Item 1. Business
Our Company
We are a multi-strategy commercial real estate company that is a self-managed and self-advised Maryland real estate investment trust, or REIT. We utilize our vertically integrated platform to originate commercial real estate loans, acquire commercial real estate properties and invest in, manage and service commercial real estate assets. We offer a comprehensive set of debt financing options to the commercial real estate industry and provide asset and property management services. We also own and manage a portfolio of commercial real estate properties and manage real estate assets for third parties. We were formed in August 1997 and commenced operations in January 1998.
During 2014, we conducted our business through the following core business lines:
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Our commercial real estate, or CRE, business line concentrates on three business activities: real estate lending, and owning and managing commercial real estate assets throughout the United States. The form of our investments may range from first mortgage loans to equity ownership of a commercial real estate property. We manage our investments in-house through our asset management and property management professionals.
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Independence Realty Trust, Inc., or IRT, business activities concentrate on the ownership of apartment properties in opportunistic markets throughout the United States.
Historically, we also conducted business through our non-core Taberna business line. Our Taberna business line included serving as collateral manager for three securitizations collateralized primarily by trust preferred securities, or TruPS, issued by real estate companies, namely Taberna Preferred Funding I, Ltd., or T1, Taberna Preferred Funding VIII, Ltd., or T8, and Taberna Preferred Funding IX, Ltd., or T9, and holding retained interests in T8 and T9 resulting in our consolidation of those securitizations. We had exited this business line by the end of 2014. See Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Taberna Exit” below.
In 2014 we continued to focus on our core competencies: commercial real estate lending, direct ownership of real estate and managing commercial real estate. In 2014, we also diversified the revenue generated from our commercial real estate loans and properties and reduced or removed other non-core assets and activities. In our CRE and IRT business lines, we expanded our origination of loans, grew our portfolio of properties and attracted capital to RAIT and IRT to fuel our growth, resulting in increased assets and revenue. As a result, we increased distributions on our common shares by 27% in 2014 from 2013. Although we are reporting a net loss for the year, we believe RAIT is positioned to take advantage of opportunities resulting from improved commercial real estate market fundamentals and sources of financing. The 2014 net loss resulted primarily from unrealized losses relating to non-cash mark-to-market adjustments in the Taberna business line and the associated hedges and a non-cash loss we took upon deconsolidation of the Taberna business line.
Our current portfolio of investments in our CRE and IRT business lines consists primarily of the following asset classes:
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investments in real estate or in entities that own commercial real estate; and
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commercial real estate mortgages, mezzanine loans, conduit loans, other loans and preferred equity interests.
Our revenue from our CRE and IRT business lines is generated primarily from:
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rental income from our owned real estate assets;
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interest income from our investments; and
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fee income generated from:
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originating, servicing and managing assets, and
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selling conduit loans to commercial mortgage backed securities, or CMBS, securitizations.
A discussion of our business lines as segments is incorporated by reference to Note 19 of Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data.
Business Strategy
We are focused on managing our existing portfolio while investing capital into our core business lines with the goal of providing our shareholders with total returns over time, including the combination of recurring common dividends and stock appreciation. We believe our multi-strategy approach of combining commercial real estate lending and direct ownership and management of commercial real estate properties diversifies our portfolio, blending our higher yielding lending business with the stability and recurring income stream from owning and managing properties. The core components of our business strategy are described in more detail below.
Own commercial real estate. We believe our investments in real estate in our portfolio permits us to maximize value over time and adds stability to our overall portfolio mix. This portfolio is held in our CRE business line and our IRT business line. The portion of this portfolio held in our CRE business line is comprised primarily of apartment, office and retail properties. We benefit from this portion of this portfolio primarily from the operating results of the properties as well as any increase in the value of these properties. This portfolio also includes apartment properties owned by IRT (NYSE MKT: IRT) which comprises our IRT business line. IRT is a publicly traded real estate investment trust, or REIT, focused on owning apartment properties. IRT is externally advised and consolidated by RAIT. At December 31, 2014, RAIT owned 23% of IRT’s outstanding common stock. While we consolidate IRT’s financial results, we benefit from this portion of this portfolio primarily from advisory fees and distributions we receive from IRT which are eliminated in consolidation. See “Our Investment Portfolio- Investments in Real Estate” below for a description of the investment portfolio resulting from this strategy.
Provide commercial real estate financing. We provide a comprehensive set of debt financing options to the commercial real estate industry, including bridge loans, conduit loans, mezzanine loans, other loans and preferred equity interests. We expect our origination of conduit loans to generate fee income for us when we sell the conduit loans to CMBS securitizations. We expect to retain the balance of the assets in this portfolio to generate interest income for us. See “Our Investment Portfolio-CRE Loans” below for a description of the investment portfolio resulting from this strategy.
Asset management and loan servicing. We manage a portfolio of real estate related assets. As of December 31, 2014, we had $4.5 billion of assets under management. Assets under management are comprised primarily of our consolidated assets and assets of third parties to which we provide property management services. We serve as collateral manager or servicer and special servicer to the securitizations we consolidate. Our subsidiary, RAIT Residential, provides property management services to apartment properties, including IRT’s properties. Our subsidiary, RAIT Commercial, LLC, or RAIT Commercial, provides property management services to office properties. Our subsidiary, Urban Retail Properties, LLC, or Urban Retail, provides property management services to retail properties. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Assets Under Management” below.
Financing Strategy
Investments in Loans
Our strategy involves using multiple sources of short-term financing to acquire assets with the ultimate goal of financing these investments on a long-term, non-recourse, match-funded basis or selling these assets. Match funding enables us to match the interest rates and maturities of our assets with the interest rates and maturities of
our financing, thereby reducing interest rate risk and funding risks in financing our portfolio on a long-term basis. We expect to use a variety of short-term funding sources, including warehouse facilities, repurchase agreements, bank credit facilities and bank participations, until we obtain permanent long-term financing or a buyer for these assets. We currently use short term financing provided by CMBS facilities to originate conduit loans and bridge loans prior to their ultimate sale to CMBS securitizations. Since 2013, we have sold conduit loans to unaffiliated CMBS securitizations for fee income and have sold bridge loans to CMBS securitizations we have sponsored and consolidate and for which we act as servicer and special servicer. During the year ended 2014, we sold approximately $427.1 million of conduit loans to unaffiliated CMBS securitizations and sold $415.4 million of bridge loans to two securitizations we sponsored. At December 31, 2014, we financed a majority of our consolidated investments in commercial real estate loans through three of these CMBS securitizations and two non-recourse loan securitizations, RAIT CRE CDO I, Ltd., or RAIT I, and RAIT Preferred Funding II, Ltd., or RAIT II. RAIT I and RAIT II we sponsored in 2006 and 2007, respectively. We serve as collateral manager for RAIT I and RAIT II. We may use loan participation arrangements with other lenders whereby such lenders acquire an interest in a loan that we that we have originated. These arrangements may provide equivalent, senior or subordinated interests as between us and the other lender in the loan.
We may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with our financing strategies particularly where the loans we make with the proceeds of financing we obtain are not match funded with the financing. REITs generally are able to enter into transactions to hedge indebtedness used to acquire real estate assets, provided that the total gross income from such hedges and other non-qualifying sources does not exceed 25% of the REIT’s total gross income.
Investments in Real Estate
We have financed our portfolio of investments in commercial real estate through secured mortgages held by either third party lenders or our commercial real estate securitizations. IRT also has a secured credit facility which it uses to make acquisitions which we consolidate.
Our Investment Portfolio
Our consolidated investment portfolio from our CRE and IRT business lines is currently comprised of the following asset classes:
Investments in real estate. We invest in real estate properties, primarily multi-family properties, throughout the United States. This asset class is held in our CRE and our IRT business lines. We manage substantially all of our properties through our property management subsidiaries. The table below describes certain characteristics of our investments in real estate as of December 31, 2014 (dollars in thousands, except average effective rent):
(a) Based on properties owned as of December 31, 2014.
(b) Average effective rent is rent per unit per month.
(c) Average effective rent is rent per square foot per year.
During the year ended December 31, 2014, RAIT acquired or obtained control of two multi-family properties, two retail properties and four office properties with a combined purchase price of $211.1 million. Also, RAIT disposed of one multi-family real estate property for a total sales price of $4.3 million. During the year ended December 31, 2014, IRT acquired 20 multi-family properties with a combined purchase price of $497.1 million.
The charts below describe the property types and the geographic breakdown of our investments in real estate as of December 31, 2014:
(a) Based on book value.
CRE Loans. We originate and own senior long-term mortgage loans, including bridge loans, conduit loans, subordinated, or “mezzanine,” financing and preferred equity interests. Our bridge loans are primarily floating interest rate first priority mortgage loans with an initial maturity of less than four years which meet the eligibility requirements of securitizations to collateralize the CMBS issued by those securitizations. Our conduit loans are primarily fixed interest rate first priority mortgage loans which meet the eligibility requirements of securitizations to collateralize the securities issued by those securitizations. Our mezzanine loans are subordinate in repayment priority to a senior mortgage loan or loans on a property and are typically secured by pledges of ownership interests, in whole or in part, in the entities that own the real property. We may structure our mezzanine loans so that we receive a stated fixed or variable interest rate on the loan as well as additional interest based upon a percentage of gross revenue, payable upon maturity, refinancing or sale of the property. We generate a return on our preferred equity investments primarily through distributions to us at a fixed rate based upon the net cash flow of our investment from the underlying real estate. We use this investment structure as an alternative to a mezzanine loan where the financial needs and tax situation of the borrower, the terms of senior financing secured by the underlying real estate or other circumstances necessitate holding preferred equity. These assets are in most cases “non-recourse” or limited recourse loans secured by commercial real estate assets or real estate entities. This means that we look primarily to the assets securing the loan for repayment, subject to certain standard exceptions. We may from time to time acquire existing commercial real estate loans from third parties who have originated such loans, including banks, other institutional lenders or third-party investors. Where possible, we seek to maintain direct lending relationships with borrowers, as opposed to investing in loans controlled by third party lenders. Substantially all of this asset class is held in our CRE business line.
The tables below describe certain characteristics of our commercial mortgages, mezzanine loans, other loans and preferred equity interests as of December 31, 2014 (dollars in thousands):
During the year ended December 31, 2014, we originated $983.8 million of new loans, had third party conduit loan sales of $427.1 million and loan repayments of $164.0 million, resulting in net loan growth of $392.7 million. We finance our consolidated CRE loans on a long-term basis through securitizations. See Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Securitization Summary.”
The charts below describe the property types and the geographic breakdown of our commercial mortgages, mezzanine loans, other loans, and preferred equity interests as of December 31, 2014:
(a) Based on book value.
Investment in debt securities-Other Real Estate Related Debt Securities. We have invested in CMBS, unsecured REIT notes and other real estate-related debt securities. In the past, our investments in debt securities was mainly attributable to the Taberna securitizations. During 2014, we exited the Taberna business and deconsolidated the Taberna securitizations from our balance sheet. At December 31, 2014, $20.4 million of the below investments in debt securities related to the Taberna business which were sold in January 2015.
The table and the chart below describe certain characteristics of our real estate-related debt securities as of December 31, 2014 (dollars in thousands):
Certain REIT and Investment Company Act Limits On Our Strategies
REIT Limits
We conduct our operations to qualify as a REIT. We also conduct the operations of our subsidiaries, Taberna Realty Finance Trust, or TRFT, IRT, and any REITs we may sponsor in the future, which we collectively refer to as our REIT affiliates, to each qualify as a REIT. Our exit of the Taberna business line did not involve selling TRFT, which continues to hold assets and liabilities unrelated to the Taberna business line. For a discussion of the tax implications of our and our REIT affiliates’ REIT status to us and our shareholders, see “Material U.S. Federal Income Tax Considerations” contained in Exhibit 99.1 to this Annual Report on Form 10-K. To qualify as a REIT, we and our REIT affiliates must continually satisfy various tests regarding
sources of income, nature and diversification of assets, amounts distributed to shareholders and the ownership of common shares. In order to satisfy these tests, we and our REIT affiliates may be required to forgo investments that might otherwise be made. Accordingly, compliance with the REIT requirements may hinder our or our REIT affiliates’ investment performance. These requirements include the following:
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For each of ourselves and our REIT affiliates, at least 75% of total assets and 75% of gross income must be derived from qualifying real estate assets, whether or not such assets would otherwise represent our or our REIT affiliates’ best investment alternative. For example, since our investments in the debt or equity of securitizations are not qualifying real estate assets, to the extent that we have historically invested in such assets, or may do so in the future, we must hold substantial investments in qualifying real estate assets, including mortgage loans and CMBS, which may have lower yields than such investments. Also, at least 95% of each of our and our REIT affiliates’ gross income in each taxable year, excluding gross income from prohibited transactions, must be derived from some combination of income that qualifies under the 75% gross income test described above, as well as other dividends, interest, and gain from the sale or disposition of shares or securities, which need not have any relation to real property.
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A REIT’s net income from prohibited transactions is subject to a 100% penalty tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including any mortgage loans, held in inventory or primarily for sale to customers in the ordinary course of business. The prohibited transaction tax may apply to any sale of assets to a securitization and to any sale of securitization securities, and therefore may limit our and our REIT affiliates’ ability to sell assets to or equity in securitizations and other assets.
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Overall, no more than 25% of the value of a REIT’s assets may consist of securities of one or more taxable REIT subsidiaries, or TRSs. Our TRSs that currently hold assets include: RAIT Jupiter Holdings, LLC (the holding company for our interest in RAIT Residential, RAIT Commercial and RAIT Urban Holdings, LLC), RAIT TRS, LLC (the holding company for Independence Realty Advisors, LLC, IRT’s external advisor), Taberna Equity Funding, Ltd. (the holding company for equity issued by T9) and RAIT Funding LLC (the holding company for the entities that issued our junior subordinated notes and the entities party to our conduit and bridge CMBS facilities referred to below). Our and our REIT affiliates’ ability to grow or expand the fee-generating businesses held in a TRSs, as well as the business of future TRSs we or our REIT affiliates may form, will be limited by our and our REIT affiliates’ need to meet this 25% test.
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The REIT provisions of the Internal Revenue Code limit our and our REIT affiliates’ ability to hedge mortgage-backed securities, preferred securities and related borrowings. Except to the extent provided by the regulations promulgated by the U.S. Treasury Department, or the Treasury regulations, any income from a hedging transaction we or our REIT affiliates enter into in the normal course of business primarily to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets, which is clearly identified as specified in the Treasury regulations before the close of the day on which it was acquired, originated, or entered into, including gain from the sale or disposition of such a transaction, will not constitute gross income for purposes of the 95% gross income test (and will generally constitute non-qualifying income for purposes of the 75% gross income test). To the extent that we or our REIT affiliates enter into other types of hedging transactions, the income from those transactions is likely to be treated as non- qualifying income for purposes of both of the gross income tests. As a result, we or our REIT affiliates might have to limit use of advantageous hedging techniques or implement those hedges through TRSs. This could increase the cost of our or our REIT affiliates’ hedging activities or expose it or us to greater risks associated with changes in interest rates than we or it would otherwise want to bear.
There are other risks arising out of our and our REIT affiliates’ need to comply with REIT requirements. See Item 1A
Item 1A. Risk Factors
This section describes material risks affecting our business.
Risks Related to Our Business
Changes in general economic conditions may adversely affect our business.
Our business and operations depend on the commercial real estate industry generally, which in turn depends upon broad economic conditions in the U.S. and abroad. A worsening of economic conditions would likely have a negative impact on the commercial real estate industry generally and on our business and operations specifically. Additionally, disruptions in the global economy may also have a negative impact on the commercial real estate market domestically. Adverse conditions in the commercial real estate industry could harm our business and financial condition by, among other factors, reducing the value of our existing assets, limiting our access to debt and equity capital, limiting our ability to originate new commercial real estate debt or acquire or finance investments in real estate and otherwise negatively impacting our operations.
We rely on outside sources of capital to maintain our liquidity and any restrictions on our ability to access these sources would materially adversely affect our financial performance.
We require significant outside capital to fund and grow our businesses. A primary source of liquidity for us has been the equity and debt capital markets, including sales of loans to securitizations, repurchase agreements, issuances of common equity, preferred equity and convertible senior notes. Our origination and sales of conduit loans is currently dependent on our ability to access short term financing through repurchase agreements followed by sales to unaffiliated third party sponsored CMBS securitizations. Our origination of bridge loans is currently dependent on our ability to access short term financing through repurchase agreements followed by our ability to use these loans to collateralize securitizations we sponsor and have these securitizations issue debt to unaffiliated investors. If these financing sources were no longer available for these types of assets, our ability to originate these assets and our returns from these assets might be materially adversely affected. In general, our financial performance would be materially adversely affected if our access to liquidity were restricted, whether by economic conditions or capital market developments affecting commercial real estate or our historical sources of financing or for any other reason. If we fail to secure financing on acceptable terms or in sufficient amounts, our income may be reduced by limiting our ability to originate loans, acquire properties and make other investments. We depend on our portfolio of investments to generate our cash available for distribution and any
significant restriction on our liquidity could impair our ability to pay distributions to our shareholders. We cannot assure you that any, or sufficient, funding or capital will be available to us in the future on terms that are acceptable to us. For information about our available sources of funds, refer to Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources” and the notes to the consolidated financial statements located in Part II, Item 8 of this Annual Report on Form 10-K.
The price of our common shares and other securities historically has been volatile. This volatility may affect the price at which anyone holding our common shares or other securities could sell them, and the sale of substantial amounts of our common shares or such other securities could adversely affect the price of our common shares or such other securities.
The market price for our common shares has varied between a high of $8.53 on April 1, 2014 and a low of $6.70 on January 14, 2015 in the twelve month period ending on March 13, 2015. This volatility may affect the price at which you could sell the common shares. Other securities we have issued have also had volatile market prices. The market prices of our securities are likely to continue to be volatile and the trading volume subject to significant fluctuations in response to market and other factors, including the other risk factors discussed in this report; variations in our quarterly operating results from our expectations or those of securities analysts or investors, downward revisions in securities analysts’ estimates, and announcement by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments.
Our reliance on debt to finance investments may require us to make balloon payments upon maturity, upon the exercise of any applicable put rights or otherwise, and an increased risk of loss may reduce our return on investments, reduce our ability to pay distributions to our shareholders and possibly result in the foreclosure of any assets subject to secured financing.
We have historically incurred debt to finance our investments, which could compound losses and reduce our ability to pay distributions to our shareholders. Our debt service payments could reduce the net income available for distributions to our shareholders and reduce our liquidity available to make distributions to our shareholders each calendar year that are required for REIT qualification. Most of our assets are pledged as collateral for borrowings. In addition, the assets of the securitizations that we consolidate collateralize the debt obligations of the securitizations and are not available to satisfy our other creditors. To the extent that we fail to meet debt service obligations, we risk the loss of some or all of our respective assets to foreclosure or sale to satisfy these debt obligations. Currently, our declaration of trust and bylaws do not impose any limitations on the extent to which we may leverage our respective assets.
We are subject to the risks normally associated with debt financing, including the risk that our cash flows will be insufficient to meet required principal and interest payments and the risk that we will be unable to refinance our indebtedness when it becomes due, or that the terms of such refinancing will not be as favorable as the terms of our indebtedness. Included in our debt instruments are provisions providing for the lump sum payment of significant amounts of principal, whether upon maturity, upon the exercise of any applicable put rights or otherwise, which we refer to as balloon payments. Most of our debt provides for balloon payments that are payable at maturity. If collateral underlying any secured credit facility we are party to defaults or otherwise fails to meet specified conditions, we may have to repay that facility to the extent it was secured by that collateral. Our ability to make these payments when due will depend upon several factors, which may not be in our control. These factors include our liquidity or our ability to convert assets owned by us into liquidity on or prior to such put or maturity dates and the amount by which we have been able to reduce indebtedness prior to such put or maturity date though exchanges, refinancing, extensions, collateralization or other similar transactions (any of which transactions may also have the effect of reducing liquidity or liquid assets). Our ability to accomplish these goals will be affected by various factors existing at the relevant time, such as the state of the national and regional economies, local real estate conditions, available interest rate levels, the lease terms for and equity in any related collateral, our financial condition and the operating history of the collateral. If we are unable
to pay, redeem, restructure, refinance, extend or otherwise enter into transactions to satisfy any of our debt, this could result in defaults under, and acceleration of, our debt and we may be required to sell assets in significant amounts and at times when market conditions are not favorable, which could result in our incurring significant losses.
Our issuance of Series D preferred shares with mandatory redemption rights and warrants and share appreciation rights with put rights may increase our risk of loss if we need to satisfy these redemption rights and put rights.
We have issued our Series D preferred shares of beneficial interest which provide a holder with redemption rights in defined circumstances and warrants and share appreciation rights which have put rights in defined circumstances. While these Series D preferred shares and such warrants and share appreciation rights provide that any exercise of such redemption and put rights may be satisfied by RAIT issuing a note, the exercise of these redemption and put rights may adversely affect our liquidity and reduce amounts available for distribution to our shareholders. Events which have occurred or may occur in the future relating to the investigation of our subsidiary, Taberna Capital Management, LLC, or TCM, by the SEC may come within the circumstances giving rise to such redemption and put rights. For a description of this investigation, see “Item 3 - Legal Proceedings” below.
The accounting method for convertible debt securities that may be settled in cash could have a material effect on our reported financial results.
Under Accounting Standards Codification 470-20, Debt with Conversion and Other Options, which we refer to as ASC 470-20, issued by the Financial Standards Board, or FASB, an entity must separately account for the liability and equity components of convertible debt instruments that may be settled entirely or partially in cash upon conversion in a manner that reflects the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for all of our currently outstanding senior convertible notes is that the equity component is required to be included in the additional paid-in capital section of shareholders’ equity on our consolidated balance sheet and the value of the equity component would be treated as original issue discount for purposes of accounting for the debt component of these notes. As a result, we will be required to record a greater amount of non-cash interest expense in current periods presented as a result of the amortization of the discounted carrying value of the notes to their face amount over the term of these notes. We will report lower net income in our financial results because ASC 470-20 will require interest to include both the current period’s amortization of the debt discount and the instrument’s coupon interest, which could adversely affect our reported or future financial results, the trading price of our common shares and the trading price of these notes. We expect that any notes we may issue in the future that are convertible into our common shares would receive similar accounting treatment.
Future sales of our common shares in the public market could lower the market price for our common shares and adversely impact the trading price of the notes.
In the future, we may sell additional common shares to raise capital. In addition, a substantial number of our common shares are reserved for issuance upon the exercise of the issued and issuable warrants, or the warrants, described below (see Part II Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Series D preferred shares”) and upon conversion of our outstanding senior convertible notes. We cannot predict the size of future issuances or the effect, if any, that they may have on the market price for our common shares. The issuance and sale of substantial amounts of common shares, or the perception that such issuances and sales may occur, could adversely affect the market price of our common shares and impair our ability to raise capital through the sale of additional equity securities.
The exercise of our issued and issuable warrants and conversion of our outstanding convertible senior notes may dilute the ownership interest of existing common shareholders.
The exercise of our issued and issuable warrants and conversion of some or all of our outstanding convertible senior notes may dilute the ownership interests of existing shareholders. Any sales in the public market of any of our common shares issuable upon such exercise or conversion could adversely affect prevailing market prices of our common shares or the anticipation of such exercise or conversion could depress the price of our common shares.
We may seek to acquire, redeem, restructure, refinance or otherwise enter into transactions to satisfy our debt which may include any combination of material payments of cash, issuances of our debt and/or equity securities, sales or exchanges of our assets or other methods.
From time to time our collateralized debt obligation, or CDO, notes payable and our other indebtedness may trade at discounts to their respective face amounts. In order to reduce future cash interest payments, as well as future principal amounts due upon any applicable put dates, at maturity or upon redemption, or to otherwise benefit RAIT, we may, from time to time, purchase such CDO notes payable or other indebtedness for cash, in exchange for our equity or debt securities, or for any combination of cash and our equity or debt securities, in each case in open market purchases, privately negotiated transactions, exchange offers and consent solicitations or otherwise. We will evaluate any such transactions in light of then-existing market conditions, contractual restrictions and other factors, taking into account our current liquidity and prospects for future access to capital. The amounts involved in any such transactions, individually or in the aggregate, may be material and may materially reduce our liquidity or reduce or eliminate our ability to convert assets into liquidity. Any material issuances of our equity securities may have a material dilutive effect on our current shareholders.
If RAIT I and RAIT II were to fail to meet their performance tests, including over-collateralization requirements, our cash flow would be materially reduced.
The terms of RAIT I and RAIT II generally provide that the principal amount of assets must exceed the principal balance of the related securities issued by them by a certain amount, commonly referred to as “over-collateralization.” These terms provide that, if delinquencies and/or losses exceed specified levels based on the analysis by the rating agencies (or any financial guaranty insurer) of the characteristics of the assets collateralizing the securities issued in the securitization, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses or delinquencies did not exceed those levels. In addition, a failure by these securitizations to satisfy an over-collateralization test may result in accelerated distributions to the holders of the senior debt securities issued by them. Our equity holdings, any debt interests and our subordinated management fees, if any, are subordinate in right of payment to the other classes of debt securities issued by the securitization entity. Other tests (based on delinquency levels or other criteria) may restrict our ability to receive cash distributions from assets collateralizing the securities issued by the securitization entity or our ability to effectively manage the assets held in the securitizations. We cannot assure you that any performance test will be satisfied.
We currently receive a substantial portion of our cash flow from RAIT I and RAIT II through our retained interests in these securitizations and management fees paid to us for managing these securitizations. If either or both of these securitizations were to fail to meet their respective over-collateralization or other tests, our cash flow would be materially reduced.
We receive collateral management fees pursuant to collateral management agreements for services we provide as the collateral manager of RAIT I and RAIT II. If a collateral management agreement is terminated or if the securities serving as collateral for a securitization are prepaid or go into default, the collateral management fees will be reduced or eliminated.
We receive collateral management fees pursuant to collateral management agreements for acting as the collateral manager of RAIT I and RAIT II. If all the notes issued by one of those securitizations are redeemed, or if the collateral management agreement is otherwise terminated, we will no longer receive collateral management fees from that securitization. In general, a collateral management agreement may be terminated both with and without cause at the direction of holders of a specified supermajority in principal amount of the notes issued by the securitization. Furthermore, such fees are based on the total amount of collateral held by the securitizations. If the assets serving as collateral for a securitization are prepaid or go into default, we will receive lower collateral management fees than expected or the collateral management fees may be eliminated.
In addition, collateral management agreements typically provide that if certain over-collateralization tests are failed, the collateral management agreement may be terminated by a vote of the security holders resulting in our loss of management fees from these securitizations.
If any of our securitizations fail to meet over-collateralization tests relevant to the securitization’s most senior existing debt, an event of default may occur. Upon an event of default, our ability to manage the securitization may be terminated and our ability to attempt to cure any defaults in the securitization would be limited, which would increase the likelihood of a reduction or elimination of cash flow and returns to us in those securitizations for an indefinite time.
We receive servicing and special servicing fees pursuant to servicing agreements with the consolidated securitizations we sponsor collateralized primarily by bridge loans, or the FL securitizations, for services we provide as the servicer and special servicer of the FL securitizations and expect to enter into similar agreements in the future with respect to future similar securitizations . If these or any similar servicing agreements are terminated or if the loans serving as collateral for a securitization are prepaid or go into default, the servicing fees will be reduced or eliminated.
We receive servicing fees pursuant to servicing agreements for acting as the servicer and special servicer of each of the FL securitizations. If all the notes issued by any of the FL securitizations are redeemed, or if a servicing agreement is otherwise terminated, we will no longer receive servicing fees from the affected FL securitization. In general, these servicing agreements may be terminated upon the occurrence of a termination event, which includes our failure to remit required payments, make required advances, material breaches of covenants or representations, defined bankruptcy and insolvency events and a ratings downgrade citing servicing concerns as a material factor. Furthermore, the fees payable by each securitization are based on the total amount of collateral held by the securitization. If the assets serving as collateral for a securitization are prepaid or go into default, we will receive lower servicing fees than expected or the servicing fees may be eliminated. We may enter into additional similar servicing agreements in the future in connection with future securitizations.
We receive advisory fees pursuant to an advisory agreement, or the IRT advisory agreement, with IRT for advisory services we provide as the external advisor of IRT. If this advisory agreement is terminated, the advisory fees will be reduced or eliminated.
The IRT advisory agreement provides that IRT may terminate the IRT advisory agreement for cause only upon the affirmative vote of two-thirds of IRT’s independent directors or a majority of IRT’s outstanding common stock or a change of control of RAIT or IRT’s advisor (each as defined in the IRT advisory agreement) if a majority of IRT’s independent directors determine that such a change of control of RAIT or IRT’s advisor is materially detrimental to IRT. If IRT terminates the agreement without cause, or if IRT’s advisor terminates the agreement because of a material breach of the agreement by IRT or as a result of a change of control of IRT, IRT must pay IRT“s advisor a termination fee. If the IRT advisory agreement is terminated, the advisory fees will be reduced or eliminated, even if such termination results in the payment of a termination fee.
