued use of the Company’s existing share repurchase program in order to repurchase up to $20.0 million of the currently outstanding shares of the Company’s common stock through March 31, 2021. In March 2021, our Board authorized the extension of the previous $20.0 million authorization through the second quarter of 2021 or until the $20.0 million is fully deployed. Additionally, the Board authorized the Company to enter into written trading plans under Rule 10b5-1 of the Securities Exchange Act of 1934. During the year ended December 31, 2020, the Company repurchased $5.4 million of its common stock, representing approximately 535,485 shares. During the years ended December 31, 2019 and 2018, the Company did not repurchase any shares of its common or preferred stock through this program. At December 31, 2020, $14.6 million remains available under this repurchase plan. From January 1, 2021 through February 28, 2021, the Company repurchased $6.9 million of its common stock, representing approximately 565,285 shares and approximately $7.7 million remains available under the plan.
In connection with the Note and Warrant Purchase Agreement, as discussed in Note 11, the Senior Unsecured Notes due 2027 give Oaktree and MassMutual warrants to purchase an aggregate of up to 1.2 million shares of common stock at an exercise price of $0.03 per share, subject to certain potential adjustments. On July 31, 2020, concurrently with the issuance of the Senior Unsecured Notes due 2027, the Company issued to Oaktree warrants to purchase 391,995 shares of common stock for an aggregate purchase price of $42.0 million and issued to MassMutual warrants to purchase 74,666 shares of common stock for an aggregate purchase price of $8.0 million. The warrants are recorded in additional paid-in capital on the consolidated balance sheet at their fair value of $3.1 million at issuance. At any time and from time to time prior to January 31, 2022, the Company may elect to issue to Oaktree and MassMutual warrants to purchase an additional 699,992 shares of the common stock for a purchase price equal to the principal amount of the additional Senior Unsecured Notes due 2027 being issued. The warrants are immediately exercisable on issuance and expire seven years from the issuance date. The warrants can be exercised with cash or as a net exercise.
NOTE 13 - SHARE-BASED COMPENSATION
In June 2019, the Company’s shareholders approved the Exantas Capital Corp. Second Amended and Restated Omnibus Equity Compensation Plan (the “June 2019 Plan”), which amended the May 2014 plan. The June 2019 Plan (i) increased the number of shares authorized for issuance from 1,091,666 shares to 1,591,666 shares; (ii) extended the expiration date from May 2024 to June 2029; and (iii) made other clarifying and updating amendments.
The following table summarizes the Company’s restricted common stock transactions:
(1)
Non-employees were employees of C-III or Resource America, Inc. (“Resource America”) from January 1, 2020 to July 31, 2020. On July 31, 2020, the Company’s management contract was purchased from the Prior Manager by the Manager in the ACRES acquisition. See Note 1.
On July 31, 2020, all unvested restricted stock awards were accelerated upon the close of the ACRES acquisition.
The fair values at grant date of the shares of restricted common stock granted to non-employees during the years ended December 31, 2020, 2019 and 2018 were $2.1 million, $2.0 million and $2.0 million, respectively. The fair values at grant date of the shares of restricted common stock issued to the Company’s eight non-employee directors that served at any time during the years ended December 31, 2020, 2019 and 2018 were $255,000, $300,000 and $255,000, respectively.
At December 31, 2019, the total unrecognized restricted common stock expense for non-employees was $1.1 million, with a weighted average amortization period remaining of 1.8 years. There was no unrecognized restricted common stock expense for non-employees at December 31, 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following table summarizes restricted common stock grants during the year ended December 31, 2020:
(1)
All unvested restricted stock grants made before July 31, 2020 were accelerated on July 31, 2020 upon the close of the ACRES acquisition.
The following table summarizes the status of the Company’s vested stock options at December 31, 2020:
There were no options granted during the years ended December 31, 2020 or 2019. The outstanding stock options have contractual terms of ten years and will expire in 2021.
The components of equity compensation expense for the periods presented are as follows (in thousands):
(1)
Non-employees were employees of C-III or Resource America from January 1, 2020 to July 31, 2020. On July 31, 2020, the Company’s management contract was purchased from the Prior Manager by the Manager in the ACRES acquisition. See Note 1.
Under the Company’s Fourth Amended and Restated Management Agreement, as amended (“Management Agreement”), incentive compensation is paid quarterly. Up to 75% of the incentive compensation is paid in cash and at least 25% is paid in the form of an award of common stock recorded in management fees on the consolidated statements of operations. The Manager received no incentive management compensation for the years ended December 31, 2020 and 2018. During the year ended December 31, 2019, the Company incurred incentive compensation payable to the Prior Manager of $606,000 of which $455,000 was paid in cash and $151,000, representing 4,435 shares, was paid in common stock.
All equity awards, apart from incentive compensation under the Management Agreement, are discretionary in nature and subject to approval by the compensation committee of the Board.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 14 - EARNINGS PER SHARE
The following table presents a reconciliation of basic and diluted earnings (losses) per common share for the periods presented as follows (dollars in thousands, except per share amounts):
(1)
See Note 12 for further details regarding the warrants.
For the 4.50% Convertible Senior Notes, the Company has the intent and ability to settle the principal amount in cash and intends to settle the conversion feature for the amount above the conversion price, or the conversion spread, if any, in common stock. The Company uses the treasury stock method for calculating any potential dilutive effect of the conversion spread on diluted EPS, if applicable. The conversion spread will have a dilutive impact on diluted EPS when the average market price of the Company’s common stock for a given period exceeds the conversion price of the 4.50% Convertible Senior Notes. For the years ended December 31, 2020, 2019 and 2018, the average market price of the Company’s common stock did not exceed the conversion price of the 4.50% Convertible Senior Notes, 6.00% Convertible Senior Notes and 8.00% Convertible Senior notes and as such the Convertible Senior Notes have been excluded from the computation of diluted earnings per share. The conversion rate and conversion price for the 4.50% Convertible Senior Notes are described further in Note 11.
NOTE 15 - DISTRIBUTIONS
In order to qualify as a REIT, the Company must currently distribute at least 90% of its taxable income. In addition, the Company must distribute 100% of its taxable income in order to not be subject to corporate federal income taxes on retained income. The Company anticipates it will distribute substantially all of its taxable income to its stockholders. Because taxable income differs from cash flow from operations due to non-cash revenues or expenses (such as provisions for loan and lease losses and depreciation), in certain circumstances the Company may generate operating cash flow in excess of its distributions or, alternatively, may be required to borrow funds to make sufficient distribution payments.
The Company’s 2021 dividends will be determined by the Company’s Board, which will also consider the composition of any dividends declared, including the option of paying a portion in cash and the balance in additional shares of common stock.
