Item 1. BUSINESS
INTRODUCTION
PMC Commercial Trust (“PMC Commercial” and together with its wholly-owned subsidiaries, the “Company,” “our” or “we”) is a real estate investment trust (“REIT”) that primarily originates loans to small businesses collateralized by first liens on the real estate of the related business. Our loans are primarily to borrowers in the limited service hospitality industry. We also originate loans for commercial real estate primarily in the service, retail, multi-family and manufacturing industries. In addition, our investments include the ownership of commercial properties in the hospitality industry. Our common shares are traded on the American Stock Exchange under the symbol “PCC.” On February 29, 2004, PMC Capital, Inc. (“PMC Capital”), our affiliate through common management, merged with and into PMC Commercial.
Our mission is to derive income primarily from the origination of real estate collateralized loans and from ownership in income producing real estate. Through conservative underwriting and exceptional service, we strive to provide our shareholders with the highest dividend, consistent with the focus on preservation of investment capital.
We generated revenue primarily from the yield earned on our investments, rental income from property ownership and other fee income from our lending activities. Our operations are centralized in Dallas, Texas and include originating, servicing and selling commercial loans and property ownership. During the years ended December 31, 2005 and 2004, our total revenues were approximately $25.6 million and $21.2 million, respectively, and our net income was approximately $11.3 million and $24.8 million, respectively. Our 2004 net income includes an extraordinary gain of approximately $11.6 million from negative goodwill resulting from the merger. See “Item 8. Consolidated Financial Statements and Supplementary Data” for additional financial information.
Our wholly-owned lending subsidiaries are: First Western SBLC, Inc. (“First Western”), PMC Investment Corporation (“PMCIC”) and Western Financial Capital Corporation (“Western Financial”). First Western is licensed as a small business lending company (“SBLC”) that originates loans through the Small Business Administration’s (“SBA”) 7(a) Guaranteed Loan Program (“SBA 7(a) Loan Program”). PMCIC and Western Financial are small business investment companies (“SBICs”).
First Western is currently a “Preferred Lender,” as designated by the SBA, in Dallas, Texas and Oklahoma City, Oklahoma and originates, sells and services small business loans throughout the continental United States. As a non-bank SBA 7(a) Loan Program lender, First Western is able to originate loans on which a substantial portion of the loan (generally 75%) is guaranteed as to payment of principal and interest by the SBA. A market exists for the sale of the guaranteed portion of First Western’s loans and we receive cash premiums at the time of sale that
approximate up to 10% of the principal amount of the loan sold. To the extent we were to increase our volume of loans originated by our SBLC, there should be a corresponding increase in premiums received. In addition, due to the existence of the SBA guarantee, we are able to originate loans in industries that we would typically not lend to due to the profitability of the loan including the premium received. See “Lending Activities - SBA Programs.”
As a REIT, we seek to maximize shareholder value through long-term growth in dividends paid to our shareholders. We must distribute at least 90% of our REIT taxable income to shareholders to maintain our REIT status. See “Tax Status.” We pay dividends from the cash flow generated from operations.
Our ability to generate interest income, as well as other loan related fees, is dependent upon economic, regulatory and competitive factors that influence interest rates and loan originations and our ability to source financing for investment activities. The amount of income earned varies based on the volume of loans funded, the timing and amount of structured loan financings, the volume of loans which prepay and the resultant applicable prepayment fees, if any, the mix of loans (construction versus non-construction), the interest rate on loans originated and the general level of interest rates.
Generally, in order to fund new loans, we need to borrow funds or sell loans. Since 1996, our primary source of funds has been structured loan transactions. In a structured loan transaction, we contribute loans receivable to a special purpose entity (“SPE”) in exchange for cash and a subordinate financial interest in that entity. If the SPE meets the definition of a qualifying special purpose entity (“QSPE”), we account for the transaction as a sale of our loans receivable; and as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements. See “Structured Loan Transactions.”
We operate in two identifiable reportable segments: (i) the lending division, which originates loans to small businesses primarily in the hospitality industry, which comprised 90% of our total assets at December 31, 2005, and (ii) the property division, which owns our hotel properties and operates certain of our hotel properties, which comprised 10% of our total assets at December 31, 2005. We are in the process of selling most of our assets in the property division to focus our operations on the lending division. See detailed financial information regarding our segments in “Item 8. Consolidated Financial Statements and Supplementary Data.”
LENDING ACTIVITIES
Overview
Our lending division originates loans to small businesses, primarily in the hospitality industry. For the year ended December 31, 2005, total revenues and income from continuing operations of our lending division were approximately $24.2 million (94% of our total revenues) and $12.4 million, respectively. This compares favorably with our total revenues and income from continuing operations of our lending division during 2004 of $19.9 million and $10.5 million, respectively. The increased revenues and income from continuing operations were primarily a result of increases in variable interest rates. Total assets allocated to the lending division were approximately $232.6 million (90% of our total assets) at December 31, 2005. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary.”
We are a national lender that primarily originates small business loans in the limited service sector of the hospitality industry. By utilizing our SBA 7(a) Loan Program, we increased our loan originations to the convenience store and gas station, restaurant, service, retail and commercial real estate industries. In addition to first liens on real estate of the related business, our loans are generally personally guaranteed by the principals of the entities obligated on the loans.
In addition to our historical underwriting criteria, we are now originating loans utilizing underwriting criteria which generally have higher loan-to-value ratios than we had prior to the merger (i.e., SBA 7(a) Loan Program). As a result, our loans may incur losses in future periods in greater amounts than had historically been realized. See “Item 1A
Item 1A. RISK FACTORS
Management has identified the following important factors that could cause actual results to differ materially from those reflected in forward-looking statements or from our historical results. These factors, which are not all-inclusive, could have a material impact on our asset valuations, results of operations or financial condition. In addition, these factors could impair our ability to maintain dividend distributions at current levels.
Investment Risks - Lending Activities
Competition might prevent us from originating loans at favorable yields, which would harm our results of operations and our ability to continue paying dividends at current levels.
Our net income depends on our ability to originate loans at favorable spreads over our borrowing costs. In originating loans, we compete with other specialty commercial lenders, banks, other REITs, savings and loan associations, insurance companies and other entities that originate loans, many of which have greater financial resources than us. As a result, we may not be able to originate sufficient loans at favorable spreads over our borrowing costs, which would harm our results of operations and consequently, our ability to continue paying dividends at current levels.
There are significant risks in lending to small businesses.
Our loans receivable consist primarily of loans to small, privately-owned businesses. There is no publicly available information about these businesses; therefore, we must rely on our own due diligence to obtain information in connection with our investment decisions. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by banks. A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or other negative economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan. In addition, small businesses typically depend on the management talents and efforts of one person or a small group of people for their success. The loss of services of one or more of these persons could have an adverse impact on the operations of the small business. Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need additional capital to expand or compete. These factors may have an impact on the ultimate recovery of our loans receivable from such businesses. Loans to small businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative.
There is volatility in the valuation of our loans receivable which can require the establishment of loan loss reserves.
There is typically no public market or established trading market for the loans we originate. The illiquid nature of our loans may adversely affect our ability to dispose of such loans at times when it may be advantageous for us to liquidate such investments.
To the extent one or several of our borrowers experience significant operating difficulties and we are forced to liquidate the collateral underlying the loan, future losses may be substantial. The determination of whether significant doubt exists and whether a loan loss reserve is necessary for each loan requires judgment and consideration of the facts and circumstances existing at the evaluation date. Changes to the facts and circumstances of the borrower and/or the physical condition of the collateral underlying the loan, the hospitality industry and the economy may require the establishment of significant additional loan loss reserves.
Changes in interest rates could negatively affect lending operations, which could result in reduced earnings.
The net income of our lending operations is materially dependent upon the “spread” between the rate at which we borrow funds and the rate at which we loan these funds. During periods of changing interest rates, interest rate mismatches could negatively impact our net income, dividend yield, and the market price of our common shares.
At the present time, we primarily originate variable-rate loans and have certain debt which is long-term and at fixed interest rates and preferred stock which is long-term with a fixed dividend yield. If the yield on loans originated with funds obtained from fixed-rate borrowings or preferred stock fails to cover the cost of such funds, our cash flow will be reduced.
As a result of our dependence on variable-rate loans (all of our current commitments are for variable-rate loans), our interest income will be reduced during low interest rate environments. To the extent that LIBOR or the prime rate decreases from current levels, interest income on our currently outstanding loans receivable will decline.
Changes in interest rates do not have an immediate impact on the interest income of our fixed-rate loans receivable. Our interest rate risk on our fixed-rate loans receivable is primarily due to loan prepayments and maturities. The average maturity of our loan portfolio is less than their average contractual terms because of prepayments. The average life of mortgage loans receivable tends to increase when the current mortgage rates are substantially higher than rates on existing mortgage loans receivable and, conversely, decrease when the current mortgage rates are substantially lower than rates on existing mortgage loans receivable (due to refinancings of fixed-rate loans receivable at lower rates).
We depend on the accuracy and completeness of information about potential borrowers and guarantors.
In deciding whether or not to extend credit or enter into transactions with potential borrowers and/or their guarantors, we rely on information furnished to us by or on behalf of potential borrowers and/or guarantors, including financial statements, construction invoices and other financial information. We also rely on representations of potential borrowers and/or guarantors as to the accuracy and completeness of that information. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that are materially misleading.
Investment Risks - General
There is no market for our Retained Interests and the value is volatile.
Due to the limited number of entities that conduct transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists for our Retained Interests. Therefore, our estimate of the fair value may vary significantly from what a willing buyer would pay for these assets. If a ready market existed for our Retained Interests, the value would be different and such difference may be significant.
The following is a sensitivity analysis of our Retained Interests as of December 31, 2005 to highlight the volatility that results when prepayments, loan losses and discount rates are different than our assumptions:
(1)
Any depreciation of our Retained Interests is either included in the accompanying statement of income as a realized loss (if there is a reduction in expected future cash flows) or on our balance sheet in beneficiaries’ equity as an unrealized loss.
(2)
If we experience significant losses (i.e., in excess of anticipated losses), the effect on our Retained Interests would first be to reduce the value of the interest-only strip receivables. To the extent the interest-only strip receivables could not fully absorb the losses, the effect would then be to reduce the value of our reserve funds and then the value of our required overcollateralization.
(3)
For example, an 8% assumed rate of prepayment would be increased to 13% or 18% based on increases of 5% or 10% per annum, respectively.
These sensitivities are hypothetical and should be used with caution. Values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumptions to the change in value may not be linear. The effect of a variation in a particular assumption on the estimated fair value of our Retained Interests is calculated without changing any other assumption. In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities.
Changes in any of these assumptions or actual results which deviate from assumptions will affect the estimated fair value of our Retained Interests, possibly to a material degree. There can be no assurance as to the accuracy of these estimates.
We have a concentration of investments in the hospitality industry and in certain states, which may negatively impact our financial condition and results of operations.
Substantially all of our revenue is generated from loans collateralized by hospitality properties and the ownership of Hotel Properties. At December 31, 2005, our loans receivable were approximately 95% concentrated in the hospitality industry and approximately 93% of the loans sold to our QSPEs were concentrated in the hospitality industry. Any economic factors that negatively impact the hospitality industry, including terrorism, travel restrictions, bankruptcies or other political or geopolitical events, could have a material adverse effect on our financial condition and results of operations.
At December 31, 2005, approximately 15% of our loans receivable were collateralized by properties in Texas, approximately 10% were collateralized by properties in Arizona and approximately 28% of the loans sold to our QSPEs were collateralized by properties in Texas. No other state had a concentration of 10% or greater of our loans receivable, loans sold to our QSPEs or Aggregate Portfolio at December 31, 2005. See “Properties” in Item 2 of this Form 10-K for information on state concentrations related to our Hotel Properties. A decline in economic conditions in any state in which we have a concentration of investments could have a material adverse effect on our financial condition and results of operations.
We are subject to prepayment risk on our Retained Interests and loans receivable which could result in losses or reduced earnings and negatively affect our cash available for distribution to shareholders.
Prepayments of fixed-rate loans generally increase during times of declining interest rates. Conversely, prepayments of variable-rate loans generally increase during times of increasing interest rates. The proceeds from the prepayments we receive are either used to repay debt or invested initially in temporary investments. During reducing interest rate environments and when competition is greater, prepayments of our fixed-rate loans have generally been re-loaned or committed to be re-loaned at lower interest rates than the prepaid loans receivable. For
prepayments on variable-rate loans, if the spread we charge over LIBOR or the prime rate were to decrease, the lower interest rates we would receive on these new loans receivable would have an adverse effect on our results of operations and depending upon the rate of future prepayments may further impact our results of operations.
Prepayments on loans sold to the QSPEs may have a negative impact on our financial condition or results of operations. Prepayments of loans receivable with higher interest rates negatively impact the value of our Retained Interests to a greater extent than prepayments of loans receivable with lower interest rates. Prepayments in excess of assumptions will cause a decline in the fair value of our Retained Interests primarily relating to a reduction in the excess funds (our interest-only strip receivable) expected from our structured loan sale transactions. For example, if a $1.0 million loan with an interest rate of 10% prepays and the “all-in cost” of that QSPE’s structured notes was 7%, we would lose the 3% spread we had expected to receive on that loan in future periods. Our “all-in costs” include interest, servicing, trustee and other ongoing costs. The “spread” that is lost may be offset in part or in whole by any prepayment fee that we collect.
Our SBLC sells the guaranteed portion of most of its originated loans through private placements (“Secondary Market Sales”). These sales are particularly sensitive to prepayments. Our Retained Interests in these loan sales consists only of the spread between the interest collected from the borrower and the interest paid to the purchaser of the guaranteed portion of the loan. Therefore, to the extent the prepayments of these loans exceed estimates, we lose the estimated fair value of the associated Retained Interests.
Our Board of Trust Managers may change operating policies and strategies without shareholder approval or prior notice and such change could harm our business and results of operations and the value of our stock.
Our Board of Trust Managers has the authority to modify or waive our current operating policies and strategies, including PMC Commercial’s election to operate as a REIT, without prior notice and without shareholder approval. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and value of our stock; however, the effect could be adverse.
Liquidity and Capital Resources Risks
Our operating results could be negatively impacted by our inability to access certain financial markets.
We rely upon access to capital markets as a source of liquidity to satisfy our working capital needs, grow our business and invest in loans. Although we believe that we maintain sufficient access to these financial markets, adverse changes in the economy, the overall health of the limited service hospitality industry and increased loan losses could limit access to these markets and restrict us from continuing our current operating strategy or implementing new operating strategies.
The market for structured loan transactions may decline, which would decrease the availability of, and increase the cost of, working capital and negatively affect the potential for growth.
We will continue to need capital to fund loans. Historically, we have sold loans receivable as part of structured loan transactions, borrowed from financial institutions and issued equity securities to raise capital. A reduction in the availability of funds from financial institutions or the asset-backed securities market could have a material adverse effect on our financial condition and our results of operations. We must distribute at least 90% of our REIT taxable income to our shareholders to maintain our REIT status under the Code. As a result, that income will not be available to fund loans. Our long-term ability to continue to grow depends, to a large extent, on our ability to sell asset-backed securities through structured loan transactions. In certain economic markets the availability of funds may be diminished or the “spread” charged for funds may increase causing us to delay a structured loan transaction. In addition, terrorist attacks or political or geopolitical events could impact the availability and cost of capital.