Our investments in securitizations are exposed to greater uncertainty and risk of loss than investments in higher grade securities in these securitizations.
When we securitize assets such as commercial mortgage loans and mezzanine loans, the various tranches of investment grade and non-investment grade debt obligations and equity securities have differing priorities and rights to the cash flows of the underlying assets being securitized. We structured our securitization transactions to enable us to place debt and equity securities with investors in the capital markets at various pricing levels based on the credit position created for each tranche of debt and equity securities. The higher rated debt tranches have priority over the lower rated debt securities and the equity securities issued by the particular securitization entity with respect to payments of interest and principal using the cash flows from the collateral assets. The relative cost of capital increases as each tranche of capital becomes further subordinated, as does the associated risk of loss if cash flows from the assets are insufficient to repay fully interest and principal or pay dividends.
Since we own in many cases the “BBB,” “BB,” “B” and unrated debt and equity classes of securitizations, we are in a “first loss” position because the rights of the securities that we hold are subordinate in right of payment and in liquidation to the rights of higher rated debt securities issued by the securitization entities. Accordingly, we have incurred and may in the future incur significant losses when investing in these securities. In the event of default, we may not be able to recover all of our respective investments in these securities. In addition, we may experience significant losses if the underlying portfolio has been overvalued or if the values subsequently decline and, as a result, less collateral is available to satisfy interest, principal and dividend payments due on the related securities. The prices of lower credit quality securities are generally less sensitive to interest rate changes than higher rated investments, but are more sensitive to economic downturns or developments specific to a particular issuer. Current credit market conditions have caused a decline in the price of lower credit quality securities because the ability of obligors on the underlying assets to make principal, interest and dividend payments may be impaired. In addition, existing credit support in a number of the securitizations in which we have invested have been, and may in the future be, insufficient to protect us against loss of our investments in these securities.
Representations and warranties made by us in connection with loan sales to securitization vehicles may subject us to liability that could result in loan losses and could harm our operating results and, therefore distributions we make to our shareholders.
In connection with loan sales to securitization vehicles, we are required to make representations and warranties regarding, among other things, the borrowers, guarantors, collateral, originators and servicers of the loans sold to the depositor of such assets into securitization trusts. In the event of a breach of such representations or warranties, we may be required to repurchase the affected loans at their face value or otherwise make payments to the owner of the loan. While we may have recourse to loan originators (if not us), borrowers, guarantors and/or other third parties whose representations, warranties, certifications, reports and/or other statements or work product we relied upon in making our representations and warranties, there can be no guaranty that such parties will be able to fully or partially cover any liability we may have in such circumstances. Furthermore, if we discover, prior to the securitization of an asset, that there is any fraud or misrepresentation with respect to the origination of such asset by a third party and are unable to force that third party to repurchase the loan, then we may not be able to sell the loan to a securitization or we may have to sell it at a discount. In any such case, we may incur losses and our cash flows may be impaired.
Our financing arrangements contain covenants that restrict our operations, and any default under these arrangements would inhibit our ability to grow our business, increase revenue and pay distributions to our shareholders.
Our financing arrangements contain restrictions, covenants and events of default. Failure to meet or satisfy any of these covenants could result in an event of default under these agreements. These agreements may contain cross- default provisions so that an event of default under one agreement will trigger an event of default under
other agreements. Defaults generally give our lenders the right to declare all amounts outstanding under their particular credit agreement to be immediately due and payable, and enforce their rights by foreclosing on or otherwise liquidating collateral pledged under these agreements. These restrictions may interfere with our ability to obtain financing or to engage in other business activities. Furthermore, our default under any of our financing arrangements could materially reduce our liquidity and our ability to make distributions to our shareholders.
We operate in a highly competitive market which may harm our business, financial condition, liquidity and results of operations.
Historically, we have been subject to significant competition in all of our business lines. We compete with many third parties engaged in finance and real estate investment activities, including other REITs, specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms and broker-dealers, property managers, investment advisers, lenders, governmental bodies and other entities. Some of these competitors have, or in the future may have, substantially greater financial resources than we do and generally may be able to accept more risk. As such, they have the ability to make larger loans and to reduce the risk of loss from any one loan by having a more diversified loan portfolio. They may also enjoy significant competitive advantages that result from, among other things, a lower cost of, and greater access to, capital and enhanced operating efficiencies. An increase in the general availability of funds to lenders, or a decrease in the amount of borrowing activity, may increase competition for making loans and may reduce obtainable yields or increase the credit risk inherent in the available loans.
Competition may limit the number of suitable investment opportunities offered to us. It may also result in higher prices, lower yields and a narrower spread of yields over our borrowing costs, making it more difficult for us to acquire new investments on attractive terms and reducing the fee income we realize from the origination, structuring and management of securitizations. It may also make it more difficult to obtain appreciation interests and increase the price, and thus reduce potential yields, on discounted loans we acquire.
We face significant competition in our investments in real estate from other owners, operators and developers of properties, many of which own properties similar to ours in markets where we operate. Such competition may affect our ability to attract and retain tenants and reduce the rents we are able to charge. These competing properties may have vacancy rates higher than our properties, which may result in their owners being willing to rent space at lower rental rates than we would or providing greater tenant improvement allowances or other leasing concessions. This combination of circumstances could adversely affect our revenues and financial performance.
Loss of our management team or the ability to attract and retain key employees could harm our business.
The real estate finance business is very labor-intensive. We depend on our management team to manage our investments and attract customers for financing by, among other things, developing relationships with issuers, financial institutions and others. The market for skilled personnel is highly competitive and has historically experienced a high rate of turnover. Due to the nature of our business, we compete for qualified personnel not only with companies in our business, but also in other sectors of the financial services industry. Competition for qualified personnel may lead to increased hiring and retention costs. We cannot guarantee that we will be able to attract or retain qualified personnel at reasonable costs or at all. If we are unable to attract or retain a sufficient number of skilled personnel at manageable costs, it could impair our ability to manage our investments and execute our investment strategies successfully, thereby reducing our earnings.
Our board of trustees may change our policies without shareholder consent.
Our board of trustees reviews our policies developed by management and, in particular, our investment policies. Our board of trustees may amend our policies or approve transactions that deviate from these policies without a vote of or notice to our shareholders. Policy changes could adversely affect the market price of our shares and our ability to make distributions. Our board of trustees cannot take any action to disqualify us as a REIT or to otherwise revoke our election to be taxed as a REIT without the approval of a majority of our outstanding voting shares.
Our organizational documents do not limit our ability to enter into new lines of business, and we may enter into new businesses, make future strategic investments or acquisitions or enter into joint ventures, each of which may result in additional risks and uncertainties in our business.
Our organizational documents do not limit us to our current business lines. Accordingly, we may pursue growth through strategic investments, acquisitions or joint ventures, which may include entering into new lines of business. In addition, we expect opportunities will arise to acquire other companies, including REITs, managers of investment products or originators of real estate debt. To the extent we make strategic investments or acquisitions, enter into joint ventures, or enter into a new line of business, we will face numerous risks and uncertainties, including risks associated with:
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the required investment of capital and other resources,
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the possibility that we have insufficient expertise to engage in such activities profitably or without incurring inappropriate amounts of risk,
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combining or integrating operational and management systems and controls and
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compliance with applicable regulatory requirements including those required under the Internal Revenue Code and the Investment Company Act.
Entry into certain lines of business may subject us to new laws and regulations with which we are not familiar, or from which we are currently exempt, and may lead to increased litigation and regulatory risk. If a new business generates insufficient revenue or if we are unable to efficiently manage our expanded operations, our results of operations will be adversely affected. In the case of joint ventures, we are subject to additional risks and uncertainties in that we may be dependent upon, and subject to liability, losses or reputation damage relating to, systems, controls and personnel that are not under our control.
We engage in transactions with related parties and our policies and procedures regarding these transactions may be insufficient to address any conflicts of interest that may arise.
Under our code of business conduct, we have established procedures regarding the review, approval and ratification of transactions which may give rise to a conflict of interest between us and any employee, officer, trustee, their immediate family members, other businesses under their control and other related persons. In the ordinary course of our business operations, we have ongoing relationships and have engaged in transactions with several related entities. These procedures do not guarantee that all potential conflicts will be identified, reviewed or sufficiently addressed.
Our transactions with, and investments in, certain securitization vehicles may create perceived or actual conflicts of interest.
We have engaged in transactions with, and invested in, certain of the securitization vehicles under which we also serve as collateral manager, and may do so in the future. These transactions have included, and may include in the future, surrendering for cancellation notes we hold issued by these vehicles and exchanges of our or others’ securities with these vehicles for assets collateralizing these vehicles. In addition, we have previously, and may in the future, purchase investments in these vehicles that are senior or junior to, or have rights and interests different from or adverse to, other investors or credit support providers in the debt or other securities of such securitization vehicles. Such situations may create perceived or actual conflicts of interest between us and such other investors or credit support providers for such investors. Our interests in such transactions and investments may conflict with the interests of such other investors or credit support providers at the time of origination or in the event of a default or restructuring of a securitization vehicle or underlying assets.
Furthermore, if we are involved in structuring the securitization vehicles or such securitization vehicles are structured as our subsidiaries, then our managers may have conflicts between us and other entities managed by them that purchase debt or other securities in such securitization vehicles with regard to setting subordination levels, determining interest rates, pricing the securities, providing for divesting or deferring distributions that
would otherwise be made to equity interests, or otherwise setting the amounts and priorities of distributions to the holders of debt and equity interests in the securitization vehicles.
Although we seek to make decisions with respect to our securitization vehicles in a manner that we believe is fair and consistent with the operative legal documents governing these vehicles, perceived or actual conflicts may create dissatisfaction among the other investors in such vehicles or litigation or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and our reputation could be damaged if we fail to deal appropriately with one or more perceived or actual conflicts of interest. Regulatory scrutiny of, or litigation in connection with, such conflicts of interest could materially adversely affect our ability to manage or generate income or cash flow from our securitizations business, cause harm to our reputation and adversely affect our ability to attract investors for future vehicles.
The organization and management of IRT may create conflicts of interest.
Our subsidiary serves as the external advisor of IRT. IRT currently holds, or may hold in the future, assets that we determine should be acquired by it and doing so may create conflicts of interest, including between investors in IRT and our shareholders, since many investment opportunities that are suitable for us may also be suitable for IRT. Additionally, our management and other real estate and debt finance professionals may face conflicts of interest in allocating their time among RAIT and IRT. Although as a company we will seek to make these decisions in a manner that we believe is fair and consistent with the operative legal documents governing us and IRT, including our investment allocation policy, the transfer or allocation of these assets may give rise to investor dissatisfaction or litigation or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged if we fail to deal appropriately with one or more potential or actual conflicts of interest. Regulatory scrutiny of, or litigation in connection with, conflicts of interest would have a material adverse effect on our reputation which would materially adversely affect our ability to manage or generate income or cash flow from IRT.
We are exposed to loss if lenders under our repurchase agreements, warehouse facilities or other short-term debt liquidate the portfolio assets collateralizing or otherwise providing credit support for such debt. Moreover, assets financed by us pursuant to our repurchase agreements, warehouse facilities or other short-term debt may not be suitable for refinancing through, or sales to, future securitization transactions, which may require us to seek more costly financing for these assets, to liquidate assets or to repurchase these assets .
We have entered into repurchase agreements, and may in the future enter into other repurchase agreements, warehouse facilities or other short term debt with similar terms. Our lenders have the right under our current repurchase agreements, and may have the right under such other debt, to liquidate assets acquired thereunder upon the occurrence of certain events, such as an event of default. We are exposed to loss if the proceeds received by the lender upon any such liquidation are insufficient to satisfy our obligation to the lender. We are also subject to the risk that the assets subject to such repurchase agreements, warehouse facilities or other debt with similar terms might not be suitable for refinancing through, or sales to, future securitization transactions. If we were unable to refinance these assets through, or sell these assets to, future securitization transactions, we might be required to seek more costly financing for these assets, to liquidate assets or to repurchase assets under time constraints that may not produce the optimal return to us.
We will lose money on our repurchase transactions if the counterparty to the transaction defaults on its obligation to resell the underlying asset back to us at the end of the transaction term, or if the value of the underlying asset has declined as of the end of the term or if we default on our obligations under the repurchase agreement.
When we engage in a repurchase transaction, we generally sell assets to the transaction counterparty and receive cash from the counterparty. The counterparty must resell the assets back to us at the end of the term of the transaction. Because the cash we receive from the counterparty when we initially sell the assets to the
counterparty is less than the market value of those assets, if the counterparty defaults on its obligation to resell the assets back to us we will incur a loss on the transaction. We will also incur a loss if the value of the underlying assets has declined as of the end of the transaction term, as we will have to repurchase the assets for their initial value but would receive assets worth less than that amount. Any losses we incur on our repurchase transactions could reduce our earnings, and thus our cash available for distribution to our shareholders.
Our financing of our REIT qualifying assets with repurchase agreements and warehouse facilities could adversely affect our ability to qualify as a REIT.
We have entered into and intend to enter into, sale and repurchase agreements under which we nominally sell certain REIT qualifying assets to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that we will be treated for U.S. federal income tax purposes as the owners of the assets that are the subject of any such agreement notwithstanding that we may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case our ability to qualify as a REIT would be adversely affected because it would reduce the amount of assets that helps us meet relevant REIT asset tests. Similarly, if any of our REIT qualifying assets are subject to a repurchase agreement and are sold by the counterparty in connection with a margin call, the loss of those assets could impair our ability to qualify as a REIT because it would reduce the amount of assets that helps us meet relevant REIT asset tests. Accordingly, unlike other REITs, we may be subject to additional risk regarding our ability to qualify and maintain our qualification as a REIT.
If we deconsolidate any of RAIT I, RAIT II, the FL securitizations or IRT, it may have a material effect on our financial statements.
Our consolidated financial statements reflect our accounts and the accounts of our majority-owned and/or controlled subsidiaries and of entities that are variable interest entities, or VIEs, where we have determined that we are the primary beneficiary of such entities in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 810, “Consolidation.” If we were to cease serving as the collateral manager, servicer and special servicer for any of RAIT I, RAIT II, or servicer and special servicer for any of the FL securitizations and/or if we determined that our retained interests in any such securitizations no longer made us its primary beneficiary, our determination to consolidate such securitization could change. If we deconsolidate any of these securitizations for these or any other reasons, such deconsolidation would have a material effect on our financial statements, including a material reduction of our assets, liabilities, equity and income. Similarly, IRT’s securities offerings have resulted in our holding a minority interest in IRT, while we remain the largest single shareholder. Because we hold a minority interest, if we were to cease serving as the advisor for IRT for any reason and/or if we determined that our retained interests in IRT no longer made us its primary beneficiary that could affect our determination to consolidate IRT. We have contributed a substantial amount of assets to IRT and may make similar transfers of our assets in the future and IRT has acquired other assets and otherwise engage in significant activity while we consolidate it. If we deconsolidate IRT for these or any other reasons, such deconsolidation may have a material effect on our financial statements, including a material reduction of our assets, liabilities, equity and income.
Quarterly results may fluctuate and may not be indicative of future quarterly performance.
Our quarterly operating results could fluctuate; therefore, you should not rely on past quarterly results to be indicative of our performance in future quarters. Factors that could cause quarterly operating results to fluctuate include, among others, variations in our investment origination volume, variations in the timing of repayments of debt financing, variations in the amount of time between our receipt of the proceeds of a securities offering and our investment of those proceeds in loans or real estate, market conditions that result in increased cost of funds or material fluctuations in the fair value of our assets and liabilities, the degree to which we encounter competition in our markets, general economic conditions and other factors referred to elsewhere in this section.
We have identified, and may identify in the future, a material weakness in our internal control over financial reporting, which may require us to incur substantial costs and divert management resources in connection with our efforts to remediate this material weakness.
We have determined that a material weakness in internal controls over financial reporting existed as of December 31, 2014. A detailed description of this material weakness is provided in Part II, Item 9A - “Controls and Procedures” of this Annual Report on Form 10-K. Due solely to this material weakness, management has concluded that we did not maintain an effective internal control over financial reporting as of December 31, 2014 (and, solely as a result of this material weakness, we have concluded that our disclosure controls and procedures were not effective as of December 31, 2014). We are in the process of developing and implementing new processes and procedures to remediate this material weakness. We cannot be certain that any remedial measures we take will ensure that we design, implement and maintain adequate controls over our financial processes and reporting in the future and, accordingly, additional material weaknesses may occur in the future. It is possible that additional control deficiencies may be identified in addition to, or that are unrelated to, the material weakness described above. These control deficiencies may represent one or more material weaknesses. Our inability to remedy any additional deficiencies or material weaknesses that may be identified in the future could, among other things, cause us to fail to file timely our periodic reports with the SEC (which may have a material adverse effect on our ability to access the capital markets); prevent us from providing reliable and accurate financial information and forecasts or from avoiding or detecting fraud; or require us to incur additional costs or divert management resources to, among other things, comply with Section 404 of the Sarbanes-Oxley Act of 2002.
Risks Related to Our Investments
Our reserves for loan losses may prove inadequate, which could have a material adverse effect on our financial results.
We maintain loan loss reserves to protect against potential losses and conduct a review of the adequacy of these reserves on a quarterly basis. Our general loan loss reserve reflects management’s then-current estimation of the probability and severity of losses within our portfolio, based on this quarterly review. In addition, our determination of asset-specific loan loss reserves relies on material estimates regarding the fair value of loan collateral. Estimation of ultimate loan losses, provision expenses and loss reserves is a complex and subjective process. As such, there can be no assurance that management’s judgment will prove to be correct and that reserves will be adequate over time to protect against potential future losses. Such losses could be caused by factors including, but not limited to, unanticipated adverse changes in the economy or events adversely affecting specific assets, borrowers, industries in which our borrowers operate, markets in which our borrowers or their properties are located or an inability to collect accrued interest receivable on loans which accrue interest at a higher rate than their stated pay rate. If our reserves for credit losses prove inadequate we may suffer additional losses which would have a material adverse effect on our financial performance and results of operations.
We may not realize gains or income from investments and have realized, and may continue to realize, losses from some of our investments, including our portfolio of debt securities.
We seek to generate both current income and capital appreciation. However, our investments may not appreciate in value and may decline in value. In addition, some of the financings that we originated and the loans and securities in which we invest have defaulted, and may continue to be in default on interest and/or principal payments. Accordingly, we may not be able to realize gains or income from investments and may realize losses. Any gains that we do realize may not be sufficient to offset any other losses we experience. Any income that we realize may not be sufficient to offset our respective expenses.
Uninsured and underinsured losses may affect the value of, or our return from, our real estate.
Our properties, and the properties underlying our loans, have comprehensive insurance in amounts we believe are sufficient to permit the replacement of the properties in the event of a total loss, subject to applicable
deductibles. There are, however, certain types of losses, such as earthquakes, sinkholes, floods, hurricanes and terrorism that may be uninsurable or not economically insurable. Also, inflation, changes in building codes and ordinances, environmental considerations and other factors might make it impractical to use insurance proceeds to replace a damaged or destroyed property. If any of these or similar events occurs, it may reduce our return from an affected property and the value of our investment.
Real estate with environmental problems may create liability for us.
The existence of hazardous or toxic substances on a property will adversely affect its value and our ability to sell or borrow against the property. Contamination of real estate by hazardous substances or toxic wastes not only may give rise to a lien on that property to assure payment of the cost of remediation, but also can result in liability to us as owner, operator or lender for that cost. Many environmental laws can impose liability whether we know of, or are responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site, even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses, and may materially limit our use of our properties and our ability to make distributions to our shareholders. In addition, future or amended laws, or more stringent interpretations or enforcement policies with respect to existing environmental requirements, may increase our exposure to environmental liability.
Our investment portfolio may have material geographic, sector, property-type and sponsor concentrations.
We may have material geographic concentrations related to our investments in commercial real estate loans and properties. The REITs and real estate operating companies in whose securities we invest in may also have material geographic concentrations related to their investments in real estate, loans secured by real estate or other investments. We also have material concentrations in the property types that comprise our commercial loan portfolio and in the industry sectors that comprise our unsecured securities portfolio. We also may have material concentrations in the sponsors of properties that comprise our commercial loan portfolio. Where we have any kind of concentration risk in our investments, an adverse development in that area of concentration could reduce the value of our investment and our return on that investment and, if the concentration affects a material amount of our investments, impair our ability to execute our investment strategies successfully, reduce our earnings and reduce our ability to make distributions.
Our due diligence efforts before making an investment may not identify all the risks related to that investment.
Before originating a loan or investment for, or making a loan to or investment in, an entity, we will assess the strength and skills of the entity’s management and other factors that we believe will determine the success of the loan or investment. In making the assessment and otherwise conducting customary due diligence, we expect to rely on available resources and, in some cases, an investigation by third parties. This process is particularly important and subjective with respect to newly organized entities because there may be little or no information publicly available about the entities. As a result, there can be no assurance that the due diligence processes we conduct will uncover all relevant facts or that any investment will be successful.
Our investments are relatively illiquid which may make it difficult for us to sell such investments if the need arises and any sales may be at a loss to us.
Our commercial real estate loans and our investments in real estate are relatively illiquid investments and we may be unable to vary our portfolio promptly in response to changing economic, financial and investment conditions or dispose of these assets quickly or at all in the event we need additional liquidity. We make and hold investments in securities issued by private companies and other illiquid investments. A portion of these investments may be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly traded securities. The illiquidity of these investments may make it difficult for us to sell such investments if the need arises and may impair the value of these investments. Any sales of investments we make may result in our recognizing a loss on the sale.
Our subordinated real estate investments such as mezzanine loans and preferred equity interests in entities owning real estate involve increased risk of loss.
We invest in mezzanine loans and other forms of subordinated financing, such as investments consisting of preferred equity interests in entities owning real estate. Because of their subordinate position, these subordinated investments carry a greater credit risk than senior lien financing, including a substantially greater risk of non-payment. If a borrower defaults on our subordinated investment or on debt senior to us, our subordinated investment will be satisfied only after the senior debt is paid off, which may result in our being unable to recover the full amount, or any, of our investment. A decline in the real estate market could reduce the value of the property so that the aggregate outstanding balances of senior liens may exceed the value of the underlying property.
Where debt senior to our investment exists, the presence of inter-creditor arrangements may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies (through “standstill” periods) and control decisions made in bankruptcy proceedings relating to borrowers. Bankruptcy and borrower litigation can significantly increase the time needed for us to acquire the underlying collateral in the event of a default, during which time the collateral may decline in value. In addition, there are significant costs and delays associated with the foreclosure process. In the event of a default on a senior loan, we may elect to make payments, if we have the right to do so, in order to prevent foreclosure on the senior loans. When we originate or acquire a subordinated investment, we may not have the right to service senior loans. The servicers of the senior loans are responsible to the holders of those loans, whose interests will likely not coincide with ours, particularly in the event of a default. Accordingly, the senior loans may not be serviced in a manner advantageous to us. It is also possible that, in some cases, a “due on sale” clause included in a senior mortgage, which accelerates the amount due under the senior mortgage in case of the sale of the property, may apply to the sale of the property if we foreclose, increasing our risk of loss.
We have loans that are not collateralized by recorded or perfected liens on the real estate underlying our loans. Some of the loans not collateralized by liens are secured instead by deeds-in-lieu of foreclosure, also known as “pocket deeds.” A deed-in-lieu of foreclosure is a deed executed in blank that the holder is entitled to record immediately upon a default in the loan. Loans that are not collateralized by recorded or perfected liens are subordinate not only to existing liens encumbering the underlying property, but also to future judgments or other liens that may arise as well as to the claims of general creditors of the borrower. Moreover, filing a deed-in-lieu of foreclosure with respect to these loans will usually constitute an event of default under any related senior debt. Any such default would require us to assume or pay off the senior debt in order to protect our investment. Furthermore, in a borrower’s bankruptcy, we will have materially fewer rights than secured creditors and, if our loan is secured by equity interests in the borrower, fewer rights than the borrower’s general creditors. Our rights also will be subordinate to the lien-like rights of the bankruptcy trustee. Moreover, enforcement of our loans against the underlying properties will involve a longer, more complex, and likely, more expensive legal process than enforcement of a mortgage loan. In addition, we may lose lien priority in many jurisdictions, to persons who supply labor and materials to a property. For these and other reasons, the total amount that we may recover from one of our investments may be less than the total amount of that investment or our cost of an acquisition of an investment.
We may not control the special servicing of the mortgage loans or other debt underlying the debt securities in which we invest and, in such cases, the special servicer may take actions that could adversely affect our interest.
In circumstances where we do not maintain a first mortgage position, overall control over the special servicing of the mortgage loans or other debt underlying the debt securities in which we invest may be held by a directing certificate holder which is typically appointed by the holders of the most subordinate class of such debt security then outstanding. We ordinarily do not have the right to appoint the directing certificate holder. In connection with the servicing of the specially serviced loans, the related special servicer may, at the direction of the directing certificate holder, take actions that could adversely affect our interest.
Acquisitions of discounted loans may involve increased risk of loss.
We may acquire existing loans at a discount from both the outstanding balances of the loans and the appraised value of the properties underlying the loans. These loans typically are in default under the original loan terms or other requirements and are subject to forbearance agreements. A forbearance agreement typically requires a borrower to pay to the lender all revenue from a property after payment of the property’s operating expenses in return for the lender’s agreement to withhold exercising its rights under the loan documents. Acquiring loans at a discount involves a substantially higher degree of risk of non-collection than loans that conform to institutional underwriting criteria. We do not acquire a loan unless material steps have been taken toward resolving problems with the loan, or its underlying property.
Financing with high loan-to-value ratios may involve increased risk of loss.
A loan-to-value ratio is the ratio of the amount of our financing, plus the amount of any senior indebtedness, to the appraised value of the property underlying the loan. We expect to continue to hold loans with high loan-to-value ratios. By reducing the margin available to cover fluctuations in property value, a high loan-to-value ratio increases the risk that, upon default, the amount obtainable from the sale of the underlying property may be insufficient to repay the financing.
Preferred equity investments in REITs may involve a greater risk of loss than traditional debt financing and specific risks relating to particular issuers.
We have invested, and may continue to invest in preferred securities of REITs, depending upon our ability to finance such assets directly or indirectly in accordance with our financing strategy. Preferred equity investments involve a higher degree of risk than traditional debt financing due to a variety of factors, including that such investments are subordinate to debt and are not secured by property underlying the investment. Furthermore, should an issuer of preferred equity default on our investment, we would only be able to proceed against the issuer, and not the property owned by the issuer. In most cases, a preferred equity holder has no recourse against an issuer for a failure to pay stated dividends; rather, unpaid dividends typically accrue and the preferred shareholder maintains a liquidation preference in the event of a liquidation of the issuer of the preferred securities. An issuer may not have sufficient assets to satisfy any liquidation preference to which we may be entitled. As a result, we may not recover some or all of our investments in preferred equity securities.
The commercial mortgage loans in which we invest and the commercial mortgage loans underlying the CMBS in which we invest are subject to delinquency, foreclosure and loss, which could result in losses to us that may result in reduced earnings or losses and reduce our ability to pay distributions to our shareholders.
We hold substantial portfolios of commercial mortgage loans and CMBS which are secured by apartment or other commercial property and are subject to risks of delinquency and foreclosure. The ability of a borrower to repay a non-recourse loan secured by an income-producing property typically depends primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expense or limit rents that may be charged, any need to address environmental contamination at the property, the occurrence of any uninsured casualty at the property, changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real estate values, declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, terrorism, social unrest and civil disturbances.
In the event of any default under a commercial mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loan, which could have a material adverse effect on our cash flow from operations. In the event of the bankruptcy of a commercial mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure of a commercial mortgage loan can be an expensive and lengthy process, which could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan. CMBS evidence interests in or are secured by a single commercial mortgage loan or a pool of commercial mortgage loans. Accordingly, the mortgage-backed securities in which we invest are subject to all of the risks of the underlying mortgage loans.
If we are unable to improve the performance of commercial real estate properties we take control of in connection with restructurings, workouts and foreclosures of investments, our financial performance may be adversely affected.
We have taken control of properties underlying our commercial real estate investments in connection with restructurings, workouts and foreclosures of these investments. If we are unable to improve the performance of these properties from their performance under their prior owners, our cash flow may be adversely affected if the properties’ cash flow is insufficient to support payments due on any related debt and we may not be able to sell these properties at a price that will allow us to recover our investment.
We may need to make significant capital improvements to our properties in order to remain competitive.
Our investments in real estate may face competition from newer, more updated properties. In order to remain competitive, we may need to make significant capital improvements to these properties. In addition, if we need to re-lease a property, we may need to make significant tenant improvements. Any financing of such improvements may reduce our ability to operate the property profitably and, if financing is not available, we may use our available cash resources which would reduce our cash flow, liquidity and ability to make distributions to shareholders.