For the year ended December 31, 2020, the Company did not pay any common share distributions. For the years ended December 31, 2019 and 2018, the Company declared and subsequently paid dividends of $2.85 and $1.425 per common share, respectively.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following tables present dividends declared (on a per share basis) for the years ended December 31, 2020, 2019 and 2018 and for the period from January 1, 2018 through March 26, 2018 with respect to the Company’s Series B Preferred Stock:
NOTE 16 - ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The following table presents the changes in each component of accumulated other comprehensive income (loss) for the year ended December 31, 2020 (in thousands):
(1)
Amounts reclassified from accumulated other comprehensive income are reclassified to interest expense and net realized and unrealized gain (loss) on investment securities available-for-sale and loans and derivatives on the Company’s consolidated statements of operations.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 17 - RELATED PARTY TRANSACTIONS
Management Agreement
In March 2005, the Company entered into a Management Agreement, which was last amended and restated on July 31, 2020, with the Manager pursuant to which the Manager provides the day-to-day management of the Company’s operations. The Management Agreement requires the Manager to manage the Company’s business affairs in conformity with the policies and investment guidelines established by the Company’s Board. The Manager provides its services under the supervision and direction of the Company’s Board. The Manager is responsible for the selection, purchase and sale of the Company’s portfolio investments, its financing activities and providing investment advisory services. The Manager and its affiliates also provides the Company with a Chief Financial Officer and a sufficient number of additional accounting, finance, tax and investor relations professionals. The Manager receives fees and is reimbursed for its expenses as follows:
•
A monthly base management fee equal to 1/12th of the amount of the Company’s equity multiplied by 1.50% ; provided, however, that for each calendar month through July 31, 2022, such fee is equal to a minimum of $442,000. During the year ended December 31, 2018, the monthly base management fee was fixed at $937,500 per month. Under the Management Agreement, “equity” is equal to the net proceeds from issuances of shares of capital stock (or the value of common shares upon the conversion of convertible securities), after deducting any underwriting discounts and commissions and other expenses and costs relating to such issuance, plus or minus the Company’s retained earnings (excluding non-cash equity compensation incurred in current or prior periods) less all amounts the Company has paid for common stock and preferred stock repurchases. The calculation is adjusted for one-time events due to changes in GAAP, as well as other non-cash charges, upon approval of the Company’s independent directors.
•
Incentive compensation, calculated quarterly until the quarter ended December 31, 2022 as follows: (A) 20% of the amount by which the Company’s core earnings (as defined in the Management Agreement) for a quarter exceeds the product of (i) the weighted average of (x) the book value divided by 10,293,783 and (y) the per share price (including the conversion price, if applicable) paid for the Company’s common shares in each offering (or issuance, upon the conversion of convertible securities) by it subsequent to September 30, 2017, multiplied by (ii) the greater of (x) 1.75% and (y) 0.4375% plus one-fourth of the Ten Year Treasury Rate for such quarter; multiplied by (B) the weighted average number of common shares outstanding during such quarter; subject to adjustment (a) to exclude events pursuant to changes in GAAP or the application of GAAP as well as non-recurring or unusual transactions or events, after discussion between the Manager and the independent directors and approval by a majority of the independent directors in the case of non-recurring or unusual transactions or events, and (b) to deduct an amount equal to any fees paid directly by a TRS (or any subsidiary thereof) to employees, agents and/or affiliates of the Manager with respect to profits of such TRS (or subsidiary thereof) generated from the services of such employees, agents and/or affiliates, the fee structure of which shall have been approved by a majority of the independent directors and which fees may not exceed 20% of the net income (before such fees) of such TRS (or subsidiary thereof).
With respect to each fiscal quarter commencing with the quarter ending December 31, 2022, an incentive management fee calculated and payable in arrears in an amount, not less than zero, equal to:
•
for the first full calendar quarter ending December 31, 2022, the product of (a) 20% and (b) the excess of (i) core earnings of the Company for such calendar quarter, over (ii) the product of (A) the Company’s book value equity as of the end of such calendar quarter, and (B) 7% per annum;
•
for each of the second, third and fourth full calendar quarters following the calendar quarter ending December 31, 2022, the excess of (1) the product of (a) 20% and (b) the excess of (i) core earnings of the Company for the calendar quarter(s) following September 30, 2022, over (ii) the product of (A) the Company’s book value equity in the calendar quarter(s) following September 30, 2022, and (B) 7% per annum, over (2) the sum of any incentive compensation paid to the Manager with respect to the prior calendar quarter(s) following September 30, 2022 (other than the most recent calendar quarter); and
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
•
for each calendar quarter thereafter, the excess of (1) the product of (a) 20% and (b) the excess of (i) core earnings of the Company for the previous 12-month period, over (ii) the product of (A) the Company’s book value equity in the previous 12-month period, and (B) 7% per annum, over (2) the sum of any incentive compensation paid to the Manager with respect to the first three calendar quarters of such previous 12-month period; provided, however, that no incentive compensation shall be payable with respect to any calendar quarter unless Core Earnings for the 12 most recently completed calendar quarters (or such lesser number of completed calendar quarters from September 30, 2022) in the aggregate is greater than zero.
•
Per loan underwriting and review fees in connection with valuations of and potential investments in certain subordinate commercial mortgage pass-through certificates, in amounts approved by a majority of the independent directors.
•
Reimbursement of expenses for personnel of our Manager or its affiliates for their services in connection with the making of fixed-rate commercial real estate loans by us, in an amount equal to one percent of the principal amount of each such loan made.
•
Reimbursement of out-of-pocket expenses and certain other costs incurred by the Manager and its affiliates that relate directly to the Company and its operations.
•
Reimbursement of the Manager’s and its affiliates’ expenses for (A) wages, salaries and benefits of the Company’s Chief Financial Officer, and (B) a portion of the wages, salaries and benefits of accounting, finance, tax and investor relations professionals, in proportion to such personnel’s percentage of time allocated to its operations.
Incentive compensation is calculated and payable quarterly to the Manager to the extent it is earned. Up to 75% of the incentive compensation is payable in cash and at least 25% is payable in the form of an award of common stock. The Manager may elect to receive more than 25% in incentive compensation in common stock. All shares are fully vested upon issuance, however, the Manager may not sell such shares for one year after the incentive compensation becomes due and payable unless the Management Agreement is terminated. Shares payable as incentive compensation are valued as follows:
•
if such shares are traded on a securities exchange, at the average of the closing prices of the shares on such exchange over the 30-day period ending three days prior to the issuance of such shares;
•
if such shares are actively traded over-the-counter, at the average of the closing bid or sales price as applicable over the 30-day period ending three days prior to the issuance of such shares; and
•
if there is no active market for such shares, at the fair market value as reasonably determined in good faith by the Board of the Company.