A number of factors could impair our ability, or alter our decision, to complete a structured loan transaction. These factors include, but are not limited to:
• As a result of certain economic conditions, investors in the type of asset-backed securities that we place may increase our cost of capital by widening the “spreads” (over a benchmark such as LIBOR or treasury rates) they require in order to purchase the asset-backed securities or cease acquiring our type of asset-backed security;
• A deterioration in the performance of our loans receivable or the loans receivable of our prior transactions (for example, higher than expected loan losses or delinquencies) may deter potential investors from purchasing our asset-backed securities;
• A deterioration in the operations or market perception of the limited service sector of the hospitality industry may deter potential investors from purchasing our asset-backed securities or lower the available rating from the rating agencies; and
• A change in the underlying criteria utilized by the rating agencies may cause transactions to receive lower ratings than previously issued thereby increasing the cost on our transactions.
Significant changes in any of these criteria may result in us temporarily suspending the use of structured loan transactions and we may seek other sources of financing. A reduction in the availability or an increased cost of this source of funds could have a material adverse effect on our financial condition and results of operations since working capital may not be available or available at acceptable “spreads” to fund future loan originations or to acquire real estate.
We use leverage to fund our capital needs which magnifies the effect of changing interest rates on our earnings.
We have borrowed funds and intend to obtain additional funds. As a result, we use leverage to fund our capital needs. Private lenders and the SBA have fixed dollar claims on our assets superior to the claims of the holders of our common shares. Leverage magnifies the effect that rising or falling interest rates have on our earnings. Any increase in the interest rate earned by us on investments in excess of the interest rate on the funds obtained from borrowings would cause our net income and earnings per share to increase more than they would without leverage, while any decrease in the interest rate earned by us on investments would cause net income and earnings per share to decline by a greater amount than they would without leverage. Leverage is thus generally considered a speculative investment technique. In order for us to repay indebtedness on a timely basis, we may be required to dispose of assets when we would not otherwise do so and at prices which may be below the net book value of such assets. Dispositions of assets could have a material adverse effect on our financial condition and results of operations.
Operating Risks
Economic slowdowns, negative political events and changes in the competitive environment could adversely affect operating results.
Several factors may impact the hospitality industry. Many of the businesses to which we have made, or will make, loans may be susceptible to economic slowdowns or recessions. During economic downturns, there may be reductions in business travel and consumers generally take fewer vacations. Terrorism, bankruptcies or other political or geopolitical events could negatively affect our borrowers or our Hotel Properties. Our non-performing assets are likely to increase during these periods. These conditions could lead to losses in our portfolio and a decrease in our interest income, net income and assets.
Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans are located on interstate highways. When gas prices sharply increase, occupancy rates for properties located on interstate highways may decrease. These factors may cause a reduction in revenue per available room. If revenue for the limited service sector of the hospitality industry were to experience significant sustained reductions, (1) the ability of our borrowers to meet their obligations could be impaired and loan losses could increase and (2) revenues would decrease for our Hotel Properties and losses could result.
Many of our competitors have greater financial and managerial resources than us and are able to provide services we are not able to provide (i.e., depository services). As a result of these competitors’ greater financial resources, they may be better able to withstand the impact of economic downturns.
There may be significant fluctuations in our quarterly results which may adversely affect our stock price.
Our quarterly operating results fluctuate based on a number of factors, including, among others:
• Interest rate changes;
• The volume and timing of loan originations and prepayments of our loans receivable;
• The recognition of gains or losses on investments including our Hotel Properties;
• The level of competition in our markets; and
• General economic conditions, especially those which affect the hospitality industry.
As a result of the above factors, quarterly results should not be relied upon as being indicative of performance in future quarters.
We depend on our key personnel, and the loss of any of our key personnel could adversely affect our operations.
We depend on the diligence, experience and skill of our key personnel (executive officers) who provide management services to us for the selection, acquisition, structuring, monitoring and sale of our portfolio assets and the borrowings used to acquire these assets. We have entered into employment agreements with our executive officers. The loss of any executive officer could harm our business, financial condition, cash flow and results of operations.
We operate in a highly regulated environment, changes in which could adversely affect our financial condition or results of operations.
As a company whose common shares are publicly traded, we are subject to the rules and regulations of the SEC. In addition, we are regulated by the SBA. Changes in laws that govern our entities may significantly affect our business. Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations are also subject to change. Any change in the laws or regulations governing our business could have a material impact on our financial condition or results of operations.
At any time, U.S. Federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations thereof may take effect retroactively and could adversely affect us. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate on both dividends and long-term capital gains for most non-corporate taxpayers to 15% until 2008. This reduced maximum tax rate generally does not apply to ordinary REIT dividends, which continue to be subject to tax at the higher tax rates applicable to ordinary income (a maximum rate of 35%). However, the 15% maximum tax rate does apply to certain REIT distributions. This legislation may cause shares in non-REIT corporations to be a more attractive investment to individual investors than shares in REITs and may adversely affect the market price of our common shares.
To the extent a loan becomes a problem loan, we will deliver a default notice and begin foreclosure and liquidation proceedings when we determine that pursuit of these remedies is the most appropriate course of action. Foreclosure and bankruptcy are complex and sometimes time consuming processes that are subject to Federal and state laws and regulations, as well as various guidelines imposed by mortgage investors.
In conjunction with the operations of our assets acquired in liquidation and Hotel Properties, we are subject to numerous Federal, state and local laws and government regulations including environmental, occupational health and safety, state and local taxes and laws relating to access for disabled persons.
Under various Federal, state and local laws, ordinances and regulations, a current or former owner or operator of real estate may be considered liable for the costs of remediating or removing hazardous substances found on its property, regardless of whether or not the property owner or operator was responsible for its presence. Such liability may be imposed by the Environmental Protection Agency or any state or local government authority regardless of fault. The ultimate costs under environmental laws and the timing of these costs are difficult to predict, and the liability under some environmental laws related to contaminated sites can be imposed retroactively, may be on a joint and several basis and could be material to our financial statements or results of operations.
The Americans with Disabilities Act of 1990 (“ADA”) requires all public accommodations and commercial facilities to meet federal requirements related to access and use by disabled persons. Compliance with the ADA requirements could require removal of access barriers. Although we believe that the properties that we own or
finance are substantially in compliance with these requirements, a determination that the properties are not in compliance with the ADA could result in the imposition of fines by the U.S. Government or an award of damages to private litigants.
REIT Related Risks
Failure to qualify as a REIT would subject us to U.S. Federal income tax.
If a company meets certain income and asset diversification and income distribution requirements under the Code, it can qualify as a REIT and be entitled to pass-through tax treatment. We would cease to qualify for pass-through tax treatment if we were unable to comply with these requirements. PMC Commercial is also subject to a non-deductible 4% excise tax (and, in certain cases, corporate level income tax) if we fail to make certain distributions. Failure to qualify as a REIT would subject us to Federal income tax as if we were an ordinary corporation, resulting in a substantial reduction in both our net assets and the amount of income available for distribution to our shareholders.
We believe that we have operated in a manner that allows us to qualify as a REIT under the Code and intend to continue to so operate. Although we believe that we are organized and operate as a REIT, no assurance can be given that we will continue to remain qualified as a REIT. Qualification as a REIT involves the application of technical and complex provisions of the Code for which there are limited judicial or administrative interpretations and involves the determination of various factual matters and circumstances not entirely within our control. In addition, no assurance can be given that new legislation, regulations, administrative interpretations or court decisions will not significantly change the tax laws with respect to qualification as a REIT or the Federal income tax consequences of such qualification.
At any time, new laws, interpretations, or court decisions may change the Federal tax laws regarding, or the U.S. Federal income tax consequences of, qualification as a REIT. In addition, compliance with the REIT qualification tests could restrict our ability to take advantage of attractive investment opportunities in non-qualifying assets, which would negatively affect the cash available for distribution to our shareholders.
If PMC Commercial fails to qualify as a REIT, we may, among other things:
• not be allowed a deduction for distributions to our shareholders in computing our taxable income;
• be subject to U.S. Federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates;
• be subject to increased state and local taxes; and,
• unless entitled to relief under certain statutory provisions, be disqualified from treatment as a REIT for the taxable year in which we lost our qualification and the four taxable years following the year during which we lost our qualification.
As a result of these factors, failure to qualify as a REIT could also impair our ability to expand our business and raise capital, substantially reduce the funds available for distribution to our shareholders and may reduce the market price of our common shares.
Ownership limitation associated with our REIT status may restrict change of control or business combination opportunities.
In order for us to qualify as a REIT, no more than 50% in value of our outstanding capital shares may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year. “Individuals” include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts.
To preserve our REIT status, our declaration of trust generally prohibits any shareholder from directly or indirectly owning more than 9.8% of any class or series of our outstanding common shares or preferred shares. The ownership limitation could have the effect of discouraging a takeover or other transaction in which holders of our common shares might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests.
Failure to make required distributions to our shareholders would subject us to tax.
In order to qualify as a REIT, an entity generally must distribute to its shareholders, each taxable year, at least 90% of its taxable income, other than any net capital gain and excluding the non-distributed taxable income of
taxable REIT subsidiaries. As a result, our shareholders receive periodic distributions from us. Such distributions are taxable as ordinary income to the extent that they are made out of current or accumulated earnings and profits. To the extent that a REIT satisfies the 90% distribution requirement, but distributes less than 100% of its taxable income, it will be subject to federal corporate income tax on its undistributed income. In addition, the REIT will incur a 4% nondeductible excise tax on the amount, if any, by which its distributions in any calendar year are less than the sum of:
We have paid out, and intend to continue to pay out, our REIT taxable income to shareholders in a manner intended to satisfy the 90% distribution requirement and to avoid both Federal corporate income tax and the 4% excise tax.
Our taxable income may substantially exceed our net income as determined based on generally accepted accounting principles (“GAAP”) because, for example, capital losses will be deducted in determining GAAP income, but may not be deductible in computing 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 excess non-cash income. Although some types of non-cash income are excluded in determining the 90% distribution requirement, we will incur Federal corporate income tax and the 4% excise tax with respect to any non-cash income items if we do not distribute those items on an annual basis. As a result of the foregoing, we may generate less cash flow than taxable income in a particular year. In that event, 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 federal corporate income tax and the 4% excise tax in that year.
Our ownership of and relationship with our taxable REIT subsidiaries will be limited, and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax.
Subject to certain restrictions, a REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a taxable REIT subsidiary. A corporation of which a taxable REIT subsidiary directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a taxable REIT subsidiary. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries. A taxable REIT subsidiary generally will pay income tax at regular corporate rates on any taxable income that it earns. In addition, the taxable REIT subsidiary rules limit the deductibility of interest paid or accrued by a taxable REIT subsidiary to its parent REIT to assure that the taxable REIT subsidiary is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis.
Our taxable REIT subsidiaries are PMCIC, First Western, PMC Funding Corp. and PMC Properties, Inc. (“PMC Properties”). PMC Funding Corp. holds assets on our behalf. PMC Properties is the operator, through third party management companies, of certain of our Hotel Properties.
Our taxable REIT subsidiaries are subject to normal corporate income taxes. We will monitor at all times the value of our investments in taxable REIT subsidiaries for the purpose of ensuring compliance with the rule that no more than 20% of the value of our assets may consist of taxable REIT subsidiary stock and securities (which is applied at the end of each calendar quarter). The aggregate value of our taxable REIT subsidiary stock and securities is less than 20% of the value of our total assets (including our taxable REIT subsidiary stock and securities). In addition, we will scrutinize all of our transactions with our taxable REIT subsidiaries for the purpose of ensuring that they are entered into on arm’s-length terms in order to avoid incurring the 100% excise tax described above. There are no distribution requirements applicable to the taxable REIT subsidiaries and after-tax earnings may be retained. There can be no assurance, however, that we will be able to comply with the 20% limitation on ownership of taxable REIT subsidiary stock and securities on an ongoing basis so as to maintain REIT status or to avoid application of the 100% excise tax imposed on certain non-arm’s-length transactions.
Hotel Property Ownership Risks
We are dependent on third party management for the operation and management of our Hotel Properties and we are subject to operating risks of Hotel Properties.
We are currently dependent upon third party managers to operate and manage our Hotel Properties. As a REIT, PMC Commercial cannot directly operate the Hotel Properties. The operating results of our Hotel Properties are subject to a variety of risks which could negatively impact their cash flows.
Arlington rejected the remaining 12 individual property leases on January 13, 2006. As a result, we are incurring costs including holding costs and operating costs until the properties are sold. While we are unable to currently quantify these costs, we anticipate, based on the properties’ past operating results, that working capital shortfalls may occur during the winter months. In addition, our properties are typically located in tertiary markets and as a result are generally dependent on the local economy and businesses to generate revenue. We expect to sell properties in an orderly and timely manner. In addition, we may seek to locate new tenants for some or all of our Hotel Properties. There can be no assurance that we will be able to find new tenants for our Hotel Properties or negotiate to receive the same amount of historical lease income.
Our ability to sell the Hotel Properties at favorable prices could be adversely affected by market conditions or other factors.
The expected sales proceeds from our Hotel Properties could be impacted by numerous factors including supply and demand of hotel properties and negotiations with buyers regarding acceptable down payments and eligibility of financing. We generally require a down payment of 20% on any Hotel Property sale. There can be no assurance that we will receive our expected net proceeds from the Hotel Property sales.
We could encounter risks that adversely affect real estate ownership.
Our real estate investments are subject to a variety of risks including, but not limited to:
• adverse changes in general or local economic or real estate market conditions;
• changes in zoning laws;
• changes in traffic patterns and neighborhood characteristics;
• increases in assessed valuation and real estate tax rates;
• increases in the cost of property insurance;
• governmental regulations and fiscal policies;
• the potential for uninsured or underinsured property losses; and
• the impact of environmental laws and regulations.
Materialization of any of these risks could cause us to incur losses, and our results of operations and financial condition could be adversely impacted.
Uninsured and underinsured losses could result in a loss of value of our Hotel Properties.
Our insurance coverage may not be sufficient to fully insure our businesses and assets from claims and/or liabilities, including environmental liabilities. In the event that losses or claims are beyond the scope of our coverage, we could incur losses which could be substantial and our results of operations and financial position could be materially adversely affected.
We may be required to make significant capital improvements to maintain our Hotel Properties and their flags.
We may be required to replace furniture, fixtures and equipment or to make other capital improvements or renovations to the Hotel Properties which could affect our liquidity. We could also need periodic capital improvements to comply with standards associated with any flag under franchise agreements. These capital improvements may cause a disruption of operations and potential lost room revenue to the extent not covered by insurance and/or a reduction of return on our investment in these Hotel Properties including not being able to recoup these costs from the buyers of our Hotel Properties and impairment losses could result.
We may be adversely affected by the requirements of our franchise and licensing agreements for our Hotel Properties.
Subsequent to December 31, 2005, we executed franchise agreements on our Hotel Properties. These agreements contain standards required for the operation and maintenance of our Hotel Properties.
To the extent we sell our Hotel Properties as Amerihost Inns, the buyer will be subject to the approval of the franchisor. At times, it may be more difficult to receive their approval to sell a Hotel Property. However, we may sell our Hotel Properties as independents (without a flag) or as other franchises. If this occurs, the buyer would be subjected to costs of “re-flagging” the property which could reduce the price at which we could sell the property and impairment losses could result.