Lease expirations, lease defaults and lease terminations may adversely affect our revenue.
Lease expirations, lease defaults and lease terminations may result in reduced revenue from our real estate if the lease payments received from replacement tenants are less than the lease payments received from the expiring, defaulting or terminating tenants. In addition, lease defaults by one or more significant tenants, lease terminations by tenants following events causing significant damage to the property or takings by eminent domain, or the failure of tenants under expiring leases to elect to renew their leases, could cause us to experience long periods with reduced or no revenue from a property and to incur substantial capital expenditures in order to obtain replacement tenants. See Item 2 - “Properties,” for a ten-year lease expiration schedule for our non-residential properties as of December 31, 2014.
Risks Relating to the Fair Value of Our Assets and Liabilities
A decline in the market value of the assets we finance pursuant to repurchase agreements or warehouse facilities may result in margin calls that may force us to sell assets under adverse market conditions.
Our current repurchase agreements allow, and we expect any warehouse facilities and repurchase agreements we enter into in the future to allow, our lender to make margin calls that would require us to make cash payments or deliver additional assets to our lender in the event that there is a decline in the market value of the assets that collateralize our repurchase agreements or debt under our warehouse facilities. As a result, a
decline in the market value of assets collateralizing any such debt may result in our lenders initiating margin calls and requiring a pledge of additional collateral or cash. Posting additional collateral or cash to support our borrowings would reduce our liquidity and limit our ability to leverage our assets, which could adversely affect our business. As a result, we could be forced to sell some of our assets in order to maintain liquidity. Forced sales typically result in lower sales prices than do market sales made in the normal course of business. If our investments were liquidated at prices below the amortized cost basis of such investments, we would incur losses, which could result in a rapid deterioration of our financial condition.
A portion of our assets and liabilities are recorded at fair value as determined in good faith by our management and, as a result, there may be uncertainty as to the value of these investments.
We reflect certain investments in securities, certain CDO notes payable, certain derivative instruments and other assets and liabilities at fair value in our balance sheet, with all changes in fair value recorded in earnings. Most of these investments are securities or other assets that are not publicly traded. The fair value of securities and other investments that are not publicly traded may not be readily determinable. For further discussion of the fair value of our financial instruments, see Item 8 - “Financial Statements and Supplementary Data-Note 2: Summary of Significant Accounting Policies-Fair Value of Financial Investments.” We value these investments quarterly at fair value. Because such valuations are inherently uncertain, may fluctuate over short periods of time and are based on assumptions and estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these investments existed. If our determinations regarding the fair value of these investments are not realized, we could record a loss upon their disposal.
When we acquire properties through the foreclosure of commercial real estate loans, we may recognize losses if the fair value of the property internally determined upon such acquisition is less than the previous carrying amount of the foreclosed loan.
We periodically acquire properties through the foreclosure of commercial real estate loans. Upon acquisition, we value the property and its related assets and liabilities. We determine the fair values based primarily upon discounted cash flow or capitalization rate models, the use of which requires critical assumptions including discount rates, capitalization rates, vacancy rates and growth rates based, in part, on the properties’ operating history and third party data. We may recognize losses if the fair value of the property internally determined upon acquisition is less than the previous carrying amount of the foreclosed loan.
The fair value of assets that we record at their fair value under the fair value option may decline, which may decrease our net income.
The fair value of investments that we record on our financial statements at their fair value under FASB ASC Topic 825, may decline, which may decrease our net income.
Interest rate changes may reduce the value of our investments.
Changes in interest rates affect the market value of our investment portfolio. In general, the market value of a loan will change in inverse relation to an interest rate change where a loan has a fixed interest rate or only limited interest rate adjustments. Accordingly, in a period of rising interest rates, the market value of such a loan will decrease. Moreover, in a period of declining interest rates, real estate loans with rates that are fixed or variable only to a limited extent may have less value than other income-producing securities due to possible prepayments. Interest rate changes will also affect the return we obtain on new loans. In particular, during a period of declining rates, our reinvestment of loan repayments may be at lower rates than we obtained in prior investments or on the repaid loans. Also, increases in interest rates on debt we incur may not be reflected in increased rates of return on the investments funded through such debt, which would reduce our return on those investments. Accordingly, interest rate changes may materially affect the total return on our investment portfolio, which in turn will affect the amount available for distribution to shareholders.
The value of our investments depends on conditions beyond our control.
Our investments include loans secured directly or indirectly by real estate, interests in entities whose principal or sole assets are real estate or direct ownership of real estate. As a result, the value of these investments depends primarily upon the value of the real estate underlying these investments which is affected by numerous factors beyond our control including general and local economic conditions, neighborhood values, competitive overbuilding, weather, casualty losses, occupancy rates and other factors beyond our control. The value of this underlying real estate may also be affected by factors such as the costs of compliance with use, occupancy and similar regulations, potential or actual liabilities under applicable environmental laws, changes in interest rates and the availability of financing. Income from a property will be reduced if a significant number of tenants are unable to pay rent or if available space cannot be rented on favorable terms. Operating and other expenses of this underlying real estate, particularly significant expenses such as mortgage payments, insurance, real estate taxes and maintenance costs, generally do not decrease when income decreases and, even if revenue increases, operating and other expenses may increase faster than revenues.
Any investment may also be affected by a borrower’s failure to comply with the terms of our investment, its bankruptcy, insolvency or reorganization or its properties becoming subject to foreclosure proceedings, all of which may require us to become involved in expensive and time-consuming litigation. Some of our investments defer some portion of our return to loan maturity or the mandatory redemption date. The borrower’s ability to satisfy these deferred obligations may depend upon its ability to obtain suitable refinancing or to otherwise raise a substantial amount of cash. These risks may be subject to the same considerations we describe in this “Risks Related to Our Investments” section.
Risks Relating to Our Use of Derivatives and Hedging Instruments
Our hedging transactions may not insulate us from interest rate risk, which could cause volatility in our earnings.
Subject to limits imposed by our desire to maintain our qualification as a REIT, we enter into hedging transactions to limit exposure to changes in interest rates. We are therefore exposed to risks associated with such transactions. We have entered into, and expect to continue to enter into, interest rate swap agreements. We may also use instruments such as forward contracts and interest rate caps, currency swaps, collars and floors to seek to hedge against fluctuations in the relative values of portfolio positions from changes in market interest rates. Hedging against a decline in the values of portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the portfolio positions should increase. Moreover, it may not be possible to hedge against an interest rate fluctuation that is so generally anticipated that we would not be able to enter into a hedging transaction at an acceptable price.
The success of hedging transactions undertaken by us will depend on our ability to structure and execute effective hedges for the assets we hold and, to a degree, on our ability to anticipate interest rate or currency value fluctuations, the expected life of our assets or other factors. Our failure to do so may result in poorer overall investment performance than if we had not engaged in such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged may vary. Moreover, for a variety of reasons, we may not establish a perfect correlation between such hedging instruments and the portfolio holdings being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss.
Changes in fair value can be caused by changes in interest rates that are not fully hedged. To the extent that we fail to hedge fully against adverse fluctuations in interest rates, our earnings will be reduced or we could have losses.
While we use hedging to mitigate certain risks, our failure to completely insulate the portfolios from those risks may cause greater volatility in our earnings.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks of default by the hedging counterparty and illiquidity.
Subject to maintaining our qualification as a REIT, part of our investment strategy involves entering into puts and calls on securities or indices of securities, interest rate swaps, caps and collars, including options and forward contracts, and interest rate lock agreements, principally Treasury lock agreements, to seek to hedge against mismatches between the cash flows from our assets and the interest payments on our liabilities. Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. There are often no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements.
The business failure of a counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we entered into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. Although generally we seek to reserve the right to terminate our hedging positions, we may not always be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. A liquid secondary market may not exist for hedging instruments purchased or sold, and we may have to maintain a position until exercise or expiration, which could result in losses.
The Dodd Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, may impose significant requirements on hedging instruments we use. Our compliance efforts and any need for us to change the manner in which we structure our hedges may result in increased expenses. Also, the Dodd-Frank Act provides for the creation of a clearing house for hedging instruments and require the posting of cash collateral based on the fair value of any hedging instruments. Any such posting requirement could reduce our liquidity or limit our ability to hedge.
Our ability to enter into hedging transactions at commercially reasonable rates may be limited by developments relating to the counterparties we used historically and economic and credit market conditions generally.
Most of the counterparties under our outstanding hedging instruments are affiliates of investment banks that have subsequently been acquired by other financial institutions. We cannot assure you that as our outstanding hedges reach their termination dates or as we seek to enter into new hedging transactions, that our historical counterparties or other institutions with acceptable credit ratings will enter into hedging transactions with us on commercially reasonable terms or at all. If we cannot enter into interest rate hedges on commercially reasonable terms, our exposure to interest rate risk will increase. The risk of defaults by our counterparties may increase in the event the markets for hedging transactions shrink or otherwise become more volatile.
We may enter into derivative contracts that could expose us to contingent liabilities in the future.
Part of our investment strategy involves entering into derivative contracts like the interest rate swaps we use to limit our exposure to interest rate movements. Most of our derivative contracts require us to fund cash payments upon the early termination of a derivative agreement caused by an event of default or other early termination event. The amount due would be equal to the unrealized loss of the open swap positions with the
respective counterparty and could also include other fees and charges. In addition, some of these derivative arrangements require that we maintain specified percentages of cash collateral with the counterparty to fund potential liabilities under the derivative contract. We may have to make cash payments in order to maintain the required percentage of collateral with the counterparty. These economic losses would be reflected in our results of operations, and our ability to fund these obligations would depend on the liquidity of our respective assets and access to capital at the time. The need to fund these obligations could adversely impact our results of operations and liquidity. Our due diligence may not reveal all of an entity’s liabilities and may not reveal other weaknesses in the entity’s business.
Tax Risks
We and our REIT affiliates may fail to qualify as a REIT, and such failure to qualify would have significant adverse consequences on the value of our common shares. In addition, if we fail, or any REIT Affiliate fails, to qualify as a REIT, our respective dividends will not be deductible, and the entity will be subject to corporate-level tax on its net taxable income, which would reduce the cash available to make distributions.
We believe that we have been organized and operated in a manner that will allow us to qualify as a REIT. We have not requested, and do not plan to request, a ruling from the IRS that we and our REIT affiliates qualify as a REIT and any statements in our filings or the filings of our REIT affiliates with the SEC are not binding on the IRS or any court. Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions, for which there are only limited judicial and administrative interpretations. The determination of various factual matters and circumstances not entirely within our control may also affect our abilities and those of our REIT affiliates to qualify as a REIT. In order to qualify as a REIT, we and our REIT affiliates must each satisfy a number of requirements, including requirements regarding the composition of our respective assets and sources of our respective gross income. Also, we must each make distributions to our respective shareholders aggregating annually at least 90% of our respective net taxable incomes, excluding net capital gains. In addition, our respective ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership or REIT for U.S. federal income tax purposes. As an example, to the extent we invest in preferred equity securities of other REIT issuers, our qualification as a REIT will depend upon the continued qualification of such issuers as REITs under the Internal Revenue Code. Accordingly, unlike other REITs, we and our REIT affiliates may be subject to additional risk regarding our respective ability to qualify and maintain our respective qualification as a REIT. The reduction in our rate of originating new assets, operations and liquidity may adversely impact our and our REIT affiliates’ ability to meet REIT requirements and we and our REIT affiliates may be less able to make changes to our respective investment portfolios to adjust our respective REIT qualifying assets and income depending on our respective ability to deploy capital and maintain assets under management.
There can be no assurance that we and our REIT affiliates will be successful in operating in a manner that will allow us to each qualify as a REIT. Because we receive significant distributions from TRFT, and may in the future receive significant distributions from other of our REIT affiliates, the failure of one or more of such REIT affiliates to maintain its REIT status could cause us to lose our REIT status. In addition, legislation, new regulations, administrative interpretations or court decisions may adversely affect our investors, our respective ability to qualify as a REIT or the desirability of an investment in a REIT relative to other investments.
If we or any of our REIT affiliates fail to qualify as a REIT or lose our respective qualification as a REIT at any time, we, or such REIT affiliate, would face serious tax consequences that would substantially reduce the funds available for distribution to our respective shareholders for each of the years involved because:
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we, or such REIT affiliate, would not be allowed a deduction for distributions to our respective shareholders in computing taxable income and would be subject to U.S. federal income tax at regular corporate rates;
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we, or such REIT affiliate, also could be subject to the U.S. federal alternative minimum tax and possibly increased state and local taxes; and
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unless statutory relief provisions apply, we, or such REIT affiliate, could not elect to be taxed as a REIT for four taxable years following the year of disqualification.
In addition, if we, or such REIT affiliate, fail to qualify as a REIT, such entity will not be required to make distributions to its shareholders, and all distributions to shareholders will be subject to tax as regular corporate dividends to the extent of current and accumulated earnings and profits.
Complying with REIT requirements may cause us to forgo otherwise attractive opportunities.
To qualify as a REIT, we and our REIT affiliates must each continually satisfy various tests regarding sources of income, nature and diversification of assets, amounts distributed to shareholders and the ownership of common shares. In order to satisfy these tests, we and our REIT affiliates may be required to forgo investments that might otherwise be made. Accordingly, compliance with the REIT requirements may hinder our and our REIT affiliates’ investment performance.
In particular, at least 75% of our and our REIT affiliates total assets at the end of each calendar quarter must each consist of real estate assets, government securities, and cash or cash items. For this purpose, “real estate assets” generally include interests in real property, such as land, buildings, leasehold interests in real property, stock of other entities that qualify as REITs, interests in mortgage loans secured by real property, investments in stock or debt instruments during the one-year period following the receipt of new capital and regular or residual interests in a real estate mortgage investment conduit, or REMIC. In addition, the amount of securities of a single issuer that we and each of our REIT affiliates hold must generally not exceed either 5% of the value of our gross assets or 10% of the vote or value of the issuer’s outstanding securities.
Certain of the assets that we or our REIT affiliates hold or intend to hold will not be qualified real estate assets for the purposes of the REIT asset tests. In addition, although preferred equity securities of REITs should generally be treated as qualified real estate assets, this will require that (i) they are treated as equity for U.S. tax purposes, and (ii) their issuers maintain their qualification as REITs. CMBS should generally qualify as real estate assets. However, to the extent that we or our REIT affiliates own non-REMIC collateralized mortgage obligations or other debt instruments secured by mortgage loans (rather than by real property) or secured by non-real estate assets, or debt securities issued by corporations that are not secured by mortgages on real property, those securities will likely not be qualifying real estate assets for purposes of the REIT asset tests.
We and our REIT affiliates generally will be treated as the owner of any assets that collateralize a securitization transaction to the extent that we or such affiliates retain all of the equity of the securitization entity and do not make an election to treat such securitization entity as a TRS, as described in further detail below.
As noted above, in order to comply with the REIT asset tests and 75% gross income test, at least 75% of each of our respective total assets and 75% of gross income must be derived from qualifying real estate assets, whether or not such assets would otherwise represent our respective best investment alternative.
A REIT’s net income from prohibited transactions is subject to a 100% penalty tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including any mortgage loans, held in inventory or primarily for sale to customers in the ordinary course of business. The prohibited transaction tax may apply to any sale of assets to a securitization and to any sale of securitization securities, and therefore may limit our respective ability to sell assets to or equity in securitizations and other assets.
It may be possible to reduce the impact of the prohibited transaction tax and the holding of assets not qualifying as real estate assets for purposes of the REIT asset tests by conducting certain activities, holding non-qualifying REIT assets or engaging in securitization transactions through our TRSs, subject to certain limitations as described below. To the extent that we and our REIT affiliates engage in such activities through TRSs, the income associated with such activities may be subject to full U.S. federal corporate income tax.
Each of our and our REIT affiliates’ qualifications as a REIT and exemption from U.S. federal income tax with respect to certain assets may be dependent on the issuers of the REIT securities in which we invest maintaining their REIT qualification and the accuracy of legal opinions rendered to or statements made by the issuers of securities, including securitizations, in which we invest.
When purchasing securities issued by REITs, we and our REIT affiliates may each rely on opinions of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining whether such issuer qualifies as a REIT for U.S. federal income tax purposes and whether such securities represent debt or equity securities for U.S. federal income tax purposes, and therefore to what extent those securities constitute REIT real estate assets for purposes of the REIT asset tests and produce income which qualifies under the 75% REIT gross income test. In addition, when purchasing securitization equity, we and our REIT affiliates may each rely on opinions of counsel regarding the qualification of the securitization for exemption from U.S. corporate income tax. The inaccuracy of any such opinions or statements may adversely affect our or our REIT affiliates respective REIT qualification and/or result in significant corporate-level tax. In addition, if the issuer of any REIT equity securities in which we or our REIT affiliates invest were to fail to maintain its qualification as a REIT, the securities of such issuer held by us or such affiliate will fail to qualify as real estate assets for purposes of maintaining REIT qualification and the income generated by such securities will not represent qualifying income for purposes of the 75% REIT gross income test and therefore could cause us or such affiliate to fail to qualify as a REIT.
We have federal and state tax obligations.
Even if we qualify as REITs for U.S. federal income tax purposes, we will be required to pay U.S. federal, state and local taxes on income and property. In addition, our domestic TRSs are fully taxable corporations that will be subject to taxes on their income, and they may be limited in their ability to deduct interest payments made to us. We also will be subject to a 100% penalty tax on certain amounts if the economic arrangements among us and TRSs are not comparable to similar arrangements among unrelated parties or if we receive payments for inventory or property held for sale to customers in the ordinary course of business. We may be taxable at the highest corporate income tax rate on a portion of the income arising from a taxable mortgage pool that is allocable to shares held by “disqualified organizations.” In addition, under certain circumstances we could be subject to a penalty tax for failure to meet certain REIT requirements but nonetheless maintains its qualification as a REIT. For example, we may be required to pay a penalty tax with respect to income earned in connection with securitization equity in the event such income is determined not to be qualifying income for purposes of the REIT 95% gross income test but we are otherwise able to remain qualified as a REIT. To the extent that we or the TRSs are required to pay U.S. federal, state or local taxes, we will have less to distribute to shareholders.
Failure to make required distributions would subject us to tax, which would reduce the ability to pay distributions to our shareholders.
In order to qualify as a REIT, we and our REIT affiliates must each distribute to our respective shareholders each calendar year at least 90% of our respective REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain. To the extent that we and our REIT affiliates each satisfy the 90% distribution requirement, but distribute less than 100% of net taxable income, we or such affiliate will be subject to U.S. federal corporate income tax. In addition, we or our REIT affiliates will incur a 4% nondeductible excise tax on the amount, if any, by which our respective distributions in any calendar year are less than the sum of:
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85% of ordinary income for that year;
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95% of capital gain net income for that year; and
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100% undistributed taxable income from prior years.
We and our REIT affiliates each intend to distribute our respective net income to our respective shareholders in a manner intended to satisfy the 90% distribution requirement and to avoid both corporate
income tax and the 4% nondeductible excise tax. There is no requirement that any TRS of ours or our REIT affiliates distribute their after-tax net income to us or our REIT affiliates and such TRSs may, to the extent consistent with maintaining our or our REIT affiliates’ qualification as a REIT, determine not to make any current distributions to us or our REIT affiliates.
Our or our REIT affiliates’ respective taxable income may substantially exceed our or their respective net income as determined by accounting principles generally accepted in the United States, or GAAP, because, for example, expected capital losses will be deducted in determining our respective GAAP net income, but may not be deductible in computing our or their respective taxable income. GAAP net income may also be reduced to the extent we or our REIT affiliates have to “markdown” the value of our respective assets to reflect their current value. Prior to the sale of such assets, those mark-downs do not comparably reduce taxable income. In addition, we or our REIT affiliates may invest in assets including the equity of securitization entities that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets. This taxable income may arise for us in the following ways:
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Repurchase of our debt at a discount, including our convertible senior notes or CDO notes payable, will generally result in our recognizing REIT taxable income in the form of cancellation of indebtedness income generally equal to the amount of the discount.
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Origination of loans with appreciation interests may be deemed to have original issue discount for federal income tax purposes. Original issue discount is generally equal to the difference between an obligation’s issue price and its stated redemption price at maturity. This “discount” must be recognized as income over the life of the loan even though the corresponding cash will not be received until maturity.
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Our or our REIT affiliates’ loan terms may provide for both an interest “pay” rate and “accrual” rate. When this occurs, we recognize interest based on the sum of the pay rate and the accrual rate, but only receive cash at the pay rate until maturity of the loan, at which time all accrued interest is due and payable.
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Our or our REIT affiliates’ loans or unconsolidated real estate may contain provisions whereby the benefit of any principal amortization of the underlying senior debt inures to us or our REIT affiliates. We or our REIT affiliates recognize this benefit as income as the amortization occurs, with no related cash receipts until repayment of our loan.
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Sales or other dispositions of investments in real estate, as well as significant modifications to loan terms may result in timing differences between income recognition and cash receipts.
Although some types of taxable income are excluded to the extent they exceed 5% of our net income in determining the 90% distribution requirement, we will incur corporate income tax and the 4% nondeductible excise tax with respect to any taxable 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 or it regard as unfavorable in order to satisfy the distribution requirement and to avoid U.S. federal corporate income tax and the 4% deductible excise tax in that year.
If our securitizations are subject to U.S. federal income tax at the entity level, it would greatly reduce the amounts those entities would have available to distribute to us and pay their creditors.
We own foreign securitizations. There is a specific exemption from U.S. federal income tax for non-U.S. corporations that restrict their activities in the United States to trading stock and securities (or any activity closely related thereto) for their own account whether such trading (or such other activity) is conducted by the corporation or its employees through a resident broker, commission agent, custodian or other agent. We intend that the consolidated securitization subsidiaries and any other non-U.S. securitizations that are TRSs will rely on
that exemption or otherwise operate in a manner so that they will not be subject to U.S. federal income tax on their net income at the entity level. If the IRS were to succeed in challenging the tax treatment of our securitizations, it could greatly reduce the amount that those securitizations would have available to distribute to their shareholders and to pay to their creditors. Any reduced distributions would reduce amounts available for distribution to our shareholders.
Our and our REIT affiliates’ ownership of and relationship with TRSs will be limited, and a failure to comply with the limits would jeopardize our and its REIT qualification and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more TRSs. A TRS may hold assets and earn income that would not be qualifying assets or income if held or earned directly by a REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 25% (20% for taxable years prior to 2009) of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis.
Any domestic TRSs that we or our REIT affiliates own or that we or our REIT affiliates acquire in the future will pay U.S. federal, state and local income tax on their taxable income, and their after-tax net income will be available for distribution but will not be required to be distributed.
The value of the securities that we or our REIT affiliates hold in TRSs may not be subject to precise valuation. Accordingly, there can be no assurance that we or our REIT affiliates will be able to comply with the 25% limitation discussed above or avoid application of the 100% excise tax discussed above.
Compliance with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code limit our ability to hedge mortgage-backed securities, preferred securities and related borrowings. Except to the extent provided by the regulations promulgated by the U.S. Treasury Department, or the Treasury regulations, any income from a hedging transaction we enter into in the normal course of business primarily to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets, which is clearly identified as specified in the Treasury regulations before the close of the day on which it was acquired, originated, or entered into, including gain from the sale or disposition of such a transaction, will not constitute gross income for purposes of the 95% gross income test (and will generally constitute non-qualifying income for purposes of the 75% gross income test). To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both of the gross income tests. As a result, we might have to limit use of advantageous hedging techniques or implement those hedges through TRSs. This could increase the cost of our hedging activities or expose it or us to greater risks associated with changes in interest rates than we or it would otherwise want to bear.
We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our common shares.
At any time, the U.S. federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new U.S. federal income tax law, regulation or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. We could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.
Fees we or our REIT affiliates receive will not be REIT qualifying income.
We and our REIT affiliates must satisfy two gross income tests annually to maintain qualification as a REIT. First, at least 75% of a REIT’s gross income for each taxable year must consist of defined types of income that derive, directly or indirectly, from investments relating to real property or mortgages on real property or temporary investment income. Qualifying income for purposes of that 75% gross income test generally includes:
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rents from real property,
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interest on debt secured by mortgages on real property or on interests in real property, and
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dividends or other distributions on and gain from the sale of shares in other REITs.
Second, in general, at least 95% of a REIT’s gross income for each taxable year must consist of income that is qualifying income for purposes of the 75% gross income test, dividends, other types of interest, gain from the sale or disposition of stock or securities, income from certain interest rate hedging contracts, or any combination of the foregoing. Gross income from any origination fees we or our REIT affiliates obtain or from our sale of property that are held primarily for sale to customers in the ordinary course of business is excluded from both income tests.
Any origination fees we or our REIT affiliates receive will not be qualifying income for purposes of the 75% or 95% gross income tests applicable to REITs under the Internal Revenue Code. We typically receive, and our REIT affiliates may receive, initial payments, or “points,” from borrowers as commitment fees or additional interest. So long as the payment is for the use of money, rather than for other services provided by us or our REIT affiliates, we believe that this income should not be classified as non-qualifying origination fees. However, the Internal Revenue Service may seek to reclassify this income as origination fees instead of commitment fees or interest. If we cannot satisfy the Internal Revenue Code’s income tests as a result of a successful challenge of our classification of this income, we may not qualify as a REIT. Any fees for services, such as advisory fees or broker-dealer fees, received by us or our REIT affiliates will not qualify for either income test. Any such fees earned by a TRS of ours or of one of our REIT affiliates would not be subject to tax, and any distributions from TRSs would be qualifying income for purposes of the 95% gross income test but not for the 75% gross income test.
A portion of the dividends we distribute may be deemed a return of capital for federal income tax purposes.
The amount of dividends we distribute to our common and preferred shareholders in a given quarter may not correspond to our taxable income for such quarter. Consequently, a portion of the dividends we distribute may be deemed a return of capital for federal income tax purposes, and will not be taxable but will reduce shareholders’ basis in the underlying common or preferred shares.
Our ability to use TRSs, and consequently our ability to establish fee-generating businesses and invest in securitizations, will be limited by the election made by us to be taxed as a REIT, which may adversely affect returns to our shareholders.
Overall, no more than 25% of the value of a REIT’s assets may consist of securities of one or more TRSs. We and TRFT currently own, and we, TRFT and any other REIT affiliates may own in the future, interests in additional TRSs. However, our ability to expand the fee-generating businesses of our and TRFT’s current TRSs and future TRSs we or our REIT affiliates may form, will be limited by our and our REIT affiliates need to meet this 25% test, which may adversely affect distributions we pay to our shareholders.
If TRFT fails to qualify as a REIT, then we also would very likely fail to qualify as a REIT and if any other significant REIT affiliate fails to qualify as a REIT, it would adversely affect our ability to qualify as a REIT .
TRFT is a REIT subject to all of the risks discussed above with respect to RAIT. If TRFT fails to qualify as a REIT, then we also would very likely fail to qualify as a REIT, because the income we receive from, and assets
we hold through, TRFT make up a significant portion of our total income and assets and materially affect our ability to meet REIT qualification tests. The same is true with respect to other REIT affiliates if the income derived from such REIT affiliate becomes a significant part of our income.
Other Regulatory and Legal Risks of Our Business
We cannot assure you that our settlement with the SEC of its investigation concerning our subsidiary, TCM, will be finalized and/or approved or that any final settlement will not have different or additional material terms.
On September 16, 2014, we reached an agreement in principle with SEC staff to resolve a non-public investigation initiated by the SEC staff regarding our subsidiary, TCM. This agreement in principle remains subject to final documentation and approval by the SEC. Under the terms of the agreement in principle, among other things, TCM will pay $21.5 million and RAIT will guarantee this payment obligation. As a result of this agreement in principle, RAIT took a charge of $21.5 million in 2014. We cannot assure you that the settlement with the SEC will be finalized and/or approved or that any final settlement will not have different or additional material terms. In addition, two former executive officers and a former employee of RAIT received “Wells Notices” from the SEC staff relating to the subject of such investigation. We cannot provide any assurance what the ultimate resolution of these Wells Notices or any related action will be or whether any such resolution may have an adverse effect on us. For a description of this investigation and such Wells Notices, see “Item 3 - Legal Proceedings” below.
Our reputation, business and operations could be adversely affected by regulatory compliance failures.
Potential regulatory action poses a significant risk to our reputation and thereby to our business. Our business is subject to extensive regulation in the United States. We operate our business so as to comply with the Internal Revenue Code’s REIT rules and regulations and so as to remain exempt from registration as an investment company under the Investment Company Act. In addition, we are subject to regulation under the Exchange Act and various other statutes. A number of our investing activities, such as our lending business, are subject to regulation by various U.S. state regulators. Each of the regulatory bodies with jurisdiction over us has regulatory powers dealing with many aspects of our business, including the authority to grant, and in specific circumstances to cancel, permissions to carry on particular businesses. A failure to comply with the obligations imposed by any of the regulations binding on us or to maintain any of the licenses required to be maintained by us could result in investigations, sanctions, monetary penalties and reputational damage.