The Management Agreement’s current contract term ends on July 31, 2023 and the agreement provides for automatic one year renewals on such date and on each July 31 thereafter until terminated. The Company’s Board reviews the Manager’s performance annually. The Management Agreement may be terminated annually upon the affirmative vote of at least two-thirds of the Company’s independent directors, or by the affirmative vote of the holders of at least a majority of the outstanding shares of its common stock, based upon unsatisfactory performance that is materially detrimental to the Company or a determination by its independent directors that the management fees payable to the Manager are not fair, subject to the Manager’s right to prevent such a compensation termination by accepting a mutually acceptable reduction of management fees. The Company’s Board must provide 180 days’ prior notice of any such termination. If the Company terminates the Management Agreement, the Manager is entitled to a termination fee equal to four times the sum of the average annual base management fee and the average annual incentive compensation earned by the Manager during the two 12-month periods immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter before the date of termination.
The Company may also terminate the Management Agreement for cause with 30 days’ prior written notice from its Board. No termination fee is payable in the event of a termination for cause. The Management Agreement defines cause as:
•
the Manager’s continued material breach of any provision of the Management Agreement following a period of 30 days after written notice thereof;
•
the Manager’s fraud, misappropriation of funds, or embezzlement against the Company;
•
the Manager’s gross negligence in the performance of its duties under the Management Agreement;
•
the dissolution, bankruptcy or insolvency, or the filing of a voluntary bankruptcy petition, by the Manager; or
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
•
a change of control (as defined in the Management Agreement) of the Manager if a majority of the Company’s independent directors determines, at any point during the 18 months following the change of control, that the change of control was detrimental to the ability of the Manager to perform its duties in substantially the same manner conducted before the change of control.
Cause does not include unsatisfactory performance that is materially detrimental to the Company’s business.
The Manager may terminate the Management Agreement at its option, (A) in the event that the Company defaults in the performance or observance of any material term, condition or covenant contained in the Management Agreement and such default continues for a period of 30 days after written notice thereof, or (B) without payment of a termination fee by the Company, if it becomes regulated as an investment company under the Investment Company Act of 1940, with such termination deemed to occur immediately before such event.
Relationship with ACRES Capital Corp. and certain of its Subsidiaries
Relationship with ACRES Capital Corp. and certain of its Subsidiaries. The Manager is a subsidiary of ACRES Capital Corp., of which Andrew Fentress, the Company’s Chairman, serves as Managing Partner and Mark Fogel, the Company’s President, Chief Executive Officer and Director, serves as Chief Executive Officer and President.
Effective on July 31, 2020, the Company has a Management Agreement with the Manager pursuant to which the Manager provides the day-to-day management of the Company’s operations and receives management fees. For the year ended December 31, 2020, the Manager earned base management fees of approximately $2.2 million. No incentive compensation was earned for the year ended December 31, 2020. At December 31, 2020, $442,000 of base management fees were payable by the Company to the Manager. There was no incentive compensation payable at December 31, 2020. The Manager and its affiliates provided the Company with a Chief Financial Officer and a sufficient number of additional accounting, finance, tax and investor relations professionals. The Company reimbursed the Manager’s expenses for (a) the wages, salaries and benefits of the Chief Financial Officer, and (b) a portion of the wages, salaries and benefits of accounting, finance, tax and investor relations professionals, in proportion to such personnel’s percentage of time allocated to the Company’s operations. The Company reimbursed out-of-pocket expenses and certain other costs incurred by the Manager that related directly to the Company’s operations. For the year ended December 31, 2020, the Company reimbursed the Manager $1.8 million for all such compensation and costs. At December 31, 2020, the Company had payables to the Manager pursuant to the Management Agreement totaling approximately $380,000 related to such compensation and costs. The Company’s base management fee payable and expense reimbursements payable were recorded in management fee payable and accounts payable and other liabilities on the consolidated balance sheet, respectively.
On July 31, 2020, ACRES RF, a direct, wholly owned subsidiary of the Company, provided a $12.0 million loan (the “ACRES Loan”) to ACRES Capital Corp. evidenced by the Promissory Note from ACRES Capital Corp.
The ACRES Loan accrues interest at 3.00% per annum payable monthly. The monthly amortization payment is $25,000. The ACRES Loan matures in six years, subject to two one-year extensions (at ACRES Capital Corp.’s option) subject to the payment of a 0.5% extension fee to ACRES RF on the outstanding principal amount of the ACRES Loan.
During the year ended December 31, 2020, the Company recorded interest income of $153,000 on the ACRES Loan in other income on the consolidated statements of operations. At December 31, 2020, the ACRES Loan had a principal balance of $11.9 million recorded in loan receivable - related party on the consolidated balance sheet. At December 31, 2020, the ACRES loan had no interest receivable.
During the year ended December 31, 2020, the Company originated two CRE whole loans with a total par of $24.0 million that were refinanced from loans originated by affiliates of the Manager.
At December 31, 2020, the Company retained equity in one securitization entity that was structured for the Company by the Manager. Under the Management Agreement, the Manager was not separately compensated by the Company for executing this transaction and was not separately compensated for managing the securitization entity and its assets.
Relationship with ACRES Capital Servicing LLC. Under the MassMutual Loan Agreement, ACRES Capital Servicing LLC (“ACRES Capital Servicing”), an affiliate of ACRES Capital Corp. and the Manager, serves as the portfolio servicer. Additionally, ACRES Capital Servicing serves as special servicer of XAN 2020-RSO9. During the year ended December 31, 2020, ACRES Capital Servicing received no portfolio servicing fees or special servicing fees.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Relationship with C-III and certain of its Subsidiaries
Relationship with C-III and certain of its Subsidiaries. The Prior Manager was a wholly-owned subsidiary of Resource America, which is a wholly-owned subsidiary of C-III. C-III is indirectly controlled and partially owned by Island Capital Group LLC (“Island Capital”). Effective July 31, 2020, in connection with the ACRES acquisition, Andrew L. Farkas, the managing member of Island Capital and the chairman and chief executive officer of C-III, resigned his position as the Company’s Chairman. In addition, Robert C. Lieber and Matthew J. Stern, each executive managing directors of both C-III and Island Capital, resigned their positions as the Company’s Chief Executive Officer and President, respectively. Lastly, Jeffrey P. Cohen, president of C-III and Island Capital, resigned his position as a member of the Board. Those officers and the Company’s other executive officers were also officers of the Company’s Prior Manager, Resource America, C-III and/or affiliates of those companies. Prior to September 8, 2020, a non-employee director of the Company held the position of Executive Vice President at Resource America.
Prior to July 31, 2020, the Company had a management agreement with the Prior Manager pursuant to which the Prior Manager provided the day-to-day management of the Company’s operations and received substantial fees. For the years ended December 31, 2020, 2019 and 2018, the Prior Manager earned base management fees of $3.8 million, $8.3 million and $11.3 million, respectively. The Prior Manager did not earn incentive compensation for the years ended December 31, 2020 and 2018. For the year ended December 31, 2019, the Prior Manager earned incentive compensation of $606,000, of which $455,000 was paid in cash and $151,000 was paid in common stock. At December 31, 2020, there was no base management fees payable by the Company to the Prior Manager. At December 31, 2019, $701,000 of base management fees were payable by the Company to the Prior Manager. There was no incentive compensation payable at December 31, 2020 and 2019. The Prior Manager and its affiliates provided the Company with a Chief Financial Officer and a sufficient number of additional accounting, finance, tax and investor relations professionals. The Company reimbursed the Prior Manager’s and its affiliates’ expenses for (a) the wages, salaries and benefits of the Chief Financial Officer, (b) a portion of the wages, salaries and benefits of accounting, finance, tax and investor relations professionals, in proportion to such personnel’s percentage of time allocated to the Company’s operations, and (c) personnel principally devoted to the Company’s ancillary operating subsidiaries. The Company reimbursed out-of-pocket expenses and certain other costs incurred by the Prior Manager and its affiliates that relate directly to the Company’s operations. For the years ended December 31, 2020, 2019 and 2018, the Company reimbursed the Prior Manager $4.1 million, $4.2 million and $5.0 million, respectively, for all such compensation and costs. At December 31, 2019, the Company had payables to Resource America and its subsidiaries pursuant to the management agreement totaling approximately $1.1 million. The Company had no payables to Resource America and its subsidiaries at December 31, 2020. The Company’s base management fee payable and expense reimbursements payable were recorded in management fee payable and accounts payable and other liabilities on the consolidated balance sheets, respectively.
In July 2020, ACRES and the Company entered into agreements with Resource America pursuant to which Resource America provides office space and other office-related services as well as performs an internal audit program. During the year ended December 31, 2020, the Company incurred $40,000 of expenses in connection with these agreements. In September 2020, the agreements were transferred to Resource Real Estate Opportunity REIT, Inc. (“Resource Real Estate Opportunity REIT”).
At December 31, 2020, the Company retained equity in five securitization entities that were structured for the Company by the Prior Manager, although three of the securitization entities were substantially liquidated as of December 31, 2020. Under the Management Agreement, the Prior Manager was not separately compensated by the Company for executing these transactions and was not separately compensated for managing the securitizations entities and their assets.
Relationship with Resource Real Estate, LLC. Resource Real Estate, LLC (“Resource Real Estate”), an indirect wholly-owned subsidiary of Resource America and C-III, originated, financed and managed the Company’s CRE loan portfolio until the ACRES acquisition on July 31, 2020. The Company reimbursed Resource Real Estate for loan origination costs associated with all loans originated. At December 31, 2019, the Company had receivables from Resource Real Estate for loan deposits of $101,000. There were no receivables from Resource Real Estate for loan deposits at December 31, 2020.
Resource Real Estate served as special servicer for the following liquidated real estate securitization transactions, which provided financing for CRE loans: (i) Resource Capital Corp. 2014-CRE2, Ltd., a $353.9 million securitization that closed in July 2014 and liquidated in August 2017; (ii) Resource Capital Corp. 2015-CRE3, Ltd., a $346.2 million securitization that closed in February 2015 and liquidated in August 2018; (iii) Resource Capital Corp. 2015-CRE4, Ltd., a $312.9 million securitization that closed in August 2015 and liquidated in July 2018; and (iv) RCC 2017-CRE5, a $376.7 million securitization that closed in July 2017 and liquidated in July 2019. Resource Real Estate also served as special servicer for XAN 2020-RSO8, a $522.6 million securitization that closed on March 2020. Resource Real Estate did not earn any special servicing fees during the years ended December 31, 2020, 2019 and 2018.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Relationship with C-III Commercial Mortgage LLC and C3AM. In May 2019, ACRES RF entered into a Mortgage Loan Sale and Purchase Agreement (the “May 2019 Loan Acquisition Agreement”) with C-III Commercial Mortgage LLC (“C-III Commercial Mortgage”), a wholly-owned subsidiary of C-III, that provided for the acquisition by ACRES RF of certain CRE loans on a servicing-released basis at par, plus accrued and unpaid interest on each loan for an aggregate purchase price of $197.6 million. In accordance with the terms of the May 2019 Loan Acquisition Agreement, C-III Commercial Mortgage retains its title to all exit fees in excess of 0.50% of the outstanding principal balance. During the years ended December 31, 2020 and 2019, C-III Commercial Mortgage earned approximately $74,000 and $108,000, respectively, in exit fees. The Company had outstanding payables to C-III Commercial Mortgage of $48,000 at December 31, 2020 and none at December 31, 2019.
C3AM served as the primary servicer for the CRE loans acquired in the May 2019 Loan Acquisition Agreement and for the CRE loans collateralizing RCC 2017-CRE5, XAN 2018-RSO6, a $514.2 million securitization that closed in June 2018 and liquidated in September 2020, and XAN 2019-RSO7, a $687.2 million securitization that closed in April 2019. C3AM received servicing fees, payable monthly on an asset-by-asset basis. C3AM served as special servicer for C40, XAN 2018-RSO6 and XAN 2019-RSO7, under which it received a base special servicing fee. During the years ended December 31, 2019 and 2018, C3AM earned approximately $565,000 and $321,000, respectively. The Company had payables to C3AM of approximately $37,000 at December 31, 2019.
On December 31, 2019, C3AM was sold by C-III to an unaffiliated third party. As such, C3AM ceased being a related party under common control effective January 1, 2020.
Relationship with Resource Real Estate Opportunity REIT
In July 2020, ACRES and the Company entered into agreements with Resource America pursuant to which Resource America provided office space and other office-related services as well as performed an internal audit program. In September 2020, the sublease was assigned from Resource America to Resource Real Estate Opportunity REIT and the internal audit engagement letter was assigned from Resource America to Resource NewCo LLC, a subsidiary of Resource Real Estate Opportunity REIT. A non-employee director of the Company is an executive at, and a director of, Resource Real Estate Opportunity REIT. During the year ended December 31, 2020, the Company incurred $45,000 of expenses in connection with these agreements. The Company had no payables to Resource Real Estate Opportunity REIT of approximately at December 31, 2020.