We may not be able to compete effectively with other hotels for guests.
The limited service hospitality segment of the hotel business is highly competitive. As such, our Hotel Properties compete on the basis of price, quality, reputation, services and reservation systems, among other things. Other hotel brands may have greater resources than us and may be able to provide other services that we cannot. There is no assurance that we will be able to compete effectively and losses could result which could adversely affect our results of operations or financial condition.
We are subject to increasing operating costs at our hotels.
We are subject to a variety of risks associated with operating our Hotel Properties, including, but not limited to increases in the following costs:
These operating costs are relatively fixed in nature and generally cannot be curtailed if our revenues decrease. As such, we may incur operating losses.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS
None.
Item 2.
Item 2. PROPERTIES
We lease office space for our corporate headquarters in Dallas, Texas under an operating lease which expires in October 2011.
At December 31, 2005, we owned 13 Hotel Properties of which four Hotel Properties were sold prior to March 14, 2006. Except for one property, at December 31, 2005, the Hotel Properties were leased to AII pursuant to individual property leases, as amended, which were subject to the terms of a Master Lease Agreement. On January 13, 2006, we received rejection notices on the remaining 12 individual property leases. As a result of the rejection of the leases, we have now taken possession of the properties and hired third party management companies to operate the properties. See “Item 1. - Business - Property Ownership.”
The following table describes the location, number of rooms and year built relating to our Hotel Properties:
Item 3.
Item 3. LEGAL PROCEEDINGS
In the normal course of business, including the ownership and operations of our assets acquired in liquidation, we are periodically party to certain legal actions and proceedings involving matters that are generally incidental to our business (i.e., collection of loans receivable). In management’s opinion, the resolution of these legal actions and proceedings will not have a material adverse effect on our consolidated financial statements.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 2005.
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Common Shares are traded on the American Stock Exchange (the “AMEX”) under the symbol “PCC.” The following table sets forth, for the periods indicated, the high and low sales prices as reported on the AMEX and the regular dividends per share declared by us for each such period.
On March 7, 2006, there were approximately 1,200 holders of record of Common Shares and the last reported sales price of the Common Shares was $13.15.
Our shareholders are entitled to receive dividends when and as declared by our Board of Trust Managers (the “Board”). Our Board considers many factors in determining dividend policy including, but not limited to, expectations for future earnings, REIT taxable income, the interest rate environment, competition, our ability to obtain leverage and our loan portfolio activity. The Board also uses REIT taxable income plus tax depreciation in determining the amount of dividends declared. In addition, as a REIT we are required to pay out 90% of taxable income. Consequently, the dividend rate on a quarterly basis will not necessarily correlate directly to any single factor such as REIT taxable income or earnings expectations. The Board anticipates that the minimum quarterly dividend per common share during 2006 will be $0.30.
We have certain covenants within our debt facilities that limit our ability to pay out returns of capital as part of our dividends. These restrictions have not historically limited the amount of dividends we have paid and management does not believe that they will restrict future dividend payments. See “Selected Consolidated Financial Data” in Item 6, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” in Item 7 and “Consolidated Financial Statements and Supplementary Data” in Item 8 for additional information concerning dividends.
We have not had any sales of unregistered securities during the last three years.
See Item 12 in this Form 10-K for information regarding our equity compensation plans.
Item 6.
Item 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following is a summary of our Selected Consolidated Financial Data as of and for the five years in the period ended December 31, 2005. The following data should be read in conjunction with our consolidated financial statements and the notes thereto and “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 the related notes that appear elsewhere in this document.
BUSINESS
Our mission is to derive income primarily from the origination of collateralized loans and from ownership in income producing real estate. Through conservative underwriting and exceptional service, we strive to provide our shareholders with the highest dividend, consistent with the focus on preservation of investment capital.
We are primarily a commercial lender that originates loans to small businesses that are principally collateralized by first liens on the real estate of the related business. We then sell certain of our loans receivable through privately-placed structured loan transactions. Historically, we have retained residual interests in all loans receivable sold through our subordinate financial interest in the related qualifying special purpose entities (“QSPEs”).
Our revenues have historically included the following:
• Interest earned on our loans receivable;
• Lease income on our Hotel Properties;
• Income on our Retained Interests; and
• Other related loan fees, including late fees, prepayment fees and construction monitoring fees.
Our ability to generate interest income, as well as other revenue sources, is dependent on economic, regulatory and competitive factors that influence interest rates and loan originations, and our ability to secure financing for our investment activities. The amount of income earned will vary based on the volume of loans funded, the timing and amount of structured loan financings, the volume of loans receivable which prepay, the mix of loans (construction versus non-construction), the interest rate and type of loans originated (whether fixed or variable) as well as the general level of interest rates. For a more detailed description of the risks affecting our financial condition and results of operations, see “Risk Factors” in Item 1A of this Form 10-K.
EXECUTIVE SUMMARY
We have gone through a period of transition, with 2005 being the first full year of combined operations following the merger of our affiliate, PMC Capital, into PMC Commercial. During 2005, we were faced with several challenges including (1) the loan products which we offer to our borrowers do not include a viable fixed-rate loan product, (2) the margins we currently receive between the interest rate we charge our borrowers and the interest rate we are charged by our lenders has been diminishing, (3) the tenant for our owned Hotel Properties filed for bankruptcy and (4) we needed to provide liquidity to build a portfolio of variable-rate loans to securitize.
As a result of the flattening of the yield curve (i.e., compression of long-term and short-term interest rates) combined with increased competition from fixed-rate lenders, our margins for fixed-rate loans have contracted to the point where they are not economically viable. Our volume and commitments have therefore been primarily variable-rate. Until the yield curve combined with fixed-rate competition changes, we expect this trend to continue. We believe that the market has changed so that a greater percentage of borrowers are looking for fixed-rate loans; however, we are constrained by our cost of funds. The local banks offer a five-year maturity, 20-year amortization loan (“mini-perm loan”) at a more attractive rate than we can offer based on our current cost of funds. For the first two months of 2006, our loan originations were approximately $10.8 million of which approximately $8.2 million were originated in connection with sales of Amerihost Inn hotels and $1.0 million represents a loan repurchased from a securitization.
Even if we were to originate fixed-rate loans, the securitization market cost of funds may cause us to have a lower spread than we have historically achieved on our fixed-rate securitizations. In addition, during the interim period between when we make loans with fixed interest rates and when we complete a fixed-rate structured loan transaction, if rates were to rise, our spreads would narrow. Therefore, until interest rate markets and competition revert back to conditions in 2002 and prior or we find an alternative source of funds, we expect continued strong competition and therefore, limited originations of fixed-rate loans. We continue to actively pursue alternative
sources of funds, including interest rate hedges, to reduce our cost of funds which will allow us to originate fixed-rate loans at competitive rates.
For our liquidity needs, in February 2005, we completed a $100 million conduit warehouse facility which operates as a revolving credit line and is collateralized by loans we originated. The advantages of this facility are to lower our cost of funds and increase our capacity to originate variable-rate loans. Then, in March 2005, we received net proceeds of approximately $26 million through the issuance of junior subordinated notes. While the floating interest rate on these notes is relatively high at LIBOR plus 3.25%, they provide a long-term source of capital with a maturity of 30 years which can be prepaid at our option any time after the initial five years. These notes are subordinate to our other debt and have few corporate restrictions. We believe that the issuance of these junior subordinated notes is a favorable alternative to an equity issuance.
In June 2005, after we did not receive our May and June rent payments, the lessee of our Hotel Properties, Arlington Inns, Inc. (“AII”) filed for bankruptcy protection. This was followed in August 2005 with the bankruptcy filing of Arlington Hospitality, Inc. (“AHI” and together with AII, “Arlington”), the parent of AII and the guarantor of all lease obligations. AII operated the properties under its bankruptcy plan and paid us an aggregate of approximately $1.5 million in rent from July 2005 through January 2006.
On January 13, 2006, AII rejected the leases and turned over property operations on those properties as well as two additional properties that were owned by Arlington and served as collateral on two of our loans receivable. Due to the lease rejection, no additional rent payments will be received from Arlington. We originally purchased a total of 30 properties, operated as Amerihost Inns, during 1998 and 1999. We commenced selling properties during 2000, and we began 2005 with 19 owned Hotel Properties and four securitized loans on Amerihost properties owned by Arlington for a total of 23 properties. We have reduced our ownership through the sale of twelve properties (six during 2005 and six during 2006 through March 14, 2006) and the repayment in full on two loans, so that our ownership has been reduced to nine Hotel Properties with two of those properties under contract for sale with significant deposits. The six properties sold during 2005 resulted in gains of approximately $1.3 million. During 2005, as a result of the Arlington bankruptcies and anticipated lease rejection, we recorded impairment losses on our Hotel Properties of approximately $2.2 million and a reserve on our rent and related receivables relating to Arlington of approximately $1.3 million.
Arlington has completed the sale of substantially all of its assets. We have significant outstanding claims against Arlington’s bankruptcy estate. Based on information provided through the bankruptcy proceedings, an estimate of net cash proceeds available to the unsecured creditors we recorded an impairment on these claims and valued those claims at approximately $1.5 million at December 31, 2005. There can be no assurance that we will collect our claims from Arlington.
We anticipate selling certain of our Amerihost hotels before the end of the summer season (August) and to lease the other properties which have mortgages with significant prepayment penalties. As a REIT, we cannot directly operate hotel properties. As a result, we hired third party management companies to operate the properties. While the annualized leases payments we were receiving from AII were approximately $2.4 million for the 12 hotel properties operated by Arlington at December 31, 2005, based on operating data provided by Arlington, the properties’ cash flow from operations commonly referred to as EBITDAR (earnings before interest, taxes, depreciation, amortization and rent) was approximately $1.0 million. In addition, the first quarter of the year is typically the slowest period for hotel operations and the projected data provided by Arlington shows negligible EBITDAR generated during the first quarter.
CURRENT OPERATING OVERVIEW AND ECONOMIC FACTORS
The following provides a summary of our current operating overview and significant economic factors that may have an impact on our financial condition and results of operations. The factors described below could impact the volume of loan originations, the income we earn on our assets, our ability to complete a securitization, the performance of our loans, the operations of our properties and/or the performance of the QSPEs.
Lending Division
Loans originated during 2005 were $58.9 million which is greater than the $53.7 million of loans we originated during 2004. We currently anticipate loan originations to be between $60 million and $80 million during 2006. At December 31, 2005 and 2004, our outstanding commitments to fund new loans were approximately $50.5 million and $30.3 million, respectively. All of our current commitments are for variable-rate loans which provide an
interest rate match with our present sources of funds. Our outstanding commitments to fund new loans have been increasing and are expected to continue at these levels. The majority of these commitments are for construction loans and loans committed to refinance construction loans upon project completion which should provide a stronger funding base for 2006. The funding of construction and construction takeout loans generally takes place over a longer period of time compared to non-construction loans.
Several key concerns affect our estimates of future loan originations as detailed below:
• our inability to originate fixed-rate loans with an adequate spread;
• borrowers looking to fix their cost of capital (borrow at fixed rates) in anticipation of continuation of rising interest rates;
• uncertainty as to the cost of funds of future securitizations; and
• local banks, with a substantially lower cost of capital than us, lending to operators in the limited service hospitality industry.
In order to effectively compete for variable-rate loans, we are currently reducing the interest rate spreads that we charged during 2005 by approximately 25 to 50 basis points related to our LIBOR based loans. We believe that the spread reduction will still provide us with appropriate rewards for the risk related to the types of loans that we are originating but such loans will not be as profitable as in prior years.
We believe that the market has changed so that a greater percentage of borrowers are looking for fixed-rate loans; however, we are constrained by our cost of funds and potential exposure to interest rate risk. Local bank competition offers, among other things, five-year fixed-rate loans whose rates are well below the long-term interest rates that we can presently offer. Historically, the rate charged to our borrowers for our fixed-rate product needed to be around 3.75% to 4% over the 10-year treasury in order to provide us with what management believed was a reasonable spread. With the 10-year treasury at approximately 4.75%, the rate we needed to obtain is approximately 8.5% to 8.75% for a quality loan with a 20-year amortization and maturity. The local banks offer a five-year maturity, 20-year amortization loan at approximately 7.0% to 7.5%. Management believes that the difference between the bank’s rate and ours is causing a greater percentage of borrowers to take on the refinancing risk that rates will not rise by more than 1.75% in the next five years and they are therefore taking the “mini-perm” bank loan.
Our net interest margin is dependent upon the difference between the cost of our borrowed funds and the rate at which we invest these funds (the “net interest spread”). A significant reduction in net interest spread may have a material adverse effect on our results of operations and may cause us to re-evaluate our lending focus. Over the past few years the spread has been reduced causing decreased income from continuing operations (excluding the increase from loans acquired in the merger) and there can be no assurance that it will not continue to decrease. We believe that our LIBOR-based loan program allows us to compete more effectively with variable-rate products of our competitors, provides us with a more attractive securitization product and provides us with a net interest spread that is less susceptible to interest rate fluctuations than any fixed-rate loan programs.
Property Division
We owned 13 Hotel Properties at December 31, 2005 of which four Hotel Properties were sold prior to March 14, 2006. As a REIT, PMC Commercial cannot directly operate these properties. As a result, we are dependent upon third party management companies to operate and manage our Hotel Properties. We entered into a Master Lease Agreement with AHI and AII covering all the properties and entered into a guaranty agreement with AHI whereby AHI guaranteed all obligations of AII under the individual property lease agreements. The Master Lease Agreement, as amended, with the individual property lease agreements being known as the “Lease Agreement.” AII filed for bankruptcy protection under Chapter 11 on June 22, 2005. Since Arlington defaulted on the amended master lease agreement (“Master Lease Agreement”), there is no assurance that we will be able to sell the Hotel Properties, find a new operator for our Hotel Properties, negotiate to receive the same amount of lease income or collect on the guarantee of Arlington. In addition, we are incurring costs, including additional holding costs and legal fees and may incur costs to re-franchise the properties.
It is our intention to sell the Hotel Properties in an orderly and efficient manner. While there can be no assurance of the net proceeds that we will receive from selling our properties, we believe that the net proceeds on an aggregate basis for our nine remaining Hotel Properties held for sale with a net book value of approximately $15.4 million will be approximately $18.2 million. As of March 14, 2006, we have sold four Hotel Properties with an aggregate net book value of approximately $7.2 million for approximately $8.9 million. While management believes these values are appropriate based on current market conditions, these values may change based on the
numerous factors that impact the (1) local and national economy, (2) prospects for the hospitality industry, (3) timing of particular sales, (4) franchise affiliation and (5) particular operating results of the property.
Our Hotel Properties are reviewed for impairment whenever events or circumstances indicate that the carrying amount of the property may not be recoverable, but in no event less than on a quarterly basis. To the extent Hotel Properties are sold, we will receive the net proceeds, after payment of any mortgage debt related to individual properties (as of December 31, 2005 we have mortgage debt of approximately $11.5 million on nine of the properties, including approximately $5.9 million on the properties deemed held for sale). Mortgage debt of approximately $4.7 million was repaid during 2006.