Loss of our Investment Company Act exemption would affect us adversely.
We seek to conduct our operations so that we are not required to register as an investment company. Under Section 3(a)(1) of the Investment Company Act, a company is not deemed to be an “investment company” if:
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it neither is, nor holds itself out as being, engaged primarily, nor proposes to engage primarily, in the business of investing, reinvesting or trading in securities; and
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it neither is engaged nor proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and does not own or propose to acquire “investment securities” having a value exceeding 40% of the value of its total assets exclusive of government securities and cash items on an unconsolidated basis, which we refer to as the 40% test. “Investment securities” excludes U.S. government securities and securities of majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (relating to issuers whose securities are held by not more than 100 persons or whose securities are held only by qualified purchasers, as defined).
We rely on the 40% test because we are a holding company that conducts our businesses through wholly-owned or majority-owned subsidiaries. As a result, the securities issued by our subsidiaries that are excepted
from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, together with any other investment securities we may own, may not have a combined value in excess of 40% of the value of our total assets exclusive of government securities and cash items on an unconsolidated basis. Based on the relative value of our investment in TRFT, on the one hand, and our investment in RAIT Partnership, on the other hand, we can comply with the 40% test only if RAIT Partnership itself complies with the 40% test (or an exemption other than those provided by Sections 3(c)(1) or 3(c)(7)). Because the principal exemptions that RAIT Partnership relies upon to allow it to meet the 40% test are those provided by Sections 3(c)(5)(c) or 3(c)(6) (relating to subsidiaries primarily engaged in specified real estate activities), we are limited in the types of businesses in which we may engage through our subsidiaries.
Because RAIT Partnership and the two wholly-owned subsidiaries through which we hold 100% of the partnership interests in RAIT Partnership-RAIT General, Inc. and RAIT Limited, Inc.-will not be relying on Section 3(c)(1) or 3(c)(7) for their respective Investment Company Act exemptions, our investments in these securities will not constitute “investment securities” for purposes of the 40% test if RAIT Partnership is otherwise exempt from the Investment Company Act.
RAIT Partnership, our subsidiary that holds, directly and through wholly-owned or majority-owned subsidiaries, a substantial portion of our assets, intends to conduct its operations so that it is not required to register as an investment company in reliance on the exemption from Investment Company Act regulation provided under Section 3(c)(5)(c). RAIT Partnership may also from time to time rely on the exemption from Investment Company Act regulation provided under Section 3(c)(6).
Any entity relying on Section 3(c)(5)(C) for its Investment Company Act exemption must have at least 55% of its portfolio invested in qualifying assets (which in general must consist of mortgage loans, mortgage backed securities that represent the entire ownership in a pool of mortgage loans and other liens on and interests in real estate) and another 25% of its portfolio invested in other real estate-related assets. Based on no-action letters issued by the staff of the SEC, we classify our investments in mortgage loans as qualifying assets, as long as the loans are “fully secured” by an interest in real estate. That is, if the loan-to-value ratio of the loan is equal to or less than 100%, then we consider the loan to be a qualifying asset. We do not consider loans with loan-to-value ratios in excess of 100% to be qualifying assets that come within the 55% basket, but only real estate-related assets that come within the 25% basket. Based on a no-action letter issued by the staff of the SEC, we treat most of our mezzanine loans as qualifying assets because we usually obtain a first lien position on the entire ownership interest of a special purpose entity, or SPE, that owns only real property, or that owns the entire ownership interest in a second SPE that owns only real property, and otherwise comes within the conditions of the no-action letter, and we treat any remaining mezzanine loans as real estate-related assets that come within the 25% basket. The treatment of other investments as qualifying assets and real estate-related assets, including equity investments in subsidiaries, is based on the characteristics of the underlying asset, in the case of a directly held investment, or the characteristics of the assets of the subsidiary, in the case of equity investments in subsidiaries.
Any entity relying on Section 3(c)(6) for its Investment Company Act exemption must be primarily engaged, directly or through majority-owned subsidiaries, in one or more specified businesses, including a business described in Section 3(c)(5)(c), or in one or more of such businesses (from which not less than 25% of its gross income during its last fiscal year was derived), together with an additional business or businesses other than investing, reinvesting, owning, holding or trading in securities.
TRFT, like RAIT, is a holding company that conducts its operations through subsidiaries. Accordingly, we intend to monitor TRFT’s holdings such that it will satisfy the 40% test. Similar to securities issued to us, the securities issued to TRFT by its subsidiaries that are excepted from the definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the Investment Company Act, together with any other investment securities TRFT may own, may not have a combined value in excess of 40% of the value of its total assets on an unconsolidated basis. This requirement limits the types of businesses in which TRFT may engage through these subsidiaries.
We make the determination of whether an entity is a majority-owned subsidiary of RAIT, RAIT Partnership or TRFT. The Investment Company Act defines a majority-owned subsidiary of a person as a company 50% or more of the outstanding voting securities of which are owned by such person, or by another company which is a majority-owned subsidiary of such person. The Investment Company Act further defines voting securities as any security presently entitling its owner or holder to vote for the election of directors of a company. We treat companies, including future securitization subsidiaries, in which we own at least a majority of the outstanding voting securities as majority-owned subsidiaries for purposes of the 40% test. Neither RAIT, RAIT Partnership nor TRFT has requested the SEC to approve our treatment of any company as a majority-owned subsidiary and the SEC has not done so. If the SEC were to disagree with our treatment of one or more companies, including securitizations, as majority-owned subsidiaries, we would need to adjust our respective investment strategies and invest our respective assets in order to continue to pass the 40% test. Any such adjustment in its investment strategy could have a material adverse effect on TRFT and us.
A majority of TRFT’s subsidiaries are limited by the provisions of the Investment Company Act and the rules and regulations promulgated under the Act with respect to the assets in which they can invest to avoid being regulated as an investment company. In particular, TRFT’s subsidiaries that are securitizations generally rely on Rule 3a-7, an exemption from the Investment Company Act provided for certain structured financing vehicles that pool income-producing assets and issue securities backed by those assets. Such structured financings may not engage in portfolio management practices resembling those employed by mutual funds. Accordingly, each TRFT securitization subsidiary that relies on Rule 3a-7 is subject to an indenture which contains specific guidelines and restrictions limiting the discretion of the securitization. The indenture prohibits the securitization from acquiring and disposing of assets primarily for the purpose of recognizing gains or decreasing losses resulting from market value changes. Certain sales and purchases of assets, such as dispositions of collateral that has gone into default or is at risk of imminent default, may be made so long as they do not violate the guidelines contained in each indenture and are not based primarily on changes in market value. The proceeds of permitted dispositions may be reinvested in collateral that is consistent with the credit profile of the securitization under specific and predetermined guidelines. In addition, absent obtaining further guidance from the SEC, substitutions of assets may not be made solely for the purpose of enhancing the investment returns of the holders of the equity securities issued by the securitization. As a result of these restrictions, TRFT’s securitization subsidiaries may suffer losses on their assets and TRFT may suffer losses on its investments in its securitization subsidiaries.
If the combined value of the investment securities issued to TRFT by its subsidiaries that are excepted by Section 3(c)(1) or 3(c)(7) of the Investment Company Act, together with any other investment securities TRFT may own, exceeds 40% of TRFT’s total assets on an unconsolidated basis, TRFT may be required either to substantially change the manner in which it conducts its operations or to rely on Section 3(c)(1) or 3(c)(7) to avoid having to register as an investment company. As a result of the relative values of RAIT Partnership and TRFT, it is likely that TRFT would rely on the Section 3(c)(1) or 3(c)(7) exemptions, which would increase the assets we hold included in the 40% basket for purposes of the 40% test, which would increase the effects that variations in the value of RAIT Partnership’s assets would have on its ability to comply with the 40% test and, accordingly, our ability to remain exempt from registration as an investment company.
None of RAIT, RAIT Partnership or TRFT has received a no-action letter from the SEC regarding whether it complies with the Investment Company Act or how its investment or financing strategies fit within the exclusions from regulation under the Investment Company Act that it is using. To the extent that the SEC provides more specific or different guidance regarding, for example, the treatment of assets as qualifying real estate assets or real estate-related assets, we may be required to adjust these investment and financing strategies accordingly. Any additional guidance from the SEC could provide additional flexibility to us and TRFT, or it could further inhibit the ability of TRFT and our combined company to pursue our respective investment and financing strategies which could have a material adverse effect on us. See Item 1 - “Business-Certain REIT and Investment Company Act Limits On Our Strategies-Investment Company Act Limits.”
Our ownership limitation may restrict business combination opportunities.
To qualify as a REIT under the Internal Revenue Code, 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 each taxable year. To preserve our REIT qualification, our declaration of trust generally prohibits any person from owning more than 8.3% or, with respect to our original promoter, Resource America, Inc., 15%, of our outstanding common shares and provides that:
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A transfer that violates the limitation is void.
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A transferee gets no rights to the shares that violate the limitation.
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Shares acquired that violate the limitation transfer automatically to a trust whose trustee has all voting and other rights.
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Shares in the trust will be sold and the record holder will receive the net proceeds of the sale.
The ownership limitation may discourage a takeover or other transaction that our shareholders believe to be desirable.
Preferred shares may prevent change in control.
Our declaration of trust authorizes our board of trustees to issue preferred shares, to establish the preferences and rights of any preferred shares issued, to classify any unissued preferred shares and reclassify any previously classified but unissued preferred shares, without shareholder approval. The issuance of preferred shares could delay or prevent a change in control, apart from the ownership limitation, even if a majority of our shareholders want control to change.
Maryland anti-takeover statutes may restrict business combination opportunities.
As a Maryland REIT, we are subject to various provisions of Maryland law which impose restrictions and require that specified procedures be followed with respect to the acquisition of “control shares” representing at least ten percent of our aggregate voting power and certain takeover offers and business combinations, including, but not limited to, combinations with persons who own one-tenth or more of our outstanding shares. While we have elected to “opt out” of the control share acquisition statute, our board of trustees has the right to rescind the election at any time without notice to our shareholders.
If our subsidiaries that are not registered as investment advisers under the Investment Advisers Act that provide collateral management and advisory services to securitizations or other investment vehicles were required to so register, it could hinder our operating performance and negatively impact our business and subject us to additional regulatory burdens and costs that we are not currently subject.
Where our subsidiary provides collateral management, servicing or advisory services solely to one or more entities that do not invest in “securities” or regarding assets that are not “securities portfolios” that provide sufficient “regulatory assets under management”, as such terms are defined in the Investment Advisers Act, such subsidiary will not engage in activities that would require it to register as an investment adviser under the Investment Advisers Act. We have determined that none of RAIT Partnership, RAIT’s affiliates providing servicing to the FL securitizations or IRT’s advisor need to register as an investment adviser for RAIT Partnership’s collateral management services to RAIT I and RAIT II, RAIT’s affiliates providing servicing to the FL securitizations or for the IRT advisor’s advisory services to IRT, respectively. We have not requested the SEC to approve our determination that these subsidiaries do not need to register as investment advisers under the Investment Advisers Act and the SEC has not done so. If the SEC or any applicable state regulatory authority were to disagree with our determination, we would need to register those companies as investment advisers and comply with all applicable requirements, which might require those subsidiaries to adjust the manner in which they provide services which could hinder their respective operating performance and negatively impact their respective business and subject them to additional regulatory burdens and costs that they are not currently subject to.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
For our investments in real estate, the leases for our multi-family properties are generally one-year or less and leases for our office and retail properties are operating leases. The following table represents a ten-year lease expiration schedule for our non-residential properties as of December 31, 2014.
(a) “Final Annualized Rent” for each lease scheduled to expire represents the cash rental rates of the respective tenants for the final month prior to expiration multiplied by 12.
For a description of our investments in real estate, see Item 1 - “Business-Our Investment Portfolio-Investments in real estate” and Item 8 - “Financial Statements and Supplementary Data-Schedule III.”
Item 3.
Item 3. Legal Proceedings
We are involved from time to time in litigation on various matters, including disputes with tenants of owned properties, disputes arising out of agreements to purchase or sell properties and disputes arising out of our loan portfolio. Given the nature of our business activities, these lawsuits are considered routine to the conduct of our business. The result of any particular lawsuit cannot be predicted, because of the very nature of litigation, the litigation process and its adversarial nature, and the jury system. We do not expect that the liabilities, if any, that may ultimately result from such routine legal actions will have a material adverse effect on our consolidated financial position, results of operations or cash flows.
On March 13, 2012, the staff of the SEC notified us that they had initiated a non-public investigation concerning our subsidiary, TCM. The investigation relates to TCM’s receipt of approximately $15 million of restructuring fees from issuers of securities collateralizing securitizations for which TCM served as collateral manager in connection with certain exchange transactions involving these securities and securitizations. TCM participated in these exchange transactions between March 2, 2009 and November 28, 2012 and has not subsequently participated in any exchange transactions in which it has collected a fee. The SEC staff has issued administrative subpoenas seeking testimony and information from us in connection with this matter, and we are cooperating fully in providing such information.
On September 16, 2014, we reached an agreement in principle with SEC staff to resolve a non-public investigation initiated by the SEC staff regarding our subsidiary, TCM. This agreement in principle remains subject to final documentation and approval by the SEC. Under the terms of the agreement in principle, among other things, TCM will pay $21.5 million and RAIT will guarantee this payment obligation. As a result of this agreement in principle, RAIT took a charge of $21.5 million in 2014. We cannot assure you that the settlement with the SEC will be finalized and/or approved or that any final settlement will not have different or additional material terms. In addition, two former executive officers and a former employee of RAIT received “Wells Notices” from the SEC staff relating to the subject of such investigation. We cannot provide any assurance what the ultimate resolution of these Wells Notices or any related action will be or whether any such resolution may have an adverse effect on us.
On October 8, 2014, two former executive officers and one former employee of RAIT each received a written “Wells Notice” from the SEC staff. A Wells Notice is neither a formal allegation of wrongdoing nor a finding that any of the recipients violated any law. Rather, it provides a recipient an opportunity to respond to issues raised by the SEC staff and to present any reasons of law, policy or fact why the SEC staff should not recommend that the SEC initiate an enforcement action. The Wells Notices in this matter indicate the SEC staff has made a preliminary determination to recommend to the SEC that the SEC file an action against each of the named individuals relating to the individuals’ activities on behalf of TCM in connection with the matters that were the subject of the investigation described above. The former executive officers left RAIT as of December 31, 2014 and the former employee left RAIT in 2010.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Our Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Our common shares trade on the New York Stock Exchange, or the NYSE, under the symbol “RAS.” We have adopted a Code of Business Conduct and Ethics, which we refer to as the Code, for our trustees, officers and employees intended to satisfy New York Stock Exchange listing standards and the definition of a “code of ethics” set forth in Item 406 of Regulation S-K. Any information relating to amendments to the Code or waivers of a provision of the Code otherwise required to be disclosed pursuant to Item 5.05 of Form 8-K will be disclosed through our website.
MARKET PRICE OF AND DIVIDENDS ON OUR COMMON SHARES
The following table shows the high and low reported sales prices per common share on the NYSE composite transactions reporting system and the quarterly cash dividends declared per common share for the periods indicated. For further discussion of our dividend policies, see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations-REIT Taxable Income.” Past price performance is not necessarily indicative of likely future performance. Because the market price of our common shares will fluctuate, you are urged to obtain current market prices for our common shares.
As of March 13, 2015, there were 82,811,326 of our common shares outstanding held by 438 holders of record.
Our Series A Cumulative Redeemable Preferred Shares, or Series A Preferred Shares, are listed on the NYSE and traded under the symbol “RAS PrA.” Since their date of original issuance, RAIT has declared and paid all specified quarterly dividends and no dividends are currently in arrears on the Series A Preferred Shares.
Our Series B Cumulative Redeemable Preferred Shares, or Series B Preferred Shares, are listed on the NYSE and traded under the symbol “RAS PrB.” Since their date of original issuance, RAIT has declared and paid all specified quarterly dividends and no dividends are currently in arrears on the Series B Preferred Shares.
Our Series C Cumulative Redeemable Preferred Shares, or Series C Preferred Shares, are listed on the NYSE and traded under the symbol “RAS PrC.” Since their date of original issuance, RAIT has declared and paid all specified quarterly dividends and no dividends are currently in arrears on the Series C Preferred Shares.
See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Series D Preferred Shares” for the terms of the purchase agreement described below limiting our ability to declare dividends.
ISSUER PURCHASES OF EQUITY SECURITIES
We withheld the following common shares to satisfy tax withholding obligations during the quarter ending December, 31, 2014 arising from the vesting of restricted share awards made pursuant to the RAIT Financial Trust 2012 Incentive Award Plan. These common shares may be deemed to be “issuer purchases” of common shares that are required to be disclosed pursuant to the item.
(1) The price reported is the price paid per share using our closing stock price on the New York Stock Exchange on the vesting date of the relevant award.
PERFORMANCE GRAPH
The following graph compares the index of the cumulative total shareholder return on our common shares for the measurement period commencing December 31, 2009 and ending December 31, 2014 with the cumulative total returns of the National Association of Real Estate Investment Trusts (NAREIT) Mortgage REIT index, the NAREIT Equity index and the S&P 500 Index. The following graph assumes that each index was 100 on the initial day of the relevant measurement period and that all dividends were reinvested.
Item 6.
Item 6. Selected Financial Data
The following selected financial data information should be read in conjunction with Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a multi-strategy commercial real estate company that is a self-managed and self-advised Maryland real estate investment trust, or REIT. We use our vertically integrated platform to originate commercial real estate loans, acquire commercial real estate properties and invest in, manage and service commercial real estate assets. We offer a comprehensive set of debt financing options to the commercial real estate industry and provide asset and property management services. We also own and manage a portfolio of commercial real estate properties and manage real estate assets for third parties. We believe this approach delivers diversification to our investment portfolio blending the higher-yielding lending business with the stability and recurring income stream from owning and managing properties.
During 2014, we conducted our business through the following core business lines:
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Our CRE business line concentrates on three business activities: real estate lending, and owning and managing commercial real estate assets throughout the United States. The form of our investments may range from first mortgage loans to equity ownership of a commercial real estate property. We manage our investments in-house through our asset management and property management professionals.
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Our Independence Realty Trust, Inc., or IRT, business activities concentrate on the ownership and management of apartment properties in opportunistic markets throughout the United States.
Historically, we also conducted business through our non-core Taberna business line. Our Taberna business line included serving as collateral manager for T1, T8 and T9. We had exited this business line by the end of 2014.
In 2014 we continued to focus on our core competencies: commercial real estate lending, direct ownership of real estate and managing commercial real estate. In 2014, we also diversified the revenue generated from our commercial real estate loans and properties and reduced or removed other non-core assets and activities. In our core business lines, we expanded our origination of loans, grew our portfolio of properties and attracted capital to RAIT and IRT to fuel our growth, resulting in increased assets and revenue.
During the year ended December 31, 2014, we originated $983.8 million of new loans, had conduit loan sales of $427.1 million and loan repayments of $164.0 million, resulting in net loan growth of $392.7 million. In addition, during 2014 we had stable credit performance in our investment in loans, with an $11.8 million decrease in non-accrual loans from December 31, 2013 and RAIT I and RAIT II continuing to satisfy their respective OC triggers and IC triggers as described below. With regards to our owned commercial real estate portfolios, due primarily to growth in our IRT business line, we continue to see improvements in the key measures of their performance: occupancy and rental rates. As a result, the net operating income at our owned properties increased to $80.7 million during the year ended December 31, 2014. Our rental income increased due to the acquisition of 28 properties during 2014 with an aggregate cost of $708.2 million. Improving occupancy and rental rates in our historical portfolio also increased our rental income and net operating income. Rental income includes $49.2 million related to rental income associated with IRT. As a result, we increased distributions on our common shares by 27% in 2014 from 2013.
We generated a GAAP net loss allocable to common shares of $318.5 million, or $3.92 per common share-diluted, during the year ended December 31, 2014. We attribute this loss primarily to the $215.8 million loss from the deconsolidation of T8 and T9 and the $98.8 million of non-cash negative changes in the fair value of various financial instruments, primarily related to T8 and T9. Because of these items, management uses non-GAAP financial measures such as cash available for distribution, or CAD, as indicators of our performance. Please see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Non-GAAP Financial Measures.” Although we are reporting a net loss for the year, we believe RAIT is positioned to take advantage of opportunities resulting from improved commercial real estate market fundamentals and sources of financing.
In order to take advantage of market opportunities in the future, and to maximize shareholder value over time, we will continue to focus on:
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expanding RAIT’s commercial real estate revenue by investing in commercial real estate-related assets, managing and servicing investments for our own account or for others, and providing property management services;
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creating value through investing in our commercial real estate properties and implementing cost savings programs to help maximize property value over time;
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maintaining and expanding our sources of liquidity;
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managing our leverage to provide risk-adjusted returns for our shareholders; and
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managing our investment portfolios to reposition under-performing assets, increase our cash flows and ultimately recover the value of our assets over time.
Set forth below are key statistics relating to our business for the years indicated (dollars in thousands, except share and per share data):
(a) CRE Loan Portfolio includes commercial mortgages, mezzanine loans, and preferred equity interests only. See Note 3-“Investments in Mortgages, Loans and Preferred Equity Interests” in the Notes to Consolidated Financial Statements for information relating to all loans held by RAIT.
(b) Includes 30 apartment properties owned by IRT with 8,819 units and a book value of $665.7 million as of December 31, 2014.
(c) Based on properties owned as of December 31, 2014.
(d) Average effective rent is rent per unit per month.
(e) Average effective rent is rent per square foot per year.
Trends That May Affect Our Business
The following trends may affect our business:
Commercial Real Estate Lending Environment. We continue to see an improving commercial real estate lending environment. This includes improved economic performance in areas relevant to our investment portfolio and increased availability of liquidity to finance assets similar to those in our investment portfolios which has increased our ability to finance new investments in our targeted asset classes. In particular, the availability of financing from CMBS securitizations for assets we originate remains strong. While this reduces the risk of defaults upon the maturity of loans due to the lack of sources of refinancing, it also increases the opportunity for borrowers to prepay our loans and debt securities, as described below. We expect a substantial amount of commercial real estate related debt to mature through 2019 which should create a lending opportunity for us in areas we identify as having a suitable risk-adjusted rate of return.
Trends Relating to Originating and Financing Conduit Loans and Bridge Loans. Competition to originate conduit loans increased in 2014 which, when combined with market volatility, resulted in lower spreads and lower gain on sale profits on an individual loan basis. We expect to increase our origination of conduit loans in 2015, which we expect to mitigate the current lower spread environment. Though our spreads on conduit loans have decreased since we began originating those types of loans, spreads are volatile and improved slightly in the first quarter of 2015, although we cannot predict whether that will continue. Despite the increase in competition, our yields on conduit loans continue to be attractive in 2014. Competition to originate bridge loans also increased in 2014, although to a lesser degree than conduit loans. Because pricing on both the bridge loans we originate and the notes issued by CMBS securitizations we use to finance bridge loans have reduced, we expect to be able to maintain our spreads on bridge loans. We expect our subordinate interests in the FL securitizations to generate a high teens return over the life of the collateral. We expect to increase the volume of our bridge loans in 2015 and are seeking to close our fourth FL securitization in the second quarter of 2015.
Trends Relating to Investments in Real Estate. We expect to continue adding multi-family properties to IRT’s portfolio in current and new markets consistent with IRT’s investment strategy. We also see an opportunity to invest in retail property assets using our Urban platform through which we believe we will expect to generate strong recurring risk adjusted returns and create another stable revenue stream for RAIT. Additionally, we have begun marketing for sale three non-IRT multifamily properties aggregating 1,020 units as we see opportunities to generate solid gains in the current environment by selling these properties. We anticipate completing these sales during the second quarter of 2015. In addition, we expect to sell additional non-IRT properties in 2015. We expect the occupancy and rental rates of our properties to improve during 2015.
Interest rate environment. Interest rates in 2014 continued to remain at historically low levels with volatility increasing in late 2014. Due to the general low interest rate environment, we have seen fewer subordinated lending opportunities offering attractive risk-adjusted returns. Any volatility may impact the value of our assets, liabilities and interest rate hedges and may impact the interest income or expense they generate in the future. We believe market participants expect that the future interest rate environment may be higher. In the event interest rates rise significantly, see our discussion below under Item 7A
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk results primarily from changes in the credit risks of our portfolio and changes in interest rates. We are exposed to credit risk and interest rate risk related to our investments in commercial and mezzanine loans and debt instruments.
Credit Risk Management
Credit risk is the risk of loss arising from adverse changes in a borrower’s ability to meet its financial obligations under agreed-upon terms. The degree of credit risk varies based on many factors including the
concentration of the asset or transaction relative to our entire portfolio, the credit characteristics of the borrower, the contractual terms of a borrower’s agreements and the availability and quality of collateral.
Our senior management regularly evaluates and approves credit standards and oversees the credit risk management function related to our portfolio of investments. Our senior management’s responsibilities include ensuring the adequacy of our credit risk management infrastructure, overseeing credit risk management strategies and methodologies, monitoring conditions in real estate and other markets having an impact on our lending activities and evaluating and monitoring overall credit risk.
Credit Summary and Concentrations of Credit Risk
Our investment portfolio had the following key credit statistics as of December 31, 2014:
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Commercial real estate loans-We had nine loans on non-accrual, with a carrying value of $25.3 million, or 1.8% of our commercial real estate loan portfolio. Our allowance for losses for our commercial loan portfolio was $9.2 million, or 36.5% of our non-accrual loans and pertained to seven loans with an unpaid principal balance of $13.3 million.
In our normal course of business, we engage in lending activities with borrowers primarily throughout the United States. As of December 31, 2014, no single borrower or collateral issuer represented greater than 10% of our entire portfolio. The largest concentration by property type in our commercial and mezzanine portfolio was office property, which made up approximately 37.3% of our commercial and mezzanine loan portfolio. For further information on each of our portfolios, please refer to the portfolio summaries in Item 1 - “Business”. We also seek to mitigate the risk of default by borrowers on our floating rate loans in the event of significant increases in the applicable interest rates by seeking to have these borrowers enter into interest rate swap agreements capping their exposure to such increases.
Interest Rate Risk Management
Interest rates may be affected by economic, geo-political, monetary and fiscal policy, market supply and demand and other factors generally outside our control, and such factors may be highly volatile. Our interest rate risk sensitive assets and liabilities and financial derivatives will be typically held for long-term investment and not held for sale purposes. Historically, we have used securitizations to finance our investments to limit interest rate risk by matching the terms of our investment assets with the terms of our liabilities and, to the extent necessary, through the use of hedging instruments. We intend to reduce interest rate and funding risk, allowing us to focus on managing credit risk through our underwriting process and continual credit analysis.
We make investments that are either floating rate or fixed rate. Our floating rate investments will generally be priced at a fixed spread over an index such as LIBOR that re-prices either quarterly or every 30 days. Given the frequency of future price changes in our floating rate investments, changes in interest rates are not expected to have a material effect on the value of these investments. Increases or decreases in LIBOR will have a corresponding increase or decrease in our interest income and the match-funded interest expense, thereby reducing the net earnings impact on our overall portfolio. Our interest income is also protected from decreases in interest rates due to interest rate floors on our investments in commercial and mezzanine loans. In the event that long-term interest rates increase, the value of our fixed-rate investments would be diminished. We may consider hedging this risk in the future if the benefit outweighs the cost of the hedging strategy. Such changes in interest rates would not have a material effect on the income from these investments.
As of December 31, 2014, we use various interest rate swap agreements to hedge variable cash flows associated with CDO notes payable. These cash flow hedges have an aggregate notional value of $496.0 million and are used to swap the variable cash flows associated with variable rate CDO notes payable into fixed-rate payments for five- and ten-year periods. As of December 31, 2014, the interest rate swaps had an aggregate
liability fair value of $20.7 million. Changes in the fair value of the ineffective portions of interest rate swaps and interest rate swaps that were not designated as hedges under FASB ASC Topic 815, “Derivatives and Hedging” are recorded in earnings.
The following table summarizes the interest income and interest expense for a 12-month period, and the change in the net fair value of our investments and indebtedness assuming an instantaneous increase or decrease of 100 basis points in the LIBOR interest rate curve, both adjusted for the effects of our interest rate hedging activities (dollars in thousands):
(a) Assumes the LIBOR interest rate will not decrease below zero. The quoted 30-day LIBOR rate was 0.16% at December 31, 2014.
We make investments that are denominated in U.S. dollars, or if made in another currency we may enter into currency swaps to convert the investment into a U.S. dollar equivalent. We may be unable to match the payment characteristics of the investment with the terms of the currency swap to fully eliminate all currency risk and such currency swaps may not be available on acceptable terms and conditions based upon a cost/benefit analysis.
Item 8.
Item 8. Financial Statements and Supplementary Data.