NOTE 18 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the Company’s financial instruments carried at fair value on a recurring basis based upon the fair value hierarchy (in thousands):
In accordance with guidance on fair value measurements and disclosures, the Company is not required to disclose quantitative information with respect to unobservable inputs contained in fair value measurements that are not developed by the Company. As a consequence, the Company has not disclosed such information associated with fair values obtained for investment securities available-for-sale and derivatives from third-party pricing sources.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following table presents additional information about the Company’s assets that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs (in thousands):
The Company reported a certain asset held for sale and indemnification liability as financial instruments that are carried at fair value on a nonrecurring basis on its consolidated balance sheet at December 31, 2019. In the fourth quarter 2020, the asset held for sale was sold and the indemnification was relieved. The following table summarizes the Company’s financial instruments measured at fair value on a nonrecurring basis based upon the fair value hierarchy (in thousands):
In November 2020, the Company received a deed in lieu of foreclosure on one CRE whole loan. The Company engaged third-party sources to determine the value of the assets relating to the real estate owned (“REO”) property. The REO property was determined to have a total fair value of $39.8 million, comprised of building improvements, site improvements, furniture and fixtures, a below market lease intangible, a franchise intangible and value relating to the existing customer list.
In November 2019, the Company foreclosed on its remaining legacy CRE loan held for sale, and obtained ownership of the underlying property, which remained classified as an asset held for sale on the consolidated balance sheets, recorded at the lower of cost or fair market value. An appraisal was received on the property in February 2020 and concluded its fair value, less estimated costs to sell, was $16.5 million, the effect of which was recorded as of December 31, 2019. At December 31, 2019 the asset held for sale had a fair value of $16.5 million. In the first quarter of 2020, the Company received a $13.5 million offer on the property, which was subsequently revoked. In the third quarter of 2020, the Company received a new offer of $11.0 million on the property. Net of approximately $715,000 of estimated costs to sell, the asset was valued at $10.3 million. The property was sold in December 2020 for proceeds of $10.3 million. During the years ended December 31, 2020, 2019 and 2018, the Company recorded losses of $8.8 million, $4.7 million and $7.2 million, respectively, on the remaining CRE asset held for sale, which included protective advances to cover borrower operating losses of $2.7 million, $1.2 million and $1.7 million, respectively. During the year ended December 31, 2020, the loss was primarily attributable to fair value charges of $6.2 million in connection with the offers received on the property adjusted for the estimated costs to sell.
The Company is required to disclose the fair value of financial instruments for which it is practicable to estimate that value. The fair values of the Company’s short-term financial instruments such as cash and cash equivalents, restricted cash, accrued interest receivable, principal paydowns receivable, accrued interest payable and distributions payable approximate their carrying values on the consolidated balance sheets. The fair values of the Company’s investment securities available-for-sale are reported in Note 9. The fair values of the Company’s derivative instruments are reported in Note 19.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The fair values of the Company’s loans held for investment are measured by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Par values of loans with variable interest rates are expected to approximate fair value unless evidence of credit deterioration exists, in which case the fair value approximates the par value less the loan’s allowance estimated through individual evaluation. Fair values of loans with fixed rates are calculated using the net present values of future cash flows, discounted at market rates. The Company’s floating-rate CRE loans had interest rates from 4.10% to 9.75% and 4.45% to 7.96% at December 31, 2020 and 2019, respectively.
The fair value of the Company’s mezzanine loan is measured by discounting the remaining contractual cash flows using the current interest rates at which similar instruments would be originated for the same remaining maturity. The Company’s mezzanine loan is discounted at a rate of 10.00%.
The fair values of the Company’s preferred equity investments are measured by discounting the instruments’ remaining contractual cash flows using current interest rates at which similar instruments would be originated for the same remaining maturities. The Company’s preferred equity investments are discounted at a rate of 12.08% and 11.54%.
The Company’s fixed-rate CRE loans are valued using third-party pricing sources.
The Company’s loan receivable - related party is estimated using a discounted cash flow model.
Senior notes in CRE securitizations are estimated using a discounted cash flow model with implied yields based on trades for similar securities.
The fair values of the junior subordinated notes RCT I and RCT II are estimated by using a discounted cash flow model.
The fair value of the convertible notes is determined using a discounted cash flow model that discounts the issuance’s contractual future cash flows using the current interest rate on similar debt issuances with similar terms and similar remaining maturities that do not have a conversion option.
The Company’s Senior Unsecured Notes due 2027 are estimated by using a discounted cash flow model.
The fair value of the senior secured financing facility is measured by discounting the facility’s remaining contractual cash flows using the current interest rate at which a similar debt instrument would be issued for the same remaining maturity. The fair value of the senior secured financing facility is estimated using a discounted cash flow model that discounts the expected future cash flows at a rate of 5.75%.
Warehouse financing facilities are variable rate debt instruments indexed to LIBOR that reset periodically and, as a result, their carrying value approximates their fair value, excluding deferred debt issuance costs.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The fair values of the Company’s remaining financial instruments that are not reported at fair value on the consolidated balance sheets are reported in the following table (in thousands):
(1)
Classified as other assets on the consolidated balance sheet.
NOTE 19 - MARKET RISK AND DERIVATIVE INSTRUMENTS
The Company is affected by changes in certain market conditions. These changes in market conditions may adversely impact the Company’s financial performance and are referred to as “market risks.” When deemed appropriate, the Company uses derivatives as a risk management tool to mitigate the potential impact of certain market risks. The primary market risk managed by the Company through the use of derivative instruments is interest rate risk and market price risk.
The Company may hold various derivatives in the ordinary course of business, including interest rate swaps. Interest rate swaps are contracts between two parties to exchange cash flows based on specified underlying notional amounts, assets and/or indices.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
A significant market risk to the Company is interest rate risk. 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 the Company’s control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with interest-bearing liabilities. Changes in the level of interest rates also can affect the value of the Company’s interest-earning assets and the Company’s ability to realize gains from the sale of these assets. A decline in the value of the Company’s interest-earning assets pledged as collateral for borrowings could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.
The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. The Company seeks to mitigate the potential impact on net income of adverse fluctuations in interest rates incurred on its borrowings by entering into hedging agreements.
The Company classifies its interest rate risk hedges as cash flow hedges, which are hedges that eliminate the risk of changes in the cash flows of a financial asset or liability. The Company records changes in fair value of derivatives designated and effective as cash flow hedges in accumulated other comprehensive (loss) income, and records changes in fair value of derivatives designated and ineffective as cash flow hedges in earnings.
Regulations promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandate that the Company clear certain new interest rate swap transactions through a central counterparty. Transactions that are centrally cleared result in the Company facing a clearing house, rather than a swap dealer, as counterparty. Central clearing requires the Company to post collateral in the form of initial and variation margin to satisfy potential future obligations.
At December 31, 2020, the Company had no interest rate swap hedge contracts outstanding. At December 31, 2019, the Company had 19 interest rate swap contracts outstanding whereby the Company paid a weighted average fixed rate of 2.47% and received a variable rate equal to one-month LIBOR. The aggregate notional amount of these contracts was $90.2 million at December 31, 2019. The counterparty for the Company’s designated interest rate hedge contracts at December 31, 2019, was Wells Fargo.
The Company had a master netting agreement with Wells Fargo at December 31, 2019, which was terminated during the year ended December 31, 2020. At December 31, 2019, the estimated fair value of the Company’s centrally-cleared interest rate swap hedge contracts in an asset position was $30,000. At December 31, 2019, the estimated fair value of the Company’s centrally cleared interest rate swap hedge contracts in a liability position was $4.6 million. The Company had aggregate unrealized losses of $4.0 million on the interest rate swap hedge contracts at December 31, 2019, which were recorded in accumulated other comprehensive income (loss) on the consolidated balance sheets.
The Company terminated all of its interest rate swap positions associated with its financed CMBS portfolio in April 2020. At termination, the Company realized a loss of $11.8 million. At December 31, 2020, the Company had a loss of $10.4 million recorded in accumulated other comprehensive (loss) income, which will be amortized into earnings over the remaining life of the debt. During the year ended December 31, 2020, the Company recorded amortization expense, reported in interest expense on the consolidated statements of operations, of $1.3 million.
At December 31, 2020 and 2019, the Company had an unrealized gain of $438,000 and $530,000, respectively, attributable to two terminated interest rate swaps in accumulated other comprehensive income (loss) on the consolidated balance sheets, to be accreted into earnings over the remaining life of the debt. The Company recorded accretion income, reported in interest expense on the consolidated statements of operations, of $92,000 and $91,000 into earnings during the years ended December 31, 2020 and 2019, respectively.
The Company’s origination of fixed-rate CRE whole loans exposes it to market pricing risk in connection with the fluctuations of market interest rates. As market interest rates increase or decrease, the fair value of the fixed-rate CRE whole loans will decrease or increase accordingly. In order to mitigate this market price risk, the Company may enter into interest rate swap contracts in which it pays a fixed rate of interest in exchange for a variable rate of interest, usually three-month LIBOR. Unrealized gains and losses on the value of these swap contracts are recorded in other income on the consolidated statements of operations.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following tables present the fair value of the Company’s derivative financial instruments at December 31, 2020 and 2019 on the Company’s consolidated balance sheets and the related effect of the derivative instruments on the consolidated statements of operations during the years ended December 31, 2020, 2019 and 2018:
(1)
Interest rate swap contracts are accounted for as cash flow hedges.
(1)
Negative values indicate a decrease to the associated consolidated statements of operations line items.
NOTE 20 - OFFSETTING OF FINANCIAL ASSETS AND LIABILITIES
The following table presents a summary of the Company’s offsetting of derivative assets (in thousands):
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The following table presents a summary of the Company’s offsetting of financial liabilities and derivative liabilities (in thousands, except amounts in footnotes):
(1)
Amounts represent financial instruments pledged that are available to be offset against liability balances associated with term warehouse financing facilities, repurchase agreements and derivatives.
(2)
The combined fair value of securities and loans pledged against the Company’s various warehouse financing facilities and repurchase agreements was $20.0 million and $1.2 billion at December 31, 2020 and 2019, respectively.
(3)
The Company posted excess cash collateral of $4.6 million related to interest rate swap contracts outstanding at December 31, 2019.
All balances associated with repurchase agreements and derivatives are presented on a gross basis on the Company’s consolidated balance sheets.
Certain of the Company’s repurchase agreements and derivative transactions are governed by underlying agreements that generally provide for a right of offset in the event of default or in the event of a bankruptcy of either party to the transaction.
NOTE 21 - INCOME TAXES
The following table details the components of income taxes (in thousands):
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
A reconciliation of the income tax expense based upon the statutory tax rate to the effective income tax rate was as follows for the years presented (in thousands):
The components of deferred tax assets and liabilities were as follows (in thousands):
At December 31, 2020 and 2019, the Company had $59.4 million and $58.5 million, respectively, of total gross federal and $1.6 million and $1.5 million, respectively, of total gross state and local net operating tax loss carryforwards. The Company had full valuation allowances on its total gross federal, state and local net operating tax loss carryforwards as of December 31, 2020 and 2019.
At December 31, 2020 and 2019, the Company had $59.4 million and $28.0 million, respectively, of gross federal and $1.6 million and $1.5 million, respectively, of gross state and local net operating tax loss carryforwards (a collective deferred tax asset of $13.8 million and $7.0 million, respectively) reported in other assets in the Company’s consolidated balance sheets. The Company also generated a gross capital loss carryforward of $969,000 in 2020 (tax effected expense of $327,000). Due to changes in management’s focus regarding the non-core asset classes, the Company determined that it no longer expected to have sufficient forecasted taxable income to completely realize the tax benefits of the deferred tax assets at December 31, 2020 and 2019. Therefore, a gross valuation allowance of $62.9 million and $32.9 million (tax effected expense of $21.2 million and $9.9 million) has been recorded against the deferred tax asset at December 31, 2020 and 2019, respectively. Management will continue to assess its estimate of the amount of deferred tax assets that the Company will be able to utilize.
The Company is subject to examination by the Internal Revenue Service for calendar years including and subsequent to 2018, and is subject to examination by state and local jurisdictions for calendar years including and subsequent to 2016.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
NOTE 22 - QUARTERLY RESULTS
The following is a presentation of the quarterly results of operations:
NOTE 23 - COMMITMENTS AND CONTINGENCIES
The Company may become involved in litigation on various matters due to the nature of the Company’s business activities. The resolution of these matters may result in adverse judgments, fines, penalties, injunctions and other relief against the Company as well as monetary payments or other agreements and obligations. In addition, the Company may enter into settlements on certain matters in order to avoid the additional costs of engaging in litigation. Except as discussed below, the Company is unaware of any contingencies arising from such litigation that would require accrual or disclosure in the consolidated financial statements at December 31, 2020.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
Primary Capital Mortgage, LLC (“PCM”) is subject to potential litigation related to claims for repurchases or indemnifications on loans that PCM has sold to third parties. At December 31, 2020 and 2019, no such litigation demand was outstanding. Reserves for such potential litigation demands are included in the reserve for mortgage repurchases and indemnifications that totaled $1.5 million and $1.7 million at December 31, 2020 and 2019, respectively. The reserves for mortgage repurchases and indemnifications are included in liabilities held for sale on the consolidated balance sheets.
Settled and Dismissed Litigation Matters
In April 2018, the Company funded $2.0 million into escrow in connection with the proposed settlement of outstanding litigation, which was settled in August 2018. The Company did not have any general litigation reserve at December 31, 2020 or 2019.
The Company previously disclosed a securities litigation against the Company and certain of its current and former officers and directors titled Levin v. Resource Capital Corp. (the “Levin Action”). On February 5, 2018, the Company entered into a stipulation and agreement of settlement (the “Levin Action Settlement Agreement”), which received final approval from the United States District Court for the Southern District of New York (the “Court”) on August 3, 2018. The Levin Action Settlement Agreement settled all claims asserted in the action on behalf of the certified class (the “Settlement”), which consisted, with specified exceptions, of all persons who purchased the Company’s common stock, Series B Preferred Stock or Series C Preferred Stock between October 31, 2012 and August 5, 2015. Under the terms of the Levin Action Settlement Agreement, a payment of $9.5 million was made to settle the litigation. The settlement payment was funded principally by insurance coverage. In exchange for the settlement consideration, the Company and the individual defendants in the Levin Action (and certain related parties) have been released from all claims that have been or could have been asserted in the case by class members (and certain related parties), excluding one holder of less than 500 shares who opted out of the Settlement. The terms of the Settlement and release of claims are described in greater detail in the Levin Action Settlement Agreement filed with the Court and the Final Judgment and Order of Dismissal with Prejudice entered by the Court on August 3, 2018. The Levin Action Settlement Agreement contains no admission of misconduct by the Company or any of the individual defendants and expressly acknowledges that the Company and the individual defendants deny all allegations of wrongdoing and maintain that it and they have at all times acted in good faith and in compliance with the law.
The Company previously disclosed two consolidated shareholder derivative actions filed in the Court that purported to assert claims on behalf of the Company similar to the claims in the New York State Actions (defined below) (collectively, the “Federal Actions”): (a) by shareholders who declined to make a demand on the Board prior to filing suit (the “Federal Demand Futile Actions”), which comprised a suit filed in January 2017 (the “Greenberg Action”), and another suit filed in January 2017 (the “DeCaro Action”) and (b) by shareholders who served demands on the Board to bring litigation and allege that their demands were wrongfully refused (the “Federal Demand Refused Actions”), which comprised a suit filed in February 2017 (the “McKinney Action”), a suit filed in March 2017 (the “Sherek/Speigel Action”) and a suit filed in April 2017 (the “Sebenoler Action”). In January 2019, the parties to the Federal Actions executed a stipulation and agreement of settlement (the “Federal Actions Settlement Agreement”), which received final approval from the Court on May 17, 2019. Under the Federal Actions Settlement Agreement, the Company agreed to implement certain corporate governance changes and paid $550,000 in plaintiffs’ attorneys’ fees, funded by the Company’s insurers. In exchange for the settlement consideration, the defendants were released from liability for certain claims, including all claims asserted in the Federal Actions. Among other terms and conditions, the Federal Actions Settlement Agreement provided that the defendants deny any and all allegations of wrongdoing and maintained that they have acted lawfully and in accordance with their fiduciary duties at all times.
The Company previously disclosed six separate, additional shareholder derivative suits filed in the Supreme Court of New York purporting to assert claims on behalf of the Company (the “New York State Actions”) that were filed on the following dates: December 2015 (the “Reaves Action”); February 2017 (the “Caito Action”); March 2017 (the “Simpson Action”); March 2017 (the “Heckel Action”); May 2017 (the “Schwartz Action”); and August 2017 (the “Greff Action”). Plaintiffs in the Schwartz Action and Greff Action made demands on the Company’s Board before filing suit, but plaintiffs in the Reaves Action, Caito Action, Simpson Action and Heckel Action did not. All of the shareholder derivative suits were substantially similar and alleged that certain of the Company’s current and former officers and directors breached their fiduciary duties, wasted corporate assets and/or were unjustly enriched. Certain complaints asserted additional claims against the Manager and Resource America for unjust enrichment based on allegations that the Manager received excessive management fees from the Company. In June 2019 and July 2019, the Schwartz Action and Greff Action, respectively, were dismissed. In October 2019, the four remaining New York State Actions were dismissed.
The Company previously disclosed another shareholder derivative action filed in the United States District Court for the District of Maryland against certain of the Company’s former officers and directors and the Manager (the “Hafkey Action”). The complaint asserted a breach of fiduciary duty claim that was substantially similar to the claims at issue in the Federal Actions. In May 2019, the plaintiff in the Hafkey Action voluntarily dismissed his suit in light of the settlement and dismissal of the Federal Actions.
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ACRES COMMERCIAL REALTY CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
DECEMBER 31, 2020
The Company previously disclosed another shareholder derivative action filed in the Maryland Circuit Court against certain of the Company’s current and former officers and directors, as well as the Manager and Resource America (the “Canoles Action”). The complaint (as amended) in the Canoles Action asserted a variety of claims, including claims for breach of fiduciary duty, unjust enrichment and corporate waste, which were based on allegations substantially similar to those at issue in the Federal Demand Futile Actions. In July 2019, the plaintiff in the Canoles Action voluntarily dismissed his suit in light of the settlement and dismissal of the Federal Actions.
PCM was the subject of a lawsuit brought by a purchaser of residential mortgage loans alleging breaches of representations and warranties made on loans sold to the purchaser. The asserted repurchase claims related to loans sold to the purchaser that were subsequently sold by the purchaser to either the Federal National Mortgage Association or Federal Home Loan Mortgage Corporation and loans sold to the purchaser that were subsequently securitized and sold as residential mortgage-backed securities (“RMBS”) by the purchaser to RMBS investors. This matter was settled and dismissed in January 2018.
Impact of COVID-19
As discussed in Note 2, the impact of the COVID-19 pandemic in the U.S. and globally has, and will continue to, adversely impact the Company, its borrowers and their tenants, the properties securing its investments and the economy as a whole. The magnitude and duration of the COVID-19 pandemic could be significant and will depend on future developments, which are uncertain and cannot be predicted, including new information that may emerge about the severity of the pandemic, the extension of quarantines and restrictions on travel, the discovery of successful treatments and the ensuing reactions by consumers, companies, governmental entities and global markets. The Company had no contingent liabilities at December 31, 2020 recorded in connection with the COVID-19 pandemic, however the prolonged duration and impact of the COVID-19 pandemic has had, and may continue to have, a long-term and material impact on its results of operations, financial condition and cash flows.
Other Contingencies
As part of the May 2017 sale of its equity interest in Pearlmark Mezzanine Realty Partners IV, L.P., the Company entered into an indemnification agreement pursuant to which the Company agreed to indemnify the purchaser against realized losses of up to $4.3 million on one mezzanine loan until its final maturity date in 2020. As a result of the indemnified party’s partial sale of the mezzanine loan, the maximum exposure was reduced to $536,000 in 2019. In October 2020, the mezzanine loan paid off its balance to the indemnified party, resulting in the extinguishment of the Company’s liability. During the years ended December 31, 2020 and 2019, the Company recorded a reversal of its reserve for probable losses of $56,000 and $647,000, respectively. At December 31, 2019, the Company had a contingent liability, reported in accounts payable and other liabilities on its consolidated balance sheets, of $56,000, respectively, outstanding as a reserve for probable indemnification losses.
PCM is subject to additional claims for repurchases or indemnifications on loans that PCM has sold to investors. At December 31, 2020 and 2019, outstanding demands for indemnification, repurchase or make whole payments totaled $3.3 million. The Company’s estimated exposure for such outstanding claims, as well as unasserted claims, is included in its reserve for mortgage repurchases and indemnifications.
Unfunded Commitments
Unfunded commitments on the Company’s originated CRE loans generally fall into two categories: (1) pre-approved capital improvement projects; and (2) new or additional construction costs subject, in each case, to the borrower meeting specified criteria. Upon completion of the improvements or construction, the Company would receive additional interest income on the advanced amount. Whole loans had $67.2 million and $98.0 million in unfunded loan commitments at December 31, 2020 and 2019, respectively. Preferred equity investments had $2.5 million and $3.0 million in unfunded investment commitments at December 31, 2020 and 2019, respectively.
NOTE 24 - SUBSEQUENT EVENTS
The Company has evaluated subsequent events through the filing of this report and determined that, except for the subsequent events referred to in Note 11 and Note 12, there have not been any events that have occurred that would require adjustments to or disclosures in the consolidated financial statements.
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ITEM 9.
ITEM 9.
CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended, or the Exchange Act, reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Under the supervision of our Chief Executive Officer and Chief Financial Officer, we have carried out an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective at the reasonable assurance level.
Management’s Report on Internal Control 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. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting at December 31, 2020. In making this assessment, management used the criteria set forth in the 2013 version of the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this assessment, management concluded that our internal control over financial reporting is effective at December 31, 2020.
Our independent registered public accounting firm, Grant Thornton LLP, audited our internal control over financial reporting at December 31, 2020. Their report, dated March 11, 2021, expressed an unqualified opinion on our internal control over financial reporting. This report is included in this Item 9A.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
ACRES Commercial Realty Corp.
Opinion on internal control over financial reporting
We have audited the internal control over financial reporting of ACRES Commercial Realty Corp. (a Maryland corporation) and subsidiaries (the “Company”) as of December 31, 2020, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in the 2013 Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements of the Company as of and for the year ended December 31, 2020, and our report dated March 11, 2021 expressed an unqualified opinion on those financial statements.
Basis for opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and limitations of internal control over financial reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ GRANT THORNTON LLP
Philadelphia, Pennsylvania
March 11, 2021
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ITEM 9B.
ITEM 9B.
OTHER INFORMATION
On March 9, 2021, an indirect wholly owned subsidiary entered into the first amendment to the Master Repurchase Agreement, dated April 10, 2018 (“Repurchase Agreement”) with Barclays Bank PLC (“Barclays”) to amend the revolving period to end on October 29, 2021 rather than April 9, 2021.
The foregoing description does not purport to be complete and is qualified in its entirety by reference to the full text of the First Amendment to the Master Repurchase Agreement with Barclays Bank PLC dated March 9, 2021, which is filed as Exhibit 99.3(b) with this annual report on 10-K and is incorporated herein by reference.
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PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item will be set forth in our definitive proxy statement with respect to our 2021 annual meeting of stockholders, to be filed on or before April 30, 2021 (“2021 Proxy Statement”), which is incorporated herein by this reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
The information required by this item will be set forth in our 2021 Proxy Statement, which is incorporated herein by this reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item will be set forth in our 2021 Proxy Statement, which is incorporated herein by this reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required by this item will be set forth in our 2021 Proxy Statement, which is incorporated herein by this reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be set forth in our 2021 Proxy Statement, which is incorporated herein by this reference.
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PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
The following documents are filed as part of this Annual Report on Form 10-K:
1.
Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2020 and 2019
Consolidated Statements of Operations for the years ended December 31, 2020, 2019 and 2018
Consolidated Statements of Changes in Stockholders’ Equity for years ended December 31, 2020, 2019 and 2018
Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018
Notes to Consolidated Financial Statements
2.
Financial Statement Schedules
3.
Exhibits
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ITEM 16.
FORM 10-K SUMMARY
None.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ACRES COMMERCIAL REALTY CORP.
March 11, 2021
By:
/s/ Mark Fogel
Mark Fogel
President & Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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SCHEDULE II
ACRES Commercial Realty Corp.
Valuation and Qualifying Accounts
(in thousands)
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SCHEDULE III
ACRES Commercial Realty Corp.
Real Estate and Accumulated Depreciation
(in thousands)
(1)
The life on which depreciation in latest statements of comprehensive income is computed was calculated as the weighted average of the useful lives of the building, site improvements and furniture and fixtures, which comprise the investment in the property.
(2)
The property was acquired through a deed in lieu of foreclosure.
The following table rolls forward our gross investment in real estate and the related accumulated depreciation (in thousands):
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SCHEDULE IV
ACRES Commercial Realty Corp.
Mortgage Loans on Real Estate
At December 31, 2020
(in thousands, except amount in footnotes)
(1)
Maturity dates exclude extension options that may be available to borrower.
(2)
I/O = interest only
(3)
The net carrying amount of loans includes an individually determined allowance for credit losses of $1.9 million and a general allowance for credit losses of $32.4 million at December 31, 2020.
(4)
Includes one loan in forbearance at December 31, 2020.
(5)
Includes one interest-only office loan with a face amount of $19.9 million that had an individually determined reserve of $1.9 million for which foreclosure was deemed probable at December 31, 2020.
(6)
Includes one loan in forbearance at December 31, 2020.
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(7)
Includes one mezzanine loan with a par of $38.1 million and a carrying value of zero in default at December 31, 2020.
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The following table reconciles our CRE loans carrying amounts for the periods indicated (in thousands):
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