Lodging Industry
The prevailing lodging industry perception for 2006 and 2007 is more optimistic than 2005. Lodging demand in the United States appears to correlate to changes in U.S. GDP growth, with typically a two to three quarter lag. Therefore, given the relatively strong U.S. GDP growth in the past year, an improvement in 2006 and 2007 lodging demand is predicted by industry analysts. Such improvement will be dependent upon several factors including: the strength of the economy, the correlation of hotel demand to new hotel supply and the impact of global or domestic events on travel and the hotel industry. Leading industry analysts, PricewaterhouseCoopers LLP, have published reports that predict the industry’s results will continue to improve in 2006 and 2007. However, the economic recovery in the Midwestern United States, which is primarily where our Hotel Properties are located, has lagged behind the general United States economic recovery. In fact, the lodging industry in certain Midwestern states has not shown any significant signs of recovery. See “Property Ownership Data.”
PORTFOLIO INFORMATION
Lending Activities
General
Our lending activities consist primarily of originating loans to borrowers who operate properties in the hospitality industry. Our net loans receivable were $157.6 million and $128.2 million at December 31, 2005 and 2004, respectively.
Loans originated and principal repayments on loans were as follows:
(1)
Represents second mortgages obtained through the SBA 504 Program which are repaid by certified development companies.
At December 31, 2005, approximately $138.9 million of our loans receivable had a variable interest rate (reset on a quarterly basis) based primarily on the 90-day LIBOR, or the prime rate (primarily related to our SBA 7(a) Loan Program) with a weighted average interest rate of approximately 8.3%. The spread that we charge over LIBOR generally ranges from 3.25% to 4.50% and the spread we charge over the prime rate generally ranges from 1.75% to 2.75%. The LIBOR and prime rate used in determining interest rates during the first quarter of 2006 (set on January 1, 2006) was 4.53% and 7.25%, respectively. To the extent LIBOR or the prime rate changes, we will have changes in interest income from our variable-rate loans receivable. In addition, at December 31, 2005, approximately $18.7 million of our loans receivable had a fixed interest rate with a weighted average interest rate of approximately 9.4%. See “Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Since our consolidated balance sheet consists of items subject to interest rate risk, we are subject to market risk associated with changes in interest rates as described below. Although management believes that the analysis below is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of our consolidated balance sheet and other business developments that could affect our financial position and net income. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by these estimates.
LOANS RECEIVABLE
Our loans receivable are approximately 88% variable-rate at spreads over LIBOR or the prime rate consistent with the market. Increases or decreases in interest rates will generally not have a material impact on the fair value of our variable-rate loans receivable.
Changes in interest rates on our fixed-rate loans receivable do not have an immediate impact on our interest income. Our interest rate risk on our fixed-rate loans receivable is primarily related to loan prepayments and maturities. The average maturity of our loan portfolio is less than their average contractual terms because of prepayments. The average life of mortgage loans receivable tends to increase when the current mortgage rates are substantially higher than rates on existing mortgage loans receivable and, conversely, decrease when the current mortgage rates are substantially lower than rates on existing mortgage loans receivable (due to refinancings of fixed-rate loans).
Our loans receivable are recorded at cost and adjusted by net loan origination fees and discounts (which are recognized as adjustments of yield over the life of the loan) and loan loss reserves. We had $18.7 million and $28.1 million of fixed-rate loans receivable at December 31, 2005 and December 31, 2004, respectively. The estimated fair value of our fixed interest rate loans receivable (approximately $19.0 million at December 31, 2005) is dependent upon several factors including changes in interest rates and the market for the types of loans that we have originated. If we were required to sell our loans at a time we would not otherwise do so, our losses may be substantial.
At December 31, 2005 and 2004, we had $138.9 million and $100.1 million of variable-rate loans receivable, respectively, and $54.8 million and $28.3 million of variable-rate debt at December 31, 2005 and 2004, respectively. On the differential between our variable-rate loans receivable outstanding and our variable-rate debt ($84.1 million and $71.8 million at December 31, 2005 and 2004, respectively) we have interest rate risk. To the extent variable rates decrease our interest income net of interest expense would decrease.
As a result of $21.7 million and $22.4 million at December 31, 2005 and 2004, respectively, of our variable-rate loans receivable having interest rate floors (from 5.25% to 6%), we are deemed to have derivative instruments. However, in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, we are not required to bifurcate these investments; therefore, they are not accounted for as derivatives. To the extent that interest rates decline with respect to our loans that have floors, our interest expense on our variable-rate debt will be reduced by a higher amount than our interest income. We do not use derivatives for speculative purposes.
The sensitivity of our variable-rate loans receivable and debt to changes in interest rates is regularly monitored and analyzed by measuring the characteristics of our assets and liabilities. We assess interest rate risk in terms of the potential effect on interest income net of interest expense in an effort to ensure that we are insulated from any significant adverse effects from changes in interest rates. Based on our analysis of the sensitivity of interest income and interest expense at December 31, 2005 and 2004, if the consolidated balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, each hypothetical 100 basis point reduction in interest rates would reduce net income by approximately $624,000 and $494,000, respectively, on an annual basis.
DEBT
At December 31, 2005 and 2004, approximately $32.8 million (37%) and $50.5 million (64%) of our consolidated debt had fixed rates of interest and therefore was not affected by changes in interest rates. Any amount outstanding on our Revolver or the conduit facility is based on the prime rate and/or LIBOR (or approximates LIBOR) and thus subject to adverse changes in market interest rates. Assuming there were no increases or decreases
in the balance outstanding under our variable-rate debt at December 31, 2005, each hypothetical 100 basis points increase in interest rates would increase interest expense and therefore decrease net income by approximately $548,000.
Since our fixed-rate debt has coupon rates that are currently higher (in general) than market rates, the fair value of these financial instruments is higher than their cost thus decreasing our net worth. The majority of this debt is SBA debentures, mortgages payable and the structured notes payable from our 1998 structured loan financing. Our debentures have current prepayment penalties between 1% and 5% of the principal balance. Of our $7.9 million of fixed-rate Hotel Property mortgages at December 31, 2005, $5.6 million have significant penalties for prepayment and $2.3 million have minimal or no prepayment penalties. Subsequent to December 31, 2005, the significant prepayment penalty was waived on one of the Hotel Properties and the mortgage was repaid.
The following presents the principal amounts, weighted average interest rates and estimated fair values required by year of expected maturity to evaluate the expected cash flows and sensitivity to interest rate changes of our outstanding debt at December 31, 2005 and 2004.
Market risk disclosures related to our outstanding debt as of December 31, 2005 were as follows:
Market risk disclosures related to our outstanding debt as of December 31, 2004 were as follows:
RETAINED INTERESTS
Our Retained Interests are valued based on various factors including estimates of appropriate discount rates. Changes in the discount rates used in estimating the fair value of the Retained Interests will impact their carrying value. Any appreciation of our Retained Interests is included on our consolidated balance sheet in beneficiaries’ equity. Any depreciation of our Retained Interests is either included in the consolidated statements of income as a realized loss (if there is a reduction in expected future cash flows) or on our balance sheet in beneficiaries’ equity as an unrealized loss. Assuming all other factors (i.e., prepayments, losses, etc.) remained unchanged, if discount rates were 100 basis points and 200 basis points higher than rates estimated at December 31, 2005, the estimated fair value of our Retained Interests at December 31, 2005 would have decreased by
approximately $2.3 million and $4.5 million, respectively. Assuming all other factors (i.e., prepayments, losses, etc.) remained unchanged, if discount rates were 100 basis points and 200 basis points higher than rates estimated at December 31, 2004, the estimated fair value of our Retained Interests at December 31, 2004 would have decreased by approximately $2.8 million and $5.4 million, respectively.
Item 8.
Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item 8 is hereby incorporated by reference to our Financial Statements beginning on page of this Form 10-K.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, management has evaluated the effectiveness our disclosure controls and procedures (as defined under rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of December 31, 2005. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits to the SEC under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms and include controls and procedures designed to ensure the information required to be disclosed by the Company in such reports is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is 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.
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.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on their assessment, management determined that as of December 31, 2005, the Company’s internal control over financial reporting was effective based on those criteria.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm as stated in their report which appears herein.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. OTHER INFORMATION
None.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 with regard to directors and executive officers of the Company and compliance with Section 16(a) of the Exchange Act is hereby incorporated by reference to our definitive proxy statement to be filed with the SEC within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders.
Code of Ethics
We have adopted a Code of Business Conduct and Ethics for trust managers, officers and employees which is available on our website at www.pmctrust.com. Shareholders may request a free copy of the code of Business Conduct and Ethics from:
PMC Commercial Trust
Attention: Chief Financial Officer
17950 Preston Road, Suite 600
Dallas, Texas 75252
(972) 349-3235
www.pmctrust.com
We have also adopted a Code of Ethical Conduct for Senior Financial Officers setting forth a code of ethics applicable to our principal executive officer, principal financial officer and principal accounting officer, which is available on our website at www.pmctrust.com. Shareholders may request a free copy of the Code of Ethical Conduct for Senior Financial Officers from the address and phone number set forth above.
Corporate Governance Guidelines
We have adopted Corporate Governance Guidelines which are available on our website at www.pmctrust.com. Shareholders may request a free copy of the Corporate Governance Guidelines from the address and phone number set forth above under “-Code of Ethics.”
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this Item 11 regarding executive compensation is hereby incorporated by reference to our definitive proxy statement to be filed with the SEC within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
All of our equity compensation plans were approved by our security holders. Information regarding our equity compensation plans at December 31, 2005 was as follows:
On August 31, 2005, our Board authorized a share repurchase program for up to $10 million for the purchase of outstanding common shares, expiring August 31, 2006. The common shares may be purchased from time to time in the open market or pursuant to negotiated transactions. We purchased 129,400 common shares during 2005 in the open market as described below.
Additional information regarding security ownership of certain beneficial owners and management and related shareholder matters is hereby incorporated by reference to our definitive proxy statement to be filed with the SEC within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 regarding certain relationships and related transactions is hereby incorporated by reference to our definitive proxy statement to be filed with the SEC within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item 14 regarding principal accountant fees and services is hereby incorporated by reference to our definitive proxy statement to be filed with the SEC within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders.
PART IV
Item 15.
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Documents filed as part of this report
(1) Financial Statements -
See index to Financial Statements set forth on page of this Form 10-K.
(2) Financial Statement Schedules -
Schedule II - Valuation and Qualifying Accounts
Schedule III - Real Estate and Accumulated Depreciation
Schedule IV - Mortgage Loans on Real Estate
See Exhibit Index beginning on page E-1 of this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on our behalf by the undersigned, hereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
FORM 10-K
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Beneficiaries’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts
Schedule III - Real Estate and Accumulated Depreciation
Schedule IV - Mortgage Loans on Real Estate
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Trust Managers of
PMC Commercial Trust:
We have completed integrated audits of PMC Commercial Trust’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedules
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, beneficiaries’ equity, and cash flows present fairly, in all material respects, the financial position of PMC Commercial Trust (the “Company”) and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in “Management’s Report On Internal Control Over Financial Reporting,” appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
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 (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) 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 (iii) 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/ PricewaterhouseCoopers LLP
Dallas, Texas
March 16, 2006
PMC COMMERCIAL TRUST AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF BENEFICIARIES’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Summary of Significant Accounting Policies:
Business
PMC Commercial Trust (“PMC Commercial” or together with its wholly-owned subsidiaries, “we,” “us” or “our”) was organized in 1993 as a Texas real estate investment trust (“REIT”). Our common shares of beneficial interest (“Common Shares”) are traded on the American Stock Exchange (symbol “PCC”). We primarily obtain income from the yield earned on our investments, other related fee income from our lending activities and rental income from property ownership. To date, these investments have been principally in the hospitality industry. On February 29, 2004, PMC Capital, Inc., a regulated investment company related to us through common management, was merged with and into PMC Commercial.
Principles of Consolidation
We consolidate entities that we control by ownership of a majority voting interest as well as variable interest entities (“VIEs”) for which we are the primary beneficiary. To the extent we do not have a majority voting interest, we use the equity method to account for investments for which we have the ability to exercise significant influence over operating and financial policies. Consolidated net income includes our share of the net earnings of any entity accounted for using the equity method. The difference between consolidation and the equity method impacts certain financial ratios because of the presentation of the detailed line items reported in the financial statements. All material intercompany balances and transactions have been eliminated.
The consolidated financial statements include the accounts of PMC Commercial, First Western SBLC, Inc. (“First Western”), PMC Investment Corporation (“PMCIC”), Western Financial Capital Corporation (“Western Financial”), PMC Commercial Trust, Ltd. 1998-1 (“PMCT Trust”), PMC Funding Corp. (“PMC Funding”), PMC Asset Holding, LLC (“Asset Holding”), PMC Conduit, L.P. (“PMC Conduit”), PMC Properties, Inc. (“PMC Properties”) and four separate subsidiaries created in conjunction with the purchase of four hotel properties in 1999.
First Western is licensed as a small business lending company that originates loans through the SBA 7(a) Guaranteed Loan Program. PMCIC and Western Financial are licensed small business investment companies under the Small Business Investment Act of 1958, as amended (“SBIA”). PMCT Trust was formed in conjunction with our 1998 structured loan financing transaction. PMC Funding, Asset Holding and PMC Conduit hold assets on our behalf. PMC Properties is the operator, through third party management companies, of certain limited service hospitality properties.
In addition, we own subordinate financial interests in several non-consolidated special purpose entities (i.e., retained interests in transferred assets (“Retained Interests”)). These are PMC Capital, L.P. 1998-1 (the “1998 Partnership”), PMC Capital, L.P. 1999-1 (the “1999 Partnership”), PMC Joint Venture, L.P. 2000 (the “2000 Joint Venture”), PMC Joint Venture, L.P. 2001 (the “2001 Joint Venture”), PMC Joint Venture, L.P. 2002-1 (the “2002 Joint Venture”) and PMC Joint Venture, L.P. 2003 (the “2003 Joint Venture,” and together with the 2000 Joint Venture, the 2001 Joint Venture and the 2002 Joint Venture, the “Joint Ventures,” and the Joint Ventures together with the 1998 Partnership and the 1999 Partnership, the “QSPEs”) created in connection with structured loan sale transactions.
We account for our Retained Interests in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS No. 140”). While we are the servicer of the assets held by these QSPEs, we are required under the transaction documents to comply with strict servicing standards and are subject to the approval of the trustees and/or noteholders regarding any significant issues associated with the assets. As a result, we believe we have relinquished control of the assets sold to our QSPEs. Accordingly, the assets, liabilities, partners’ capital and results of operations of the QSPEs are not included in our consolidated financial statements.
Loans Receivable, net
We primarily originate loans to small businesses collateralized by first liens on the real estate of the related business. Loans receivable are carried at their unamortized principal balance less net loan origination fees, discounts and loan loss reserves. For loans originated under the SBA 7(a) Guaranteed Loan Program, when we sell the SBA guaranteed portion of the loans, a portion of the sale proceeds representing the difference in the face amount of the unguaranteed portion of the loans and the value of the loans (the “Retained Loan Discount”) is recorded as a reduction in basis of the retained portion of the loan rather than premium income. For purchased loans, we may have discounts representing the difference between the carrying value of the loan and its estimated fair value at the date of purchase.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A loan loss reserve is established based on a determination, through an evaluation of the recoverability of individual loans receivable, that significant doubt exists as to the ultimate realization of the loan receivable. The determination of whether significant doubt exists and whether a loan loss reserve is necessary for each loan receivable requires judgment and considers the facts and circumstances existing at the evaluation date. Our evaluation of the adequacy of the reserve is based on a review of our historical loss experience, known and inherent risks in the loan portfolio, adverse circumstances that may affect the ability of the borrower to repay interest and/or principal and, to the extent the payment of the loan appears impaired, the estimated fair value of the collateral.
Retained Interests
Retained Interests represent the subordinate interest in QSPEs created in conjunction with structured loan sale transactions. Retained Interests are carried at estimated fair value, with realized gains and losses included in net income and unrealized gains and losses recorded in beneficiaries’ equity. The estimated fair value of our Retained Interests is based on estimates of the present value of future cash flows we expect to receive. Estimated future cash flows are based in part upon an estimate of prepayment speeds and loan losses. Prepayment speeds and loan losses are estimated based on the current and anticipated interest rate and competitive environments, the performance of the loan pool and our historical experience with these and similar loans receivable. The discount rates that we utilize are determined for each of the components of the Retained Interests as estimates of market rates based on interest rate levels considering the risks inherent in the transaction. There can be no assurance of the accuracy of these estimates. Any appreciation of our Retained Interests is included in the consolidated balance sheets in beneficiaries’ equity. Any depreciation of our Retained Interests is either included in the consolidated statements of income as either a realized loss (if there is a reduction in expected future cash flows) or on our consolidated balance sheets in beneficiaries’ equity as an unrealized loss.
Real Estate Investments, net
Real estate investments are initially recorded at cost. Depreciation is provided on the straight-line method based upon estimated useful lives of 35 years for buildings and improvements and seven years for furniture, fixtures and equipment. Upon retirement or sale, the cost and related accumulated depreciation are removed from our books and any resulting gains or losses are included in the consolidated statements of income. Routine maintenance and repairs are charged to expense as incurred. Major replacements, renewals and improvements are capitalized.
We periodically review our real estate investments for impairment. If facts or circumstances support the possibility of impairment, we will prepare a projection of the undiscounted future cash flows without interest charges for the specific property. Impairment exists if the estimate of future cash flows expected to result from the use and ultimate disposition of the specific property is less than the carrying value. If impairment is indicated, an adjustment will be made to the carrying value of the property based on the difference between the current estimated fair value and the depreciated cost of the asset.
Real Estate Investments Held for Sale, net
We consider each individual hotel property to be an identifiable component of our business. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”), we do not consider hotels as “held for sale” until it is probable that the sale will be completed within one year. The determination of “held for sale” status is assessed based on all available facts and circumstances, including management’s intent and ability to eliminate the cash flows of the property from our operations and management’s intent and ability not to have significant continuing involvement in the operations of the property.
We discontinue depreciation on hotel properties if they are classified as “held for sale.” Upon designation of a hotel property as “held for sale,” we compare the carrying value of the hotel property to its estimated fair value, less costs to sell. We will reclassify the hotel property to real estate investment held for sale in our consolidated balance sheet at the lesser of the carrying value of the property or its estimated fair value, less costs to sell. Any adjustment to the carrying value of a hotel property classified as “held for sale” is reflected in discontinued operations in our consolidated statements of income. In addition, the operating results of those properties classified as “held for sale” or that have been sold are included in discontinued operations.
Cash and Cash Equivalents
We generally consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. At various times during the year we maintain cash, cash equivalents and restricted investments in
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
accounts in excess of federally insured limits with various financial institutions. We regularly monitor the financial institutions and do not believe a significant credit risk is associated with the deposits in excess of federally insured amounts.
Restricted Investments
Restricted Investments represent primarily escrow and capital expenditure accounts maintained pursuant to our lease agreement with the operator of our hotel properties and cash reserve accounts required to be held as collateral.
Rent and Related Receivables, net
We have claims against our tenant for unpaid rent, property taxes, legal fees incurred, termination damages, notes receivable and other charges. We performed an analysis of the anticipated future proceeds related to these claims to determine the collectibility of our investment based on best available information provided to us.
Mortgage-Backed Security of Affiliate
The mortgage-backed security represents our ownership interest in a special purpose entity and is valued consistent with the techniques used to value our Retained Interests.
Deferred Borrowing Costs
Costs incurred in connection with the issuance of debt are being amortized to expense over the life of the related obligation using a method that approximates the effective interest method. Deferred borrowing costs are included in other assets in our consolidated balance sheets.
Borrower Advances
In general, as part of the monitoring process to verify that the borrowers’ cash equity is utilized for its intended purpose, we receive deposits from the borrowers and release the funds upon presentation of appropriate documentation. Funds held on behalf of borrowers are included as a liability on the consolidated balance sheets.
Net Unrealized Appreciation on Retained Interests
Net unrealized appreciation on Retained Interests represents the difference between the cost and estimated fair value of our Retained Interests.
Revenue Recognition
Interest Income
Interest income includes interest earned on loans and our short-term investments and the amortization of net loan origination fees and discounts. Interest income on loans is accrued as earned with the accrual of interest generally suspended when the related loan becomes a non-accrual loan. A loan receivable is generally classified as non-accrual (a “Non-Accrual Loan”) if (1) it is past due as to payment of principal or interest for a period of more than 60 days, (2) any portion of the loan is classified as doubtful or is charged-off or (3) if the repayment in full of the principal and/or interest is in doubt. Generally, loans are charged-off when management determines that we will be unable to collect any remaining amounts due under the loan agreement, either through liquidation of collateral or other means. Interest income on a Non-Accrual Loan is recognized on either the cash basis or the cost recovery basis.
When originating a loan receivable, we charge a commitment fee. These fees, net of costs, are deferred and recognized as an adjustment of yield over the life of the related loan receivable using a method which approximates the effective interest method.
For purchased loans, we may have discounts representing the difference between the unamortized principal balance of the loan and its estimated fair value at the date of purchase. For performing loans, these discounts are recognized as an adjustment of yield over the life of the related loan receivable using a method which approximates the effective interest method.
The Retained Loan Discount is amortized to interest income over the life of the underlying loan using the effective interest method unless the underlying loan receivable is prepaid or sold.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Income from Retained Interests
The income from our Retained Interests represents the accretion (recognized using the effective interest method) on our Retained Interests which is determined based on estimates of future cash flows and includes any fees collected (i.e., late fees, prepayment fees, etc.) by the QSPEs in excess of anticipated fees. We update our cash flow assumptions on a quarterly basis and any changes to cash flow assumptions impact the yield on our Retained Interests.
Lease Income
Lease income consists of base and percentage rent on our properties and when applicable, straight-line rental income. We record percentage rent when received and the remaining lease income is recorded on a straight-line basis (when applicable) over the estimated lease term to the extent collectibility is reasonably assured. For properties deemed held for sale, lease income is included in discontinued operations.
Other Income
Other income consists primarily of servicing income, premium income, prepayment fees and other loan related fees. Servicing income is recognized in income when earned. Prepayment fees are recognized in income when loans are prepaid. Late fees and other loan related fees are recognized in income when chargeable, assuming collectibility is reasonably assured. Premium income represents the difference between the relative fair value attributable to the sale of the guaranteed portion of a loan originated under the SBA 7(a) Guaranteed Loan Program and the principal balance (cost) of the loan. The sale price includes the value attributable to any excess servicing spread retained by us plus any cash received.
Income Taxes
We have elected to be taxed as a REIT under the provisions of the Internal Revenue Code of 1986, as amended (the “Code”). To the extent we qualify for taxation as a REIT, we generally will not be subject to a Federal corporate income tax on our taxable income that is distributed to our shareholders. In order to remain qualified as a REIT under the Code, we must satisfy various requirements in each taxable year, including, among others, limitations on share ownership, asset diversification, sources of income, and the distribution of at least 90% of our taxable income within the specified time in accordance with the Code.
PMC Commercial has wholly-owned taxable REIT subsidiaries which are subject to Federal income taxes. The taxable REIT subsidiaries (“TRS’s”) are PMCIC, First Western, PMC Properties and PMC Funding. The income generated from the taxable REIT subsidiaries is taxed at normal corporate rates. We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” which uses the asset and liability method and deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
Earnings per Share
Earnings per share is computed by dividing net income by the weighted-average number of shares outstanding. Diluted earnings per share includes the dilutive effect, if any, of share-based compensation awards.
Distributions to Shareholders
Distributions to shareholders are recorded on the ex-dividend date.
Derivatives
As a result of certain of our variable-rate loans receivable having interest rate floors, we are deemed to have derivative investments. However, in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”), we are not required to bifurcate these investments; therefore, they are not accounted for as derivatives. We do not use derivatives for speculative purposes.
Share-Based Compensation Plans
At December 31, 2005, we have options outstanding under share-based compensation plans described more fully in Note 19. We use the fair value recognition provisions of SFAS No. 123R, “Accounting for Stock-Based Compensation,” to account for all awards granted, modified or settled.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires us to
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
make estimates and assumptions that affect (1) the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and, (2) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from our estimates. Our most sensitive estimates involve the valuation of our Retained Interests, determination of reserves on our receivables and impairment analysis of our long-lived assets and the valuation of our net assets acquired in connection with the merger in 2004.
Recently Issued Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections” which replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements - An Amendment of APB Opinion No. 28.” SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retroactive application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
The FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations (“FIN 47”) in March 2005. FIN 47 requires an entity to recognize a liability for a conditional asset retirement obligation when incurred if the liability can be reasonably estimated. FIN 47 clarifies that the term “Conditional Asset Retirement Obligation” refers to a legal obligation (pursuant to existing laws or by contract) to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than fiscal years ending after December 15, 2005. The adoption of FIN 47 did not have a material impact on our consolidated financial statements.
Reclassifications
Certain prior period amounts have been reclassified to conform to current year presentation. These reclassifications had no effect on previously reported net income or total beneficiaries’ equity.
Note 2. Variable Interest Entities:
General Information
A VIE is an entity for which control is achieved through means other than voting rights. An entity should consolidate a VIE if that entity will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both.
Conduit Warehouse Facility
On February 7, 2005, we entered into a $100.0 million conduit warehouse facility (the “Conduit Facility”). The Conduit Facility operates as a revolving line of credit, collateralized by loans originated by us, which have been or will be sold to PMC Conduit. The transfer of the loans to PMC Conduit did not meet the requirements of SFAS No. 140 for sale treatment. PMC Commercial has not guaranteed the repayment of the obligations of the Conduit Facility.
PMC Conduit was determined to be a VIE and PMC Commercial is the primary beneficiary of PMC Conduit; therefore, PMC Conduit is consolidated in the financial statements of PMC Commercial.
Junior Subordinated Notes
On March 15, 2005, PMC Commercial issued notes payable (the “Junior Subordinated Notes”) of approximately $27.1 million due March 30, 2035 to a special purpose subsidiary, PMC Preferred Capital Trust-A, a Delaware statutory trust (the “Preferred Trust”). The Junior Subordinated Notes are subordinated to PMC Commercial’s existing debt.
The Preferred Trust was determined to be a VIE but PMC Commercial is not considered to be the primary beneficiary of the Preferred Trust; therefore, the Preferred Trust is not consolidated in PMC Commercial’s financial statements. The equity method is used to account for our investment in the Preferred Trust.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3. Merger:
PMC Capital, Inc. merged with and into PMC Commercial on February 29, 2004. Each issued and outstanding share of PMC Capital, Inc. common stock was converted into 0.37 of a common share of PMC Commercial. As a result, we issued 4,385,800 common shares of beneficial interest on February 29, 2004 valued at $13.10 per share, which was the average closing price of our common shares for the three days preceding the date of the announcement, adjusted by declared but unpaid dividends.
The merger was accounted for using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations” as we were not deemed to be under common control. Accordingly, our consolidated results of operations have incorporated PMC Capital’s activities on a consolidated basis from the merger date. The cost of the merger was allocated to the assets acquired, liabilities assumed and preferred stock of subsidiary based on management’s estimates of their respective fair values at the date of merger. The fair value of the net assets acquired exceeded the cost of the merger, resulting in negative goodwill. The amount of negative goodwill was allocated proportionately to reduce the assigned values of the acquired assets excluding current assets, financial assets and assets held for sale. Substantially all of the assets acquired were considered to be financial assets or assets to be disposed of by sale. Accordingly, we recorded negative goodwill of $11,593,000 during 2004 representing the excess of the fair value of net assets acquired over the cost of the merger.
The cost of the merger was as follows (dollars in thousands):
The following table summarizes the estimated fair values of assets acquired, liabilities assumed and preferred stock of subsidiary as of February 29, 2004 (in thousands):
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following unaudited pro forma results of operations are based on our financial statements and the financial statements of PMC Capital and assumed the merger occurred on January 1 of the respective years:
These unaudited pro forma results have been prepared for comparative purposes only. In the opinion of management, all material adjustments necessary to reflect the effects of the merger transaction have been made. This unaudited pro forma information is not necessarily indicative of what the actual results of operations would have been had the merger transaction occurred on the indicated dates, nor does it purport to represent our results of operations for future periods.
Note 4. Loans Receivable, net:
Loans receivable, net, consisted of the following:
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Additional information on our loans receivable, net, was as follows:
Our loans receivable were approximately 95% concentrated in the hospitality industry at December 31, 2005. Any economic factors that negatively impact the hospitality industry could have a material adverse effect on our financial condition or results of operations. At December 31, 2005, approximately 15% and 10% of our loans receivable consisted of loans receivable to borrowers in Texas and Arizona, respectively. No other state had a concentration of 10% or greater at December 31, 2005.
The activity in our loan loss reserves was as follows:
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Impaired loans are defined by generally accepted accounting principles as loans for which it is probable that the lender will be unable to collect all amounts due based on the original contractual terms of the loan. Information on loans considered to be impaired loans was as follows:
(1)
Loans acquired in the merger, loans repurchased from the QSPEs and loans deemed to be repurchased from the QSPEs were recorded at their estimated fair value and as such are reflected at discounted amounts. Certain of these loans have no reserves and are thus shown in impaired loans expected to be fully recoverable with respect to our recorded investment in the loan; however, we do not expect to collect all amounts due based on the original contractual terms of the note.
(2)
Recorded primarily on the cash basis.
Our recorded investment in Non-Accrual Loans at December 31, 2005 and 2004 was approximately $5.9 million and $5.1 million, respectively. We did not have any investment in loans receivable past due 90 days or more which were accruing interest at December 31, 2005 or 2004.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 5. Real Estate Investments and Rent and Related Receivables, net:
Our real estate investments consisted of the following:
At December 31, 2005, we owned 13 hotel properties (individually, a “Hotel Property”) of which four Hotel Properties were sold prior to March 14, 2006. The properties were originally part of a sale and leaseback transaction commencing in 1998 with Arlington Hospitality, Inc. (“AHI”) whereby we purchased the properties from AHI and then leased the properties to a wholly-owned subsidiary of AHI, Arlington Inns, Inc. (“AII” and together with AHI, “Arlington”). We concurrently entered into a Master Lease Agreement with AHI and AII covering all the properties and entered into a guaranty agreement with AHI whereby AHI guaranteed all obligations of AII under the individual property lease agreements. The Master Lease Agreement, as amended, with the individual property lease agreements being known as the “Lease Agreement.”
During 2005, we sold six hotel properties for net proceeds of approximately $12.8 million and recognized net gains of approximately $1.3 million. We financed the sale of three of these properties through origination of loans aggregating approximately $4.8 million with interest rates of LIBOR plus 4% and maturity and amortization periods of 20 years. We sold four Hotel Properties for approximately $8.9 million and recognized aggregate gains of approximately $1.8 million prior to March 14, 2006. We financed the sales through originations of loans totaling approximately $7.0 million with interest rates of LIBOR plus 4.0% and maturity and amortization periods of 20 years.
The May and June 2005 lease payments due from AII were not paid and during June 2005, AII filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy”) and three of the individual property leases under the Lease Agreement were either rejected (i.e., terminated) or we began to operate them. As a result, we were given possession of the three properties which were then operated through third party management companies. We sold two of these properties during the third quarter of 2005.
On August 31, 2005, AHI filed for Bankruptcy (the “Arlington Bankruptcy”). Post filing for bankruptcy protection, AII made its July 2005 through January 2006 rent payments of approximately $224,000 per month for July 2005 through October 2005 and approximately $203,000 for November 2005 through January 2006 which was recorded as income when earned.
On January 13, 2006, we received rejection notices on the remaining 12 individual property leases. As a result of the rejection of the leases, we took possession of the properties and hired third party management companies to operate the properties.
It is our intention to sell the properties in an orderly and efficient manner. Management believes that it is probable that
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we will sell nine of the remaining 13 Hotel Properties within the next 12 months, although no assurances can be given that we will be able to do so.
In addition to the lease payments due for May 2005 and June 2005, AII has not paid property taxes that are obligated to be paid pursuant to the Lease Agreement. As a result, we paid the property taxes as they became due and incurred property tax expense of approximately $975,000 during 2005. At December 31, 2005, approximately $500,000 remained in accrued liabilities of which approximately $388,000 is due on the Hotel Properties held for sale which is included in debt and accrued expenses - real estate investments held for sale on our consolidated balance sheet. Since these property taxes were the responsibility of Arlington under the Lease Agreement, we are pursuing recovery of these property taxes from Arlington. Estimated annual tax assessments for 2006 on our remaining Hotel Properties (excluding the properties sold during 2006) total approximately $393,000.
At December 31, 2005, the nine properties that we anticipate will be sold within the next year were deemed “held for sale” and all operations relating to these properties are included in discontinued operations on our consolidated statements of income. In addition, we discontinued recording depreciation expense on the held for sale properties. For our Hotel Properties to be sold, we performed a recoverability test to determine if the expected net sales proceeds for the Hotel Properties exceeded the carrying value of the Hotel Properties. Based on this analysis, we recorded impairment losses of $1.4 million during 2005 related to the furniture, fixtures and equipment and buildings and improvements identified as impaired. Management’s estimates of the values for property sales were based on market conditions at the time the analysis was performed. These values may change based on the numerous factors that impact the (1) local and national economy, (2) prospects for the hospitality industry, (3) timing of particular sales, (4) franchise affiliation and (5) particular operating results of the property.
At December 31, 2005, four of our Hotel Properties had mortgages (which were assumed in the original purchase from AHI) with significant prepayment penalties. Therefore, we did not anticipate selling those properties until the properties’ market values increase or the prepayment penalties decrease. Subsequent to December 31, 2005, the significant prepayment penalty was waived on one of the Hotel Properties and the mortgage was repaid. Until the properties are sold, we would either operate the properties through third party management companies or lease the properties. At December 31, 2005, these four properties were considered to be “held and used” and all operations relating to these properties are included in continuing operations in our consolidated statements of income. For our Hotel Properties to be held and used, we performed a recoverability test to determine if the future undiscounted cash flows over our expected holding period for the Hotel Properties exceeded the carrying value of the Hotel Properties. Based on this analysis, we recorded impairment losses of approximately $815,000 during 2005 related to the furniture, fixtures and equipment and buildings and improvements identified as impaired. Future cash flows are based on estimated future property operations or rent payments to be received on the Hotel Properties and expected proceeds from the sale.
At December 31, 2005, our rent and related receivables consisted of unpaid rent, property taxes, legal fees incurred, termination damages, notes receivable and other charges (the “Arlington Claims”) of approximately $2,744,000 before reserves. As a result of the uncertainty and timing of collection, our claim in the Arlington Bankruptcy is well in excess of our recorded investment in the Arlington Claims.
We performed an analysis of our anticipated future proceeds related to the Arlington Bankruptcy to determine the collectibility of our investment in the rent and related receivables based on best available information provided to us through the bankruptcy proceedings. As a result, we established an allowance of approximately $1,255,000 as of December 31, 2005. Accordingly, our net recorded investment was $1,489,000 as of December 31, 2005. To the extent there is a reduction of the anticipated future proceeds, we would record an additional allowance against these receivables.
In addition, at December 31, 2005, we maintained a capital expenditures account for future capital expenditures required to maintain the real estate investments. Funds are released from this account when capital expenditures are incurred. As of December 31, 2005, the balance in our capital expenditure account was approximately $1.1 million and is included in restricted investments on our consolidated balance sheet. Upon lease rejection in January 2006, these funds were no longer restricted.
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Note 6. Retained Interests:
In our structured loan sale transactions, we contributed loans receivable to a QSPE in exchange for cash and beneficial interests in that entity. The QSPE issued notes payable (the “Structured Notes”) to unaffiliated parties (“Structured Noteholders”). The QSPE then distributed a portion of the proceeds from the Structured Notes to us. The Structured Notes are collateralized solely by the assets of the QSPE which means that should the financial assets in the QSPE be insufficient for the trustee to make payments on the Structured Notes, the Structured Noteholders have no recourse against us. Upon the completion of our structured loan sale transactions, we recorded the transfer of loans receivable as a sale in accordance with SFAS No. 140. As a result, the loans receivable contributed to the QSPE, the Structured Notes issued by the QSPE, and the operating results of the QSPE are not included in our consolidated financial statements. The difference between (1) the carrying value of the loans receivable sold and (2) the sum of (a) the cash received and (b) the relative fair value of our Retained Interests, constituted the gain or loss on sale. Retained Interests are carried at estimated fair value, with realized gains and losses recorded in net income and unrealized gains and losses recorded in beneficiaries’ equity.
We completed four joint structured loan sale transactions with PMC Capital, Inc. Our interests related to the loans receivable we contributed to these structured loan sale transactions are the “Originated Structured Loan Sale Transactions.” As a result of the merger, on February 29, 2004, we acquired PMC Capital’s retained interests in the Joint Ventures and 100% of the 1998 Partnership and the 1999 Partnership (collectively, the “Acquired Structured Loan Sale Transactions”).
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Information pertaining to the Originated Structured Loan Sale Transactions was as follows.
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Information pertaining to the Acquired Structured Loan Sale Transactions was as follows:
(1)
Variable interest rates are denoted by the spread over (under) the prime rate (“P”) or the 90-day LIBOR (“L”).
(2)
Structured Notes issued by the QSPEs were rated by Moody’s Investors Service, Inc.
(3)
The weighted average remaining life of loans was calculated by summing the product of (i) the sum of the principal collections expected in each future period multiplied by (ii) the number of periods until collection, and then dividing that total by (iii) the remaining principal balance.
(4)
Represents aggregate estimated future losses as a percentage of the principal outstanding based upon per annum estimated losses that ranged from 0.0% to 1.8%. To the extent any loans are likely to be liquidated in the next twelve months, estimated losses were assumed to occur during that period. No losses are assumed in the year ending December 31, 2006 for those structured loan sale transactions with no current potential impaired loans.
(5)
The prepayment rate was based on the actual performance of the loan pools, adjusted for anticipated principal prepayments considering other similar loans.
(6)
The discount rates utilized on the components of our Retained Interests (as described below) were (i) 7.5% to 8.4% for our required overcollateralization, (ii) 9.2% to 9.6% for our reserve funds and (iii) 12.2% to 12.6% for our interest-only strip receivables.
(7)
Represents aggregate principal losses to date as a percentage of the principal outstanding at inception. For the 2000 Joint Venture, represents historical losses incurred prior to our acquisition. For the 2001 Joint Venture and the 2002 Joint Venture, represents losses on delinquent loans receivable with a “charged-off” status repurchased by PMC Commercial subsequent to the merger.
Approximately 93% of the loans sold to the QSPEs were concentrated in the limited service hospitality industry and approximately 28% were to borrowers in Texas. No other state had a concentration of 10% or greater at December 31, 2005.
At December 31, 2005, none of the loans sold to the QSPEs were delinquent over 60 days as to payment of principal and interest.
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Previously, First Western had Retained Interests related to the sale of the unguaranteed portion of its loans receivable through a private placement in 1997. On April 15, 2005, we acquired, through exercise of our option, the $2.2 million in loans receivable remaining in the securitization for approximately $2.2 million using existing cash and the reserve fund balance of $912,000.
First Western has Retained Interests related to the sale of loans originated pursuant to the SBA 7(a) Guaranteed Loan Program. The SBA guaranteed portions of First Western’s loans receivable are sold to either dealers in government guaranteed loans receivable or institutional investors (“Secondary Market Loan Sales”) as the loans are fully funded. On all Secondary Market Loan Sales, we retain the excess spread between the interest rate paid to us from our borrowers and the rate we pay to the purchaser of the guaranteed portion of the note. At December 31, 2005, the aggregate principal balance of First Western’s serviced loans receivable on which we have an excess spread was approximately $41.3 million and the weighted average excess spread was approximately 0.7%. In determining the estimated fair value of our Retained Interests related to Secondary Market Loan Sales, our assumptions at December 31, 2005 included a prepayment speed of 20% per annum and a discount rate of 12.2%.
The estimated fair value of our Retained Interests is based upon an estimate of the discounted future cash flows we will receive. In determining the present value of expected future cash flows, estimates are made in determining the amount and timing of those cash flows and the discount rates. The amount and timing of cash flows is generally determined based on estimates of loan losses and anticipated prepayment speeds relating to the loans receivable contributed to the QSPE. Actual loan losses and prepayments may vary significantly from assumptions. The discount rates that we utilize in computing the estimated fair value are based upon estimates of the inherent risks associated with each cash flow stream. Due to the limited number of entities that conduct transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists. Therefore, our estimate of the fair value may or may not vary from what a willing buyer would pay for these assets.
The components of our Retained Interests are as follows:
(1) Our required overcollateralization (the “OC Piece”). The OC Piece represents the excess of the loans receivable contributed to the QSPE over the principal amount of the Structured Notes issued by the QSPE, which serves as additional collateral for the Structured Noteholders.
(2) The “Reserve Fund” and the interest earned thereon. The Reserve Fund represents cash that is required to be kept in a liquid cash account by the QSPE pursuant to the terms of the transaction documents, as collateral for the Structured Noteholders, a portion of which was contributed by us to the QSPE upon formation and a portion which is built up over time by the QSPE from the cash flows of the underlying loans receivable.
(3) The interest-only strip receivable (the “IO Receivable”). The IO Receivable is comprised of the cash flows that are expected to be received by us in the future after payment by the QSPE of (a) all interest and principal due to the Structured Noteholders, (b) all principal and interest on the OC Piece, (c) any required funding of the Reserve Fund and (d) on-going costs of the transaction.
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Our Retained Interests consisted of the following:
The following sensitivity analysis of our Retained Interests at December 31, 2005 highlights the volatility that results when prepayments, loan losses and discount rates are different than our assumptions:
(1)
Any depreciation of our Retained Interests is either included in the accompanying statement of income as a realized loss (if there is a reduction in expected future cash flows) or on our consolidated balance sheet in beneficiaries’ equity as an unrealized loss.
(2)
If we experience significant losses (i.e., in excess of anticipated losses), the effect on our Retained Interests would first reduce the value of our IO Receivables. To the extent the IO Receivables could not fully absorb the losses, the effect would then be to reduce the value of our Reserve Funds and then the value of our OC Pieces.
(3)
For example, an 8% assumed rate of prepayment would be increased to 13% or 18% based on increases of 5% or 10% per annum, respectively.
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These sensitivities are hypothetical and should be used with caution. Values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumptions to the change in estimated fair value is not linear. The effect of a variation in a particular assumption on the estimated fair value of our Retained Interests is calculated without changing any other assumption. In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities.
SFAS No. 140 provides requirements for an entity to be considered a QSPE, both initially and in subsequent periods. QSPE status can be impacted in subsequent periods by activities of the transferor(s) or other involved parties, including the manner in which certain servicing activities are performed. To the extent structured loan transactions meet the requirements of SFAS No. 140 and the special purpose entities created meet the requirements to be considered QSPEs, we record the transactions as sales. To the extent the special purpose entities are determined not to meet QSPE requirements, we are required to consolidate the assets, liabilities and revenues and expenses of the underlying special purpose entities.
We monitor the governing pooling and servicing agreements for each of our structured loan sale transactions and believe the servicing-related terms set forth therein are industry standard and consistent with QSPE criteria. Accounting standard setters are currently assessing servicing activities involving QSPEs and, consequently, there may now be some uncertainty with respect to the accounting for sale transactions involving QSPEs. As accounting standard setters continue to interpret QSPE criteria under SFAS No. 140, there may be a material resultant impact on our consolidated financial statements.
In accordance with SFAS No. 140, our consolidated financial statements do not include the assets, liabilities, partners’ capital, revenues or expenses of the QSPEs. As a result, at December 31, 2005 and 2004, our consolidated balance sheets do not include $276.1 million and $321.4 million in assets, respectively, and $220.8 million and $263.4 million in liabilities, respectively, related to these structured loan sale transactions recorded by the QSPEs. At December 31, 2005, the partners’ capital of our QSPEs was approximately $55.3 million compared to the value of the associated Retained Interests of $62.2 million.
The following information summarizes the financial position of the QSPEs at December 31, 2005 and 2004:
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The following information summarizes the results of operations for the QSPEs (1):
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As of the merger date, we owned 100% of the limited partnership interests in the Joint Ventures. Our limited partnership allocation of the net income of the 2000 Joint Venture, 2001 Joint Venture and 2002 Joint Venture was $1,482,000, $1,027,000 and $816,000, respectively, during 2003. In addition, our limited partnership allocation of the net income of the 2003 Joint Venture was $310,000 from October 7, 2003 (inception) to December 31, 2003.
The income from our Retained Interests represents the accretion (recognized using the effective interest method) on our Retained Interests which is determined based on estimates of future cash flows and includes any fees collected (i.e., late fees, prepayment fees, etc.) by the QSPEs in excess of anticipated fees. We update our cash flow assumptions on a quarterly basis and any changes to cash flow assumptions impact the yield on our Retained Interests. The yield on our Retained Interests, which is comprised of the income earned less realized losses, was 13.8%, 11.5% and 12.3% during 2005, 2004 and 2003, respectively.
Servicing fee income for the years ended December 31, 2005 and 2004 for loans held by the QSPEs was approximately $833,000 and $781,000, respectively. We have not established a servicing asset or liability related to the loans held by the QSPEs as the servicing fees are considered adequate compensation. We were not the servicer for the loans receivable held by the QSPEs prior to the merger; therefore, no servicing fees were earned or received by us prior to March 1, 2004.
We received approximately $15.4 million, $15.1 million and $3.7 million in cash distributions from the Joint Ventures during 2005, 2004 and 2003, respectively.
During March 2005, a defaulted loan with a principal balance of approximately $2.6 million was transferred from the 2001 Joint Venture to PMC Commercial. Previously, in accordance with Emerging Issues Task Force issue number 02-09, PMC Commercial had recorded the loan receivable and a corresponding due to affiliate at the estimated value of the loan receivable of approximately $2.1 million and reversed a previously recorded discount of $415,000. The limited service hospitality property underlying the loan receivable was sold during May 2005 for approximately $3.1 million.
During August 2005, PMC Commercial repurchased a loan from the 2002 Joint Venture which had become “charged-off” as defined in the transaction documents through delinquency and initiation of foreclosure for $1.8 million. Previously, in accordance with Emerging Issues Task Force issue number 02-09, PMC Commercial had recorded the loan receivable and a corresponding due to affiliate at the estimated fair value of the loan receivable of approximately $1.2 million. The limited service hospitality property underlying the loan receivable was sold during September 2005 for approximately $1.6 million.
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During December 2005, PMC Commercial repurchased a loan from the 2000 Joint Venture and a loan from the 2003 Joint Venture which had become “charged-off” as defined in the transaction documents through bankruptcy (previously the loans were collateralized by Amerihost Inns owned by Arlington) for approximately $3.3 million. The estimated fair value of the loans receivable included on our consolidated balance sheet was approximately $3.3 million at December 31, 2005. During 2006, we sold these assets acquired in liquidation for net proceeds of approximately $3.3 million. We financed the sales through originations of loans totaling $2.8 million at interest rates of LIBOR plus 4% and maturity and amortization periods of 20 years.
Note 7. Restricted Investments:
Restricted investments consisted of the following:
The capital expenditures account represents restricted investments maintained pursuant to our Lease Agreement. In accordance with the terms of the Lease Agreement, we previously deposited percentage rent received from Arlington into a capital expenditures account for future capital expenditures required to maintain the real estate investments. Funds were released from this account when capital expenditures are incurred. Upon lease rejection in January 2006, these funds were no longer restricted.
The structured noteholders and Conduit Facility reserve and collection accounts represent cash collected that has not yet been remitted to the noteholders or holder and reserve account balances that are required to be held as collateral on behalf of the noteholders or holder. The structured noteholders reserve account is currently at its minimum of $1.4 million. The Conduit Facility reserve account is required to be 2% of its balance outstanding. The collection and reserve accounts consist of cash and liquid money market funds.
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Note 8. Other Assets:
Other assets consisted of the following:
Note 9. Debt:
Information on our debt was as follows:
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Scheduled principal payments on our debt at December 31, 2005 were as follows (face amount):
(1)
Maturities of the structured notes are dependent upon the timing of the cash flows received from the underlying loans receivable; however, for purposes of determining our debt maturities, principal payments were estimated based on required principal payments and prepayments on the underlying loans receivable.
Debentures
Debentures represent amounts due to the SBA as a result of borrowings made pursuant to the SBIA. The debentures have a weighted average cost of funds of 6.0% and semi-annual interest only payments are due until maturity. During March 2005, we “rolled-over” $4.0 million of debentures and repaid $3.0 million of debentures. The $4.0 million of debentures bear interest at a fixed rate of 5.925% and are due on March 1, 2015.
Mortgage Notes
As of December 31, 2005, we had nine mortgage notes, each collateralized by a Hotel Property. The net book value of our mortgaged real estate investments was approximately $16.8 million at December 31, 2005. Four of the mortgage notes are through our subsidiaries formed to issue the mortgage notes and five are through PMC Commercial. During June 2005, we sold one hotel property with a mortgage note of approximately $1.3 million and the mortgage was repaid. During December 2005, we repaid, at maturity, a mortgage of approximately $0.9 million. The five mortgage notes of PMC Commercial relate to five of our Hotel Properties held for sale, have a weighted average interest rate of 6.9%, mature between March 2006 and August 2019 and have amortization periods of 20 years. At December 31, 2005 and 2004, the aggregate balances outstanding on these obligations were approximately $5.9 million and $8.3 million, respectively. During 2006, we sold three Hotel Properties with mortgage notes totaling approximately $3.2 million and the mortgages were repaid.
The four mortgage notes of our subsidiaries relate to our four Hotel Properties to be held and used and have a weighted average interest rate of approximately 8.0% at December 31, 2005. These mortgages are amortized over 20 years, mature from January 2010 to December 2017 and have restrictive provisions which provide for substantial prepayment penalties (subsequent to December 31, 2005, the significant prepayment penalty was waived on one of the Hotel Properties and the mortgage note of approximately $1.5 million was repaid). At December 31, 2005 and 2004, the aggregate balances outstanding on these mortgage notes were approximately $5.6 million and $5.9 million, respectively, of which approximately $3.0 million and $3.1 million at December 31, 2005 and 2004 were guaranteed by PMC Commercial, respectively.
Structured Notes
In June 1998, PMC Commercial formed PMCT Trust, a bankruptcy remote partnership that completed a private placement of fixed-rate loan-backed notes (the “Trust Structured Notes”). The Trust Structured Notes have a stated maturity in 2019; however, repayment of their principal is based on collections of principal on the underlying loans receivable. The Trust Structured Notes are collateralized by the loans receivable that we contributed to the partnership. At December 31, 2005 and 2004, the principal amount of the outstanding underlying loans receivable was approximately $10.8 million and $12.9 million, respectively. We have no obligation to pay the Trust Structured Notes, nor do the holders of the Trust Structured Notes have any recourse against our assets. Accordingly, if PMCT Trust fails to pay the Trust Structured Notes, the sole recourse of the holders of the Trust Structured Notes is against the assets of PMCT Trust.
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Junior Subordinated Notes
On March 15, 2005, PMC Commercial issued Junior Subordinated Notes which are subordinated to PMC Commercial’s existing debt. The Junior Subordinated Notes bear interest at a floating rate which resets on a quarterly basis at the 90-day LIBOR plus 3.25% (computed on a 360-day year). The Junior Subordinated Notes may be redeemed at par at our option beginning on March 30, 2010. Interest payments are due on a quarterly basis.
Conduit Facility
On February 7, 2005, we entered into a three-year $100.0 million Conduit Facility. Interest payments on the advances are payable by PMC Conduit on a monthly basis at a rate approximating LIBOR, plus 1%. In addition, we are charged an unused fee equal to 12.5 basis points computed based on the daily available balance. The Conduit Facility allows for advances based on the amount of eligible collateral sold to the Conduit Facility and has minimum requirements. At December 31, 2005, approximately $35.3 million of our loans were owned by PMC Conduit. The Conduit Facility has covenants, the most restrictive of which are maximum delinquency ratios for our contributed loans and serviced portfolio, as defined in the transaction documents. In addition, the Conduit Facility has cross default provisions with the revolving credit facility. At the end of each annual period, the lenders have the option to extend their respective commitments to make advances for an additional 364-day period. The annual period was extended to February 6, 2007. At December 31, 2005, we were in compliance with the covenants of this facility.
Revolving Credit Facility
PMC Commercial has a revolving credit facility that matures in December 2006 and provides us with credit availability up to $20 million. We are charged interest on the balance outstanding under the revolving credit facility at our election of either the prime rate of the lender less 75 basis points or 162.5 basis points over the 30, 60 or 90-day LIBOR. In addition, we are charged an unused fee equal to 37.5 basis points computed based on our daily available balance. The credit facility requires us to meet certain covenants, the most restrictive of which (1) provides for an asset coverage test based on our cash and cash equivalents, loans receivable, Retained Interests and real estate investments as a ratio to our senior debt and (2) limits our ability to pay out returns of capital as part of our dividends. At December 31, 2005, we were in compliance with the covenants of this facility.
Redeemable Preferred Stock of Subsidiary
PMCIC has outstanding 40,000 shares of $100 par value, 4% cumulative preferred stock (the “4% Preferred Stock”) held by the SBA pursuant to the SBIA.
The 4% Preferred Stock was issued during 1994 ($2.0 million) and 1995 ($2.0 million) and must be redeemed at par no later than 15 years from the date of issuance. In accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” we classified the 4% Preferred Stock as a liability on our consolidated balance sheet. The 4% Preferred Stock was valued at $3,420,000 at the merger date. Dividends of approximately $160,000 and $134,000 were recognized on the 4% Preferred Stock during 2005 and 2004, respectively, and are included in interest expense in our consolidated statement of income.
Interest Paid
During 2005, 2004 and 2003 interest paid was approximately $5,378,000, $4,727,000, and $3,138,000, respectively.
Note 10. Cumulative Preferred Stock of Subsidiary:
PMCIC has outstanding 30,000 shares of $100 par value, 3% cumulative preferred stock (the “3% Preferred Stock”) held by the SBA pursuant to the SBIA.
PMCIC is entitled to redeem, in whole or part, the 3% Preferred Stock by paying the par value ($3.0 million) of these securities plus dividends accumulated and unpaid on the date of redemption. While the 3% Preferred Stock may be redeemed, redemption is not mandatory. The 3% Preferred Stock was valued at $900,000 at the merger date. Dividends of approximately $90,000 and $75,000 were recognized on the 3% Preferred Stock during 2005 and 2004, respectively, and are reflected in our consolidated statements of income as minority interest.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 11. Earnings Per Share:
The computations of basic earnings per common share are based on our weighted average shares outstanding. The weighted average number of common shares outstanding was approximately 10,874,000, 10,134,000 and 6,448,000 for the years ended December 31, 2005, 2004 and 2003, respectively. For purposes of calculating diluted earnings per share, the weighted average shares outstanding were increased by approximately 5,000, 18,000 and 12,000 shares, respectively, during 2005, 2004 and 2003 for the dilutive effect of stock options.
For purposes of calculating earnings per share, the gain on sale of loans receivable of $711,000 for the year ended December 31, 2003, was combined with income from continuing operations.
Not included in the computation of diluted earnings per share were outstanding options to purchase 74,220, 59,875 and 15,000 common shares during 2005, 2004 and 2003, respectively, because the options’ exercise prices were greater than the average market price of the stock.
Note 12. Dividends Paid and Declared:
During 2005, our dividends were declared as follows:
In March 2006, the Board of Trust Managers declared a $0.30 per share quarterly dividend to common shareholders of record on March 31, 2006 which will be paid on April 10, 2006.
We have certain covenants within our debt facilities that limit our ability to pay out returns of capital as part of our dividends. These restrictions have not historically limited the amount of dividends we have paid and management does not believe that they will restrict future dividend payments.
Note 13. Taxable Income:
PMC Commercial has elected to be taxed as a REIT under the Code. To qualify as a REIT, PMC Commercial must meet a number of organizational and operational requirements, including a requirement that we distribute at least 90% of our taxable income to our shareholders. As a REIT, PMC Commercial generally will not be subject to corporate level Federal income tax on net income that is currently distributed to shareholders. We may, however, be subject to certain Federal excise taxes and state and local taxes on our income and property. If PMC Commercial fails to qualify as a REIT in any taxable year, it will be subject to Federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and will not be able to qualify as a REIT for four subsequent taxable years.
In order to meet our prior year taxable income distribution requirements, we may make an election under the Code to treat a portion of the distributions declared in the current year as distributions of the prior year’s taxable income.
PMC Commercial has wholly-owned TRS’s which are subject to Federal income taxes: PMCIC, First Western, PMC Funding and PMC Properties. The income generated from the TRS’s is taxed at normal corporate rates. We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” which uses the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The measurement of net deferred tax assets is adjusted by a valuation allowance, if, based on our ongoing assessment of this future realization, it is more likely than not that they will not be realized.
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The following reconciles our net income to REIT taxable income:
Dividends per share for dividend reporting purposes were as follows:
Income tax provision related to the TRS’s consisted of the following:
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The provision for income taxes results in effective tax rates that differ from Federal statutory rates of 35%. The reconciliation of TRS income tax attributable to net income computed at Federal statutory rates to income tax expense was as follows:
The components of the net deferred tax asset were as follows:
The net operating loss carryforwards at December 31, 2004 were generated by PMC Funding and are available to offset future taxable income of PMC Funding. At the time of the merger, management believed that we would not realize the benefit of PMC Funding’s net operating loss carryforwards and a valuation allowance was established. However, based on PMC Funding’s current pretax earnings, primarily resulting from a gain on the sale of an asset acquired in liquidation, management now believes that we will realize the full benefit of these net operating loss carryforwards. Accordingly, the valuation allowance was reversed during 2005.
The net operating loss carryforwards at December 31, 2005 were generated by PMC Properties and are available to offset future taxable income of PMC Properties. Based on estimates of future pretax earnings for the properties, management believes that we will realize the full benefit of these net operating loss carryforwards. The net operating loss carryforwards expire in 2025.
We paid $467,500 and $85,000 in income taxes during 2005 and 2004, respectively.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 14. Other Income:
Other income consisted of the following:
(1)
We earn fees for servicing all loans held by the QSPEs and First Western’s loans sold into the secondary market. Premium income results from the sale of First Western’s loans pursuant to Secondary Market Loan Sales.
(2)
Represents the revenue of our Hotel Property in continuing operations at December 31, 2005 which we operated through a third party management company.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 15. Discontinued Operations:
Discontinued operations of our hotel properties (15 hotel properties, 17 hotel properties and 18 hotel properties during 2005, 2004 and 2003, respectively) and assets acquired in liquidation (primarily two limited service hospitality property during 2005) consisted of the following:
(1)
Represents interest expense on the mortgages payable related to our hotel properties held for sale. These mortgages payable at December 31, 2005 will either be repaid as a result of the sales or as they mature. No additional interest expense was allocated to discontinued operations.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property sales included in discontinued operations consisted of the following:
Note 16. Dividend Reinvestment and Cash Purchase Plan:
We have a dividend reinvestment and cash purchase plan (the “Plan”). Participants in the Plan have the option to reinvest all or a portion of dividends received. The purchase price of the Common Shares is 100% of the average of the closing price of the Common Shares as published for the five trading days immediately prior to the dividend record date or prior to the optional cash payment purchase date, whichever is applicable. The optional cash purchase plan was suspended during January 2000. Subsequent to January 2000, no plan shares have been issued since we have been using the open market to purchase Common Shares with proceeds from the dividend reinvestment portion of the Plan.
Note 17. Share Repurchase Program:
On August 31, 2005, our Board of Trust Managers authorized a share repurchase program for up to $10.0 million for the purchase of outstanding Common Shares, expiring August 31, 2006. The Common Shares may be purchased from time to time in the open market or pursuant to negotiated transactions. As of December 31, 2005, we had acquired 129,400 Common Shares under the share repurchase program for an aggregate purchase price of approximately $1,643,000, including commissions.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 18. Profit Sharing Plan:
Commencing with the merger, we have a profit sharing plan available to our full-time employees after one year of employment. Vesting increases ratably to 100% after the sixth year of employment. Pursuant to our profit sharing plan, approximately $244,000 and $183,000 was expensed during 2005 and 2004, respectively. Contributions to the profit sharing plan are at the discretion of our Board of Trust Managers.
Note 19. Share-Based Compensation Plans:
At December 31, 2005, we have options outstanding under share-based compensation plans: the 2005 Equity Incentive Plan, the 1993 Employee Share Option Plan and the Trust Manager Share Option Plan. The 1993 Employee Share Option Plan and the Trust Manager Share Option Plan expired in December 2003; thus, no additional options will be issued under these two plans.
We use the fair value recognition provisions of SFAS No. 123R, “Accounting for Stock-Based Compensation,” to account for all awards granted, modified or settled.
The 2005 Equity Incentive Plan was approved by our shareholders on June 11, 2005 and permits the grant of options to our employees, executive officers and Board of Trust Managers and restricted shares to our executive officers and Board of Trust Managers for up to 500,000 Common Shares. We believe that these awards better align the interests of our employees, executive officers and Board of Trust Managers with those of our shareholders. We granted 36,700 option awards and 9,060 restricted shares under the 2005 Equity Incentive Plan during 2005. Option awards are granted with an exercise price equal to the market price of our Common Shares at the date of grant and vest immediately upon grant with five-year contractual terms.
The Trust Manager Share Option Plan was a nondiscretionary plan pursuant to which options to purchase 2,000 Common Shares were granted to certain trust managers on the date such trust manager took office. In addition, options to purchase 1,000 shares were granted on June 1 of each year through December 31, 2003. Such options were exercisable at the fair market value of the shares on the date of grant. The options granted under the Trust Manager Share Option Plan became exercisable one year after date of grant and expired if not exercised on the earlier of (1) 30 days after the option holder no longer held office for any reason or (2) within five years after date of grant. We issued 5,000 options under the Trust Manager Plan during 2003. Due to expiration of the Trust Manager Share Option Plan, we did not grant any options under the Trust Manager Share Option Plan during 2005 or 2004.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the status of our stock options as of December 31, 2005, 2004 and 2003 and the changes during the years ended on those dates are as follows:
Our stock option exercise prices are greater than the market price of our stock at December 31, 2005. As a result, the intrinsic value of stock options outstanding or exercisable at December 31, 2005 is zero.
Upon notification of intent to exercise stock options, our policy is to first verify that the options are exercisable, then to contact our transfer agent instructing them to issue new shares and then to collect the cash proceeds. We received approximately $123,000 and $378,000 in cash proceeds related to the cash exercise of stock options during 2005 and 2004, respectively. In addition, during 2004 we issued 6,620 Common Shares to certain of our executive officers in exchange for 27,750 stock options utilizing stock-for-stock exercise provisions of the 1993 Employee Share Option Plan.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
The expected term of the options represents the period of time that the options are expected to be outstanding and was determined based on our historical data. The risk-free rate was based on the three-year U.S. Treasury rate corresponding to the expected term of the options. Historical volatility was used to determine our expected volatility. Our historical dividend yield was used to determine our expected dividend yield. For the 2005 grant, we assumed a forfeiture rate of 5% based on our historical forfeiture experience. We recorded compensation expense of approximately $23,000 during 2005 related to the 2005 option grant.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
We issued an aggregate of 9,060 restricted shares to executive officers and our Board of Trust Managers on June 11, 2005 with a market price for the shares of $14.54 on that date. The restricted share awards vest based over two years of continuous service with one-third of the shares vesting immediately upon issuance of the shares and one-third vesting at the end of each of the next two years. Restricted share awards provide for accelerated vesting if there is a change in control (as defined in the plan). There were no forfeitures of restricted shares during 2005. Compensation expense is being recognized over the vesting period. We recorded compensation expense of approximately $83,000 during 2005 for the vested portion of our restricted share issuance. As of December 31, 2005, there was approximately $49,000 of total unrecognized compensation expense related to the unvested restricted shares which will be recognized over the next two years.
We assumed unearned share compensation in the merger representing the intrinsic value of unvested options assumed that vest as the employees provide future services. Compensation expense was recognized over the vesting period. We recorded compensation expense of approximately $7,000 during 2004 related to these unvested options.
The following table summarizes information about stock options outstanding at December 31, 2005:
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 20. Supplemental Disclosure of Cash Flow Information:
Our non-cash investing activities were as follows:
See Note 3 for information on assets acquired and liabilities assumed in connection with the merger with PMC Capital.
Note 21. Fair Values of Financial Instruments:
The estimates of fair value as required by SFAS No. 107, “Disclosures about Fair Value of Financial Instruments” differ from the carrying amounts of the financial assets and liabilities primarily as a result of the effects of discounting future cash flows. Considerable judgment is required to interpret market data and develop estimates of fair value. Accordingly, the estimates presented below may not be indicative of the amounts we could realize in a current market exchange.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The estimated fair values of our financial instruments were as follows:
Loans receivable, net: We generally estimate the fair value of variable-rate loans to approximate the remaining unamortized principal of the loan less any purchase or other discounts, unless there is doubt as to realization of the loan. In addition, we generally estimate the fair value of fixed-rate loans based on a net present value calculation utilizing current market interest rates and anticipated principal collections. A valuation reserve is established for a problem loan based on the creditor’s payment history, collateral value, guarantor support and other factors. In the absence of a readily ascertainable market value, the estimated value of our loans receivable may differ from the values that would be placed on the portfolio if a ready market for the loans receivable existed.
Retained Interests and Mortgage-backed security of affiliate: The assets are reflected in our consolidated financial statements at estimated fair value based on valuation techniques as described in Note 6.
Cash and cash equivalents: The carrying amount is a reasonable estimation of fair value due to the short maturity of these instruments.
Restricted investments: The fair value of the reserve fund associated with the 1998 structured loan financing transaction is estimated by utilizing discounted cash flow techniques based on management’s estimates of market rates including risks inherent in the transaction. The carrying amounts of the reserve fund associated with the Conduit Facility and the remaining restricted investments are considered to be a reasonable estimate of fair value due to the relatively short maturity of these funds.
Notes and debentures payable: The estimated fair value is based on a present value calculation based on prices of the same or similar instruments after considering risk, current interest rates and remaining maturities.
Redeemable preferred stock of subsidiary: The estimated fair value is based on a present value calculation based on prices of the same or similar instruments after considering risk, current interest rates and remaining maturities.
Credit facilities and junior subordinated notes: The carrying amount is a reasonable estimation of fair value as the interest rates on these instruments are variable.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Debt and accrued expenses - real estate investments held for sale: The estimated fair value of the debt is based on a present value calculation based on prices of the same or similar instruments after considering risk, current interest rates and remaining maturities.
Note 22. Related Party Transactions:
Prior to the merger, our investment advisor was a subsidiary of PMC Capital, Inc. In addition, property acquisitions were supervised pursuant to a separate agreement with the subsidiary.
Fees consisted of the following:
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 23. Selected Quarterly Financial Data: (unaudited)
The following represents our selected quarterly financial data which, in the opinion of management, reflects adjustments (comprising only normal recurring adjustments) necessary for fair presentation.
Note 24. Commitments and Contingencies:
Loan Commitments
Commitments to extend credit are agreements to lend to a customer provided the terms established in the contract are met. Our outstanding loan commitments and approvals to fund new loans were approximately $50.5 million at December 31, 2005, of which approximately (1) $8.7 million were for prime-based loans to be originated by First Western, the government guaranteed portion of which (approximately 75% of each individual loan) will be sold pursuant to Secondary Market Loan Sales and (2) approximately $2.4 million represents commitments of our SBICs. Pursuant to SBA rules and regulations, our SBICs cannot advance funds to PMC Commercial or its affiliates. Therefore, PMC Commercial will borrow funds to make investments even though our SBICs have available cash and cash equivalents.
At December 31, 2005, all of our commitments and approvals were for variable-rate loans based on the prime rate or the 90-day LIBOR at spreads over the prime rate generally ranging from 2.0% to 2.75% and over LIBOR generally ranging from 3.25% to 4.5%. The weighted average interest rate on our loan commitments and approvals at December 31, 2005 was approximately 8.1%. Commitments generally have fixed expiration dates and require payment of a fee to us. Since some commitments are expected to expire without being drawn upon, total commitment amounts do not necessarily represent future cash requirements.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Operating Lease
We lease office space in Dallas, Texas under a lease which expires in October 2011. Future minimum lease payments under this lease are as follows:
Rent expense, which is being recorded on a straight-line basis, amounted to approximately $165,000 and $133,000 during 2005 and 2004, respectively.
Employment Agreements
We have employment agreements with our executive officers. During the second quarter of 2005, we extended the outstanding employment periods of certain of these officers from July 2007 to July 2008. Future payments under these contracts are approximately $1,147,000, $1,147,000 and $669,000 for 2006, 2007 and 2008, respectively. Compensation to executive officers was approximately $1.4 million and $1.1 million during 2005 and 2004, respectively.
Structured Loan Sale Transactions
The transaction documents of the QSPEs contain provisions (the “Credit Enhancement Provisions”) that govern the assets and the inflow and outflow of funds of the QSPE formed as part of the structured loan sale transactions. The Credit Enhancement Provisions include specified limits on the delinquency, default and loss rates on the loans receivable included in each QSPE. If, at any measurement date, the delinquency, default or loss rate with respect to any QSPE were to exceed the specified limits, the Credit Enhancement Provisions would automatically increase the level of credit enhancement requirements for that QSPE. During the period in which the specified delinquency, default or loss rate was exceeded, excess cash flow from the QSPE, if any, which would otherwise be distributable to us, would be used to fund the increased credit enhancement levels up to the principal amount of such loans and would delay or reduce our distribution. In general, there can be no assurance that amounts deferred under Credit Enhancement Provisions would be received in future periods or that future deferrals or losses will not occur.
Environmental
PMC Funding has recorded a liability of approximately $300,000 for the estimated costs at December 31, 2005 to remediate an environmental obligation related to an asset it sold. The sale was financed by PMC Capital through origination of a loan with a current outstanding principal balance of approximately $450,000. Under purchase accounting, the liability was assumed and the loan was acquired by PMC Commercial in the merger with PMC Capital. Our borrower has the primary responsibility for the environmental remediation.
On February 25, 2005, we were informed by the Georgia Department of Natural Resources that the current remediation plan for the property requires revision. While our borrower has the primary responsibility for the environmental remediation, to the extent we were forced to reacquire the property, we currently believe that the estimated fair value of the collateral underlying the loan exceeds the current outstanding principal balance on the loan. At the present time, we have been unable to quantify additional costs, if any, of the potential changes in remediation methods requested by the State of Georgia; however, these costs could be material and may exceed the value of the collateral net of the recorded liability and the current outstanding principal balance of the loan.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Litigation
In the normal course of business, including our assets acquired in liquidation, we are periodically party to certain legal actions and proceedings involving matters that are generally incidental to our business (i.e., collection of loans receivable). In management’s opinion, the resolution of these legal actions and proceedings will not have a material adverse effect on our consolidated financial statements.
Other
If the SBA establishes that a loss on an SBA guaranteed loan is attributable to significant technical deficiencies in the manner in which the loan was originated, funded or serviced by First Western, the SBA may seek recovery of funds from us. With respect to the guaranteed portion of SBA loans that have been sold, the SBA will first honor its guarantee and then seek compensation from us in the event that a loss is deemed to be attributable to technical deficiencies.
Pursuant to SBA rules and regulations, distributions from our consolidated subsidiaries, First Western, PMCIC and Western Financial are limited. In order to operate as a small business lending company, a licensee is required to maintain a minimum net worth (as defined by SBA regulations) of the greater of (1) 10% of the outstanding loans receivable of our SBLC or (2) $1.0 million, as well as certain other regulatory restrictions such as change in control provisions. At December 31, 2005, dividends available for distribution were approximately $2.5 million.
Note 25. Business Segments:
Operating results and other financial data are presented for our reportable business segments. These segments are categorized by line of business which also corresponds to how they are operated. The segments include (1) the Lending Division, which originates loans receivable to small businesses primarily in the hospitality industry and (2) the Property Division which owns our Hotel Properties and operates certain of our Hotel Properties. The operations of our lending division are reviewed by our chief operating decision makers in assessing its performance, to make business decisions and to allocate resources. We do not differentiate between subsidiaries or loan programs for this purpose.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Our business segment data as of December 31, 2005, 2004 and 2003 and for the years ended December 31, 2005, 2004 and 2003 is as follows:
(1)
Interest expense specifically identifiable to a particular division is allocated to that division. Interest expense which is not specifically identifiable is allocated based on the relative total assets of each division. The property division was allocated approximately $555,000 and $585,000 of this interest during 2005 and 2004, respectively.
(2)
Salaries and related benefits were allocated to the property division based on management’s estimate of time spent for oversight. To the extent we sell our Hotel Properties, there will be no material reduction in our aggregate general and administrative expenses.
PMC COMMERCIAL TRUST AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1)
Interest expense specifically identifiable to a particular division is allocated to that division. Interest expense which is not specifically identifiable is allocated based on the relative total assets of each division. The property division was allocated approximately $600,000 of this interest during 2003.
Total assets were allocated as follows:
Additions to furniture, fixtures and equipment were as follows:
Schedule II
PMC COMMERCIAL TRUST AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
(In thousands, except footnotes)
(1)
Principal written off.
(2)
During 2004, $675,000 of previously recorded loan loss reserves was reversed due to the reduction in the expected loss on a loan collateralized by a limited service hospitality property due to repayment in full of all principal on the loan.
(3)
We acquired net operating losses in the merger with PMC Capital which were fully reserved at acquisition.
(4)
During 2005, $18,000 of previously recorded loan loss reserves were reversed due to the reduction in expected loss on a loan.
(5)
Represents recovery of loans previously written off.
(6)
At the time of the merger in 2004, management believed that we would not realize the benefit of the net operating loss carryforwards from one of our taxable REIT subsidiaries and a valuation allowance was established. However, based on current pretax earnings, management now believes we will realize the full benefit of these net operating loss carryforwards. Accordingly, the valuation allowance was reversed during 2005.
(7)
During 2005, we established an allowance against our rent and related receivables from Arlington based on best available information provided to us through the Arlington bankruptcy proceedings.
Schedule III
PMC COMMERCIAL TRUST AND SUBSIDIARIES
REAL ESTATE AND ACCUMULATED DEPRECIATION
AS OF DECEMBER 31, 2005
(In thousands, except footnotes)
Schedule III
PMC COMMERCIAL TRUST AND SUBSIDIARIES
REAL ESTATE AND ACCUMULATED DEPRECIATION
AS OF DECEMBER 31, 2005
(In thousands)
Schedule III
PMC COMMERCIAL TRUST AND SUBSIDIARIES
REAL ESTATE AND ACCUMULATED DEPRECIATION
AS OF DECEMBER 31, 2005
(In thousands, except footnotes)
Schedule IV
PMC COMMERCIAL TRUST AND SUBSIDIARIES
MORTGAGE LOANS ON REAL ESTATE
AS OF DECEMBER 31, 2005
(Dollars in thousands, except footnotes)
Conventional Loans - States 2% or greater (1):
Footnotes:
Schedule IV
PMC COMMERCIAL TRUST AND SUBSIDIARIES
MORTGAGE LOANS ON REAL ESTATE
AS OF DECEMBER 31, 2005
(Dollars in thousands, except footnotes)
SBA 7(a) Loans - States 2% or greater (1) (2):
Footnotes:
Schedule IV
PMC COMMERCIAL TRUST AND SUBSIDIARIES
MORTGAGE LOANS ON REAL ESTATE
AS OF DECEMBER 31, 2005
(In thousands, except footnotes)
Footnotes:
(1)
Includes three loans of approximately $4,770,000 which were originated in connection with the sales of hotel properties and two loans of approximately $3,725,000 which were originated in connection with sales of assets acquired in liquidation which did not require cash expenditures.
(2)
A loan receivable established through the reversal of a previously recorded discount. The loan was previously acquired from an affiliate.
EXHIBIT INDEX
E-1
E-2
E-3
E-4
E-5
*
Filed herewith.
**
Furnished herewith.
The Registrant agrees to furnish to the Securities and Exchange Commission upon request a copy of any instrument with respect to long-term debt not filed herewith as to which the total amount of securities authorized thereunder does not exceed 10 percent of the total assets of the Registrant and its subsidiaries on a consolidated basis.
E-6