RAIT FINANCIAL TRUST
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Trustees and Shareholders
RAIT Financial Trust:
We have audited the accompanying consolidated balance sheets of RAIT Financial Trust and subsidiaries as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income (loss), changes in equity, and cash flows for each of the years in the three-year period ended December 31, 2014. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules II to IV. These consolidated financial statements and financial statement schedules are the responsibility of RAIT Financial Trust’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RAIT Financial Trust and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), RAIT Financial Trust’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2015, expressed an adverse opinion on the effectiveness of RAIT Financial Trust’s internal control over financial reporting.
/s/ KPMG LLP
Philadelphia, Pennsylvania
March 16, 2015
Report of Independent Registered Public Accounting Firm
The Board of Trustees and Shareholders
RAIT Financial Trust:
We have audited RAIT Financial Trust’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). RAIT Financial Trust’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting appearing under Item 9A(b). Our responsibility is to express an opinion on RAIT Financial Trust’s internal control over financial reporting based on our audit.
We conducted our audit 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. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness related to a lack of sufficient qualified resources to ensure the appropriate design and operating effectiveness of the Company’s reconciliation controls, management review controls, and controls over complex transactions and accounting estimates has been identified and included in management’s assessment. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of RAIT Financial Trust as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income (loss), changes in equity and cash flows for each of the years in the three-year period ended December 31, 2014. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements, and this report does not affect our report dated March 16, 2015, which expressed an unqualified opinion on those consolidated financial statements.
In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, RAIT Financial Trust has not maintained effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ KPMG LLP
Philadelphia, Pennsylvania
March 16, 2015
RAIT Financial Trust
Consolidated Balance Sheets
(Dollars in thousands, except share and per share information)
The accompanying notes are an integral part of these consolidated financial statements.
RAIT Financial Trust
Consolidated Statements of Operations
(Dollars in thousands, except share and per share information)
The accompanying notes are an integral part of these consolidated financial statements.
RAIT Financial Trust
Consolidated Statements of Comprehensive Income (Loss)
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
RAIT Financial Trust
Consolidated Statements of Changes in Equity
(Dollars in thousands, except share information)
The accompanying notes are an integral part of these consolidated financial statements.
RAIT Financial Trust
Consolidated Statements of Cash Flows
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 1: THE COMPANY
RAIT Financial Trust invests in and manages a portfolio of real-estate related assets, including direct ownership of real estate properties, and provides a comprehensive set of debt financing options to the real estate industry. References to “RAIT”, “we”, “us”, and “our” refer to RAIT Financial Trust and its subsidiaries, unless the context otherwise requires. RAIT is a self-managed and self-advised Maryland real estate investment trust, or REIT.
We finance a substantial portion of our investments through borrowing and securitization strategies seeking to match the maturities and terms of our financings with the maturities and terms of those investments, and to mitigate interest rate risk through derivative instruments.
NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. Basis of Presentation
The consolidated financial statements have been prepared by management in accordance with U.S. generally accepted accounting principles, or GAAP. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly our consolidated financial position and consolidated results of operations, equity and cash flows are included.
Certain prior period amounts have been reclassified to conform with the current period presentation.
For the year ended December 31, 2014, we recorded the following adjustments in the accompanying consolidated statement of operations that related to transactions completed in a prior period: (a) gains (losses) on assets includes the write-off of assets totaling $3,001 that were associated with property transactions, (b) investment interest income includes the write-off of accrued interest receivable of $514 that was associated with investments in loans, (c) general and administrative expenses includes $132 of accrued expenses that were written-off, and (d) rental income was reduced by $1,035 for the amortization of above market or below market leases and (e) depreciation and amortization expense includes $1,724 associated with property acquisitions for in-place lease intangibles.
During the year ended December 31, 2014, we revised the Consolidated Statements of Cash Flows for the years ended December 31, 2013 and 2012. The revision consisted of classifying the origination of conduit loans and the sale of conduit loans from cash flows from investing activities to cash flows from operating activities. The impact of this revision was a decrease to cash flows from operating activities and an increase to cash flows from investing activities of $41,276 and $21,394 for the years ended December 31, 2013 and 2012, respectively. The revision had no impact to cash and cash equivalents as of December 31, 2013 and 2012. In addition, the revision did not impact any other consolidated financial statement as of and for the years ended December 31, 2013 and 2012. We evaluated these revisions and reclassifications and determined, based on quantitative and qualitative factors, the changes were not material to the consolidated financial statements taken as a whole for any previously filed consolidated financial statements.
b. Principles of Consolidation
The consolidated financial statements reflect our accounts and the accounts of our majority-owned and/or controlled subsidiaries. We also consolidate entities that are variable interest entities, or VIEs, where we have determined that we are the primary beneficiary of such entities. The portions of these entities that we do not own are presented as noncontrolling interests as of the dates and for the periods presented in the consolidated financial statements. All intercompany accounts and transactions have been eliminated in consolidation.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
In August 2007, we made a $6.0 million preferred equity investment in a retail property management firm. In November 2013, we exercised certain rights under the terms of our investment and as a result, started to consolidate its operations and incurred certain non-cash increases in other assets, intangible assets and various liabilities. The estimated fair value of the net assets acquired was $17.4 million. As a result of this consolidation, we had increases in cash of $0.1 million, other assets of $4.5 million, intangible assets of $19.1 million, indebtedness of $2.5 million and accounts payable and accrued expenses of $3.8 million.
Under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 810, “Consolidation”, the determination of whether to consolidate a VIE is based on the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance together with either the obligation to absorb losses or the right to receive benefits that could be significant to the VIE. We define the power to direct the activities that most significantly impact the VIE’s economic performance as the ability to buy, sell, refinance, or recapitalize assets or entities, and solely control other material operating events or items of the respective entity. For our commercial mortgages, mezzanine loans, and preferred equity investments, certain rights we hold are protective in nature and would preclude us from having the power to direct the activities that most significantly impact the VIE’s economic performance. Assuming both criteria are met, we would be considered the primary beneficiary and would consolidate the VIE. We will continually assess our involvement with VIEs and consolidate the VIEs when we are the primary beneficiary. See Note 9 for additional disclosures pertaining to VIEs.
c. Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The items that include significant estimates are fair value of financial instruments, valuation of our owned real estate and allowance for losses. Actual results could differ from those estimates.
d. Cash and Cash Equivalents
Cash and cash equivalents include cash held in banks and highly liquid investments with maturities of three months or less when purchased. Cash, including amounts restricted, may at times exceed the Federal Deposit Insurance Corporation deposit insurance limit of $250 per institution. We mitigate credit risk by placing cash and cash equivalents with major financial institutions. To date, we have not experienced any losses on cash and cash equivalents.
e. Restricted Cash
Restricted cash consists primarily of tenant escrows and borrowers’ funds held by us to fund certain expenditures or to be released at our discretion upon the occurrence of certain pre-specified events, and to serve as additional collateral for borrowers’ loans. As of December 31, 2014 and 2013, we had $105,207 and $50,884, respectively, of tenant escrows and borrowers’ funds.
Restricted cash also includes proceeds from the issuance of CDO notes payable by securitizations that are restricted for the purpose of funding additional investments in securities subsequent to the balance sheet date. As of December 31, 2014 and 2013, we had $19,013 and $70,705, respectively, of restricted cash held by securitizations.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
f. Investments in Mortgages, Loans and Preferred Equity Interests
We invest in commercial mortgages, mezzanine loans, preferred equity interests and other loans. We account for our investments in commercial mortgages, mezzanine loans, preferred equity interests and other loans at amortized cost. The carrying value of these investments is adjusted for origination discounts/premiums, nonrefundable fees and direct costs for originating loans which are amortized into income on a level yield basis over the terms of the loans.
g. Allowance for Losses, Impaired Loans and Non-accrual Status
We maintain an allowance for losses on our investments in commercial mortgages, mezzanine loans, preferred equity interests and other loans. Management’s periodic evaluation of the adequacy of the allowance is based upon expected and inherent risks in the portfolio, the estimated value of underlying collateral, and current economic conditions. Management reviews loans for impairment and establishes specific reserves when a loss is probable under the provisions of FASB ASC Topic 310, “Receivables.” A loan is impaired when it is probable that we may not collect all principal and interest payments according to the contractual terms. As part of the detailed loan review, we consider many factors about the specific loan, including payment history, asset performance, borrower’s financial capability and other characteristics. If any trends or characteristics indicate that it is probable that other loans, with similar characteristics to those of impaired loans, have incurred a loss, we consider whether an allowance for loss is needed. Management evaluates loans for non-accrual status each reporting period. A loan is placed on non-accrual status when the loan payment deficiencies exceed 90 days. Payments received for non-accrual or impaired loans are applied to principal until the loan is removed from non-accrual status or no longer impaired. Past due interest is recognized on non-accrual loans when they are removed from non-accrual status and are making current interest payments. The allowance for losses is increased by charges to operations and decreased by charge-offs (net of recoveries). Management charges off loans when the investment is no longer realizable and legally discharged.
h. Investments in Real Estate
Investments in real estate are shown net of accumulated depreciation. We capitalize those costs that have been evaluated to improve the real property and depreciate those costs on a straight-line basis over the useful life of the asset. We depreciate real property using the following useful lives: buildings and improvements-30 to 40 years; furniture, fixtures, and equipment-5 to 10 years; and tenant improvements-shorter of the lease term or the life of the asset. Costs for ordinary maintenance and repairs are charged to expense as incurred.
Acquisitions of real estate assets and any related intangible assets are recorded initially at fair value under FASB ASC Topic 805, “Business Combinations.” Fair value is determined by management based on market conditions and inputs at the time the asset is acquired. The fair value of the real estate acquired is allocated to the acquired tangible assets, consisting of land, building and tenant improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases for acquired in-place leases and the value of tenant relationships, based in each case on their fair values. Purchase accounting is applied to assets and liabilities associated with the real estate acquired. Transaction costs and fees incurred related to acquisitions are expensed as incurred.
Upon the acquisition of properties, we estimate the fair value of acquired tangible assets (consisting of land, building and improvements) and identified intangible assets and liabilities (consisting of above and below-market leases, in-place leases and tenant relationships), and assumed debt at the date of acquisition, based on the
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
evaluation of information and estimates available at that date. In determining the fair value of the identified intangible assets and liabilities of an acquired property, above-market and below-market in-place lease values are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the differences between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining term of the lease. The capitalized above-market lease values and the capitalized below-market lease values are amortized as an adjustment to rental income over the lease term.
The aggregate value of in-place leases is determined by evaluating various factors, including an estimate of carrying costs during the expected lease-up periods, current market conditions and similar leases. In estimating carrying costs, management includes real estate taxes, insurance and other operating expenses, and estimates of lost rental revenue during the expected lease-up periods based on current market demand. Management also estimates costs to execute similar leases including leasing commissions, legal and other related costs. The value assigned to this intangible asset is amortized over the assumed lease up period.
Management reviews our investments in real estate for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The review of recoverability is based on an estimate of the future undiscounted cash flows (excluding interest charges) expected to result from the long-lived asset’s use and eventual disposition. These cash flows consider factors such as expected future operating income, trends and prospects, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a long-lived asset, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property.
i. Investments in Securities
We account for our investments in securities under FASB ASC Topic 320, “Investments-Debt and Equity Securities”, and designate each investment security as a trading security, an available-for-sale security, or a held-to-maturity security based on our intent at the time of acquisition. Trading securities are recorded at their fair value each reporting period with fluctuations in fair value reported as a component of earnings. Available-for-sale securities are recorded at fair value with changes in fair value reported as a component of other comprehensive income (loss). When we elect to record certain available-for-sale securities under the fair value option, in accordance with FASB ASC Topic 825, “Financial Instruments,” they are recorded at fair value with changes in fair value reported as a component of earnings. See “m. Fair Value of Financial Instruments.” Upon the sale of an available-for-sale security, the realized gain or loss on the sale will be recorded as a component of earnings in the respective period. Held-to-maturity investments are carried at amortized cost at each reporting period.
We use our judgment to determine whether an investment in securities has sustained an other-than-temporary decline in value. If management determines that an available-for-sale security has sustained an other-than-temporary decline in its value, the investment is written down to its fair value by a charge to earnings, and we establish a new cost basis for the investment. Our evaluation of an other-than-temporary decline is dependent on the specific facts and circumstances. Factors that we consider in determining whether an other-than-temporary decline in value has occurred include: the estimated fair value of the investment in relation to our cost basis; the financial condition of the related entity; and the intent and ability to retain the investment for a sufficient period of time to allow for recovery of the fair value of the investment.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
j. Transfers of Financial Assets
We account for transfers of financial assets under FASB ASC Topic 860, “Transfers and Servicing”, as either sales or financings. Transfers of financial assets that result in sales accounting are those in which (1) the transfer legally isolates the transferred assets from the transferor, (2) the transferee has the right to pledge or exchange the transferred assets and no condition both constrains the transferee’s right to pledge or exchange the assets and provides more than a trivial benefit to the transferor, and (3) the transferor does not maintain effective control over the transferred assets. If the transfer does not meet these criteria, the transfer is accounted for as a financing. Financial assets that are treated as sales are removed from our accounts with any realized gain (loss) reflected in earnings during the period of sale. Financial assets that are treated as financings are maintained on the balance sheet with proceeds received from the legal transfer reflected as securitized borrowings or security-related receivables.
k. Revenue Recognition
1) Interest income-We recognize interest income from investments in commercial mortgages, mezzanine loans, other loans, preferred equity interests, and other securities on a yield to maturity basis. Upon the acquisition of a loan at a discount, we assess the portions of the discount that constitute accretable yields and non-accretable differences. The accretable yield represents the excess of our expected cash flows from the loan over the amount we paid for the loan. That amount, the accretable yield, is accreted to interest income over the remaining life of the loan. Many of our commercial mortgages and mezzanine loans provide for the accrual of interest at specified rates which differ from current payment terms. Interest income is recognized on such loans at the accrual rate subject to management’s determination that accrued interest and outstanding principal are ultimately collectible. Management will cease accruing interest on these loans when it determines that the interest income is not collectible based on the ultimate value of the underlying collateral using discounted cash flow models and market based assumptions. The accrued interest receivable associated with these loans as of December 31, 2014, 2013, 2012 and 2011 was $41,347, $30,246, $22,706 and $16,488, respectively.
For investments that we did not elect to record at fair value under FASB ASC Topic 825, “Financial Instruments”, origination fees and direct loan origination costs are deferred and amortized to net investment income, using the effective interest method, over the contractual life of the underlying loan security or loan, in accordance with FASB ASC Topic 310, “Receivables.”
For investments that we elected to record at fair value under FASB ASC Topic 825, origination fees and direct loan costs are recorded in income and are not deferred.
We recognize interest income from interests in certain securitized financial assets on an estimated effective yield to maturity basis. Management estimates the current yield on the amortized cost of the investment based on estimated cash flows after considering prepayment and credit loss experience.
2) Rental income-We generate rental income from tenant rent and other tenant-related activities at our consolidated real estate properties. For multi-family real estate properties, rental income is recorded when due from residents and recognized monthly as it is earned and realizable, under lease terms which are generally for periods of one year or less. For retail and office real estate properties, rental income is recognized on a straight-line basis from the later of the date of the commencement of the lease or the date of acquisition of the property subject to existing leases, which averages minimum rents over the terms of the leases. Leases also typically provide for tenant reimbursement of a portion of common area maintenance and other operating expenses to the extent that a tenant’s pro rata share of expenses exceeds a base year level set in the lease.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
3) Fee and other income-We generate fee and other income through our various subsidiaries by (a) funding conduit loans for sale into unaffiliated CMBS securitizations, (b) providing or arranging to provide financing to our borrowers, (c) providing ongoing asset management services to investment portfolios under cancelable management agreements, and (d) providing property management services to third parties. We recognize revenue for these activities when the fees are fixed or determinable, are evidenced by an arrangement, collection is reasonably assured and the services under the arrangement have been provided. While we may receive asset management fees when they are earned, we eliminate earned asset management fee income from securitizations while such securitizations are consolidated. During the years ended December 31, 2014, 2013, and 2012, we received $4,191, $4,732, and $4,959, respectively, of earned asset management fees. We eliminated $3,200, $3,450, and $3,704, respectively, of these earned asset management fees as it was associated with consolidated securitizations.
l. Derivative Instruments
We may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with our borrowings.
In accordance with FASB ASC Topic 815, “Derivatives and Hedging”, we measure each derivative instrument (including certain derivative instruments embedded in other contracts) at fair value and record such amounts in our consolidated balance sheet as either an asset or liability. For derivatives designated as fair value hedges, derivatives not designated as hedges, or for derivatives designated as cash flow hedges associated with debt for which we elected the fair value option under FASB ASC Topic 825, “Financial Instruments”, the changes in fair value of the derivative instrument are recorded in earnings. For derivatives designated as cash flow hedges, the changes in the fair value of the effective portions of the derivative are reported in other comprehensive income. Changes in the ineffective portions of cash flow hedges, if any, are recognized in earnings.
m. Fair Value of Financial Instruments
In accordance with FASB ASC Topic 820, “Fair Value Measurements and Disclosures”, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity for disclosure purposes. Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their value. Hierarchical levels, as defined in FASB ASC Topic 820, “Fair Value Measurements and Disclosures” and directly related to the amount of subjectivity associated with the inputs to fair valuations of these assets and liabilities, are as follows:
•
Level 1: Valuations are based on unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. The types of assets carried at level 1 fair value generally are equity securities listed in active markets. As such, valuations of these investments do not entail a significant degree of judgment.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
•
Level 2: Valuations are based on quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Fair value assets and liabilities that are generally included in this category are unsecured REIT note receivables, commercial mortgage-backed securities, or CMBS, receivables and certain financial instruments classified as derivatives where the fair value is based on observable market inputs.
•
Level 3: Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. Generally, assets and liabilities carried at fair value and included in this category were TruPs and subordinated debentures, trust preferred obligations and CDO notes payable where observable market inputs do not exist.
The availability of observable inputs can vary depending on the financial asset or liability and is affected by a wide variety of factors, including, for example, the type of investment, whether the investment is new, whether the investment is traded on an active exchange or in the secondary market, and the current market condition. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by us in determining fair value is greatest for instruments categorized in level 3.
Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, our own assumptions are set to reflect those that management believes market participants would use in pricing the asset or liability at the measurement date. We use prices and inputs that management believes are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be transferred from Level 1 to Level 2 or Level 2 to Level 3.
Many financial instruments have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that buyers in the market are willing to pay for an asset. Ask prices represent the lowest price that sellers in the market are willing to accept for an asset. For financial instruments whose inputs are based on bid-ask prices, we do not require that fair value always be a predetermined point in the bid-ask range. Our policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that results in our best estimate of fair value.
Fair value for certain of our Level 3 financial instruments is derived using internal valuation models. These internal valuation models include discounted cash flow analyses developed by management using current interest rates, estimates of the term of the particular instrument, specific issuer information and other market data for securities without an active market. In accordance with FASB ASC Topic 820, “Fair Value Measurements and Disclosures”, the impact of our own credit spreads is also considered when measuring the fair value of financial assets or liabilities, including derivative contracts. Where appropriate, valuation adjustments are made to account for various factors, including
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
bid-ask spreads, credit quality and market liquidity. These adjustments are applied on a consistent basis and are based on observable inputs where available. Management’s estimate of fair value requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and management’s assumptions.
n. Income Taxes
RAIT, Taberna Realty Finance Trust, or TRFT, and Independence Realty Trust, Inc., or IRT, have each elected to be taxed as a REIT and to comply with the related provisions of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. Accordingly, we generally will not be subject to U.S. federal income tax to the extent of our dividends to shareholders and as long as certain asset, income and share ownership tests are met. If we were to fail to meet these requirements, we would be subject to U.S. federal income tax, which could have a material adverse impact on our results of operations and amounts available for dividends to our shareholders. Management believes that all of the criteria to maintain RAIT’s, TRFT’s, and IRT’s REIT qualification have been met for the applicable periods, but there can be no assurance that these criteria will continue to be met in subsequent periods.
We maintain various taxable REIT subsidiaries, or TRSs, which may be subject to U.S. federal, state and local income taxes and foreign taxes. Current and deferred taxes are provided on the portion of earnings (losses) recognized by us with respect to our interest in domestic TRSs. Deferred income tax assets and liabilities are computed based on temporary differences between our GAAP consolidated financial statements and the federal and state income tax basis of assets and liabilities as of the consolidated balance sheet date. We evaluate the realizability of our deferred tax assets (e.g., net operating loss and capital loss carryforwards) and recognize a valuation allowance if, based on the available evidence, it is more likely than not that some portion or all of our deferred tax assets will not be realized. When evaluating the realizability of our deferred tax assets, we consider estimates of expected future taxable income, existing and projected book/tax differences, tax planning strategies available, and the general and industry specific economic outlook. This realizability analysis is inherently subjective, as it requires management to forecast our business and general economic environment in future periods. Changes in estimate of deferred tax asset realizability, if any, are included in income tax expense on the consolidated statements of operations.
Our TRS entities generate taxable revenue from advisory fees for services provided to IRT and collateral management fees from consolidated securitizations. In consolidation, these fees are eliminated as IRT and securitizations are included in the consolidated group. Nonetheless, all income taxes are expensed and are paid by the TRSs in the year in which the revenue is received. These income taxes are not eliminated when the related revenue is eliminated in consolidation.
The TRS entities may be subject to tax laws that are complex and potentially subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of these inherently complex tax laws. Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. We review the tax balances of our TRS entities quarterly and, as new information becomes available, the balances are adjusted as appropriate.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
o. Share-Based Compensation
We account for our share-based compensation in accordance with FASB ASC Topic 718, “Compensation-Stock Compensation.” We measure the cost of employee and trustee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and record compensation expense on a straight line basis, over the related vesting period, for the entire award.
p. Deferred Financing Costs and Intangible Assets
Costs incurred in connection with debt financing are capitalized as deferred financing costs and charged to interest expense over the terms of the related debt agreements, in a manner that approximates the effective interest method.
Intangible assets on our consolidated balance sheets represent identifiable intangible assets acquired in business acquisitions. We amortize identified intangible assets to expense over their estimated lives using the straight-line method. We evaluate intangible assets for impairment as events and circumstances change, in accordance with FASB ASC Topic 360, “Property, Plant, and Equipment.” The gross carrying amount for our customer relationships was $19,149 and $21,726 as of December 31, 2014 and December 31, 2013, respectively. The gross carrying amount for our in-place leases and above-market leases was $22,725 and $2,892 as of December 31, 2014 and December 31, 2013, respectively. The gross carrying amount for our trade name was $1,500 as of December 31, 2014 and December 31, 2013, respectively. The accumulated amortization for our intangible assets was $13,911 and $4,564 as of December 31, 2014 and December 31, 2013, respectively. We recorded amortization expense of $11,924, $2,379 and $638 for the years ended December 31, 2014, 2013 and 2012, respectively. Based on the intangible assets identified above, we expect to record amortization expense of intangible assets of $8,081 for 2015, $4,186 for 2016, $3,262 for 2017, $2,675 for 2018, $2,594 for 2019 and $8,665 thereafter. As of December 31, 2014, we have determined that no impairment exists on our intangible assets.
q. Goodwill
Goodwill on our consolidated balance sheet represented the amounts paid in excess of the fair value of the net assets acquired from business acquisitions accounted for under FASB ASC Topic 805, “Business Combinations.” Pursuant to FASB ASC Topic 350, “Intangibles-Goodwill and Other”, goodwill is not amortized to expense but rather is analyzed for impairment. We evaluate goodwill for impairment on an annual basis and as events and circumstances change, in accordance with FASB ASC Topic 350. As of December 31, 2014 and 2013, we have $11,014 and $7,962, respectively, of goodwill that is included in Other Assets in the accompanying consolidated balance sheets. During the year ended December 31, 2014 we revised the initial purchase price allocation related to the retail property management firm we acquired in 2013 and recorded a net increase in goodwill of $3,052 related to a deferred tax liability associated with definite-lived intangible assets and an adjustment to a liability based on its fair value. As of December 31, 2014, we have determined that no impairment exists on our goodwill.
r. Recent Accounting Pronouncements
In April 2014, the FASB issued an accounting standard classified under FASB ASC Topic 205, “Presentation of Financial Statements”. This accounting standard amends existing guidance to change reporting requirements for discontinued operations by requiring the disposal of an entity to be reported in discontinued
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
operations if the disposal represents a strategic shift that has or will have a major effect on an entity’s operations and financial results. This standard is effective for interim and annual reporting periods beginning on or after December 15, 2014. Management is currently evaluating the impact that this standard may have on our consolidated financial statements.
In May 2014, the FASB issued an accounting standard classified under FASB ASC Topic 606, “Revenue from Contracts with Customers”. This accounting standard generally replaces existing guidance by requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard is effective for annual reporting periods beginning after December 15, 2016. Management is currently evaluating the impact that this standard may have on our consolidated financial statements.
NOTE 3: INVESTMENTS IN MORTGAGES, LOANS AND PREFERRED EQUITY INTERESTS
Investments in Commercial Mortgages, Mezzanine Loans, Other Loans and Preferred Equity Interests
The following table summarizes our investments in commercial mortgages, mezzanine loans, other loans and preferred equity interests as of December 31, 2014:
(1) Weighted-average coupon is calculated on the unpaid principal amount of the underlying instruments which does not necessarily correspond to the carrying amount.
(2) Commercial mortgages includes 11 conduit loans with an unpaid principal balance and carrying amount of $93,925, a weighted-average coupon of 4.6% and maturity dates ranging from November 2019 through January 2025. These commercial mortgages are classified as loans held for sale.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes our investments in commercial mortgages, mezzanine loans, other loans and preferred equity interests as of December 31, 2013:
(1) Weighted-average coupon is calculated on the unpaid principal amount of the underlying instruments which does not necessarily correspond to the carrying amount.
(2) Commercial mortgages includes six conduit loans with an unpaid principal balance and carrying amount of $61,825, a weighted-average coupon of 5.3% and maturity dates ranging from January 2024 through January 2029. These commercial mortgages are classified as loans held for sale.
During the year ended December 31, 2014, we completed the conversion of three commercial real estate loans with a carrying value of $74,994 to real estate owned property. We recorded a gain on asset of $136 on one property as the value of the real estate exceeded the carrying amount of the converted loan and charged off $600 to the allowance for losses as the individual carrying amounts of the other two loans exceeded the fair value of each real estate property. During the year ended December 31, 2013, we did not convert any commercial real estate loans to owned real estate property. See Note 5 for property acquisitions that did not consist of the assumption of commercial real estate loans.
In June 2014, we sold all of the remaining interests, held by T8 and T9, in one of our other investments with an unpaid principal balance of $10,488 for $2,850. We recorded a loss on sale of asset of $7,638 due to the illiquid nature of the investment.
The following table summarizes the delinquency statistics of our commercial real estate loans as of December 31, 2014 and 2013:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
As of December 31, 2014 and 2013, approximately $25,281 and $37,073, respectively, of our commercial real estate loans were on non-accrual status and had a weighted-average interest rate of 5.8% and 6.3%, respectively. In 2015, we have determined the recognition of interest income on two loans, with a total investment of $79,081 and a weighted average interest rate of 8.2%, will change in 2015 from the accrual basis to the cash basis.
During the year ended December 31, 2014, we removed a loan with an unpaid principal balance of $5,500 from non-accrual status. The carrying amount of this loan was $4,330 as it was acquired at a discount. We recorded $882 of accrued interest which represents the interest during the time the loan was on non-accrual status. Management believes the entire unpaid principal balance and all accrued interest is collectible.
The following table sets forth the maturities of our investments in commercial mortgages, mezzanine loans, other loans and preferred equity interests by year:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Allowance For Losses And Impaired Loans
We closely monitor our loans which require evaluation for loan loss in two categories: satisfactory and impaired. Loans classified as impaired are generally loans which have credit weaknesses or which the credit quality of the collateral has temporarily deteriorated. We have classified our investment in loans by credit risk category as follows:
Our provision for loan losses as a percentage of our investment in loans was 0.7% and 2.0% as of December 31, 2014 and 2013, respectively.
The following table provides a roll-forward of our allowance for losses for our commercial mortgages, mezzanine loans and other loans for the years ended December 31, 2014, 2013 and 2012:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Information on those loans on our watchlist or considered to be impaired was as follows:
(1) As of December 31, 2014, this includes $5,500 of unpaid principal relating to previously identified TDRs that are on accrual status.
(1) As of December 31, 2013, there were no previously identified TDRs that were on accrual status included in impaired loans.
The average unpaid principal balance and recorded investment of total impaired loans was $66,182, $69,327, and $76,276 during the years ended December 31, 2014, 2013, and 2012, respectively. As of December 31, 2014, there are nine impaired loans with unpaid principal balances of $67,839 for which there is no allowance. We recorded interest income from impaired loans of $991, $229, and $149 for the years ended December 31, 2014, 2013, and 2012, respectively.
We have evaluated modifications to our commercial real estate loans to determine if the modification constitutes a troubled debt restructuring (TDR) under FASB ASC Topic 310, “Receivables”. During the year ended December 31, 2014, we have determined that a modification to one commercial real estate loan constituted a TDR as the borrower was experiencing financial difficulties and we, as the lender, granted a concession to the borrower by deferring principal payments to future periods. The outstanding recorded investment was $11,140 both before and after the modifications. As of December 31, 2014, there were no TDRs that subsequently defaulted.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 4: INVESTMENTS IN SECURITIES
Our investments in securities and security-related receivables are accounted for at fair value. The following table summarizes our investments in securities as of December 31, 2014:
(1) Weighted-average coupon is calculated on the unpaid principal amount of the underlying instruments which does not necessarily correspond to the carrying amount.
(2) As of December 31, 2014, this includes available-for-sale securities that are accounted for under the fair value option other than an available-for-sale security that has an amortized cost of $3,600 and a carrying value of $3,606.
(3) CMBS receivables include securities with a fair value totaling $1,250 that are rated “D” by Standard & Poor’s.
The following table summarizes our investments in securities as of December 31, 2013:
(1) Weighted-average coupon is calculated on the unpaid principal amount of the underlying instruments which does not necessarily correspond to the carrying amount.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
(2) CMBS receivables include securities with a fair value totaling $8,228 that are rated between “AAA” and “A-” by Standard & Poor’s, securities with a fair value totaling $26,594 that are rated between “BBB+” and “B-” by Standard & Poor’s, securities with a fair value totaling $8,164 that are rated “CCC” by Standard & Poor’s, and securities with a fair value totaling $1,132 that are rated “D” by Standard & Poor’s.
A substantial portion of our gross unrealized losses at December 31, 2013 were greater than 12 months.
On December 19, 2014, our subsidiary assigned or delegated its rights and responsibilities as collateral manager for the T8 and T9 securitizations. As a result of the assignment and delegation, we determined that we are no longer the primary beneficiaries of T8 and T9 and deconsolidated the two securitizations. See Note 10 for additional disclosures pertaining to the deconsolidation. In January 2015, we sold securities with an aggregate fair value of $20,419.
TruPS included above as trading securities include (a) investments in TruPS issued by VIEs of which we are not the primary beneficiary and which we do not consolidate and (b) transfers of investments in TruPS securities to us that were accounted for as a sale pursuant to FASB ASC Topic 860, “Transfers and Servicing.”
The following table summarizes the non-accrual status of our investments in securities:
The assets of our consolidated CDOs collateralize the debt of such entities and are not available to our creditors. As of December 31, 2014 and 2013, investment in securities of $0 and $653,276, respectively, in principal amount of TruPS and subordinated debentures, and $10,000 and $91,383, respectively, in principal amount of unsecured REIT note receivables and CMBS receivables, collateralized the consolidated CDO notes payable of such entities.
NOTE 5: INVESTMENTS IN REAL ESTATE
The table below summarizes our investments in real estate:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
(a) As of December 31, 2014, includes properties owned by Independence Realty Trust, Inc., with a book value of $689,112 and accumulated depreciation of $23,376. As of December 31, 2013, includes properties owned by Independence Realty Trust, Inc., with a book value of $190,096 and accumulated depreciation of $15,775.
As of December 31, 2014 and 2013, our investments in real estate were comprised of land of $338,057 and $235,052, respectively, and buildings and improvements of $1,502,394 and $896,879, respectively.
As of December 31, 2014, our investments in real estate of $1,671,971 are financed through $641,874 of mortgages held by third parties and $878,856 of mortgages held by our RAIT I and RAIT II CDO securitizations. As of December 31, 2013, our investments in real estate of $1,004,186 are financed through $171,223 of mortgages held by third parties and $864,689 of mortgages held by our RAIT I and RAIT II CDO securitizations. Together, along with commercial real estate loans held by RAIT I and RAIT II, these mortgages serve as collateral for the CDO notes payable issued by the RAIT I and RAIT II CDO securitizations. All intercompany balances and interest charges are eliminated in consolidation.
For our investments in real estate, the leases for our multi-family properties are generally one-year or less and leases for our office and retail properties are operating leases. The following table represents the minimum future rentals under expiring leases for our office and retail properties as of December 31, 2014.
Acquisitions:
During the year ended December 31, 2014, we acquired or obtained control of 22 multi-family properties, two retail properties and four office properties with a combined purchase price of $708,168. We assumed first mortgages on some of these properties. Upon acquisition, we recorded the investment in real estate, including any related working capital and intangible assets, at a fair value of $713,224 and recorded a gain on assets of $5,655 for two acquisitions for which the fair value of the property exceeded the consideration transferred. Of these acquisitions, Independence Realty Trust, Inc., or IRT, acquired 20 multi-family properties at a fair value of $502,511. We consolidate IRT as it is a VIE and we are the primary beneficiary. See Note 9 for additional disclosures pertaining to VIEs.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes the aggregate estimated fair value of the assets and liabilities associated with the 28 properties acquired during the year ended December 31, 2014, on the respective date of each acquisition, for the real estate accounted for under FASB ASC Topic 805.
The following table summarizes the consideration transferred to acquire the real estate properties and the amounts of identified assets acquired and liabilities assumed at the respective acquisition date:
During the year ended December 31, 2014, these investments contributed revenue of $38,286 and a net income allocable to common shares of $3,608. During the year ended December 31, 2014, we incurred $1,612 of third-party acquisition-related costs, which is included in the accompanying consolidated statements of operations.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The tables below present the revenue, net income and earnings per share effect of the acquired properties, as reported in our consolidated financial statements and on a pro forma basis as if the acquisitions occurred on January 1, 2013. These pro forma results are not necessarily indicative of the results which actually would have occurred if the acquisition had occurred on the first day of the periods presented, nor does the pro forma financial information purport to represent the results of operations for future periods.
We have not yet completed the process of estimating the fair value of assets acquired and liabilities assumed for properties acquired during 2014. Accordingly, our preliminary estimates and the allocation of the purchase price to the assets acquired and liabilities assumed may change as we complete the process. In accordance with FASB ASC Topic 805, changes, if any, to the preliminary estimates and allocation will be reported in our financial statements retrospectively. During the year ended December 31, 2014, we reallocated $6,565 from our investments in real estate to account for identified tangible assets and intangible assets and liabilities that related to prior period real estate acquisitions.
Dispositions:
During the year ended December 31, 2014, we disposed of one multi-family real estate property for a total sale price of $4,250. We recorded a loss on the sale of this asset of $2,526, of which $319 and $2,207 is included in the accompanying consolidated statements of operations for the years ended December 31, 2014 and 2013, respectively.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 6: INDEBTEDNESS
We maintain various forms of short-term and long-term financing arrangements. Generally, these financing agreements are collateralized by assets within securitizations.
The following table summarizes our total recourse and non-recourse indebtedness as of December 31, 2014:
(1) Our 7.0% convertible senior notes are redeemable at par, at the option of the holder, in April 2016, April 2021, and April 2026.
(2) Our 4.0% convertible senior notes are redeemable at par, at the option of the holder, in October 2018, October 2023, and October 2028.
(3) Relates to liabilities which we elected to record at fair value under FASB ASC Topic 825.
(4) Excludes CDO notes payable purchased by us which are eliminated in consolidation.
(5) Collateralized by $1,572,126 principal amount of commercial mortgages, mezzanine loans, other loans and preferred equity interests. These obligations were issued by separate legal entities and consequently the assets of the special purpose entities that collateralize these obligations are not available to our creditors.
(6) Excludes the RAIT FL1 junior notes, RAIT FL2 junior notes and RAIT FL3 junior notes purchased by us which are eliminated in consolidation. Collateralized by $490,863 principal amount of commercial mortgages loans and participation interests. These obligations were issued by separate legal entities and consequently the assets of the special purpose entities that collateralize these obligations are not available to our creditors.
(7) Includes $360,902 of unpaid principal balance with a carrying amount of $362,434 of third party mortgage indebtedness that encumbers properties owned by IRT. The weighted-average interest rate is 3.8% and has a range of maturity dates from April 2016 to January 2025.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes our total recourse and non-recourse indebtedness as of December 31, 2013:
(1) Our 7.0% convertible senior notes are redeemable at par, at the option of the holder, in April 2016, April 2021, and April 2026.
(2) Our 4.0% convertible senior notes are redeemable at par, at the option of the holder, in October 2018, October 2023, and October 2028.
(3) Relates to liabilities which we elected to record at fair value under FASB ASC Topic 825.
(4) Excludes senior secured notes issued by us with an aggregate principal amount equal to $86,000 with a weighted average coupon of 7.0%, which are eliminated in consolidation.
(5) Excludes CDO notes payable purchased by us which are eliminated in consolidation.
(6) Collateralized by $1,662,537 principal amount of commercial mortgages, mezzanine loans, other loans and preferred equity interests. These obligations were issued by separate legal entities and consequently the assets of the special purpose entities that collateralize these obligations are not available to our creditors.
(7) Collateralized by $989,781 principal amount of investments in securities and security-related receivables and loans, before fair value adjustments. The fair value of these investments as of December 31, 2013 was $746,939. These obligations were issued by separate legal entities and consequently the assets of the special purpose entities that collateralize these obligations are not available to our creditors.
(8) Excludes the RAIT FL1 junior notes purchased by us which are eliminated in consolidation. Collateralized by $131,843 principal amount of commercial mortgages loans and participation interests. These obligations were issued by separate legal entities and consequently the assets of the special purpose entities that collateralize these obligations are not available to our creditors.
(9) Includes $62,728 of unpaid principal balance and carrying amount of third party mortgage indebtedness that encumbers properties owned by IRT. The weighted-average interest rate is 3.8% and has a range of maturity dates from January 2019 to November 2022.
Recourse indebtedness refers to indebtedness that is recourse to our general assets, including the loans payable on real estate that are guaranteed by us. Non-recourse indebtedness consists of indebtedness of consolidated securitizations and loans payable on real estate which is recourse only to specific assets pledged as collateral to the lenders. The creditors of each consolidated securitization have no recourse to our general credit.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The current status or activity in our financing arrangements occurring as of or during the year ended December 31, 2014 is as follows:
Recourse Indebtedness
7.0% convertible senior notes. On March 21, 2011, we issued and sold in a public offering $115,000 aggregate principal amount of our 7.0% Convertible Senior Notes due 2031, or the 7.0% convertible senior notes. After deducting the underwriting discount and the estimated offering costs, we received approximately $109,000 of net proceeds. Interest on the 7.0% convertible senior notes is paid semi-annually and the 7.0% convertible senior notes mature on April 1, 2031.
Prior to April 5, 2016, the 7.0% convertible senior notes are not redeemable at our option, except to preserve RAIT’s status as a REIT. On or after April 5, 2016, we may redeem all or a portion of the 7.0% convertible senior notes at a redemption price equal to the principal amount plus accrued and unpaid interest. Holders of 7.0% convertible senior notes may require us to repurchase all or a portion of the 7.0% convertible senior notes at a purchase price equal to the principal amount plus accrued and unpaid interest on April 1, 2016, April 1, 2021, and April 1, 2026, or upon the occurrence of certain defined fundamental changes.
The 7.0% convertible senior notes are convertible at the option of the holder at a current conversion rate of 160.8208 common shares per $1 principal amount of 7.0% convertible senior notes (equivalent to a current conversion price of $6.22 per common share). Upon conversion of 7.0% convertible senior notes by a holder, the holder will receive cash, our common shares or a combination of cash and our common shares, at our election. We include the 7.0% convertible senior notes in diluted earnings per share using the if-converted method if the conversion value in excess of the par amount is considered in the money during the respective periods.
According to FASB ASC Topic 470, “Debt”, we recorded a discount on our issued and outstanding 7.0% convertible senior notes of $8,228. This discount reflects the fair value of the embedded conversion option within the 7.0% convertible senior notes and was recorded as an increase to additional paid in capital. The fair value was calculated by discounting the cash flows required in the indenture relating to the 7.0% convertible senior notes agreement by a discount rate that represents management’s estimate of our senior, unsecured, non-convertible debt borrowing rate at the time when the 7.0% convertible senior notes were issued. The discount will be amortized to interest expense through April 1, 2016, the date at which holders of our 7.0% convertible senior notes could require repayment.
During the year ended December 31, 2013, we repurchased from the market, a total of $80,934 in aggregate principal amount of 7.0% convertible senior notes for a total consideration of $112,559. The purchase price consisted of cash from the proceeds received from the public offering of the 4.0% Convertible Senior Notes due 2033 that were issued on December 10, 2013. As a result of this transaction, we recorded losses on extinguishment of debt of $8,407, inclusive of deferred financing costs and unamortized discounts that were written off, and $29,359 representing the reacquisition of the equity conversion right that was recorded as a reduction to additional paid in capital.
4.0% convertible senior notes. On December 10, 2013, we issued and sold in a public offering $125,000 aggregate principal amount of our 4.0% Convertible Senior Notes due 2033, or the 4.0% convertible senior notes. After deducting the underwriting discount and the estimated offering costs, we received approximately $121,250 of net proceeds. In January 2014, the underwriters exercised the overallotment option with respect to an additional $16,750 aggregate principal amount of the 4.0% convertible senior notes and we received total net
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
proceeds of $16,300 after deducting underwriting fees and adjusting for accrued interim interest. In the aggregate, we issued $141,750 aggregate principal amount of the 4.0% convertible senior notes in the offering and raised total net proceeds of approximately $137,238 after deducting underwriting fees and offering expenses. Interest on the 4.0% convertible senior notes is paid semi-annually and the 4.0% convertible senior notes mature on October 1, 2033.
Prior to October 1, 2018, the 4.0% convertible senior notes are not redeemable at our option, except to preserve RAIT’s status as a REIT. On or after October 1, 2018, we may redeem all or a portion of the 4.0% convertible senior notes at a redemption price equal to the principal amount plus accrued and unpaid interest. Holders of 4.0% convertible senior notes may require us to repurchase all or a portion of the 4.0% convertible senior notes at a purchase price equal to the principal amount plus accrued and unpaid interest on October 1, 2018, October 1, 2023, and October 1, 2028, or upon the occurrence of certain defined fundamental changes.
The 4.0% convertible senior notes are convertible at the option of the holder at a current conversion rate of 105.8429 common shares per $1 principal amount of 4.0% convertible senior notes (equivalent to a current conversion price of $9.45 per common share). Upon conversion of 4.0% convertible senior notes by a holder, the holder will receive cash, our common shares or a combination of cash and our common shares, at our election. We include the 4.0% convertible senior notes in earnings per share using the if-converted method if the conversion value in excess of the par amount is considered in the money during the respective periods.
According to FASB ASC Topic 470, “Debt”, we recorded a discount on our issued and outstanding 4.0% convertible senior notes of $8,817. This discount reflects the fair value of the embedded conversion option within the 4.0% convertible senior notes and was recorded as an increase to additional paid in capital. The fair value was calculated by discounting the cash flows required in the indenture relating to the 4.0% convertible senior notes agreement by a discount rate that represents management’s estimate of our senior, unsecured, non-convertible debt borrowing rate at the time when the 4.0% convertible senior notes were issued. The discount will be amortized to interest expense through October 1, 2018, the date at which holders of our 4.0% convertible senior notes could require repayment.
Concurrent with the offering of the 4.0% convertible senior notes, we used approximately $8,838 of the proceeds and entered into a capped call transaction with an affiliate of the underwriter. The capped call transaction has a cap price of $11.91, which is subject to certain adjustments, and an initial strike price of $9.57, which is subject to certain adjustments and is equivalent to the conversion price of the 4.0% convertible senior notes. The capped calls expire on various dates ranging from June 2018 to October 2018 and are expected to reduce the potential dilution to holders of our common stock upon the potential conversion of the 4.0% convertible senior notes. The capped call transaction is a separate transaction and is not part of the terms of the 4.0% convertible senior notes and will not affect the holders’ rights under the 4.0% convertible senior notes. The capped call transaction meets the criteria for equity classification and was recorded as a reduction to additional paid in capital. The capped call transaction is excluded from the dilutive EPS calculation as their effect would be anti-dilutive.
7.625% senior notes. On April 14, 2014, we issued and sold in a public offering $60,000 aggregate principal amount of our 7.625% Senior Notes due 2024, or the 7.625% senior notes. After deducting the underwriting discount and the offering costs, we received approximately $57,500 of net proceeds. Interest on the 7.625% senior notes is paid quarterly with a maturity date of April 15, 2024. The 7.625% senior notes are subject to redemption at our option, in whole or in part, at any time on or after April 15, 2017, at a redemption price equal to 100% of the principal amount of the notes to be redeemed, plus accrued and unpaid interest to, but
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
excluding, the redemption date and are subject to repurchase by us at the option of the holders following a defined fundamental change, at a repurchase price equal to 101% of the principal amount of the notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. The senior notes are not convertible into equity securities of RAIT. They contain financial covenants that are consistent with our other debt agreements.
7.125% senior notes. In August 2014, we issued and sold in a public offering $71,905 aggregate principal amount of our 7.125% Senior Notes due 2019, or the 7.125% senior notes. After deducting the underwriting discount and the offering costs, we received approximately $69,209 of net proceeds. Interest on the 7.125% senior notes is paid quarterly with a maturity date of August 30, 2019. The 7.125% senior notes are subject to redemption at our option, in whole or in part, at any time on or after August 30, 2017, at a redemption price equal to 100% of the principal amount of the notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date and are subject to repurchase by us at the option of the holders following a defined fundamental change, at a repurchase price equal to 101% of the principal amount of the notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. The senior notes are not convertible into equity securities of RAIT. They contain financial covenants that are consistent with our other debt agreements.
Secured credit facilities. On October 25, 2013, our subsidiary, Independence Realty Operating Partnership, LP, or IROP, the operating partnership of IRT, entered into a $20,000 secured revolving credit agreement, or the IROP credit agreement, with The Huntington National Bank to be used to acquire properties, capital expenditures and for general corporate purposes. The IROP credit agreement has a 3-year term, bears interest at LIBOR plus 2.75% and contains customary financial covenants for this type of revolving credit agreement. IRT guaranteed IROP’s obligations under the IROP credit agreement. On September 9, 2014, IRT and IROP entered into an amendment to the IROP credit agreement that increased the lender’s maximum commitment under the credit agreement from $20,000 to $30,000, changed the interest rate from LIBOR plus 2.75% to LIBOR plus 2.50% and amended certain financial covenants. As of December 31, 2014, there was $18,392 outstanding under the IROP credit agreement.
During the year ended December 31, 2014, we borrowed $40,542 and repaid $30,778 under our secured credit facilities.
Senior secured notes. On October 5, 2011, we entered into an exchange agreement with T8 pursuant to which we issued four senior secured notes, or the senior secured notes, with an aggregate principal amount equal to $100,000 to T8 in exchange for a portfolio of real estate related debt securities, or the exchanged securities, held by T8. The senior secured notes and the exchanged securities were determined to have approximately equivalent fair market value at the time of the exchange. Prior to December 19, 2014, T8 was a consolidated subsidiary and the senior secured notes and their related interest were eliminated in consolidation. When T8 was deconsolidated on December 19, 2014, these senior secured notes were no longer eliminated.
The senior secured notes were issued pursuant to an indenture agreement dated October 5, 2011 which contains customary events of default, including those relating to nonpayment of principal or interest when due and defaults based upon events of bankruptcy and insolvency. The senior secured notes are each $25,000 principal amount with a weighted average interest rate of 7.0% and have maturity dates ranging from April 2017 to April 2019. Interest is at a fixed rate and accrues from October 5, 2011 and will be payable quarterly in arrears on October 30, January 30, April 30 and July 30 of each year, beginning October 30, 2011. The senior secured notes are secured and are not convertible into equity securities of RAIT.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
During the year ended December 31, 2014, we prepaid $8,000 of the senior secured notes. As of December 31, 2014 we have $78,000 of outstanding senior secured notes.
Junior subordinated notes, at fair value. On October 16, 2008, we issued two junior subordinated notes with an aggregate principal amount of $38,052 to a third party and received $15,459 of net cash proceeds. One junior subordinated note, which we refer to as the first $18,671 junior subordinated note, has a principal amount of $18,671, a fixed interest rate of 8.65% through March 30, 2015 with a floating rate of LIBOR plus 400 basis points thereafter and a maturity date of March 30, 2035. The second junior subordinated note, which we refer to as the $19,381 junior subordinated note, had a principal amount of $19,381, a fixed interest rate of 9.64% and a maturity date of October 30, 2015. At issuance, we elected to record these junior subordinated notes at fair value under FASB ASC Topic 825, with all subsequent changes in fair value recorded in earnings.
On October 25, 2010, pursuant to a securities exchange agreement, we exchanged and cancelled the first $18,671 junior subordinated note for another junior subordinated note, which we refer to as the second $18,671 junior subordinated note, in aggregate principal amount of $18,671 with a reduced interest rate and provided $5,000 of our 6.875% convertible senior notes as collateral for the second $18,671 junior subordinated note. The second $18,671 junior subordinated note has a fixed rate of interest of 0.5% through March 30, 2015, thereafter with a floating rate of three-month LIBOR plus 400 basis points, with such floating rate not to exceed 7.0%. The maturity date remains the same at March 30, 2035. At issuance, we elected to record the second $18,671 junior subordinated note at fair value under FASB ASC Topic 825, with all subsequent changes in fair value recorded in earnings.
During the year ended December 31, 2013, we prepaid the $19,381 junior subordinated note. After reflecting the prepayment, only the second $18,671 junior subordinated note remains outstanding as of December 31, 2014. The fair value, or carrying amount, of this indebtedness was $13,102 as of December 31, 2014.
Junior subordinated notes, at amortized cost. On February 12, 2007, we formed Taberna Funding Capital Trust I which issued $25,000 of trust preferred securities to investors and $100 of common securities to us. The combined proceeds were used by Taberna Funding Capital Trust I to purchase $25,100 of junior subordinated notes issued by us. The junior subordinated notes are the sole assets of Taberna Funding Capital Trust I and mature on April 30, 2037, but are callable, at our option, on or after April 30, 2012. Interest on the junior subordinated notes is payable quarterly at a fixed rate of 7.69% through April 2012 and thereafter at a floating rate equal to three-month LIBOR plus 2.50%.
CMBS facilities. On October 27, 2011, we entered into a two year CMBS facility pursuant to which we may sell, and later repurchase, performing whole mortgage loans or senior interests in whole mortgage loans secured by first liens on stabilized commercial properties which meet current standards for inclusion in CMBS transactions. The purchase price paid for any asset purchased will be equal to 75% of the lesser of the market value (determined by the purchaser in its sole discretion, exercised in good faith) or par amount of such asset on the purchase date. On July 28, 2014, we entered into an amended and restated master repurchase agreement, or the Amended MRA. The Amended MRA added defined floating-rate whole loans and senior interests in whole loans as eligible purchased assets which we could sell to the investment bank and later repurchase. All eligible purchased assets must be acceptable to the investment bank in its sole discretion. The Amended MRA increased the aggregate principal amount available under the facility to $200,000 from $100,000 provided that the aggregate outstanding purchase price under the Amended MRA at any time for all floating rate loans cannot exceed $100,000. Fixed rate loans incur interest at LIBOR plus 250 basis points and floating rate loans incur
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
interest at LIBOR plus 200 basis points. The Amended MRA contains standard margin call provisions and financial covenants. The expiration date of the Amended MRA is July 28, 2016. As of December 31, 2014, we had $43,286 of outstanding borrowings under the Amended MRA. As of December 31, 2014, we were in compliance with all financial covenants contained in the Amended MRA.
On November 23, 2011, we entered into a one year CMBS facility, or the $150,000 CMBS facility, pursuant to which we may sell, and later repurchase, commercial mortgage loans secured by first liens on stabilized commercial properties which meet current standards for inclusion in CMBS transactions. Effective November 19, 2014, we extended the maturity of the $150,000 CMBS facility to the earlier of November 18, 2015 or the day on which an event of default occurs. The aggregate principal amount available under the $150,000 CMBS facility is $150,000 and incurs interest at LIBOR plus 250 basis points. The purchase price paid for any asset purchased is up to 75% of the lesser of the unpaid principal balance and the market value (determined by the purchaser in its sole discretion, exercised in good faith) of such purchased asset on the purchase date. The $150,000 CMBS facility contains standard margin call provisions and financial covenants. As of December 31, 2014, we had $33,120 of outstanding borrowings under the $150,000 CMBS facility. As of December 31, 2014, we were in compliance with all financial covenants contained in the $150,000 CMBS facility.
On January 27, 2014, we entered into a two year $75,000 commercial mortgage facility, or the $75,000 commercial mortgage facility, pursuant to which we may sell, and later repurchase, commercial mortgage loans and other assets meeting defined eligibility criteria which are approved by the purchaser in its sole discretion. The aggregate principal amount of the $75,000 commercial mortgage facility is $75,000 and incurs interest at LIBOR plus 200 basis points. The $75,000 commercial mortgage facility contains standard margin call provisions and financial covenants. As of December 31, 2014, we had $8,647 of outstanding borrowings under the $75,000 commercial mortgage facility. As of December 31, 2014, we were in compliance with all financial covenants contained in the $75,000 commercial mortgage facility.
On December 13, 2014, one of our commercial mortgage facilities terminated in accordance with its terms.
On December 23, 2014, we entered into a $150,000 commercial mortgage facility, or the $150,000 commercial mortgage facility, pursuant to which we may sell, and later repurchase, commercial mortgage loans and other assets meeting defined eligibility criteria which are approved by the purchaser in its reasonable discretion. The aggregate principal amount of the $150,000 commercial mortgage facility is $150,000 and incurs interest at LIBOR. The purchase price paid for any asset purchased is based on a defined percentage of the lesser of its unpaid principal balance or its defined market value. The termination date of the $150,000 commercial mortgage facility is the earlier of December 22, 2015 or the day on which an event of default occurs. The $150,000 commercial mortgage facility contains standard margin call provisions and financial covenants. As of December 31, 2014, we did not have any outstanding borrowings under the $150,000 commercial mortgage facility. As of December 31, 2014, we were in compliance with all financial covenants contained in the $150,000 commercial mortgage facility.
Non-Recourse Indebtedness
CDO notes payable, at amortized cost. CDO notes payable at amortized cost represent notes issued by consolidated CDO securitizations which are used to finance the acquisition of unsecured REIT notes, CMBS securities, commercial mortgages, mezzanine loans, and other loans in our commercial real estate portfolio.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Generally, CDO notes payable are comprised of various classes of notes payable, with each class bearing interest at variable or fixed rates. Both RAIT I and RAIT II are meeting all of their overcollateralization, or OC, and interest coverage, or IC, trigger tests as of December 31, 2014 and 2013.
During the year ended December 31, 2014, we repurchased, from the market, a total of $5,800 in aggregate principal amount of CDO notes payable issued by our RAIT I securitization. The aggregate purchase price was $3,379 and we recorded a gain on extinguishment of debt of $2,421.
During the year ended December 31, 2013, we repurchased, from the market, a total of $17,500 in aggregate principal amount of CDO notes payable issued by our RAIT I securitization. The aggregate purchase price was $10,369 and we recorded a gain on extinguishment of debt of $7,131.
During the year ended December 31, 2012, we repurchased, from the market, a total of $2,500 in aggregate principal amount of CDO notes payable issued by our RAIT I securitization. The aggregate purchase price was $926 and we recorded a gain on extinguishment of debt of $1,574.
CDO notes payable, at fair value. On December 19, 2014, our subsidiary assigned or delegated its rights and responsibilities as collateral manager for the T8 and T9 securitizations. As a result of the assignment and delegation, we determined that we are no longer the primary beneficiaries of T8 and T9 and deconsolidated the two securitizations. See Item 8 - “Financial Statements and Supplementary Data-Note 10” for additional disclosures pertaining to the deconsolidation.
CMBS securitizations. On July 31, 2013, or the closing date, we closed a CMBS securitization transaction structured to be collateralized by $135,000 of floating rate commercial mortgage loans and participation interests, or the FL1 collateral, that we originated. The CMBS securitization transaction is intended to finance the FL1 collateral on a non-recourse basis. In connection with the CMBS securitization transaction, our subsidiaries made certain customary representations, warranties and covenants.
On the closing date, our subsidiary, RAIT 2013-FL1 Trust, or the FL1 issuer, issued classes of investment grade senior notes, or the FL1 senior notes, with an aggregate principal balance of approximately $101,250 to investors, representing an advance rate of approximately 75%. Our subsidiary received the unrated classes of junior notes, or the FL1 junior notes, including a class with an aggregate principal balance of $33,750, and the equity, or the retained interests, of the FL1 issuer. The FL1 senior notes bear interest at a weighted average rate equal to LIBOR plus 1.85%. The stated maturity of the FL1 notes is January 2029, unless redeemed or repaid prior thereto. Subject to certain conditions, beginning in August 2015 or upon defined tax events, the FL1 issuer may redeem the FL1 senior notes, in whole but not in part, at the direction of defined holders of FL1 junior notes that we hold.
On the closing date, RAIT FL1 purchased FL1 collateral with an aggregate principal balance of approximately $70,762 and approximately $64,238 was reserved for the acquisition by RAIT FL1 of additional collateral meeting defined eligibility criteria during a ramp-up period which was successfully completed by December 31, 2013. Our subsidiary serves as the servicer and special servicer of RAIT FL1. RAIT FL1 does not have OC triggers or IC triggers.
On April 29, 2014, we closed a CMBS securitization transaction, or RAIT FL2, structured to be collateralized by $196,052 of floating rate commercial mortgage loans and participation interests, or the FL2
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
collateral, that we originated. The CMBS securitization transaction is intended to finance the FL2 collateral on a non-recourse basis. In connection with the CMBS securitization transaction, our subsidiaries made certain customary representations, warranties and covenants. RAIT FL2 does not have OC triggers or IC triggers.
On the closing date, our subsidiary, RAIT 2014-FL2 Trust, or the FL2 issuer, issued classes of investment grade senior notes, or the FL2 senior notes, with an aggregate principal balance of approximately $155,861 to investors, representing an advance rate of approximately 79.5%. A RAIT subsidiary received the unrated classes of junior notes, or the FL2 junior notes, including a class with an aggregate principal balance of $40,191, and the equity, or the retained interests, of the FL2 issuer. The FL2 senior notes bear interest at a weighted average rate equal to LIBOR plus 1.79%. The stated maturity of the FL2 notes is May 2031, unless redeemed or repaid prior thereto. Subject to certain conditions, beginning in April 2016 or upon defined tax events, the FL2 issuer may redeem the FL2 senior notes, in whole but not in part, at the direction of holders of FL2 junior notes that we hold.
On October 29, 2014, we closed a CMBS securitization transaction, or RAIT FL3, structured to be collateralized by $219,378 of floating rate commercial mortgage loans and participation interests, or the FL3 collateral, that we originated. The CMBS securitization transaction is intended to finance the FL3 collateral on a non-recourse basis. In connection with the CMBS securitization transaction, our subsidiaries made certain customary representations, warranties and covenants. RAIT FL3 does not have OC triggers or IC triggers.
On the closing date, our subsidiary, RAIT 2014-FL3 Trust, or the FL3 issuer, issued classes of investment grade senior notes, or the FL3 senior notes, with an aggregate principal balance of approximately $181,261 to investors, representing an advance rate of approximately 82.6%. A RAIT subsidiary received the unrated classes of junior notes, or the FL3 junior notes, including a class with an aggregate principal balance of $38,117, and the equity, or the retained interests, of the FL3 issuer. The FL3 senior notes bear interest at a weighted average rate equal to LIBOR plus 1.75%. The stated maturity of the FL3 notes is December 2031, unless redeemed or repaid prior thereto. Subject to certain conditions, beginning in October 2016 or upon defined tax events, the FL3 issuer may redeem the FL3 senior notes, in whole but not in part, at the direction of holders of FL3 junior notes that we hold.
Loans payable on real estate. As of December 31, 2014 and 2013, we had $641,874 and $171,244, respectively, of other indebtedness outstanding relating to loans payable on consolidated real estate. These loans are secured by specific consolidated real estate and commercial loans included in our consolidated balance sheets.
During the year ended December 31, 2014, we obtained or assumed 16 first mortgages on our investments in real estate from third party lenders that have a total aggregate principal balance of $409,776, maturity dates ranging from April 2016 to May 2040, and interest rates ranging from 3.4% and 5.6%, respectively. As a result of the T8 and T9 securitizations deconsolidation on December 19, 2014, our loans payable on real estate increased $64,343 in total aggregate principal balance as these mortgages were previously eliminated in consolidation. These loans payable on real estate have maturity dates ranging from September 2015 to April 2026 and have interest rates ranging from 5.0% to 10.0%.
During the year ended December 31, 2013, we obtained two first mortgages on our investments in real estate from third party lenders that have aggregate principal balances of $19,500 and $8,612, maturity dates of December 2023 and January 2021, and interest rates of 4.6% and 4.4%, respectively.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Maturity of Indebtedness
Generally, the majority of our indebtedness is payable in full upon the maturity or termination date of the underlying indebtedness. The following table displays the aggregate contractual maturities of our indebtedness by year:
(1) Includes $34,066 of our 7.0% convertible senior notes which are redeemable, at par at the option of the holder in April 2016, April 2021, and April 2026. Includes $141,750 of our 4.0% convertible senior notes which are redeemable, at par at the option of the holder in October 2018, October 2023, and October 2028.
NOTE 7: DERIVATIVE FINANCIAL INSTRUMENTS
We may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with our borrowings. The principal objective of such arrangements is to minimize the risks and/or costs associated with our operating and financial structure as well as to hedge specific anticipated transactions. The counterparties to these contractual arrangements are major financial institutions with which we and our affiliates may also have other financial relationships. In the event of nonperformance by the counterparties, we are potentially exposed to credit loss. However, because of the high credit ratings of the counterparties, we do not anticipate that any of the counterparties will fail to meet their obligations.
Interest Rate Swaps
We have entered into various interest rate swap contracts to hedge interest rate exposure on floating rate indebtedness. We designate interest rate hedge agreements at inception and determine whether or not the interest rate hedge agreement is highly effective in offsetting interest rate fluctuations associated with the identified indebtedness. At designation, certain of these interest rate swaps had a fair value not equal to zero. However, we concluded, at designation, that these hedging arrangements were highly effective during their term using regression analysis and determined that the hypothetical derivative method would be used in measuring any ineffectiveness. At each reporting period, we update our regression analysis and, as of December 31, 2014, we concluded that these hedging arrangements were highly effective during their remaining term and used the hypothetical derivative method in measuring the ineffective portions of these hedging arrangements.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes the aggregate notional amount and estimated net fair value of our derivative instruments as of December 31, 2014 and December 31, 2013:
During 2015, interest rate swap agreements relating to RAIT I and RAIT II with a notional amount of $184,035 and a weighted average strike rate of 5.25% as of December 31, 2014, will terminate in accordance with their terms.
For interest rate swaps that are considered effective hedges, we reclassified realized losses of $40,274, $32,117 and $34,956 to earnings for the years ended December 31, 2014, 2013 and 2012, respectively. During 2015, we expect to reclassify realized losses of $15,949 to earnings. For the years ended December 31, 2014, 2013 and 2012, we had no unrealized gains to reclassify to earnings for interest rate swaps that are considered ineffective.
Effective interest rate swaps are reported in accumulated other comprehensive income and the fair value of these hedge agreements is included in other assets or derivative liabilities.
NOTE 8: FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair Value of Financial Instruments
FASB ASC Topic 825, “Financial Instruments” requires disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The fair value of investments in mortgages, loans, preferred equity interests, investments in securities, CDO notes payable, convertible senior notes, junior subordinated notes, warrants and investor SARs and derivative assets and liabilities is based on significant observable and unobservable inputs. The fair value of cash and cash equivalents, restricted cash, secured credit facilities, CMBS facilities and commercial mortgage facility approximates cost due to the nature of these instruments.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes the carrying amount and the fair value of our financial instruments as of December 31, 2014:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes the carrying amount and the fair value of our financial instruments as of December 31, 2013:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Fair Value Measurements
The following tables summarize information about our assets and liabilities measured at fair value on a recurring basis as of December 31, 2014, and indicate the fair value hierarchy of the valuation techniques utilized to determine such fair value:
(a) During the year ended December 31, 2014, there were no transfers between Level 1 and Level 2, as well as, there were no transfers into and out of Level 3.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following tables summarize information about our assets and liabilities measured at fair value on a recurring basis as of December 31, 2013, and indicate the fair value hierarchy of the valuation techniques utilized to determine such fair value:
(a) During the year ended December 31, 2013, there were no transfers between Level 1 and Level 2, as well as, there were no transfers into and out of Level 3.
When estimating the fair value of our Level 3 financial instruments, management uses various observable and unobservable inputs. These inputs include yields, credit spreads, duration, effective dollar prices and overall market conditions on not only the exact financial instrument for which management is estimating the fair value, but also financial instruments that are similar or issued by the same issuer when such inputs are unavailable. Generally, an increase in the yields, credit spreads or estimated duration will decrease the fair value of our financial instruments. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value, as determined by management, may fluctuate from period to period and any ultimate liquidation or sale of the investment may result in proceeds that may be significantly different than fair value. On December 19, 2014, our subsidiary assigned or delegated its rights and responsibilities as collateral manager for the T8 and T9 securitizations. As a result of the assignment and delegation, we determined that we are no longer the primary beneficiaries of T8 and T9 and deconsolidated the two securitizations. See Note 10 for additional disclosures pertaining to the deconsolidation. The weighted average effective dollar price of our TruPS and TruPS receivables as of December 31, 2013 was 75.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
For the fair value of our junior subordinated notes, at fair value, and warrant and investor SARs classified as Level 3 liabilities, we estimate the fair value of these financial instruments using significant unobservable inputs. For the junior subordinated notes, at fair value, we use a discounted cash flow model as the valuation technique and the significant unobservable inputs as of December 31, 2014 include discount rates ranging from 10.0% to 10.7%. For the warrants and investor SARs, we use a binomial model as the valuation technique and the significant unobservable inputs as of December 31, 2014 include 21.2% for the annual volatility of our common shares of beneficial interest over the term of the warrants and investor SARs, a five year estimated term, 12.5% interest rate on our unsecured debt issued that may be issued in satisfaction of the warrants and investor SARs, and 7.5% for the dividend rate and future dividend rate on our common shares of beneficial interest.
The following tables summarize additional information about assets and liabilities that are measured at fair value on a recurring basis for which we have utilized level 3 inputs to determine fair value for the year ended December 31, 2014:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following tables summarize additional information about assets and liabilities that are measured at fair value on a recurring basis for which we have utilized level 3 inputs to determine fair value for the year ended December 31, 2013:
Our non-recurring fair value measurements relate primarily to our commercial real estate loans that are considered impaired and for which we maintain an allowance for loss. In determining the allowance for losses, we estimate the fair value of the respective commercial real estate loan and compare that fair value to our total investment in the loan. When estimating the fair value of the commercial real estate loan, management uses discounted cash flow analyses and capitalization rates on the underlying property’s net operating income. The discounted cash flow analyses and capitalization rates are based on market information and comparable sales of similar properties.
The following tables summarize the valuation technique and the level of the fair value hierarchy for financial instruments that are not recorded at fair value in the accompanying consolidated balance sheets but for
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
which fair value is required to be disclosed. The fair value of cash and cash equivalents, restricted cash, secured credit facilities, CMBS facilities and commercial mortgage facility approximates cost due to the nature of these instruments and are not included in the tables below.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Change in Fair Value of Financial Instruments
The following table summarizes realized and unrealized gains and losses on assets and liabilities for which we elected the fair value option within FASB ASC Topic 825, “Financial Instruments” as reported in change in fair value of financial instruments in the accompanying consolidated statements of operations:
The changes in the fair value for the trading securities and security-related receivables, CDO notes payable, and other liabilities for which the fair value option was elected for the years ended December 31, 2014, 2013 and 2012 was primarily attributable to changes in instrument specific credit risks. The changes in the fair value of the CDO notes payable for which the fair value option was elected was due to repayments at par because of OC failures when the CDO notes have a fair value of less than par. The changes in the fair value of derivatives for which the fair value option was elected for the years ended December 31, 2014, 2013 and 2012 was mainly due to changes in interest rates.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 9: VARIABLE INTEREST ENTITIES
The determination of when to consolidate a VIE is based on the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance together with either the obligation to absorb losses or the right to receive benefits that could be significant to the VIE. We evaluated our investments and determined as of December 31, 2014 our consolidated VIEs were: RAIT I, RAIT II, Independence Realty Trust, Inc., Willow Grove and Cherry Hill (RAIT VIE Properties). The following table presents the assets and liabilities of our consolidated VIEs as of each respective date.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The assets of the VIEs can only be used to settle obligations of the VIEs and are not available to our creditors. Certain amounts included in the table above are eliminated upon consolidation with our other subsidiaries that maintain investments in the debt or equity securities issued by these entities. We do not have any contractual obligation to provide the VIEs listed above with any financial support. We have not and do not intend to provide financial support to these VIEs that we were not previously contractually required to provide.
NOTE 10: DECONSOLIDATION OF TABERNA VIE’S
On December 19, 2014, our subsidiary, Taberna Capital Management, LLC, or TCM, completed the assignment, or the T8 Assignment, and delegation, or the T9 Delegation, of TCM’s rights and responsibilities as collateral manager under the collateral management agreements for T8 and T9, respectively, to an unaffiliated party. As a result of the T8 Assignment and T9 Delegation, we recorded a gain of $4,549, net of $1,821 severance and other costs in our accompanying consolidated statements of operations. T8 and T9 are two securitizations previously consolidated by us. In addition as a result of the T8 Assignment and the T9 Delegation, we determined that T8 and T9 no longer satisfied the requirements to remain variable interest entities consolidated by us, and we deconsolidated T8 and T9. All assets deconsolidated and related liabilities were removed from our consolidated balance sheet on the date of deconsolidation and we recorded a loss on deconsolidation of $215,804 in our accompanying consolidated statements of operations.
The following tables summarize the balance sheet and statement of operations effects of the deconsolidated VIEs as of the date of the deconsolidation on December 19, 2014 and for the years ended December 31, 2014, 2013 and 2012. The statements of operations components for the respective VIEs were included in our consolidated statement of operations through December 19, 2014 whereas the assets and liabilities have been removed from our consolidated balance sheet as of December 19, 2014. The following table also describes the non-cash changes in our assets and liabilities during 2014 caused by the deconsolidation of these VIEs.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 11: SERIES D PREFERRED SHARES
On October 1, 2012, we entered into a Securities Purchase Agreement, or the purchase agreement, with ARS VI Investor I, LLC, or the investor, an affiliate of Almanac Realty Investors, LLC, or Almanac. Under the purchase agreement, we were required to issue and sell to the investor on a private placement basis from time to time in a period up to two years, and the investor was obligated to purchase from us, for an aggregate purchase price of $100,000, or the total commitment, the following securities, in the aggregate: (i) 4,000,000 Series D Cumulative Redeemable Preferred Shares of Beneficial Interest, par value $0.01 per share, of RAIT, or the Series D preferred shares, (ii) common share purchase warrants, or the warrants, initially exercisable for 9,931,000 of our common shares, or the common shares, and (iii) common share appreciation rights, or the investor SARs initially with respect to up to 6,735,667 common shares. We are not obligated to issue any common shares upon exercise of the warrants if the issuance of such common shares would exceed that number of common shares which we may issue upon exercise of the warrants without requiring shareholder approval under the NYSE listing requirements. We will pay cash or issue a 180 day unsecured promissory note, or a combination of the foregoing, equal to the market value of any common shares it cannot issue as a result of this prohibition. The investor SARs are settled only in cash and not in common shares. These securities are issuable on a pro rata basis based on the percentage of the total commitment drawn down at the relevant closing under the purchase agreement. We used the proceeds received under the purchase agreement to fund our loan origination and investment activities, including CMBS and bridge lending.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
We are subject to certain covenants under the purchase agreement in defined periods when the investor and its permitted transferees have defined holdings of the securities issuable under the purchase agreement. These covenants include defined leverage limits on defined financing assets. In addition, commencing on the first draw down and for so long as the investor and its affiliates who are permitted transferees continue to own at least 10% of the outstanding Series D preferred shares or warrants and common shares issued upon exercise of the warrants representing at least 5% of the aggregate amount of common shares issuable upon exercise of the warrants actually issued, the board will include one person designated by the investor. This right is held only by the investor and is not transferable by it. The investor designated Andrew M. Silberstein to serve on our board. The covenants also include our agreement not to declare any extraordinary dividend except as otherwise required for us to continue to satisfy the requirements for qualification and taxation as a REIT. An extraordinary dividend is defined as any dividend or other distribution (a) on common shares other than regular quarterly dividends on the common shares or (b) on our preferred shares other than in respect of dividends accrued in accordance with the terms expressly applicable to the preferred shares.
As of December 31, 2014, the following RAIT securities have been issued pursuant to the purchase agreement, in the aggregate: (i) 4,000,000 Series D Preferred Shares; (ii) warrants exercisable for 9,931,000 common shares (which have subsequently adjusted to 10,479,889 shares as of the date of the filing of this report); and (iii) investor SARs exercisable with respect to 6,735,667 common shares (which have subsequently adjusted to 7,107,948.84 shares as of the date of the filing of this report). The number of common shares underlying the warrants and investor SARs and relevant exercise price are subject to further adjustment in defined circumstances. At December 31, 2014, the aggregate purchase price paid for the securities issued is $100,000.
The Series D preferred shares bear a cash coupon rate initially of 7.5%, increasing to 8.5% on October 1, 2015 and increasing on October 1, 2018 and each anniversary thereafter by 50 basis points. They rank on parity with our existing outstanding preferred shares. Their liquidation preference is equal to $26.25 per share for five years and $25.00 per share thereafter. In defined circumstances, the Series D preferred shares are exchangeable for Series E Cumulative Redeemable Preferred Shares of Beneficial Interest, par value $0.01 per share, of RAIT, or the Series E preferred shares. The rights and preferences of the Series E preferred shares will be similar to those of the Series D preferred shares except, among other differences, the Series E preferred shares will be mandatorily redeemable upon a change of control, will have no put right, will not have the right to designate one trustee to the board except in the event of a payment default under the Series E preferred shares and have defined registration rights.
We have the right in limited circumstances to redeem the Series D preferred shares prior to the October 1, 2017 at a redemption price of $26.25 per share. After October 1, 2017, we may redeem all or a portion of the Series D preferred shares at any time at a redemption price of $25.00 per share. We may satisfy all or a portion of the redemption price for an optional redemption with an unsecured promissory note, or a preferred note, with a maturity date of 180 days from the applicable redemption date. From and after the occurrence of a defined mandatory redemption triggering event, each holder of Series D preferred shares may elect to have all or a portion of such holder’s Series D preferred shares redeemed by us at a redemption price of $26.25 per share prior to October 1, 2017 and $25.00 per share on or after October 1, 2017. We may satisfy all or a portion of the redemption price for certain of the mandatory redemption triggering events with a preferred note. We must redeem the Series D preferred shares with up to $50,000 of net proceeds received from the loans and other investments made with proceeds of the sales under the investor purchase agreement from and after October 1, 2017 in the case of net proceeds from loans and investments other than CMBS loans and from and after October 1, 2019 in the case of net proceeds from CMBS loans, in each case, at a redemption price of $25.00 per
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
share. All amounts paid in connection with liquidation or for all redemptions of the Series D preferred shares must also include all accumulated and unpaid dividends to, but excluding, the redemption date.
The warrants had an initial strike price of $6.00 per common share, subject to adjustment. As of the filing of this report, the strike price has adjusted to $5.69. The warrants expire on October 1, 2027. The investor has certain rights to put the warrants to us at a price of $1.23 per warrant beginning on October 1, 2017, or in defined circumstances, increasing to $1.60 on October 1, 2018 and further increasing to $1.99 on October 1, 2019 and thereafter. From and after the earlier of (i) October 1, 2017 or (ii) the occurrence of a defined mandatory redemption triggering event on the Series D preferred shares, the holders of warrants may put their warrants to us for a put redemption price equal to $1.23 per common share until October 1, 2018 and increasing to set amounts at set intervals thereafter. The put redemption price must be payable in cash or (except in the event of a put for certain of the mandatory redemption triggering events) by way of a three year unsecured promissory note, or a combination of the foregoing.
The investor SARs have a strike price of $6.00, subject to adjustment. As of the filing of this report, the strike price has adjusted to $5.69. The investor SARs will be exercisable from October 1, 2014 until October 1, 2027 or in defined circumstances. From and after the earlier of October 1, 2017 or defined circumstances, the investor SARs may be put to us for $1.23 per investor SAR prior to October 1, 2018, increasing to $1.60 on October 1, 2018 and further increasing to $1.99 on October 1, 2019 and thereafter. The investor SARs are callable at our option beginning on October 1, 2014 at a price of $5.00 per investor SAR, increasing to set amounts at set intervals thereafter. We may settle the call in cash or by way of a one year unsecured promissory note, or with a combination of the foregoing. From and after the earlier of (i) October 1, 2017 or (ii) the occurrence of a defined mandatory redemption triggering event on the Series D preferred shares, the holders of investor SARs may put their investor SARs to us for a put redemption price equal to $1.23 per common share prior to October 1, 2018 and increasing to set amounts at set intervals thereafter. We may settle the exercise of the put in cash or, in the event of certain defined mandatory redemption triggering events, by way of a three year unsecured promissory note, or a combination of the foregoing.
Accounting Treatment
The accounting treatment for the Series D Preferred Shares differs from the accounting treatment of our other preferred share instruments. Based on accounting standards, the Series D Preferred Shares were determined not to be classified as equity as they contain redemption features that are not solely in our control. In addition, the Series D Preferred Shares were considered not to be classified as a liability because they are not mandatorily redeemable. As a result, the Series D Preferred shares are presented in the mezzanine section of the balance sheet, between liabilities and equity. Any costs and the initial value of the warrants and investor SARs are recorded as a discount on the Series D Preferred Shares and that discount will be amortized to earnings over the respective term.
The warrants and investor SARs were both determined to be classified as liabilities and had a combined fair value of $35,384, as of December 31, 2014. The warrants contain a put feature which can only be settled by paying cash or issuing a note (i.e. transferring assets). This put feature is a distinguishing characteristic for liability classification. The investor SARs, according to their terms, can only be settled in cash or the issuance of a note payable to the investor. This requirement for cash settlement is also a distinguishing characteristic for liability classification. As a result, the initial fair value of the warrants and investor SARs are recorded as a liability and re-measured at each reporting period until the warrants and investor SARs are settled. Changes in fair value will be recorded in earnings as a component of the change in fair value of financial instruments in the consolidated statement of operations.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
During the period from the effective date of the purchase agreement through December 31, 2014, we sold the following securities to the investor for an aggregate purchase price of $100.0 million: (i) 4,000,000 Series D Preferred Shares, (ii) warrants exercisable for 9,931,000 common shares (which have subsequently adjusted to 10,479,889 shares as of the date of filing this report); and (iii) investor SARs exercisable with respect to 6,735,667 common shares (which have subsequently adjusted to 7,107,948.84 shares as of the date of filing this report). The following table summarizes the sales activity of the Series D Preferred Shares from the effective date of the agreement through December 31, 2014:
NOTE 12: SHAREHOLDERS’ EQUITY
Preferred Shares
In 2004, we issued 2,760,000 shares of our 7.75% Series A Cumulative Redeemable Preferred Shares of Beneficial Interest, or Series A Preferred Shares. The Series A Preferred Shares accrue cumulative cash dividends at a rate of 7.75% per year of the $25.00 liquidation preference, equivalent to $1.9375 per year per share. Dividends are payable quarterly in arrears at the end of each March, June, September and December. The Series A Preferred Shares have no maturity date and we are not required to redeem the Series A Preferred Shares at any time. On or after March 19, 2009, we may, at our option, redeem the Series A Preferred Shares, in whole or part, at any time and from time to time, for cash at $25.00 per share, plus accrued and unpaid dividends, if any, to the redemption date.
In 2004, we issued 2,258,300 shares of our 8.375% Series B Cumulative Redeemable Preferred Shares of Beneficial Interest, or Series B Preferred Shares. The Series B Preferred Shares accrue cumulative cash dividends at a rate of 8.375% per year of the $25.00 liquidation preference, equivalent to $2.09375 per year per share. Dividends are payable quarterly in arrears at the end of each March, June, September and December. The Series B Preferred Shares have no maturity date and we are not required to redeem the Series B Preferred Shares at any time. On or after October 5, 2009, we may, at our option, redeem the Series B Preferred Shares, in whole or part, at any time and from time to time, for cash at $25.00 per share, plus accrued and unpaid dividends, if any, to the redemption date.
On July 5, 2007, we issued 1,600,000 shares of our 8.875% Series C Cumulative Redeemable Preferred Shares of Beneficial Interest, or the Series C Preferred Shares, in a public offering at an offering price of $25.00 per share. The Series C Preferred Shares accrue cumulative cash dividends at a rate of 8.875% per year of the $25.00 liquidation preference and are paid on a quarterly basis. The Series C Preferred Shares have no maturity date and we are not required to redeem the Series C Preferred Shares at any time. We may not redeem the Series C Preferred Shares before July 5, 2012, except for the special optional redemption to preserve our tax qualification as a REIT. On or after July 5, 2012, we may, at our option, redeem the Series C Preferred Shares, in whole or part, at any time and from time to time, for cash at $25.00 per share, plus accrued and unpaid dividends, if any, to the redemption date.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
At Market Issuance Sales Agreement (ATM)
On June 13, 2014, we entered into an At Market Issuance Sales Agreement, or the 2014 Preferred ATM agreement, with MLV & Co. LLC, or MLV, providing that, from time to time during the term of the 2014 Preferred ATM agreement, on the terms and subject to the conditions set forth therein, we may issue and sell through MLV, up to $150,000 aggregate amount of preferred shares. With respect to each series of preferred shares, the maximum amount issuable is as follows: 4,000,000 Series A Preferred Shares, 1,000,000 Series B Preferred Shares, and 1,000,000 Series C Preferred Shares. Unless the 2014 Preferred ATM agreement is earlier terminated by MLV or us, the 2014 Preferred ATM agreement automatically terminates upon the issuance and sale of all of the Series A Preferred Shares, Series B Preferred Shares, and Series C Preferred Shares subject to the 2014 Preferred ATM agreement. During the period from the effective date of the 2014 Preferred ATM agreement through December 31, 2014, pursuant to the 2014 Preferred ATM agreement, we issued a total of 706,281 Series A Preferred Shares at a weighted-average price of $23.91 and we received $16,447 of net proceeds. We did not issue any Series B Preferred Shares or Series C Preferred Shares during the year ended December 31, 2014. As of December 31, 2014, 3,293,719, 1,000,000, and 1,000,000 Series A Preferred Shares, Series B Preferred Shares, and Series C Preferred Shares, respectively, remain available for issuance under the 2014 Preferred ATM agreement.
On June 13, 2014, we amended our declaration of trust to reclassify and designate an additional 3,309,288 of our unclassified preferred shares of beneficial interest, par value $0.01 per share, as 3,309,288 Series A Preferred Shares. This reclassification increased the number of shares classified as Series A Preferred Shares from 4,760,000 shares to 8,069,288 shares. This reclassification decreased the number of unclassified preferred shares from 4,340,000 shares to 1,030,712 shares. We engaged in this reclassification in order to authorize additional Series A Preferred Shares issuable under the 2014 Preferred ATM Agreement.
On May 21, 2012, we entered into an At Market Issuance Sales Agreement, or the 2012 Preferred ATM agreement, with MLV & Co. LLC, or MLV, providing that, from time to time during the term of the 2012 Preferred ATM agreement, on the terms and subject to the conditions set forth therein, we may issue and sell through MLV, up to 2,000,000 Series A Preferred Shares, up to 2,000,000 Series B Preferred Shares, and up to 2,000,000 Series C Preferred Shares. Unless the 2012 Preferred ATM agreement is earlier terminated by MLV or us, the 2012 Preferred ATM agreement automatically terminates upon the issuance and sale of all of the Series A Preferred Shares, Series B Preferred Shares, and Series C Preferred Shares subject to the 2012 Preferred ATM agreement. During the year ended December 31, 2013, pursuant to the 2012 Preferred ATM agreement we issued a total of 945,000 Series A Preferred Shares at a weighted-average price of $23.92 per share and we received $21,829 of net proceeds. We did not issue any Series B Preferred Shares or Series C Preferred Shares during the year ended December 31, 2013. On January 10, 2014, we agreed with MLV to terminate the 2012 Preferred ATM agreement. We did not incur any termination penalties as a result of the termination of the 2012 Preferred ATM agreement. As of the termination date, pursuant to the 2012 Preferred ATM agreement, we had sold 1,309,288 Series A Preferred Shares and 690,712 Series A Preferred Shares remained unsold, we had sold 30,165 Series B Preferred Shares and 1,969,835 Series B Preferred Shares remained unsold and we had sold 40,100 Series C Preferred Shares and 1,959,900 Series C Preferred Shares remained unsold.
Common Shares
Share Issuances:
Dividend reinvestment and share purchase plan (DRSPP). We have a dividend reinvestment and share purchase plan, or DRSPP, under which we registered and reserved for issuance, in the aggregate,
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
10,500,000 common shares. During the year ended December 31, 2014, we issued a total of 7,281 common shares pursuant to the DRSPP at a weighted-average price of $7.94 per share and we received $58 of net proceeds. As of December 31, 2014, 7,770,539 common shares, in the aggregate, remain available for issuance under the DRSPP.
Capital on Demand™ Sales Agreement (COD). On November 21, 2012, we entered into a Capital on Demand™ Sales Agreement, or the COD sales agreement, with JonesTrading Institutional Services LLC, or JonesTrading, pursuant to which we may issue and sell up to 10,000,000 of our common shares from time to time through JonesTrading acting as agent and/or principal, subject to the terms and conditions of the COD sales agreement. Unless the COD sales agreement is earlier terminated by JonesTrading or us, the COD sales agreement automatically terminates upon the issuance and sale of all of the common shares subject to the COD sales agreement. During the period from the effective date of the COD sales agreement through December 31, 2014, we issued a total of 2,081,081 common shares pursuant to this agreement at a weighted-average price of $7.96 per share and we received $16,139 of net proceeds. As of December 31, 2014, 7,918,919 common shares, in the aggregate, remain available for issuance under the COD sales agreement.
Common share public offerings. In January 2014, we issued 10,000,000 common shares in an underwritten public offering. The public offering price was $8.52 per share and we received $82,570 of proceeds.
In April 2013, we issued 9,200,000 common shares in an underwritten public offering. The public offering price was $7.87 per share and we received $70,196 of proceeds.
In January 2013 in connection with an underwritten public offering in the fourth quarter of 2012, the underwriters exercised their overallotment option to purchase 1,350,000 additional common shares and we received $7,358 of proceeds.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Dividends
The following tables summarize the dividends we declared or paid during the years ended December 31, 2014 and 2013:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
On February 10, 2015, our board of trustees declared a first quarter 2015 cash dividend of $0.484375 per share on our 7.75% Series A Preferred Shares, $0.5234375 per share on our 8.375% Series B Preferred Shares and $0.5546875 per share on our 8.875% Series C Preferred Shares, and $0.4687500 per share on our Series D Preferred Shares. The dividends will be paid on March 31, 2015 to holders of record on March 2, 2015.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
Accumulated Other Comprehensive Income (Loss)
The following table summarizes the changes in accumulated other comprehensive loss by component for the year ended December 31, 2014:
Noncontrolling Interests
On August 16, 2013, our subsidiary, Independence Realty Trust, Inc., or IRT, completed an underwritten public offering of 4,000,000 shares of IRT common stock at a price of $8.50 per share and received total gross proceeds of $34,000. All of the shares were offered by IRT. The net proceeds of the offering were $31,096 after deducting underwriting discounts and commissions and offering expenses. During the year ended December 31, 2013, IRT used a portion of net proceeds of its offering to redeem all of its and its operating partnership’s outstanding preferred securities, including $3,500 of series B units of IRT’s operating partnership held by us. We held 5,764,900 shares of IRT common stock representing 59.7% of the outstanding shares of IRT common stock as of December 31, 2013. We consolidated IRT in our financial results as of December 31, 2013. During the year ended December 31, 2013, we charged off $3,885 of organizational and offering expenses, which is included in Other income (expense) on the accompanying consolidated statements of operations, we incurred with the non-traded offering of IRT prior to its public offering in August 2013.
On January 29, 2014, IRT completed an underwritten public offering selling 8,050,000 shares of IRT common stock for $8.30 per share raising net proceeds of $62,718. We purchased 1,204,819 shares of common stock in the offering, at the public offering price, for which no underwriting discounts and commissions were paid to the underwriters. On July 21, 2014, IRT completed an underwritten public offering selling 8,050,000 shares of IRT common stock for $9.50 per share raising net proceeds of $72,002. We purchased 300,000 shares of common stock in the offering, at the public offering price, for which no underwriting discounts and commissions were paid to the underwriters. On November 25, 2014, IRT completed an underwritten public offering selling 6,000,000 shares of IRT common stock for $9.60 per share raising estimated net proceeds of $54,704. As of December 31, 2014 and 2013, we held 7,269,719 and 5,764,900 shares, respectively, of IRT common stock representing 22.9% and 59.7%, respectively, of the outstanding shares of IRT common stock. As of December 31, 2014, we continue to consolidate IRT, as it is a VIE and we are the primary beneficiary, in our financial results. See Note 9 for additional disclosures pertaining to VIEs.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 13: SHARE-BASED COMPENSATION AND EMPLOYEE BENEFITS
We maintain the RAIT Financial Trust 2012 Incentive Award Plan (the “Incentive Award Plan”). The maximum aggregate number of common shares that may be issued pursuant to the Incentive Award Plan is 4,000,000. As of December 31, 2014, 2,314,235 common shares are available for issuance under this plan.
On February 10, 2015, the compensation committee awarded 48,405 common share awards, valued at $350 using our closing stock price of $7.23, to the board’s non-management trustees. These awards vested immediately. On February 10, 2015, the compensation committee awarded 338,500 restricted common share awards, valued at $2,447 using our closing stock price of $7.23, to our executive officers and non-executive officer employees. These awards generally vest over three-year periods.
On January 29, 2014, the compensation committee awarded 42,217 common share awards, valued at $350 using our closing stock price of $8.29, to the board’s non-management trustees. These awards vested immediately. On January 29, 2014, the compensation committee awarded 293,700 restricted common share awards, valued at $2,435 using our closing stock price of $8.29, to our executive officers and non-executive officer employees. These awards generally vest over three-year periods.
On July 30, 2013, the compensation committee awarded 6,578 restricted common share awards, valued at $50 using our closing stock price of $7.60, to one of the board’s non-management trustees. Three quarters of this award vested immediately and the remainder vested three months after the award date.
On January 29, 2013, the compensation committee awarded 43,536 restricted common share awards, valued at $300 using our closing stock price of $6.89, to six of the board’s non-management trustees. One quarter of these awards vested immediately and the remainder vested over a nine-month period. On January 29, 2013, the compensation committee awarded 369,500 restricted common share awards, valued at $2,577 using our closing stock price of $6.89, to our executive officers and non-executive officer employees. These awards generally vest over three-year periods.
During the years ended December 31, 2014 and 2013, there were no phantom units redeemed for common shares and during the year ended December 31, 2012 there were 220,823 phantom units redeemed for common shares. There were no phantom units forfeited during the years ended December 31, 2014, 2013 and 2012. As of December 31, 2014, there were no phantom units outstanding and as of December 31, 2013 there were 195,943 phantom units outstanding. As of December 31, 2014 and 2013, there was no deferred compensation cost relating to unvested awards and there was no remaining vesting period.
On February 10, 2015, the compensation committee awarded 1,177,500 SARs, valued at $1,126 based on a Black-Scholes option pricing model at the date of grant, to our executive officers and non-executive officer employees. The SARs vest over a three-year period and may be exercised between the date of vesting and February 10, 2020, the expiration date of the SARs.
On January 29, 2014, the compensation committee awarded 895,100 SARs, valued at $1,182 based on a Black-Scholes option pricing model at the date of grant, to our executive officers and non-executive officer employees. The SARs vest over a three-year period and may be exercised between the date of vesting and January 29, 2019, the expiration date of the SARs.
On January 29, 2013, the compensation committee awarded 1,127,500 SARs, valued at $1,332 based on a Black-Scholes option pricing model at the date of grant, to our executive officers and non-executive officer
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
employees. The SARs vest over a three-year period and may be exercised between the date of vesting and January 29, 2018, the expiration date of the SARs.
On January 24, 2012, the compensation committee awarded 2,172,000 SARs, valued at $6,091 based on a Black-Scholes option pricing model at the date of grant, to our executive officers and non-executive officer employees. The SARs vest over a three-year period and may be exercised between the date of vesting and January 24, 2017, the expiration date of the SARs.
A summary of the SARs activity of the Incentive Award Plan is presented below.
As of December 31, 2014, our closing common stock price was $7.67, which exceeded certain of the exercise prices of the SARs. The total intrinsic value of these SARs outstanding and exercisable at December 31, 2014 was $885. As of December 31, 2014, the deferred compensation cost relating to unvested SARs was $1,068.
Our assumptions used in computing the fair value of the SARs at the dates of their respective awards, using the Black-Scholes Option Pricing Model, were as follows:
The stock price used was based on the closing price on the date of the award. The strike price used is the strike price in the respective SAR awards, which was based on the closing price on the date of the award. The risk free rate represents the U.S. Treasury rate for the 5 year term of the SARs. The dividend yield was the dividend yield at the time of the SAR awards. In estimating volatility, management used recent historical volatility as a proxy for expected future volatility.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following table summarizes information about the SARs outstanding and exercisable as of December 31, 2014:
A summary of the restricted common share awards as of December 31, 2014 and 2013 of the Incentive Award Plan is presented below.
As of December 31, 2014, the deferred compensation cost relating to unvested restricted common share awards was $2,097. The estimated fair value of restricted common share awards vested during 2014 was $1,201.
Stock Options
We have granted to our officers, trustees and employees options to acquire common shares. The vesting period is determined by the compensation committee and the option term is generally ten years after the date of grant. As of December 31, 2014, there were no options outstanding and as of December 31, 2013, there were 5,749 options outstanding.
A summary of the options activity of the Incentive Award Plan is presented below.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
We did not grant options during the three years ended December 31, 2014.
During the years ended December 31, 2014, 2013 and 2012, we recorded compensation expense of $4,407, $3,441, and $2,208, respectively, associated with our stock based compensation.
Independence Realty Trust, Inc.
On February 18, 2015, the compensation committee of IRT awarded 100,000 shares of IRT restricted common stock, valued at $935 using IRT’s closing stock price of $9.35, to persons affiliated with IRT’s advisor, including their executive officers. These awards generally vest over three-year periods.
On January 31, 2014, the compensation committee of IRT awarded 40,000 shares of IRT restricted common stock, valued at $328 using IRT’s closing stock price of $8.20, to persons affiliated with IRT’s advisor, including their executive officers. These awards generally vest over three-year periods.
On February 18, 2014, the compensation committee of IRT awarded 300,000 stock appreciation rights, or IRT SARs, valued at $220 based on a Black-Scholes option pricing model at the date of grant, to persons affiliated with IRT’s advisor, including their executive officers. The IRT SARs vest over a three-year period and may be exercised between the date of vesting and February 18, 2020, the expiration date of the IRT SARs.
On January 31, 2014, the compensation committee of IRT awarded 80,000 stock appreciation rights, or IRT SARs, valued at $49 based on a Black-Scholes option pricing model at the date of grant, to persons affiliated with IRT’s advisor, including their executive officers. The IRT SARs vest over a three-year period and may be exercised between the date of vesting and January 31, 2019, the expiration date of the IRT SARs.
Employee Benefits
401(k) Profit Sharing Plan
We maintain a 401(k) profit sharing plan (the RAIT 401(k) Plan) for the benefit of our eligible employees. The RAIT 401(k) Plan offers eligible employees the opportunity to make long-term investments on a regular basis through salary contributions, which are supplemented by our matching cash contributions and potential profit sharing payments. We provide a cash match of the employee contributions up to 4% of employee compensation, which is capped at certain IRS limits, and may pay an additional 2% of eligible compensation as discretionary cash profit sharing payments. Any matching contribution made by RAIT pursuant to the RAIT 401(k) Plan vests 33% per year of service.
During the years ended December 31, 2014, 2013 and 2012, we recorded $551, $435, and $478 of contributions which is included in compensation expense on the accompanying consolidated statements of operations. During the years ended December 31, 2014, 2013, and 2012, we did not make any discretionary cash profit sharing contributions.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 14: EARNINGS (LOSS) PER SHARE
The following table presents a reconciliation of basic and diluted earnings (loss) per share for the three years ended December 31, 2014:
For the years ended December 31, 2014, 2013 and 2012, convertible senior notes, unvested restricted common share awards, warrants and investor SARs, SARs and stock options issued to employees convertible into 31,816,146, 18,026,169, and 22,282,205, common shares, respectively, were excluded from the earnings (loss) per share computations because their effect would have been anti-dilutive.
NOTE 15: INCOME TAXES
RAIT, Taberna and IRT have elected to be taxed as REITs under Sections 856 through 860 of the Internal Revenue Code. To maintain qualification as a REIT, we must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our ordinary taxable income to shareholders. We generally will not be subject to U.S. federal income tax on taxable income that is distributed to our shareholders. If RAIT, Taberna, or IRT fails to qualify as a REIT in any taxable year, we will then be subject to U.S. federal income taxes on our taxable income at regular corporate rates, and we will not be permitted to qualify for treatment as a REIT for U.S. federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service grants relief under certain statutory provisions. Such an event could materially adversely affect our net income and cash available for dividends to shareholders. However, we believe that each of RAIT, Taberna and IRT will be organized and operated in such a manner as to qualify for treatment as a REIT, and intend to operate in the foreseeable future in a manner so that each will qualify as a REIT. We may be subject to certain state and local taxes.
Our TRS entities generate taxable revenue from fees for services provided to securitizations. Some of these fees paid to the TRS entities are capitalized as deferred costs by the securitizations. In consolidation, these fees are eliminated when the securitization is included in the consolidated group. Additionally, our TRS entities generate taxable revenue from advisory fees for services provided to IRT. In consolidation, these advisory fees
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
are eliminated as IRT is included in the consolidated group. Nonetheless, all income taxes are expensed and are paid by the TRSs in the year in which the revenue is received. These income taxes are not eliminated when the related revenue is eliminated in consolidation.
The components of the provision for income taxes as it relates to our taxable income from domestic TRSs during the years ended December 31, 2014, 2013 and 2012 includes the effects of our performance of a portion of TRS services in a foreign jurisdiction that does not incur income taxes.
Certain TRS entities are domiciled in the Cayman Islands and, accordingly, taxable income generated by these entities may not be subject to local income taxation, but generally will be included in our income on a current basis as SubPart F income, whether or not distributed. Upon distribution of any previously included SubPart F income by these entities, no incremental U.S. federal, state, or local income taxes would be payable by us. Accordingly, no provision for income taxes has been recorded for these foreign TRS entities for the years ended December 31, 2014, 2013 and 2012.
The components of the income tax benefit (provision) as it relates to our taxable income (loss) from domestic and foreign TRSs during the years ended December 31, 2014, 2013 and 2012 were as follows:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
A reconciliation of the income tax benefit (provision) based upon the statutory tax rates to the effective rates of our taxable REIT subsidiaries is as follows for the years ended December 31, 2014, 2013 and 2012:
Significant components of our deferred tax assets (liabilities), at our TRSs, are as follows as of December 31, 2014 and 2013:
As of December 31, 2014, we had $32,490 of federal net operating losses, $39,042 of state net operating losses, no foreign net operating losses and no capital losses. The federal net operating losses will begin to expire in 2028, the state net operating losses will begin to expire in 2017. We have concluded that it is not more likely than not that $11,747 of federal net operating losses and $25,088 of state net operating losses will be utilized during their respective carry forward periods and, as such, we have established a valuation allowance against these deferred tax assets.
The accounting guidance for income taxes clarifies the accounting for uncertainty in income taxes, and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The guidance also provides rules on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
have no uncertain tax positions for the years ending December 31, 2014, 2013, 2012 and 2011. Income tax returns are filed in multiple jurisdictions and are subject to examination by taxing authorities. We have open tax years from 2010 through 2014 with various jurisdictions. These open years contain matters that could be subject to differing interpretations of applicable tax laws and regulations.
NOTE 16: RELATED PARTY TRANSACTIONS
In the ordinary course of our business operations, we have ongoing relationships and have engaged in transactions with the related entities described below. All of these relationships and transactions were approved or ratified by our audit committee as being on terms comparable to those available on an arm’s-length basis from an unaffiliated third party or otherwise not creating a conflict of interest.
Andrew M. Silberstein serves as a trustee on our board of trustees, as designated pursuant to the purchase agreement with ARS VI Investor I, LLC. Mr. Silberstein is an equity owner of Almanac and an officer of the investor and holds indirect equity interests in the investor. The transactions pursuant to the purchase agreement are described above in Note 11. Also, Almanac receives fees in connection with its investments made pursuant to the purchase agreement. In addition, until December 19, 2014, TCM received fees for managing T1 which was collateralized, in part, by $25,000 of TruPS issued by Advance Realty Group, or ARG. An affiliate of Almanac owns an interest in ARG and Almanac receives fees in connection with this interest. As of December 19, 2014, TCM delegated its collateral management rights to an unaffiliated third party. As a result, we do not expect to treat transactions arising out of T1’s interest in ARG as related party transactions after December 19, 2014.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 17: SUPPLEMENTAL DISCLOSURE TO STATEMENT OF CASH FLOWS
The following are supplemental disclosures to the statements of cash flows for the years ended December 31, 2014, 2013 and 2012:
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 18: QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table summarizes our quarterly financial data which, in the opinion of management, reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of our results of operations:
(a) The summation of quarterly per share amounts do not equal the full year amounts.
NOTE 19: SEGMENT REPORTING
As a group, our executive officers act as the Chief Operating Decision Maker (“CODM”). The CODM reviews operating results of our reportable segments to make decisions about investments and resources and to assess performance for each of these reportable segments. We conduct our business through the following reportable segments:
•
Our real estate lending, owning and managing segment concentrates on lending, owning and managing commercial real estate assets throughout the United States. The form of our investment may range from first mortgage loans to equity ownership of a commercial real estate property. We manage our investments in-house through our asset management and property management professionals.
•
Our Independence Realty Trust (IRT) segment concentrates on the ownership of apartment properties in opportunistic markets throughout the United States. As of December 31, 2014, IRT owns properties totaling $689.1 million in gross real estate investments, before accumulated depreciation.
•
Our Taberna Securitization segment includes the ownership and management of three real estate trust preferred securitizations, two of which we consolidate. Up to December 19, 2014, we managed these securitizations and received fees for services provided. On December 19, 2014, we sold these remaining collateral management contracts and deconsolidated the securitizations from our financial statements.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
The following tables present segment reporting:
(a) The transactions that occur between the reportable segments include advisory and property management services, as well as, providing commercial mortgages on our owned real estate.
We have no single customer that accounts for 10% or more of revenue.
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
NOTE 20: OTHER DISCLOSURES
Commitments and Contingencies
Unfunded Loan Commitments
Certain of our commercial mortgages and mezzanine loan agreements contain provisions whereby we are required to advance additional funds to our borrowers for capital improvements and upon the achievement of certain property operating hurdles. As of December 31, 2014, our incremental loan commitments were $14,613, which will be funded from either restricted cash held on deposit or revolving debt capacity dedicated for these purposes.
Employment Agreements
We are party to employment agreements with certain executives that provide for compensation and certain other benefits. The agreements also provide for severance payments under certain circumstances.
Litigation
We are involved from time to time in litigation on various matters, including disputes with tenants of owned properties, disputes arising out of agreements to purchase or sell properties and disputes arising out of our loan portfolio. Given the nature of our business activities, these lawsuits are considered routine to the conduct of our business. The result of any particular lawsuit cannot be predicted, because of the very nature of litigation, the litigation process and its adversarial nature, and the jury system. We do not expect that the liabilities, if any, that may ultimately result from such routine legal actions will have a material adverse effect on our consolidated financial position, results of operations or cash flows.
On March 13, 2012, the staff of the SEC notified us that they had initiated a non-public investigation concerning our subsidiary, TCM. The investigation relates to TCM’s receipt of approximately $15,000 of restructuring fees from issuers of securities collateralizing securitizations for which TCM served as collateral manager in connection with certain exchange transactions involving these securities and securitizations. TCM participated in these exchange transactions between March 2, 2009 and November 28, 2012 and has not subsequently participated in any exchange transactions in which it has collected a fee. The SEC staff has issued administrative subpoenas seeking testimony and information from us in connection with this matter, and we are cooperating fully in providing such information.
On September 16, 2014, we reached an agreement in principle with SEC staff to resolve a non-public investigation initiated by the SEC staff regarding our subsidiary, TCM. This agreement in principle remains subject to final documentation and approval by the SEC. Under the terms of the agreement in principle, among other things, TCM will pay $21,500 and RAIT will guarantee this payment obligation. As a result of this agreement in principle, RAIT took a charge of $21,500 in 2014. We cannot assure you that the settlement with the SEC will be finalized and/or approved or that any final settlement will not have different or additional material terms. In addition, two former executive officers and a former employee of RAIT received “Wells Notices” from the SEC staff relating to the subject of such investigation. We cannot provide any assurance what the ultimate resolution of these Wells Notices or any related action will be or whether any such resolution may have an adverse effect on us.
On October 8, 2014, two former executive officers and one former employee of RAIT each received a written “Wells Notice” from the SEC staff. A Wells Notice is neither a formal allegation of wrongdoing nor a
RAIT Financial Trust
Notes to Consolidated Financial Statements
As of December 31, 2014
(Dollars in thousands, except share and per share amounts)
finding that any of the recipients violated any law. Rather, it provides a recipient an opportunity to respond to issues raised by the SEC staff and to present any reasons of law, policy or fact why the SEC staff should not recommend that the SEC initiate an enforcement action. The Wells Notices in this matter indicate the SEC staff has made a preliminary determination to recommend to the SEC that the SEC file an action against each of the named individuals relating to the individuals’ activities on behalf of TCM in connection with the matters that were the subject of the investigation described above. The former executive officers left RAIT as of December 31, 2014 and the former employee left RAIT in 2010.
Lease Obligations
We lease office space in Philadelphia, New York City, and other locations. The annual minimum rent due pursuant to the leases for each of the next five years and thereafter is estimated to be as follows as of December 31, 2014:
Rent expense was $2,439, $2,045, and $1,967 for the years ended December 31, 2014, 2013, and 2012, respectively, and has been included in general and administrative expense or property operating expenses in the accompanying consolidated statements of operations.
RAIT Financial Trust
Schedule II
Valuation and Qualifying Accounts
For the Three Years Ended December 31, 2014
(Dollars in thousands)
RAIT Financial Trust
Schedule III
Real Estate and Accumulated Depreciation
As of December 31, 2014
(Dollars in thousands)
(1) The aggregate cost basis for federal income tax purposes of our investments in real estate approximates the carrying amount at December 31, 2014.
(2) These encumbrances are held by our consolidated securitizations, RAIT I and RAIT II
(3) Of these encumbrances, $18,622 is held by third parties and $7,125 is held by RAIT I.
(4) Of these encumbrances, $25,356 is held by third parties and $8,025 is held by RAIT I.
(5) Of these encumbrances, $8,421 is held by third parties and $1,613 is held by RAIT.
(6) Of these encumbrances, $15,723 is held by third parties and $11,917 is held by RAIT II.
(7) Of these encumbrances, $22,451 is held by third parties and $32,500 is held by RAIT I.
(8) Of these encumbrances, $5,191 is held by third parties and $11,942 is held by RAIT II.
(9) Of these encumbrances, $9,143 is held by third parties and $20,578 is held by RAIT II.
(10) Of these encumbrances, $3,912 is held by third parties and $8,723 is held by RAIT II.
(11) Of these encumbrances, $5,294 is held by third parties and $11,700 is held by RAIT II.
(12) Of these encumbrances, $8,647 is held by third parties and $19,300 is held by RAIT II.
(13) Of these encumbrances, $7,448 is held by third parties and $16,400 is held by RAIT II.
(14) Of these encumbrances, $3,963 is held by third parties and $8,612 is held by RAIT II.
(15) Of these encumbrances, $3,003 is held by third parties and $6,825 is held by RAIT II.
(16) Of these encumbrances, $3,533 is held by third parties and $8,319 is held by RAIT II.
(17) Of these encumbrances, $2,837 is held by third parties and $6,300 is held by RAIT II.
(18) Of these encumbrances, $26,320 is held by third parties and $15,526 is held by RAIT and RAIT I.
(19) Of these encumbrances, $18,864 is held by third parties and $2,857 is held by RAIT II.
(20) Of these encumbrances, $29,432 is held by third parties and $7,750 is held by RAIT I.
(21) During 2012 and 2011, these properties were acquired by our subsidiary, Independence Realty Trust, Inc.
(22) These properties were acquired in the year of acquisition, as noted in the table above, by our subsidiary, Independence Realty Trust, Inc.
(23) These encumbrances are held entirely by third parties.
RAIT Financial Trust
Schedule IV
Mortgage Loans on Real Estate
As of December 31, 2014
(Dollars in thousands)
(1) Summary of Commercial Mortgages, Mezzanine Loans and Preferred Equity Interests
(a) The tax basis of the commercial mortgages, mezzanine loans and preferred equity interests approximates the carrying amount.
(b) Relates to a $7.8 million commercial real estate loan that was restructured in 2011 to reduce the interest rate from 10.25% to 0.5%.
(c) Relates to a $3.7 million and a $4.4 million equity investments where there is no contractual interest; however, we receive returns based on the performance of the underlying real estate property.
(d) Reconciliation of carrying amount of commercial mortgages, mezzanine loans and preferred equity interests:
(a) Summary of Commercial Mortgages, Mezzanine Loans and Preferred Equity Interests by Geographic Location:
(a) Relates to a $7.8 million commercial real estate loan that was restructured in 2011 to reduce the interest rate from 10.25% to 0.5%.
(b) Relates to a $3.7 million and a $4.4 million equity investments where there is no contractual interest; however, we receive returns based on the performance of the underlying real estate property.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
(a) Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and our chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating possible controls and procedures.
Under the supervision of our chief executive officer and chief financial officer and with the participation of our disclosure committee, we have carried out an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were not effective as a result of a material weakness, identified below, in our internal control over financial reporting at December 31, 2014. As a result, adjustments, as described below, were made to the accounting records used to prepare our consolidated financial statements that increased consolidated net loss by approximately $11 million. The audited consolidated financial statements included in this report, reflect the correction of these adjustments. These adjustments did not result in a restatement of previously issued financial statements, or require revision to the 4th quarter and year-end 2014 financial earnings release as furnished in a Current Report on Form 8-K dated February 24, 2015.
As a result of this material weakness, prior to filing this report, management performed additional procedures which allowed us to conclude that our audited consolidated financial statements included in this report fairly present, in all material respects, our financial position, results of operations and cash flows as of the dates, and for the periods presented, in conformity with U.S. generally accepted accounting principles.
(b) Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. 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 our internal control over financial reporting as of December 31, 2014. 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 (1992). Upon completion of this assessment, management concluded that our internal control over financial reporting as of December 31, 2014, was not effective because of the existence of the material weakness described below.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis.
In connection with management’s assessment of the effectiveness of our internal control over financial reporting at December 31, 2014, we identified a material weakness in internal control over financial reporting that existed at December 31, 2014 because we lacked sufficient qualified resources to ensure the appropriate design and operating effectiveness of our internal control over financial reporting. Specifically, our reconciliation controls, management review controls, and controls over complex transactions and accounting estimates were not adequately designed and/or operating effectively. As a result, adjustments were made, which in the aggregate were material, to the internal accounting records used to prepare our consolidated financial statements primarily related to depreciation and amortization, fair value of financial instruments, accrued interest receivable and the loss on the deconsolidation of our Taberna VIEs.
The audited consolidated financial statements included in this report, reflect the correction of these adjustments. Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting. This report is included as part of Item 8 in this Annual Report on Form 10-K.
(c) Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting that occurred during the quarter ended December 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, other than the identification of the material weakness discussed above.
Remedial Measures
Management is in the process of developing and implementing new controls to remediate the material weakness described above. Management plans to enhance its reconciliation controls, management review controls, and controls over complex transactions and accounting estimates by (i) supplementing its resources, (ii) upgrading our outsourced internal audit function, (iii) designing and documenting additional management review controls, and (iv) providing additional training to effectively perform reconciliation controls, management review controls and controls related to complex transactions and accounting estimates.
As we add resources, we also plan to make organizational changes and further develop skills in our employees in order to strengthen and improve our internal control over financial reporting.
Management believes that these measures will remediate the material weakness discussed above. We currently are targeting to complete the implementation of the control enhancements during 2015. We will test the ongoing effectiveness of the new controls subsequent to implementation, and will consider the material weakness remediated after the applicable remedial controls operate effectively for a sufficient period of time.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Trustees, Executive Officers and Trust Governance
The information required by this item will be set forth in our definitive proxy statement with respect to our 2015 annual meeting of shareholders to be filed on or before April 30, 2015, and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information required by this item will be set forth in our definitive proxy statement with respect to our 2015 annual meeting of shareholders, and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
The information required by this item will be set forth in our definitive proxy statement with respect to our 2015 annual meeting of shareholders, and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions and Trustee Independence
The information required by this item will be set forth in our definitive proxy statement with respect to our 2015 annual meeting of shareholders, and is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item will be set forth in our definitive proxy statement with respect to our 2015 annual meeting of shareholders, and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a) Listed below are all financial statements, financial statement schedules, and exhibits filed as part of this 10-K and herein included.
(1) Financial Statements
All other schedules are not applicable or are omitted since either (i) the required information is not material or (ii) the information required is included in the consolidated financial statements and notes thereto.
(2) Exhibits
The Exhibits furnished as part of this annual report on Form 10-K are identified in the Exhibit Index immediately following the signature pages of this annual report. Such Exhibit Index is incorporated herein by reference.
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 its behalf by the undersigned, thereunto duly authorized.
RAIT FINANCIAL TRUST
By:
/s/ SCOTT F. SCHAEFFER
Scott F. Schaeffer
Chairman of the Board and Chief Executive Officer
March 16, 2015
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX