ITEM 1.
BUSINESS.
Our Company
We are a real estate investment and finance company. We focus on investments in commercial, hospitality, industrial and residential real estate and mortgages secured by those assets. The Company seeks opportunities to invest in real estate-related platforms and projects in partnership with other experienced real estate investment firms, and to sponsor and co-invest in real estate mortgages and other real estate-based investment vehicles. In addition, the Company intends to expand its hospitality footprint and use of the L’Auberge brand through the acquisition or management of other luxury boutique hotels.
Recent Developments
Operations and Investments
During 2017, the Company continued to aggressively pursue enforcement against current and former defaulted borrowers through foreclosure actions and recovery of other guarantor assets. As of December 31, 2017, substantially all of the Company’s non-operating REO assets (assets held for sale and other real estate owned) were obtained through foreclosure or related processes.
In February 2017, we sold two hotels located in Sedona, Arizona (the “Sedona hotels”) which had been acquired through deed-in-lieu of foreclosure in 2013 for $97.0 million, generating net proceeds to the Company of $45.0 million after payoff of the related $50.0 million mortgage and closing costs, and resulting in a gain on sale of approximately $6.8 million. Concurrent with the sale, we entered into an agreement to provide management services to the Sedona hotels. This management agreement was terminated in accordance with its terms in the fourth quarter of 2017.
In October 2017, the Company acquired the MacArthur Place Hotel & Spa in Sonoma, California (“MacArthur Place”) for $36.0 million. The acquisition was funded through a combination of Company equity and a loan from MidFirst Bank. Simultaneously with the acquisition of MacArthur Place, a hotel management subsidiary of the Company entered into a five year management agreement to provide hotel and resort management services in exchange for monthly and annual management fees at commercially standard terms. Shortly after our purchase of MacArthur Place, massive fires spread throughout Santa Rosa, Sonoma and Napa counties that burned over 245,000 acres. While MacArthur Place sustained no physical damage, we decided to evacuate our guests and staff for approximately 10 days due to the hotel’s proximity of the fire. MacArthur Place operations, along with most other businesses in the surrounding areas, were negatively impacted immediately following extinguishment of the fires. We do not believe that the fire’s impact on the local hospitality market or MacArthur Place was extensive or will be long-lived.
During 2017, the Company made two mezzanine loan investments with a face value of $19.9 million bearing variable rates ranging from 7.25% to 9.75% plus one month LIBOR. We also identified and closed on two other mortgage investments totaling $26.6 million subsequent to year end.
Hotel Fund
In November 2017, the Company sponsored and commenced an offering of up to $25.0 million of preferred limited liability company interests (the “Preferred Interests”) in L’Auberge de Sonoma Resort Fund, LLC (the “Hotel Fund”) pursuant to Regulation D and Regulation S promulgated under the Securities Act. The Company made initial contributions of $17.8 million through December 31, 2017 for its common member interest in the Hotel Fund. The net proceeds of this offering are being used (i) to redeem the Company’s initial contributions to the Hotel Fund and (ii) to fund certain renovations to MacArthur Place. The Company is expected to retain a 10.0% Preferred Interest in the Fund. The Hotel Fund intends to pursue a liquidity event in approximately four to six years.
Senior Debt Financing and Retirement
In connection with the acquisition of MacArthur Place, the Company borrowed $32.3 million (the “MacArthur Loan”) from MidFirst Bank, of which approximately $19.4 million was utilized for the purchase of MacArthur Place, $10.0 million is being set aside to fund planned hotel improvements, and the balance to fund interest reserves and operating capital. The loan has an initial term of three years and, subject to certain conditions and the payment of certain fees, may be extended for two (2) one-year periods. The MacArthur Loan requires interest-only payments during the initial three-year term and bears floating interest equal to the 30-day LIBOR rate plus 3.75% subject to certain adjustments.
The MacArthur Loan is secured by a deed of trust on all MacArthur Place real property and improvements, and a security interest in all furniture, fixtures and equipment, licenses and permits, and MacArthur Place related revenues. The Company has agreed
to provide a construction completion guaranty with respect to the planned hotel improvement project which shall be released upon payment of all project costs and receipt of a certificate of occupancy. In addition, the Company has provided a loan repayment guaranty equal to fifty percent (50%) of the MacArthur Loan principal along with a guaranty of interest and operating deficits, as well as other customary non-recourse carve-out matters such as bankruptcy and environmental matters. Under the guarantees, the Company is required to maintain a minimum tangible net worth of $50.0 million and minimum liquidity of $5.0 million throughout the term of the loan. Preferred equity is included as a component of equity with respect to the minimum tangible net worth covenant. In addition, the MacArthur Loan requires MacArthur Place to establish various operating and reserve accounts at MidFirst Bank which are subject to a cash management agreement. In the event of default, MidFirst Bank has the ability to take control of such accounts for the allocation and distribution of proceeds in accordance with the cash management agreement.
Transfer of Series B-2 Preferred Shares and Issuance of B-3 Preferred Shares
On April 11, 2017, JPMorgan Chase Funding Inc., a Delaware corporation (“JPM Funding”), an affiliate of JPMorgan Chase & Co., purchased all of the Company’s outstanding Series B-2 Preferred Shares from SRE Monarch, LLC (“SRE Monarch”) pursuant to a Preferred Stock Purchase Agreement among the Company, JPM Funding and SRE Monarch (“Series B-2 Purchase Agreement”). Pursuant to the Series B-2 Purchase Agreement, the Company paid SRE Monarch all accrued and unpaid dividends on the Series B Preferred Shares and $0.3 million as an expense reimbursement. In connection with this transaction, the Company’s board of directors approved for filing with Secretary of State of the State of Delaware, an Amended and Restated Certificate of Designation of the Cumulative Convertible Series B-1 Preferred Stock and Cumulative Convertible Series B-2 Preferred Stock (“Restated Certificate of Designation”) pursuant to which JPM Funding replaced SRE Monarch as the holder of the Company’s Series B-2 Preferred Stock and, in general, succeeded to the rights of SRE Monarch thereunder.
On February 9, 2018, the Company issued 2,352,941 shares of its newly-authorized Series B-3 Cumulative Convertible Preferred Stock to JPM Funding at a purchase price of $3.40 per share, for a total purchase price of $8.0 million. Dividends on the Series B-3 Preferred Stock are cumulative and accrue from the issue date and compound quarterly at the rate of 5.65% of the issue price per year, and are payable quarterly in arrears. The Company intends to use the proceeds from the sale of these shares for general corporate purposes. In connection with this transaction, the Company’s board of directors approved for filing with Secretary of State of the State of Delaware, the Second Amended and Restated Certificate of Designation of Series B-1 Cumulative Convertible Preferred Stock, Series B-2 Cumulative Convertible Preferred Stock and Series B-3 Cumulative Convertible Preferred Stock of the Company (the “Second Amended Certificate of Designation”). Concurrent with its issuance of these shares of Series B-3 Preferred Stock, the Company issued to JPM Funding a warrant to acquire up to 600,000 shares of the Company’s common stock (the “JPM Warrant”). The JPM Warrant is exercisable at any time on or after February 9, 2021 for a two (2) year period, and has an exercise price of $2.25 per share. The JPM Warrant provides for certain adjustments that may be made to the exercise price and the number of shares issuable upon exercise due to customary anti-dilution provisions based on future corporate events. The JPM Warrant is exercisable in cash, and subject to certain conditions may also be exercised on a cashless basis.
Our History and Structure
We are a Delaware corporation formed in 2010 as a result of the conversion of our predecessor entity, IMH Secured Loan Fund, LLC (“Fund”), from a Delaware limited liability company into a Delaware corporation. The primary business of the Fund, which was organized in May 2003, was making investments in senior short-term whole commercial real estate mortgage loans collateralized by first mortgages on real property. The Fund was externally managed by Investors Mortgage Holdings, Inc. (the “Manager”), an Arizona-licensed mortgage banker. In 2012, IMH Holdings, LLC, a Delaware limited liability company and a wholly-owned subsidiary of the Company (“Holdings”), obtained its mortgage banker’s license in the State of Arizona.
In June 2010, following approval by members representing 89% of membership units of the Fund voting on the matter, the Fund became internally-managed through the acquisition of the Manager and converted into a Delaware corporation in a series of transactions that we refer to as the “Conversion Transactions.” As part of the Conversion Transactions, the former executive officers and employees of the Manager became our executive officers and employees, and assumed the duties previously performed by the Manager. We ceased paying management fees to the Manager and we now retain all management, origination fees, gains and basis points previously allocated to the Manager. As part of the Conversion Transactions, we issued 3,811,342 shares of Class B-1 common stock, 3,811,342 shares of Class B-2 common stock, 7,735,169 shares of Class B-3 common stock, 627,579 shares of Class B-4 common stock and 838,448 shares of Class C common stock.
Our Market Opportunity
Prior to 2017, our commercial mortgage lending activities were limited to originating seller carryback loans in connection with our disposition of certain REO assets. However, we re-initiated our commercial mortgage investment activities in 2017 and expect to expand these activities as we generate additional liquidity.
Assuming sufficient liquidity, we expect to focus on various opportunities such as: (a) acquiring real estate-backed loan portfolios from sellers seeking to create more liquidity; (b) acquiring distressed assets of other real estate companies; (c) funding the development or completion of partially developed real estate projects; and (d) providing senior and mezzanine loans on stabilized income-producing properties that meet our investment criteria.
In addition, we are seeking to leverage our hospitality expertise through the management, acquisition, renovation and disposition of hospitality assets with commensurate risk-adjusted returns.
We plan to develop an earning asset base that is well-diversified by underlying property type, geography, and borrower concentration risks, subject to our financial resources, real estate market conditions, and investment opportunities.
We intend to continue the process of disposing our remaining legacy loan portfolio, REO assets, and other real estate related assets, individually or in bulk, and to reinvest the proceeds from those dispositions in our target assets. We may also attempt to create additional value from certain of our REO assets that are viable multifamily land or other parcels by developing them into new communities in joint ventures or alternative structures.
Our Target Assets
Although we have historically focused on the origination of senior short-term commercial bridge loans with maturities of 12 to 36 months, we intend to expand our business focus to include: (a) purchasing or investing in commercial and other mortgage and mezzanine loans, individually or in pools (b) originating mortgage loans that are collateralized by real property located throughout the United States, and (c) pursuing, in an opportunistic manner, other real estate investments such as participation interests in loans, whole and bridge loans, commercial or residential mortgage-backed securities, equity or other ownership interests in entities that are the direct or indirect owners of real property, and direct or indirect investments in real property, such as those that may be obtained in a joint venture or by acquiring the securities of other entities which own real property. In addition, as we endeavor to expand our hospitality footprint, we are seeking to acquire and/or manage boutique hotel properties in unique locations that have significant potential for value appreciation through renovation and improved management. We refer to the assets we will target for acquisition or origination as our “target assets.”
We intend to diversify our target asset acquisitions across selected asset classes: in interim loans or other short-term loans originated by us; performing whole or participating interests in commercial real estate mortgage loans we acquire; whole performing and non-performing commercial real estate loans we acquire; and in other types of real estate-related assets and real estate-related debt instruments (which may include the acquisition of or financing of the acquisition of residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), and operating properties). Assuming sufficient liquidity and other capital resources, we expect the diversification of our portfolio to continue to evolve in response to market conditions, including consideration of factors such as asset class, borrower group, geography, transaction size, and investment terms.
Investment Committee
In July 2014, our Board created an Investment Committee to assist the Board in (i) reviewing our investment policies, strategies, and performance and (ii) overseeing our capital and financial resources. Other than with respect to transactions that are carried out in substantial accordance with an approved annual budget and certain other transactions and actions specified in the charter of the Investment Committee, no investment may be made without approval of the Investment Committee or of a delegate of the Investment Committee pursuant to an appropriate delegation of the Investment Committee’s authority. The Investment Committee does not participate in matters such as corporate or property financings that involve “day-to-day” cash management decisions or treasury functions. The Investment Committee consists of three members, two of whom are the Series B-1 Director and the Series B-2 Director and the other of whom is a director then serving as the Company’s chief executive officer. The current members of the Investment Committee are Jay Wolf (as the Series B-1 Director), Lawrence D. Bain (as our CEO), and Chad Parsons (as the Series B-2 Director).
Seasonality
Our revenues are derived from hospitality operations and management, and mortgage and related loan investments. Revenues from our hospitality properties are generally seasonal in nature, which may vary in significance depending on the micro climate weather patterns and timing of seasonal events that spur demand. Based on our current hotel asset holdings, revenues are typically highest in the third quarter, with modest reductions during the second and fourth quarters, and lowest in the first quarter of the year. Revenues from traditional mortgage and related investments are not seasonal in nature and are generally recognized more evenly during the term of the investment.
Employees
As of December 31, 2017, we had 22 full-time employees and 2 full-time outside consultants working in our corporate offices, and 101 full-time and 42 part-time employees working at MacArthur Place. We consider relations with our employees to be good.
We utilized an outside professional management company during a part of 2017 to run the day-to-day operations of our Arizona golf course property. This management company provided on-site personnel who were employees of the management company. Effective January 31, 2017, we terminated the management agreement for our golf course operation and converted the asset to a self-managed operation. We sold the golf course operation in June 2017.
Competition
The lending industry in which we operate is serviced primarily by commercial banks, insurance companies, mortgage brokers, pension funds, and private and other institutional lenders. There are also a relatively smaller number of non-conventional lenders that are similar to us.
In addition, we are subject to competition with other investors in real property and real estate-related investments. Numerous REITs, banks, insurance companies, and pension funds, as well as corporate and individual developers and owners of real estate, compete with us in seeking real estate assets for acquisition.
We are also subject to competition with professional hospitality management companies who seek to manage hotel properties in the same areas in which we operate.
Regulation
Our operations are subject to oversight by various state and federal regulatory authorities, including, without limitation, the Arizona Corporation Commission, the Arizona Department of Revenue, the Arizona Department of Financial Institutions (Banking), and the Securities and Exchange Commission (“SEC”).
Mortgage Banker Regulations
Our operations as a mortgage banker are subject to regulation by federal, state, and local laws and governmental authorities. Under applicable Arizona law, regulators have broad discretionary authority over our mortgage banking activities. We are not subject, however, to the underwriting, capital ratio, or concentration guidelines and requirements that are generally imposed on more traditional lenders. One of our subsidiaries is currently licensed as a mortgage banker by the state of Arizona.
Investment Company Status
We seek to manage our operations and expect to deploy our capital in a manner to qualify for an exemption from registration as an “investment company” under the Investment Company Act of 1940, as amended (the “Investment Company Act”).
Usury Laws
Usury laws in some states limit the interest that lenders are entitled to receive on a mortgage loan. State law and court interpretations thereof applicable to determining whether the interest rate on a loan is usurious and the consequences for exceeding the maximum rate vary. For example, we may be required to forfeit interest above the applicable limit or to pay a specified penalty. In such a situation, the borrower may have the recorded mortgage or deed of trust canceled upon paying its debt with lawful interest, or the lender may foreclose, but only for the debt plus lawful interest. In the alternative, a violation of some usury laws results in the invalidation of the transaction, thereby permitting the borrower to have the recorded mortgage or deed of trust cancelled without any payment and prohibiting the lender from foreclosing.
In California, we only invest in loans which are made or arranged through real estate brokers licensed by the California Department of Real Estate because these loans are exempt from the California usury law provisions. Prior to November 2006, all California loans were brokered to us only by unrelated third-party licensed brokers. In November 2006, we formed a wholly-owned California subsidiary which is licensed by the California Department of Real Estate as a real estate broker. Substantially all California loans are now brokered to us by our California-organized subsidiary.
Environmental Matters
Our REO assets and the operations conducted on real property are subject to federal, state, and local laws and regulations relating to environmental protection and human health and safety. Under these laws, courts and government agencies may have the authority under certain circumstances to require us, as the owner of a contaminated property, to clean up the property even if we did not know of or were not responsible for the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation, and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. State and federal laws in this area are constantly evolving and we intend to take commercially reasonable steps to protect ourselves from the impact of these laws, including obtaining environmental assessments of most properties that we acquire. As of the date of this filing, we are unaware of any significant environmental issues affecting the properties we own or properties that serve as collateral under our loans. In addition, we maintain environmental insurance coverage on all properties, subject to certain exclusions, that we believe would limit the amount of liability if such matters were discovered.
Available Information
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed or furnished pursuant to Sections 13(a) and 15(d) of the Exchange Act are available on our website at http://www.imhfc.com as soon as reasonably practicable after we electronically file such reports with, or furnish those reports to, the SEC. The other information on our website is not a part of or incorporated into this Annual Report. Stockholders may request free copies of these documents from:
IMH Financial Corporation
Attention: Investor Relations
7001 N. Scottsdale Road - Suite 2050
Scottsdale, AZ 85253
(480) 840-8400
ITEM 1A.
ITEM 1A.
RISK FACTORS.
Our business involves a high degree of risk. You should carefully consider the following information about risks, together with the other information contained in this Form 10-K. The risks described below are those that we believe are the material risks relating to us. If any of the circumstances or events described below, or others that we did not anticipate, actually arise or occur, our business, prospects, financial condition, results of operations, and cash flows could be harmed.
Risks Related to Our Business Strategy and Our Operations:
We have continued to record losses as a result of limited income-producing assets, significant operating and overhead costs, significant interest and dividend expenses, provisions for credit losses, and impairment losses which may continue to harm our results of operations.
We reported net losses of $1.6 million and $7.7 million for the years ended December 31, 2017 and 2016, respectively, due primarily to the limited number of our income producing assets coupled with (i) the high cost of our debt financing, (ii) significant dividend payments to the holders of our preferred shares, and (iii) professional fees we incurred in connection with loan and guarantee enforcement activities. As of December 31, 2017, our accumulated deficit aggregated $679.5 million. We may continue to record net losses in the future as a result of a lack of income-producing assets, significant operating and overhead costs, significant interest and dividend expenses, provisions for credit losses, and impairment losses on real estate owned, which may further harm our results of operations.
While we have, to date, been able to secure the necessary debt or equity financing to provide us with sufficient working capital and have generated additional liquidity through asset sales and mortgage receivable collections, there is no assurance that we will be successful in selling our remaining loan and REO assets in a timely manner or in obtaining additional financing to sufficiently fund future operations, repay existing debt, or to implement our investment strategy. Furthermore, under the Second Amended Certificate of Designation for the Series B Preferred Shares, the holders of our Series B Preferred Stock (the “Series B Investors”) have significant approval rights over asset sales. Our failure to (x) generate sustainable earning assets, (y) sufficiently reduce our expenses, and/or (z) successfully liquidate a sufficient number of our loans and REO assets may have a material adverse effect on our business, results of operations and financial position. Under the Second Amended Certificate of Designation for the Series B Preferred Shares, we cannot exceed 103% of the aggregate line item expenditures in our annual operating budget approved by the Series B Investors without their prior written approval. We were in breach of this covenant for the year ended December 31, 2017. However, subsequent to December 31, 2017, we obtained a waiver of this breach from the Series B Investors.
Our business model and investment strategies involve substantial risk and may not be successful.
We have made certain recent changes to our business strategy. Initiating new business activities and significantly expanding existing business activities are two ways to grow our business and respond to changing circumstances in our industry. However, they may expose us to new risks and regulatory compliance requirements. We cannot be certain that we will be able to manage these risks and compliance requirements effectively. Furthermore, our efforts may not succeed and any revenues we earn from any new or expanded business initiative may not be sufficient to offset the initial and ongoing costs of that initiative, which would result in a loss with respect to that initiative. In particular, a change in our business strategy, including the manner in which we allocate our resources across our commercial mortgage loans, or the types of assets we seek to acquire, may increase our exposure to certain risks, including, but not limited to, interest rate risk, default risk, and real estate market fluctuations. Efforts we have made and continue to make to significantly expand our investing activity in commercial real-estate related assets and to develop new methods and channels for acquiring and selling residential and commercial real estate-related investment assets may expose us to new risks, may not succeed, and may not generate sufficient revenue to offset our related costs. In addition, we may in the future use leverage at times and in amounts deemed prudent by our management in its discretion, and such decisions would not be subject to stockholder approval. Any new activities that we engage in may increase our fiduciary responsibilities, result in conflicts of interest arising from our investment activities and the activities of the entities we manage, increase our exposure to litigation, and expose us to other risks.
We are subject to the business, financial, and operating risks common to the hotel and hospitality industries, which could reduce our revenues and limit opportunities for growth.
We intend to remain active in the hospitality industry through the acquisition and/or management of hotel operations. Business, financial, and operating risks common to the hotel and hospitality industries include:
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significant competition from multiple hospitality providers;
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the costs and administrative burdens associated with complying with applicable laws and regulations in the geographic regions in which we operate;
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delays in, cancellations of, or underestimated costs of planned or future refurbishment projects;
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changes in the desirability of the geographic region of the hotels in our business;
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decreases in the demand for transient rooms and related lodging services, including a reduction in business travel as a result of alternatives to in-person meetings (including virtual meetings hosted on-line or over private teleconferencing networks) or due to general economic conditions;
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decreased corporate or governmental travel-related budgets and spending, as well as cancellations, deferrals or renegotiations of group business such as industry conventions; and
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negative public perception of corporate travel-related activities.
Our operating results could fluctuate to the extent that our business relies on leisure travel.
Our operating results could fluctuate because our hospitality business relies on revenue generated by leisure travelers. Therefore, there are numerous factors beyond our control that affect our operating results. For any of the reasons listed below, or for other reasons we do not presently anticipate, it is possible that our operating results will be below market or our expectations. Leisure travelers are typically sensitive to discretionary spending levels, tend to curtail travel during general economic downturns, and are affected by other trends or events that may include:
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bad weather or natural disasters;
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fuel price increases;
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travel-related accidents;
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hotel, airline or other travel-industry related strikes;
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financial notability of the airline industry;
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acts of terrorism; and
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war or political instability.
Other factors that may adversely affect our operating results include:
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the number of properties we own and/or manage;
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the number of rooms booked at the properties we own and/or manage;
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our ability to expand into new markets;
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our ability to develop strong brand recognition or customer loyalty; and
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the announcement or introduction of lower prices or new travel services and products by our competitors.
Our new programs and new branded products may not be successful.
In connection with our acquisition of MacArthur Place, we intend to implement a rebranding campaign under the “L’Auberge” name. We cannot be assured that this or any other brand we choose to adopt, or any other new programs or products we may launch in the future, will be accepted by hotel owners, the traveling public, or other guests. We also cannot be certain that we will recover the costs we incurred in developing or acquiring the brands or any new programs or products, or that those brands, programs, or products will be successful. In addition, some of our new or newly acquired brands involve or may involve cooperation and/or consultation with one or more third parties, including some shared control over product design and development, sales and marketing, and brand standards. Disagreements with these third parties could slow the development of these new brands and/or impair our ability to take actions we believe to be advisable for the success and profitability of such brands.
We are required to fund certain amounts for the Hotel Fund if the hotel does not achieve specified levels of operating profit and cash flows.
Under the terms of the limited liability company operating agreement of the Hotel Fund, Preferred Investors are entitled to a monthly distribution equal to 7.0% per annum of their invested capital, on a cumulative and non-compounding basis. In the event that the hotel is unable to generate sufficient cash flow to pay the preferred distribution in a given month, the Company is obligated to fund the amount of any such shortfall via a common capital contribution to the Hotel Fund. Moreover, the Company has agreed to assume via a common capital contribution obligation payment of certain selling commissions and non-accountable expense obligations relating to the offering of the Preferred Interests. To the extent that the hotel does not generate sufficient operating profit or cash flows to fully fund the required distributions to holders of the Preferred Interests, the Company would have to use cash that it might otherwise have used to carry out our investment strategy and thereby negatively impacting our ability to successfully implement such investment strategy and/or seek other sources of capital to fund such required distributions, which might not be available at the time needed or, if available, be on terms that are not attractive to the Company. Furthermore, if we
are unable to dispose of MacArthur Place at a price sufficient to return our common capital contributions, we may not be able to recover some or all of our common capital contributions which could cause us to suffer a loss and reduce our cash flows.
We anticipate that a portion of our portfolio will continue to include non-performing and distressed commercial real estate mortgage loans, or loans that may become non-performing and distressed, which are subject to increased risks relative to performing mortgage loans.
We anticipate that our future portfolio will continue to include non-performing and distressed commercial and residential real estate mortgage loans, or loans that may become non-performing and distressed. These loans may already be, or may become, non-performing or distressed for a variety of reasons, including, without limitation, because the underlying property is too highly leveraged, the borrower is or becomes financially distressed, or the borrower is unable to obtain takeout financing prior to loan maturity, in any case, resulting in the borrower being unable to meet its debt service or repayment obligations to us. These non-performing or distressed loans may require a substantial amount of workout negotiations or restructuring, which may divert the attention of our management from other activities and entail, among other things, a substantial reduction in the interest rate, capitalization of interest payments, and a substantial write-down of the principal and interest of our loans. However, even if we successfully accomplish these restructurings, our borrowers may not be able or willing to maintain the restructured payments or refinance the restructured loans upon maturity. In addition, claims may be assessed against us on account of our position as mortgage holder or property owner, including responsibility for tax payments, environmental contamination, and other liabilities, which could harm our results of operations and financial condition.
In addition, certain non-performing or distressed loans that we acquire may have been originated by financial institutions that are or may become insolvent, suffer from serious financial stress, or are no longer in existence. As a result, the recourse to the selling institution or the standards by which these loans are being serviced or operated may be adversely affected. Further, loans on properties operating under the close supervision of a mortgage lender are, in certain circumstances, subject to certain additional potential liabilities that may exceed the value of our investment.
We may continue to foreclose on the remaining loans in our portfolio, which could harm our results of operations and financial condition.
We may find it necessary or desirable to foreclose on loans we originate or acquire. The foreclosure process can be lengthy and expensive. We cannot be assured as to the adequacy of the protection of the terms of the applicable loan, including the validity or enforceability of the loan, the maintenance of the anticipated priority, and perfection of the applicable security interests. Furthermore, claims may be asserted by lenders or borrowers that might interfere with enforcement of our rights. Borrowers may resist mortgage foreclosure actions by asserting numerous claims, counterclaims, and defenses against us, including, without limitation, lender liability claims and defenses, even when the assertions may have no basis in fact, in an effort to prolong the foreclosure action and seek to force us to modify the terms of the loan or buy-out the borrower’s position in the loan on terms more favorable to the borrower than would otherwise be the case. In some states, foreclosure actions can take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the foreclosure process and potentially result in a reduction or discharge of a borrower’s mortgage debt. Foreclosure may create a negative public perception of the related mortgaged property, resulting in a diminution of its value. Even if we are successful in foreclosing on a loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our cost basis in the loan, resulting in a loss to us. Furthermore, any costs or delays involved in the foreclosure of the loan or a liquidation of the underlying property will further reduce the net proceeds and, thus, increase the loss.
If our exposure to a particular borrower or borrower group increases, the failure by that borrower or borrower group to perform on its loan obligations could harm our results of operations and financial condition.
Our investment policy provides that aggregate loans outstanding to a borrower or affiliated borrowers should not exceed 20% of the Company’s investment portfolio. Following the origination of a loan, however, the aggregate loans outstanding to a borrower or affiliated borrowers may exceed those thresholds as a result of changes in the size and composition of our overall investment portfolio. When loans outstanding to a borrower or affiliated borrowers exceed these thresholds, the failure of a borrower or affiliated borrowers (as opposed to a diversified group of borrowers) to perform its loan obligations could harm our results of operations and financial condition.
If we are unable to properly analyze potential investment opportunities for our assets, we may incur losses that could further impair our financial condition and results of operations.
Our success depends, in part, on our ability to properly analyze the potential investment opportunities of our assets in order to assess the level of risk-adjusted returns that we should expect from any particular asset. To estimate the value of a particular asset, we may use historical assumptions that may or may not be appropriate. To the extent that we use historical assumptions that are inappropriate under then-current market conditions, we may lend on a real estate asset that we otherwise might not lend against, overpay for an asset or acquire an asset that we otherwise might not acquire, or be required to later write-down the value of assets acquired on the basis of such assumptions, which may harm our financial condition and results of operations.
We have limited personnel with experience in developing real estate and we may not be able to solely manage the real estate we acquire or foreclose upon or develop the underlying projects in a timely or cost-effective manner, or at all, which could harm our financial condition and results of operations.
Because we have limited personnel with experience in developing real estate, we occasionally engage external professionals in the related fields to assist us in this effort. When we acquire real estate through purchase or foreclosure on one of our loans or otherwise, we may seek to complete the underlying projects, either alone or through joint ventures. We may not be able to manage the development process in a timely or cost-effective manner or at all. In addition, we may, however, be unable to obtain such assistance at an attractive cost or at all. Even if we are able to obtain such assistance, we may be exposed to the risks associated with the failure to complete the development of the project as expected or desired.
If we enter into joint ventures to manage or develop projects, such joint ventures involve certain risks, including, without limitation, that:
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we may not have voting control over the joint venture;
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we may not be able to maintain good relationships with our joint venture partners;
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our joint venture partner may have economic or business interests that are inconsistent with our interests;
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our joint venture partner may fail to fund its share of operations and development activities, or fulfill its other commitments, including providing accurate and timely accounting and financial information to us;
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the joint venture or our joint venture partner could lose key personnel;
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our joint venture partner could become insolvent or bankrupt;
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disputes may arise between us and our joint venture partners that result in litigation or arbitration that would increase our expenses and possibly jeopardize the successful completion of the project; and
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we may incur unexpected liabilities as a result of actions taken by our joint venture partners.
Any one or more of these risks could harm our financial condition and results of operations.
If we are unable to sell our existing assets, or are only able to do so at a loss, we may be unable to implement our investment strategy in the time-frame sought or at all.
We are marketing substantially all of our remaining legacy assets, individually or in bulk, to generate additional liquidity and capital in order to implement our investment strategy. In addition, we have pursued or are pursuing enforcement (in most cases, foreclosure) on our remaining loans in default, and expect to take ownership or otherwise dispose of the underlying collateral and position the asset for future monetization. We may be unable to sell our legacy assets on a timely basis or may be required to do so at a price below our adjusted carrying value, which could harm our business, our financial condition, and our ability to implement our investment strategy.
If we do not resume our mortgage investing activities or investing activities, we will not be able to grow our business and our results of operations and financial condition will be harmed.
While we made two new mortgage investments during 2017, we have not engaged in lending activities at any meaningful level since late 2008. Our failure to fund new loans or instruments prevents us from capitalizing on interest-generating or other fee paying assets, and managing interest rate and other risk as our existing assets are sold, restructured or refinanced, which harms our results of operations and financial condition.
Acquiring ownership of property, through foreclosure or otherwise, subjects us to the various risks of owning real property and we could incur unexpected costs and expenses, which could harm our business.
We acquired the majority of our REO as a result of foreclosing on the associated loans and related enforcement actions taken, and we may acquire additional real property in this manner in the future. As of December 31, 2017, we owned 18 properties with an aggregate net carrying value of $64.6 million. As an owner of real property, we will incur some of the same obligations and be exposed to some of the same risks as the borrower was prior to our foreclosure on the associated loan. See the risk factor below entitled “Our borrowers are exposed to risks associated with owning real estate.”
The supply of commercial mortgage loans available at significant discounts will likely decrease as the economy improves, which could prevent us from implementing our business strategies or maximizing our returns on such investments.
Part of our business strategy includes, among other things, the acquisition and origination of mortgage loans, mezzanine loans, and other debt instruments, as well as equity and preferred equity interests or investments. Conditions in the commercial mortgage market, the financial markets, and the overall economy may reduce the availability of borrowers and projects meeting our underwriting criteria and current business objectives and strategies. We also may face increasing competition from other capital sources. As a result, we may be unable to successfully pursue any of our current or future investment strategies. Additionally, the manner in which we compete and the types of assets we seek to acquire may be affected by sudden changes in our industry, the regulatory environment, the role of government-sponsored entities, the role of credit rating agencies or their rating criteria or process, or the U.S. and global economies generally. If we do not effectively respond to these changes, or if our strategies to respond to these changes are not successful, our financial condition and results of operations may be harmed.
A secondary market for our loans or other assets we acquire may not develop, in which case we may not be able to diversify our assets in response to changes in economic and other conditions, and we may be forced to bear the risk of deteriorating real estate markets, which could increase borrower defaults on our loans and cause us to experience losses.
Many of our target assets, including commercial mortgage loan related assets, generally experience periods of illiquidity. In the event that a secondary market for our portfolio loans or other assets does not develop, we may be required to bear all the risk of our assets until the loans mature, are repaid, or are sold. A lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale, or the unavailability of financing for these assets. In addition, certain of our target assets, such as bridge loans and other commercial real estate mortgage loans, may also be particularly illiquid assets due to their short life, their potential unsuitability for securitization, and the greater difficulty of recovery in the event of a borrower’s default. There is generally a very limited secondary market for the loan assets we hold.
The illiquidity of our assets makes it difficult for us to sell such assets at advantageous times or at favorable prices, including, if necessary, to maintain our exemption from the Investment Company Act. Moreover, we may need to invest our capital in a manner and at times other than we would have otherwise preferred or intended, in order to be able to rely on an exemption under the Investment Company Act so as to avoid redemption of the Series B Preferred Shares as required under the Series B Investment Agreement. See “Maintenance of our exemption from registration under the Investment Company Act will impose significant limitations on our operations, which may have a material adverse effect on our ability to execute our business strategy” below in these Risk Factors. Moreover, adverse market conditions could harm the liquidity of our assets. As a result, our ability to sell our assets and purchase new assets has been, and may in the future, continue to be, relatively limited, which may cause us to incur losses. If we are required to sell all or a portion of our assets quickly, we may realize significantly less than the value at which we have previously recorded those assets. This will limit our ability to mitigate our risk in changing real estate markets and may have an adverse effect on our results of operations and financial condition.
Our access to public capital markets and private sources of financing has been limited and, thus, our ability to make investments in our target assets has been limited.
To date, we have had no access to public capital markets and limited access to private sources of financing on terms that are acceptable to us. Our access to public capital markets and private sources of financing will depend upon our results of operations and financial condition, as well as a number of factors over which we have little or no control, including, among others, the following:
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general market conditions;
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the market’s perception of the quality of our assets;
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the market’s perception of our management;
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the market’s perception of our growth potential;
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our current and potential future earnings and cash distributions; and
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the market price, if any, of our common stock.
If we are unable to obtain financing on favorable terms or at all, we may have to continue to curtail our investment activities, which would further limit our growth prospects, and force us to dispose of assets at inopportune times in order to maintain our Investment Company Act exemption or to otherwise obtain necessary liquidity.
Depending on market conditions at the relevant time, we may have to rely more heavily on additional equity issuances, which may be dilutive to our stockholders, or on more expensive forms of debt financing that require a larger portion of our cash flow from operations, thereby reducing funds available for our operations, future business opportunities, cash dividends to our stockholders, and other purposes. We may not have access to such equity or debt capital on favorable terms at the desired times, or at all, which may cause us to curtail our investment activities or to dispose of assets at inopportune times and could harm our results of operations, financial condition, and growth prospects.
We may lack control over certain of our commercial mortgage loans and other investments, which may result in dispositions of these investments that are inconsistent with our economic, business, and other interests and goals.
Our ability to manage our portfolio of loans and other investments may be limited by the form in which they are made. We may purchase commercial mortgage loans jointly with other lenders, acquire investments subject to rights of senior classes and servicers under inter-creditor or servicing agreements; acquire only a participation interest in an underlying investment; or rely on independent third-party management or strategic partners with respect to the management of an asset. Therefore, we may not be able to exercise control over the loan or investment. Such financial assets may involve risks not present in investments where senior creditors, servicers or third-party controlling investors are not involved. Our rights to enforcement following a borrower default may be subject to the rights of senior creditors or servicers or third-party partners with economic, business, or other interests or goals which may be inconsistent with ours. In addition, we may, in certain circumstances, be liable for the actions of our third-party partners. These decisions and judgments may be different than those we would make and may be adverse to us.
Short-term loans that we may originate or acquire may involve a greater risk of loss than traditional investment-grade mortgage loans with fully insured borrowers, which could result in greater losses.
We have historically originated or acquired commercial real estate-bridge (i.e., short-term) loans secured by first lien mortgages on properties of borrowers who are typically seeking short-term capital to be used in the acquisition, construction, or rehabilitation of properties, and we may continue to do so. The typical borrower under a short-term loan has usually identified what it believes is an undervalued asset that may have been under-managed or located in a recovering market. If the market in which the asset is located fails to recover according to the borrower’s projections, or if the borrower fails to improve the quality of the asset’s management, or the value of the asset, the borrower may not receive a sufficient return on the asset to satisfy the short-term loan, and we bear the risk that our loan may not be fully and/or timely repaid.
In addition, borrowers under a bridge loan usually use the proceeds of a conventional mortgage loan to repay the bridge loan. Thus, the repayment of a bridge loan is subject to the risk that the borrower will be unable to obtain permanent financing. Bridge loans are also subject to the risk associated with all commercial mortgage loans - borrower defaults, bankruptcies, fraud, losses and “special hazard” losses that are not covered by standard hazard insurance. In the event of a default, we bear the risk of loss of principal and non-payment of interest and fees to the extent of any deficiency between the value of the mortgage collateral and the principal amount and unpaid interest accrued under the loan. Our results of operations and financial condition would be adversely affected by any such losses we were to suffer with respect to these loans.
The subordinated loan assets that we may acquire, which involve greater risks of loss than senior loans secured by income-producing properties, could result in losses that could harm our results of operations and financial condition.
We have historically, and may in the future, acquire subordinated loans secured by junior mortgages on the underlying property or by a pledge of the ownership interests of either the entity owning the property or the entity that owns the interest in the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property because the loan may become unsecured as a result of foreclosure by the senior lender. In addition, these loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal, particularly to the junior lender. If a borrower defaults on our subordinated loan or on debt senior to our loan, or in the event of a borrower bankruptcy, our subordinated loan will be satisfied only after the senior debt is paid in full or otherwise to the satisfaction of the senior lender. Where debt senior to our portfolio loan exists, intercreditor arrangements may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies, and control decisions made in bankruptcy proceedings relating to borrowers. As a result, we may not recover some or all of our investment, which could result in losses to us. Our willingness to acquire such loans also may be negatively affected by our need
to rely on an exemption from registration under the Investment Company Act. In addition, even if we are able to foreclose on the underlying collateral following a borrower’s default on a subordinated loan, we may assume the rights and obligations of the defaulting borrower under the loan and, to the extent income generated on the underlying property is insufficient to meet outstanding debt obligations on the property, we may need to commit substantial additional capital to stabilize the property and prevent additional defaults to lenders with existing liens on the property. Significant losses related to our subordinated loans could harm our results of operations and financial condition.
Our due diligence may not reveal all of a borrower’s assets or liabilities and may not reveal other investment risks or weaknesses in a business which could result in loan losses.
Before acquiring an asset or making a loan to a borrower, we assess the asset strength and skills of the prospective borrower and other factors that we believe are material to the performance of the asset. In making this assessment and otherwise conducting customary due diligence, we rely on numerous resources reasonably available to us and, in some cases, an investigation by third parties. This process is particularly subjective, and of lesser value than would otherwise be the case, with respect to newly organized entities because there may be little or no information publicly available about those entities. There can be no assurance that our due diligence processes will uncover all relevant facts or problems, or that any particular asset will be a successful investment.
Legislative and regulatory initiatives could harm our business.
The U.S., state, and foreign governments have taken certain legislative and regulatory actions in an attempt to address events and circumstances that occurred during the 2008 financial crisis and the severe decline in the global economy. These actions, or other actions under consideration, could result in unintended consequences or new regulatory requirements which may be difficult or costly to comply with and could have a significant impact on our business, financial condition, and results of operations. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced, or how such changes may affect us. For example, bankruptcy legislation could be enacted that would hinder the ability to foreclose promptly on defaulted mortgage loans or permit limited assignee liability for certain violations in the mortgage origination process, any or all of which could adversely affect our business or result in us being held responsible for violations in the mortgage loan origination process even when we were not the originator of the loan. Other laws, regulations, and programs at the federal, state, and local levels are under consideration that seek to address real estate and other markets, and may impose new regulations on various participants in the financial system. These or other actions could harm our business, results of operations, and financial condition.
Our business is subject to regulation by several government agencies and a disciplinary or civil action that occurs as a result of an actual or alleged violation of any rules or regulations to which we are subject could harm our business.
We are subject to extensive regulation and oversight by various state and federal regulatory authorities, including, without limitation, the Arizona Corporation Commission, the Arizona Department of Financial Institutions (Banking), and the SEC. Many of these authorities have generally increased their scrutiny of the entities they regulate following recent events in the homebuilding, finance, and capital markets sectors. We are also subject to various federal and state securities laws regulating the issuance and sale of securities. In the future, we may be required to obtain various approvals and/or licenses from federal or state governmental authorities, or government sponsored entities in connection with our mortgage-related, or real estate development activities. There is no assurance that we will be able to obtain or maintain any or all of the approvals that we need in a timely manner. In the event that we do not adhere to these license and approval requirements and other laws and regulations which apply to us, we could face potential fines, disciplinary action, or other civil action that could restrict or otherwise harm our business.
Holders of our Series B Preferred Shares, have substantial approval rights over our operations. Their interests may not coincide with holders of our Common Stock and they may make decisions with which we disagree.
The holders of our Series B Preferred Shares hold, in the aggregate, approximately, 38% of our total voting shares and have certain director designation rights. Under the Second Amended Certificate of Designation we may not undertake certain actions without the consent of the holders of at least 85% of the shares of Series B Preferred Shares outstanding, including entering into major contracts, entering into new lines of business, or selling REO assets other than within certain defined parameters. For example, under the Second Amended Certificate of Designation, the sale of any of our assets for an amount less than 95% of the value of that asset, as set forth in the annual operating budget approved by our board of directors, requires the prior approval of the Series B Investors. Further, certain actions, including breaching any of our material obligations to the holders of Series B Preferred Shares under the Second Amended Certificate of Designation or under the Series B Restated Investment Agreement could allow the holders of the Series B Preferred Shares to demand that we redeem the Series B Preferred Shares. The interests of the holders
of our Series B Preferred Shares may not always coincide with our interests as a company or with the interests of our other stockholders.
Our prior or future loan agreements have contained or may contain restrictive covenants relating to our operations that could materially adversely affect our business, results of operations, and financial condition. A breach of any of these restrictive covenants that results in an event of default under the applicable loan agreement could result in, among other things, accelerated maturity of the applicable loan, early redemption of our Series B Preferred Shares, and other ramifications that could be detrimental to our financial position and liquidity.
We have previously entered into loan agreements which contained certain restrictive covenants that had the effect of requiring us to obtain the lender’s consent prior to taking certain actions, including the sale, encumbering, or transfer of certain assets, declaring or paying dividends, or incurring additional indebtedness. We also have entered into various loan guaranty agreements, including a construction completion guaranty with respect to the planned hotel improvement project at MacArthur Place equal to fifty percent (50%) of the MacArthur Loan principal along with a guaranty of interest and operating deficits, containing various financial and operating covenants, including minimum liquidity covenants and minimum net worth covenants. If we fail to meet or satisfy such covenants, we could be in default under those loan agreements, and the lender could elect to declare the full amount outstanding under those loans due and payable, require the posting of additional collateral, and/or enforce their respective interests against existing collateral from us. A default also could limit significantly our financing alternatives, which could cause us to curtail our investment activities or prematurely dispose of assets, any of which could have a material adverse effect on our business, results of operations, and financial condition. Also, a default under these loans or guarantees could trigger a non-compliance event under our Second Amended Certificate of Designation which could result in, among other things, early redemption of our Series B Preferred Shares, and other ramifications that could be detrimental to our financial position and liquidity.
Any borrowing by us will increase our risk, which may reduce the return on our assets, reduce cash available for distribution to our stockholders, and increase losses.
Subject to market conditions and availability, we have historically used, and may continue to use borrowings to provide us with the necessary cash to pay our operating expenses, pay the principal and interest due under our loans, make dividend payments to our Series B preferred shareholders, finance our assets, or make other investments. Any such borrowings will require us to carefully manage our cost of funds and we may not be successful in this effort. To the extent we are permitted under our existing loan or other agreements, we may borrow funds from a number of sources, including through repurchase agreements, re-securitizations, securitizations, warehouse facilities, and bank credit facilities (including term loans and revolving facilities), and the terms of any indebtedness we incur may vary. Although we are not currently required to maintain any particular assets-to-equity leverage ratio, the amount of leverage we may deploy will depend on our available capital, our ability to access financing arrangements, the stability of cash flows generated from the assets in our portfolio, our assessment of the risk-adjusted returns associated with those assets, our ability to enter into repurchase agreements, re-securitizations, securitizations, warehouse facilities and bank credit facilities (including term loans and revolving facilities), available credit limits and financing rates, the type or amount of collateral required to be pledged, and our assessment of the appropriate amount of leverage for the particular assets we are funding.
Borrowing subjects us to a number of other risks, including, among others, the following:
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if we are unable to repay any indebtedness or make interest payments on any loans we incur, our lenders would likely declare us in default, resulting in the acceleration of the associated debt (and any other debt containing a cross-default or cross-acceleration provision) and could require that we repay all amounts outstanding under our loan facilities, which we may be unable to pay from internal resources or refinance on favorable terms, if at all;
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restricting our ability to borrow unused amounts under our financing arrangements, even if we are current in payments on our borrowings under those arrangements;
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the potential loss of some or all of our assets securing the loans to foreclosure or sale;
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increasing our vulnerability to adverse economic and industry conditions with no assurance that investment yields will increase with higher financing costs;
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requiring us to dedicate a substantial portion of our cash flow from operations to interest and principal payments on our debt, thereby reducing funds available for operations;
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negatively affecting our ability to refinance debt that matures prior to sale or other disposition of the investment it was used to finance on favorable terms, or at all; and
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causing our lenders to require as a condition of making a loan to us that the lender receive a priority on mortgage repayments received by us on our mortgage portfolio, thereby requiring the first dollars we collect to go to our lenders.
Any of the foregoing events could materially harm our business, results of operations, and financial condition.
Any repurchase agreements and bank credit facilities into which we may enter in the future to finance our operations may require us to provide additional collateral or pay down debt which could have the effect of reducing the capital that might otherwise be available to be used to fund our operations or expand our business.
We have used, and may continue to utilize, repurchase agreements and bank credit facilities (including term loans and revolving facilities) to finance our operations, assuming such financing is available to us on acceptable terms. Such financing arrangements involve the risk that the market value of the loans pledged or sold by us to the repurchase agreement counter-party or provider of the bank credit facility may decline in value, in which case the counter-party or lender may require us to provide additional collateral or to repay all or a portion of the funds advanced. We may not have the funds available to repay our debt at that time, which would likely result in defaults unless we are able to raise the funds from alternative sources, which we may not be able to do on favorable terms or at all. A lender’s or counter-party’s requirement that we post additional collateral would reduce our liquidity and limit our ability to leverage our assets. If we cannot meet these requirements, the lender or counter-party could accelerate our indebtedness, increase the interest rate on advanced funds, and terminate our ability to borrow funds from it, which could harm our financial condition and ability to implement our business plan. In addition, in the event that a lender or counter-party files for bankruptcy or becomes insolvent, the loans to us may become subject to bankruptcy or insolvency proceedings, thus depriving us, at least temporarily, of the benefit of these assets. Such an event could restrict our access to bank credit facilities and increase our cost of capital. The providers of repurchase agreement financing and bank credit facilities may also require us to maintain a certain amount of cash or set aside assets sufficient to maintain a specified liquidity position that would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose which could reduce our return on assets. In the event that we are unable to meet these collateral obligations, our financial condition and prospects could deteriorate rapidly.
Our loans may contain restrictive covenants relating to our operations which could harm our business, results of operations, and financial condition.
To the extent we borrow funds pursuant to loan or similar agreements, these agreements may impose restrictions on us with respect to our ability to: (i) incur additional debt; (ii) make acquisitions; (iii) reduce liquidity below certain levels; (iv) pay dividends to our stockholders; (v) redeem debt or equity securities; or (vi) conduct the operation of our business and the carrying out of our investment strategy as determined by management. If we fail to meet or satisfy any of the covenants in our current or future loan agreements, we would be in default under these agreements, and our lenders could elect to declare loans outstanding to us due and payable, terminate their commitments to provide future funding, require the posting of additional collateral, and enforce their respective interests against existing collateral from us, or any combination of the foregoing. Also, a default could constitute a Noncompliance Event under our Second Amended Certificate of Designation which could result in, among other things, accelerated maturity under our loan agreements, early redemption of our Series B Preferred Shares, and other ramifications that could be detrimental to our financial position and liquidity. We also may be subject to cross-default and acceleration rights and, with respect to collateralized debt, requirements for us to post additional collateral, and foreclosure rights upon default. A default also could significantly limit our financing alternatives, which could cause us to curtail or suspend all of our investment activities or prematurely dispose of assets.
We have experienced defaults on our commercial mortgage loan assets and expect to experience such defaults in the future, which may harm our business.
We are in the business of acquiring, originating, marketing and selling commercial mortgage loans and, as such, we are at risk of default by borrowers. Any failure of a borrower to repay the mortgage loans or to pay interest on such loans will reduce our revenue and have an adverse effect on our results of operations and financial condition. At December 31, 2017, two of our four loans with outstanding principal and interest balances totaling $12.7 million were in default and past their respective scheduled maturity dates.
Our borrowers are exposed to risks associated with owning real estate.
Our borrowers are subject to risks, expenses, and liabilities associated with owning real estate including, among others:
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the expense of maintaining, operating, developing, and protecting the real estate that serves as collateral for our loans;
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the risk of a decline in value of such real estate due to market or other forces;
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the absence of financing for development and construction activities;
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the risk of default by tenants who have rental obligations to the owners of such real estate;
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the risks of zoning, rezoning, and other regulatory matters affecting such real estate;
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acts of God, including earthquakes, floods, and other natural disasters, which may result in uninsured losses;
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acts of war or terrorism;
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adverse changes in national and local economic and market conditions;
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changes in, related costs of compliance with, fines, or private damage awards for failure to comply with existing or future federal, state, and local laws and regulations, fiscal policies, and zoning ordinances;
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costs of remediation and liabilities associated with environmental conditions;
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the potential for uninsured or under-insured property losses;
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financial and tort liability risks, including construction defect claims, associated with the ownership, development, and construction on such real estate;
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fluctuations in occupancy rates;
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competition for tenants and/or customers;
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ability to renew leases or re-let spaces as leases expire; and
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market risk and the possibility that they will not be able to develop, sell, or operate such real estate to generate the income expected from such real estate.
Any or all of these risks, if not properly managed by the borrower, could impose substantial costs or other burdens on our borrower, or result in a reduction in the value of the real estate underlying our loan to the borrower, thereby increasing the likelihood of default by the borrower. In addition, to the extent we foreclose on any such real estate securing that loan, we would become directly subject to the same risks.
If commercial property borrowers are unable to generate net income from operating the property, we may experience losses on those loans.
The ability of a commercial mortgage loan borrower to repay a loan secured by an income-producing property, such as a multi-family or commercial office building, typically is dependent primarily upon the successful operation of the property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay our 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 expenses 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 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 recourse or non-recourse commercial mortgage loan held directly by us, we generally bear a risk of loss of principal to the extent of any deficiency between the value of the collateral (or our ability to realize such value through foreclosure or otherwise) and the principal and accrued interest on the mortgage loan. 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 commercial 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 and could have a substantial negative effect on our anticipated return on the foreclosed commercial mortgage loan.
We rely on the value of our real estate collateral to help protect us from incurring losses on our commercial mortgage loans, and the realizable value of that real estate collateral is subject to appraisal errors and events beyond our control.
We often rely on third-party appraisers to value the real estate used as collateral for the loans that we make. Any errors or mistakes in judgment by such appraisers may cause an over-valuation of such real estate collateral. Also, the realizable value of the real estate securing our loans may decrease due to a general downturn in the real estate market. As a result, the value of the collateral securing our mortgage loans may be less than anticipated at the time the applicable commercial mortgage loan was originated or acquired. If the value of the collateral supporting our commercial mortgage loans declines and a foreclosure sale occurs, we may not recover the full amount of our commercial mortgage loan.
Our underwriting standards and procedures may not adequately protect us from loan defaults, which could harm our business.
Due to the nature of our business model, we believe the underwriting standards and procedures we use are different from conventional lenders. Accordingly, there is a risk that the underwriting we performed did not, and the underwriting we perform in the future may not, reveal all material facts pertaining to the borrower and the collateral, and there may be a greater risk of default by our borrowers which, as described above, could harm our business.
Guarantors of our loans may not have sufficient assets to support their guarantees, which, in the event of a loan default where the realizable value of the underlying collateral is insufficient to fully amortize our loan.
Our commercial mortgage loans are not insured or guaranteed by any federal, state or local government agency. Our loans are generally guaranteed by individuals or entities affiliated with the borrower. These guarantors may not have sufficient assets to back up their guarantees, in whole or in part, and collections pursuant to any such guarantees may be difficult and costly. Consequently, if there is a default on a particular commercial mortgage loan and guarantee, our only practical recourse may be to foreclose upon the mortgaged real property. If the value of the foreclosed property is less than the amount outstanding under the corresponding loan, we may incur losses.
We may experience a further decline in the fair value of our assets, which could harm our results of operations and our financial condition.
Our real estate assets are subject to increases and decreases in fair value. A decline in the fair value of our assets may require us to recognize a provision for credit loss or an impairment charge against such assets under U.S. generally accepted accounting principles (“GAAP”), if we were to determine that, with respect to any assets in unrealized loss positions, we do not have the ability and intent to hold such assets to maturity or for a period of time sufficient to allow for recovery to the amortized cost of such assets. If such a determination were to be made, we would recognize unrealized losses through earnings and write down the amortized cost of such assets to a new cost basis, based on the fair value of such assets on the date they are considered to be impaired. For example, we recorded a provision for credit loss of $0.7 million year ended December 31, 2017, which was offset by cash recoveries of $0.1 million during the year. For further information, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations for the Years Ended December 31, 2017 and 2016 - Costs and Expenses - Provision for Credit Losses.” We could be required to record additional valuation adjustments in the future. Even in the absence of decreases in the value of real estate, we may be required to recognize provisions for credit losses as a result of the accrual of unpaid taxes on the collateral underlying a loan. We also may be required to recognize impairment charges if we reclassify particular REO assets from being held for development or operating to being held for sale or other REO. Such a provision for credit losses or impairment charges reflects non-cash losses at the time of recognition. Subsequent disposition or sale of such assets could further affect our future results of operations, as they are based on the difference between the sale price received and carrying value of such assets at the time of sale. If we experience a decline in the fair value of our assets, our results of operations and financial condition could be harmed.
Many of our assets are recorded at the lower of cost or fair value assessments, and as a result, there may be uncertainty as to the value of these assets.
The fair value of many of our assets may not be readily determinable, requiring us to make certain estimates and adjustments. We value certain of these investments quarterly at fair value, as determined in accordance with applicable accounting guidance, which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may differ materially from the values that would have been used if a ready market for these assets existed. Moreover, even if the fair values of our REO assets increase, we are generally unable to reflect the value of those assets on our balance sheet above their REO carrying values. As such, the value of such an increase would only be recognized upon disposition of the asset, if any.
Valuations of certain assets may be difficult to obtain or unreliable. When appropriate, the Company will obtain information from third-party valuation specialists and real estate brokers to assist us in valuing our assets. These valuations are often subject to various disclaimers and conditions. Depending on the complexity and lack of liquidity of an asset, valuations of the same asset can vary substantially from one third party valuation provider to another. In certain circumstances, we may be required to determine the fair value of our investments based on our own judgment. Our results of operations for a given period could be harmed if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon their disposal.
Competition for buyers of real estate that we own, or for permanent take-out financing for our borrowers, places severe pressure on asset values, and we may not be able to realize the full value of any of our assets as a result.
The industry in which we operate is serviced primarily by conventional mortgage lenders and loan investors, which include commercial banks, insurance companies, mortgage brokers, pension funds, and private and other institutional lenders. As we resume lending operations, we expect to compete with these lenders as well as new entrants to the competitive landscape who are also focused on originating and acquiring commercial mortgage loans. Additionally, as we seek to locate purchasers for real estate or loans we have acquired, we compete with other real estate owners seeking to sell property or loans acquired through foreclosure or otherwise. Many of these market participants are willing to sell their property or accept permanent take-out financing in amounts
less than their original principal investment. If we are not able to compete successfully in the real estate marketplace, our ability to realize value from our existing REO and loans may be harmed or delayed, and we may not be able to grow our asset portfolio.
Our historical focus on originating and acquiring construction loans exposes us to risks associated with the uncertainty of completion of the underlying project, which may result in losses on those loans.
We have historically originated and acquired, and may continue to originate and acquire, construction loans, which are inherently risky because the collateral securing the loan typically has not been built or is only partially built. As a result, if we do not fund our entire commitment on a construction loan, or if a borrower otherwise fails to complete the construction of a project, there could be adverse consequences to us associated with the loan, including: a loss of the potential value of the property securing the loan, especially if the borrower is unable to raise funds to complete it from other sources; claims against us for failure to perform our obligations as a lender under the loan documents; increased costs for the borrower that the borrower is unable to pay which could lead to default on the loan; a bankruptcy filing by the borrower, which could make it difficult to collect on the loan on a timely basis, if at all; and abandonment by the borrower of the collateral for our loan, which could significantly decrease the value of the collateral.
Risks of cost overruns and non-completion of renovation of the properties underlying rehabilitation loans may result in losses.
We may continue to originate and acquire, rehabilitation loans. In addition, we have acquired a hotel with the intent of making significant renovations in order to increase the overall market value. The renovation, refurbishment, or expansion of such assets involves risks of cost overruns and non-completion. Estimates of the costs of improvements to bring an acquired property up to standards established for the market position intended for that property may prove inaccurate. Other risks may include: rehabilitation costs exceeding original estimates, possibly making a project uneconomical; environmental risks; and rehabilitation and subsequent leasing of the property not being completed on schedule. If such renovation is not completed in a timely manner, or if renovation costs are more than expected, the borrower may experience a prolonged impairment of net operating income and may not be able to make payments to us on our loan on a timely basis or at all, which could result in significant losses to us.
Our loans and real estate assets are concentrated geographically and a downturn in the economies or markets in which we operate could harm our asset values.
We have commercial mortgage loans and own real property (or hold interests in entities that own real property) in the following states: Arizona, California, New Mexico, Utah, Minnesota, Missouri, and Texas. Because we are not diversified geographically and are not required to observe any specific geographic diversification criteria, a downturn in the economies of the states in which we own real estate or have commercial mortgage loans, could harm our loan, real estate or investment portfolio.
We may have difficulty protecting our rights as a secured lender, which could reduce the value or amount of collateral available to us upon foreclosure and harm our business.
While our loan documents provide us with certain enforcement rights with respect to those loans, the manner in which the foreclosure process is conducted and the rights of borrowers and the rights of other secured lenders may prevent or limit our ability to realize substantial benefits from these enforcement rights. For example:
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Foreclosure is subject to delays in the legal processes involved and our collateral may deteriorate and decrease in value during the foreclosure process.
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The borrower’s right of redemption following foreclosure proceedings can delay or deter the sale of our collateral and can, for practical purposes, require us to own and manage any property acquired through foreclosure for an extended period of time.
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Unforeseen environmental contamination may subject us to unexpected liability and procedural delays in exercising our rights.
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The rights of junior secured creditors in the same property can create procedural hurdles for us when we foreclose on collateral.
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We may not be able to obtain a deficiency judgment after we foreclose on collateral. Even if a deficiency judgment is obtained, it may be difficult or impossible to collect on such a judgment.
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State and federal bankruptcy laws can temporarily prevent us from pursuing any actions against a borrower or guarantor, regardless of the progress in any suits or proceedings and can, at times, permit our borrowers to incur liens with greater priority than the liens held by us.
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Lawsuits alleging lender liabilities, regardless of the merit of such claims, may delay or preclude foreclosure.
We may be subject to substantial liabilities if claims are made under lender liability laws.
A number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed “lender liability.” Generally, lender liability is based on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty by the lender to the borrower or its other creditors or stockholders. We may be required to incur substantial legal and other defense costs in the event such a claim is made against us, and if such a claim were to be ultimately successful or resolved through settlement, subject us to significant liability.
If any of the real estate upon which we have foreclosed were to suffer an uninsured loss, we could lose the capital invested in such properties as well as the anticipated future cash flows from the loans secured by those properties.
Through foreclosure, we have acquired a substantial number of real property assets. We carry comprehensive liability, fire, extended coverage, earthquake, business interruption, and rental loss insurance covering all of these properties under various insurance policies. We also maintain title insurance to protect us against defects affecting these real property assets. We select policy specifications and insured limits which we believe to be appropriate given the perceived relative risk of loss, the cost of the coverage and our understanding of industry practice. We do not carry insurance for certain uninsured losses such as loss from riots, war, or nuclear reactions. Our policies are insured subject to certain limitations, including, among others, large deductibles or co-payments and policy limits which may not be sufficient to cover all our losses. In addition, we may discontinue certain policies on some or all of our properties in the future if the cost of premiums for any of these policies exceeds, in our judgment, the value of the coverage relative to the perceived risk of loss. If we, or one or more of our borrowers, experiences a loss which is uninsured or which exceeds policy limits or which the applicable insurance policy does not cover, we could lose the capital invested in those real property assets or in loans secured by such properties as well as the anticipated future cash flows from the assets or loans secured by those properties (or, in the event of foreclosure, from those properties themselves).
Our development activities expose us to project cost, completion, and resale risks.
We occasionally develop or renovate hotel and residential properties, both directly and through partnerships, joint ventures, and other business structures with third parties. Our ongoing involvement in the development of such properties presents a number of risks, including that: (1) continued weakness in the capital markets may limit our ability, or that of third parties with whom we do business, to raise capital for completion of projects that have commenced or for development of future properties; (2) properties that we develop could become less attractive due to decreases in demand for hotel and residential properties, market absorption or oversupply, with the result that we may not be able to sell such properties for a profit or at the prices or selling pace we anticipate, potentially requiring additional changes in our pricing strategy that could result in impairment charges; (3) construction delays or cost overruns, including those due to a shortage of skilled labor, lender financial defaults, or so called “Acts of God” such as earthquakes, hurricanes, floods, or fires may increase overall project costs or result in project cancellations; and (4) we may be unable to recover development costs we incur for any projects that we do not pursue to completion.
In connection with the MacArthur Loan, the Company has agreed to provide a construction completion guaranty with respect to the planned hotel improvement project which shall be released upon payment of all project costs and receipt of a certificate of occupancy. In addition, the Company has provided a loan repayment guaranty equal to fifty percent (50%) of the MacArthur Loan principal along with a guaranty of interest and operating deficits, as well as other customary non-recourse carve-out matters such as bankruptcy and environmental matters. If the Hotel Fund is unable to raise adequate debt or equity capital to fund excessive renovation costs, it would cause the Company to utilize its resources to meet such requirements which could have a detrimental material effect on our liquidity.
We may be exposed to liabilities for risks associated with the use of hazardous substances on any of our properties.
Under various federal, state, and local laws, an owner or operator of real property may become liable for the costs of removal of certain hazardous substances released on its property. These laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. The presence of hazardous substances may harm an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of a property underlying one of our loans becomes liable for removal costs, the ability of the owner to make payments to us may be reduced, which in turn may diminish the value of the relevant mortgage asset held by us. If we acquire a property through foreclosure or otherwise, the presence of hazardous substances on such property may harm our ability to sell the property and we may incur substantial remediation costs, which could harm our results of operations and financial condition.
Other Risk Factors:
We may not be able to utilize our net operating loss carryforwards and built-in tax losses as anticipated, which could result in greater than anticipated tax liabilities.
We have accumulated net operating loss carryforwards of approximately $439.1 million as of December 31, 2017. In addition, we have built-in unrealized tax losses in our portfolio of loans and REO assets, as well as other deferred tax assets, totaling approximately $53.5 million. Subject to certain limitations, such net operating loss carryforwards and unrealized built-in losses may be available to offset future taxable income and gain from our existing assets as well as any income and gain from new assets we acquire. Our ability to use our net operating loss carryforwards and built-in losses is dependent upon our ability to generate taxable income in future periods. In addition, the use of our net operating loss carryforwards and built-in losses is subject to various limitations, including possible changes in the tax laws or regulations relating to the use of these potential tax benefits. For example, there will be limitations on our ability to use our built-in losses or other net operating losses if we undergo a “change in ownership” for U.S. federal income tax purposes. In addition, it is possible that our built-in losses may not be fully available or usable in the manner anticipated. To the extent these limitations occurred or governmental challenges were asserted and sustained with respect to such built-in losses, we may not be permitted to use our built-in losses to offset our taxable income, in which case our tax liabilities could be greater than anticipated.
Uncertainties in the interpretation and application of the 2017 Tax Cuts and Jobs Act could materially affect our tax obligations and effective tax rate.
On December 22, 2017, the U.S. enacted comprehensive tax legislation, commonly referred to as the 2017 Tax Cuts and Jobs Act (the “2017 Tax Act”), which significantly affected U.S. tax law by changing how the U.S. imposes income tax on corporations. The 2017 Tax Act requires complex computations not previously required by U.S. tax law. As such, the application of accounting guidance for such items is currently uncertain. Further, compliance with the 2017 Tax Act and the accounting for such provisions require preparation and analysis of information not previously required or regularly produced. In addition, the U.S. Department of Treasury has broad authority to issue regulations and interpretative guidance that may significantly impact how we will apply the law and impact our results of operations in future periods. Accordingly, while we have provided a provisional estimate on the effect of the 2017 Tax Act in our Financial Statements, further regulatory or GAAP accounting guidance for the 2017 Tax Act, our further analysis on the application of the law, and refinement of our initial estimates and calculations could materially change our current provisional estimates, which could in turn materially affect our tax obligations and effective tax rate.
Our decisions about raising capital may adversely affect our business and financial results. Furthermore, our growth may be limited if we are not able to raise additional capital.
We rely on our ability to raise capital to fund our continuing operations and achieve our investment objectives. We may raise capital through a variety of methods, including, but not limited to, issuing new shares of our common stock or preferred stock, and issuing convertible and non-convertible debt securities. The number of our unissued shares of stock authorized for issuance establishes a limit on the amount of capital we can raise through issuances of shares of stock unless we seek and receive approval from our stockholders to increase the authorized number of our shares in our charter. Also, certain “change of ownership” tests under U.S. federal income tax laws may limit our ability to raise needed equity capital and/or could limit our future use of tax losses to offset any income tax obligations we may incur in the future.
In addition, we may not be able to raise capital when needed or desired. As a result, we may not be able to finance our continuing operations or growth in our business and in our portfolio of assets. If we are unable to raise capital and expand our business and our portfolio of investments, we may have to forgo attractive business and investment opportunities, and our operating expenses may increase significantly relative to our capital base, adversely affecting our business and financial condition.
To the extent we have capital that is available for investment, we have broad discretion over how to invest that capital and you will be relying on the judgment of our management regarding its use. To the extent we invest capital in our business or in portfolio assets, we may not be successful in achieving favorable returns.
A financial downturn, recession or other declines in the U.S. real estate market could further adversely affect our operating results and liquidity.
If the financial or real estate markets were to experience a decline, we could experience additional losses and write-downs of assets, and could face serious capital and liquidity constraints and other business challenges.
We depend on key personnel and an error in judgment or the loss of their services could harm our business.
Our success depends upon the experience, skills, resources, relationships, contacts and continued efforts of certain key personnel. If any of these individuals were to make an error in judgment in conducting our operations, our business could be harmed. If any of these individuals were to cease employment with us, our business and operating results could suffer. Our future success also depends in large part upon our ability to hire and retain highly skilled managerial, operational, and marketing personnel. Competition for such personnel is intense. Should we be unable to attract and retain such key personnel, our ability to make prudent investment decisions may be impaired, which could harm our results of operations and prospects.
Our risk management efforts may not be effective.
We could incur substantial losses and our business operations could be disrupted if we are unable to effectively identify, manage, monitor, and mitigate financial risks, such as credit risk, interest rate risk, prepayment risk, liquidity risk, and other market-related risks, as well as operational risks related to our business, assets, and liabilities. Our risk management policies, procedures, and techniques may not be sufficient to identify all of the risks we are exposed to, mitigate the risks we have identified, or to identify additional risks to which we may become subject in the future. Expansion of our business activities may also result in our being exposed to risks that we have not previously been exposed to or may increase our exposure to certain types of risks and we may not effectively identify, manage, monitor, and mitigate these risks as our business activity changes or increases.
Our technology infrastructure and systems are important and any significant disruption or breach of the security of this infrastructure or these systems could have an adverse effect on our business. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business.
In order to analyze, acquire, and manage our investments, manage the operations and risks associated with our business, assets, and liabilities, and prepare our financial statements, we rely upon computer hardware and software systems. Some of these systems are located at our offices and some are maintained by third party vendors or located at facilities maintained by third parties. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business. Any significant interruption in the availability or functionality of these systems could impair our access to liquidity, damage our reputation, and have an adverse effect on our operations and on our ability to timely and accurately report our financial results. In addition, any breach of the security of these systems could have an adverse effect on our operations and the preparation of our financial statements. Steps we have taken to provide for the security of our systems and data may not effectively prevent others from obtaining improper access to our systems data. Improper access could expose us to risks of data loss, litigation, and liabilities to third parties, and otherwise disrupt our operations. For example, our systems and the systems of third parties who provide services to us and with whom we transact business may contain non-public personal information that an identity thief could utilize in engaging in fraudulent activity or theft. We may be liable for losses suffered by individuals whose identities are stolen as a result of a breach of the security of these systems, and any such liability could be material.
Failure to prevent or detect a malicious cyber-attack on our systems and databases could result in a misappropriation of confidential information or access to highly sensitive information.
Cyber-attacks are becoming more sophisticated and pervasive. Across our business we hold large volumes of personally identifiable information including that of employees and customers. Individuals may try to gain unauthorized access to our data in order to misappropriate such information for potentially fraudulent purposes, and our security measures may fail to prevent such unauthorized access. A significant breach could have a material adverse effect on our operations, reputation, and financial condition. In addition, if we were unable to prove that our systems are properly designed to detect an intrusion, we could be subject to severe penalties and loss of existing or future business. Further, third parties, such as hosted solution providers, that provide services to us, could also be a source of security risk in the event of a failure of their own security systems and infrastructure. The costs to mitigate or address security threats and vulnerabilities before or after a cyber incident could be significant. Our remediation efforts may not be successful and could result in interruptions, delays or cessation of service, and loss of business. As threats related to cyber attacks develop and grow, we may also find it necessary to make further investments to protect our data and infrastructure, which may impact our profitability.
Conducting our business in a manner so that we are exempt from registration under the Investment Company Act may reduce our flexibility and could limit our ability to pursue certain opportunities. At the same time, failure to continue to qualify for exemption from the Investment Company Act could adversely affect us.
Under the Investment Company Act, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates. However, companies primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate are exempt from the requirements of the Investment Company Act. We believe that we have conducted our business so that we are exempt from the Investment Company Act. Rapid changes in the values of assets we own, however, can disrupt our efforts to conduct our business to meet the requirements of these exemptions.
If we failed to meet these requirements, we could, among other things, be required either (i) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) to register as an investment company, either of which could adversely affect us by, among other things, requiring us to dispose of certain assets or to change the structure of our business in ways that we may not believe to be in our best interests. Legislative or regulatory changes relating to the Investment Company Act or which affect our efforts to comply with the exemption requirements could also result in these adverse effects on us.
If we were deemed an unregistered investment company, we could be subject to monetary penalties and injunctive relief and we could be unable to enforce contracts with third parties, and third parties could seek to obtain rescission of transactions undertaken during the period we were deemed an unregistered investment company, unless the court found that under the circumstances, enforcement (or denial of rescission) would produce a more equitable result than no enforcement (or grant of rescission) and would not be inconsistent with the Investment Company Act.
In addition, concurrent with the execution of the Series B-2 Purchase Agreement, the Company, JCP Realty Partners, LLC, Juniper NVM, LLC, and JPM Funding entered into an Investment Agreement (“Series B Investment Agreement”) pursuant to which the Company made certain representations and covenants, including, but not limited to, a covenant that the Company take all commercially reasonable actions as are reasonably necessary for the Company to be eligible to rely on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act of 1940, as amended, commonly referred to as the “Real Estate Exemption,” and to remain eligible to rely on that exemption at all times thereafter. Furthermore, under the Series B-2 Purchase Agreement, the Company was obligated not to take any action, the result of which would reasonably be expected to cause the Company to become ineligible for the Real Estate Exemption without the prior written consent of JPM Funding.
We do not believe that we are an investment company under the Investment Company Act. Nevertheless, it is possible that we will not be eligible for exemption under the Investment Company Act which, in such event, could require us to redeem our Series B Preferred Shares at a time which is prior to such time as is otherwise required under the Second Amended Certificate of Designation. Such a required redemption could force us to sell our assets at below their fair value or to borrow funds at rates higher than would ordinarily be the case in order to have the funds to redeem such shares, and could even force the liquidation of the Company.
Risks Related to our Common Stock:
Under our Second Amended Certificate of Designation, we are not permitted to pay dividends on our common stock and we may not meet Delaware law requirements or have sufficient cash to pay dividends in the future.
We are not required to pay dividends to the holders of our Common Stock and the holders of our Common Stock do not have contractual or other rights to receive them other than certain dividends payable in connection with an “initial public offering” as set forth in our Certificate of Incorporation. Under our Second Amended Certificate of Designation, we are allowed to pay dividends to the holders of our Common Stock only under limited circumstances.
In addition, under Delaware law, our board of directors may not authorize a dividend unless it is paid out of our surplus (calculated in accordance with the Delaware General Corporation law), or, if we do not have a surplus, it is paid out of our net profits for the fiscal year in which the dividend is declared and the preceding fiscal year.
Any and all dividends will be paid at the discretion of our board of directors. Our ability to pay dividends in the future will depend on numerous factors, including:
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our obligations under agreements governing our outstanding indebtedness:
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our obligations under our Second Amended Certificate of Designation;
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the state of our business, the environment in which we operate, and the various risks we face, including financing risks and other risks summarized in this report;
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the results of our operations, financial condition, liquidity needs, and capital resources;
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our expected cash needs, including for interest and any future principal payments on indebtedness or the redemption of our Preferred Stock; and
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potential sources of liquidity, including borrowing under our credit facilities and possible asset sales.
Under the terms of our Second Amended Certificate of Designation, no dividends may be paid on our Common Stock during any fiscal year unless all accrued dividends on the Series B-1, Series B-2 and Series B-3 preferred stock have been paid in full. The Second Amended Certificate of Designation does permit the Company to authorize quarterly dividends on our Common Stock of up to $375,000 in the aggregate. In addition to that amount, the Company may authorize additional quarterly dividends on our Common Stock provided that the Company also pays to the Series B preferred stockholders a dividend in an amount equal to what those preferred stockholders would have received had their preferred stock been converted to common stock as of the ex-dividend date.
See Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities - Dividends” below for further discussion regarding limitations on our ability to declare and pay dividends to shareholders.
A limited number of shareholders own shares of our Series B Preferred Stock that are convertible into a significant percentage of our fully-diluted Common Stock, which could have adverse consequences to other holders of our Common Stock.
As of December 31, 2017, based on filings of Schedules 13D with the SEC, our Series B Investors own shares of our Series B Preferred Stock that are convertible into 38%, in the aggregate, of our outstanding Common Stock. Significant ownership stakes held by the holders of our Series B Preferred Shares could have adverse consequences for other stockholders because the holders of our Series B Preferred Stock have a significant influence over the outcome of matters submitted to a vote of our stockholders, including the election of our directors and transactions involving a change in control, and in the investment strategies pursued by the Company.
We may use debt or equity securities, which would be senior to our common stock in liquidation, and for the purposes of dividends and distributions, would dilute our existing stockholders’ interests.
In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes, preferred stock or common stock. The terms of our charter documents do not preclude us from issuing additional debt or equity securities. Our certificate of incorporation permits our board of directors, without the approval of the holders of our Common Stock, to authorize the issuance of common or preferred stock in connection with equity offerings, acquisitions of securities or other assets of companies, divide and issue shares of preferred stock in series and fix the voting power and any designations, preferences, and relative, participating, optional or other special rights of any preferred stock, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over your common stock with respect to voting. We have issued shares of our Series B Preferred Stock which accounted for 38% of our capital stock as of December 31, 2017. We are not required to offer any such shares to existing stockholders on a preemptive basis. Therefore, it may not be possible for existing stockholders to participate in future stock issuances. Additional equity offerings by us may dilute your interest in us. Our Series B Preferred Shares have a preference on distribution payments that could limit our ability to make a distribution to the holders of our common stock. If we issue additional debt securities, we could become more highly leveraged, resulting in (i) an increase in debt service that could harm our ability to make dividends to our stockholders, and (ii) an increased risk of default on our obligations. If we were to liquidate, holders of our debt and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets before the holders of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, you will bear the risk that any future offerings by us could dilute your interest in us.
Certain provisions of our certificate of incorporation, bylaws, debt instruments and the Delaware General Corporation Law could make it more difficult for a third-party to acquire us, even if doing so would benefit our stockholders.
Certain provisions of the Delaware General Corporation Law, (“DGCL”), may have the effect of deterring hostile takeovers or otherwise delaying or preventing changes in our management or in the control of our company, including transactions in which our stockholders might otherwise receive a premium over the fair market value of their securities. In particular, Section 203 of the DGCL may, under certain circumstances, make it more difficult for a person who would be an “interested stockholder” (defined
generally as a person with 15% or more of a corporation’s outstanding voting stock) to effect a “business combination” (defined generally as mergers, consolidations and certain other transactions, including sales, leases or other dispositions of assets with an aggregate market value equal to 10% or more of the aggregate market value of the corporation) with the corporation for a three-year period. Under Section 203, a corporation may under certain circumstances avoid the restrictions imposed by Section 203. Moreover, a corporation’s certificate of incorporation or bylaws may exclude a corporation from the restrictions imposed by Section 203. We have not made this election, and accordingly we are subject to the restrictions of Section 203 of the DGCL. Furthermore, upon any “change of control” transaction, the restrictions on transfer applicable to the shares of our Class B and Class C common stock will terminate, which could act to discourage certain change of control transactions.
Shares of our Common Stock are subject to certain restrictions on transfer under Article V of the Company’s Bylaws, which could restrict your ability to sell your shares in certain circumstances.
In order to preserve our significant net operating loss carryforward, we have adopted certain restrictions on the transfer of shares of our common stock. Under section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), our ability to utilize our net operating loss carryforward and certain other tax benefits would be severely curtailed upon the occurrence of a “change in control” (defined generally as a more than 50 percentage point increase in the ownership of the Company by certain equity holders who are defined in section 382 of the Code as “5 percent shareholders”). In order to preserve our net operating loss carryforwards, we must ensure that there has not been a “change in control” of the Company. Accordingly, we have adopted provisions in our Bylaws in order to ensure that no “change in control” occurs without the consent of the Company. Specifically, under Section 5.03 of the Company’s Bylaws, with limited exception, the following transfers of common stock are prohibited without prior written consent of the board: (1) any sale or other transfer that would result in any person (or group of related persons) becoming a “5 percent shareholder” under section 382 of the Code, or (2) any sale or other transfer that would result in an increase in the ownership of the Company by any existing 5 percent shareholder. In addition to the transfer restrictions found in our Bylaws, the Company has adopted additional transfer restrictions which severely limit the ability of shareholders to transfer their shares. The board of directors may withhold its consent to any prohibited transfer in its sole and absolute discretion. Accordingly, if you intend to sell or otherwise transfer your shares, and the intended transfer is prohibited under the Company’s Bylaws, you may not be able to consummate the sale or transfer without the prior consent of the board of directors, and the board of directors has no obligation to approve the sale or transfer. Thus, in that circumstance, you may be required to hold your shares indefinitely. Further, even if you are not subject to the foregoing transfer restrictions, those restrictions could have an adverse effect on the marketability of your shares, which could decrease the value of your shares.
The ability to take action against our directors and officers is limited by our charter and bylaws and provisions of Delaware law and we may (or, in some cases, are obligated to) indemnify our current and former directors and officers against certain losses relating to their service to us.
Our charter limits the liability of our directors and officers to us and to shareholders for pecuniary damages to the fullest extent permitted by Delaware law. In addition, our charter authorizes our Board of Directors to indemnify our officers and directors (and those of our subsidiaries or affiliates) for losses relating to their service to us to the full extent required or permitted by Delaware law. In addition, we have entered into, and may in the future enter into, indemnification agreements with our directors and certain of our officers and the directors which obligate us to indemnify them against certain losses relating to their service to us and the related costs of defense.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS.
None.
ITEM 2.
ITEM 2.
PROPERTIES.
Other than MacArthur Place, the majority of properties owned by us were acquired through the exercise of our enforcement rights under legacy loans in our loan portfolio. Our executive and administrative offices are located in Scottsdale, Arizona where we lease approximately 11,000 square feet under a lease that expires September 30, 2022.
A description of our REO and operating properties with a total net carrying value of $64.6 million as of December 31, 2017 follows:
Properties by Development Classification
The following summarizes our REO properties by development classification as of December 31, 2017 (dollars in thousands):
Other information about our REO assets is included in Note 4 of the accompanying consolidated financial statements.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS.
In September 2017, the Supreme Court of the State of Arizona ordered the termination of the receivership over Stockholder, LLC, a wholly-owned subsidiary of the Company (“Stockholder”). Stockholder is the owner of all of the shares of stock in certain corporations that act as the general partner / limited liability company manager of several entities that own land and/or certain water interests in New Mexico. As a result of this termination, the Company consolidated its interests in a number of those entities that were previously accounted for under the equity method.
In December 2017, the Supreme Court of the State of Arizona entered an interim “stay” order in the Company’s case against judgment debtor David P. Maniatis and his affiliates (“Maniatis”) enjoining the Company from taking any further collection action against, pending an accounting of all previous debt collection activities and a trial on certain limited issues involving the calculation of interest and penalties on the original defaulted debt guaranteed by Maniatis. The stay order also temporarily inhibits the Company from effecting the sale or transfer of all or any part of the property previously acquired by the Company through litigation involving Maniatis, including approximately 7,000 acres of land and related water interests in New Mexico and 111 acres of land in Texas.
For a description of other legal proceedings, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 15 of the accompanying notes to consolidated financial statements.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES.
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
We are required to file reports with the SEC in accordance with Section 12(g) of the Exchange Act. Our shares have not been traded or quoted on any exchange or quotation system. There is no public market for our shares.
Shareholders
As of March 29, 2018, there were 4,514, 4,520, and 4,793 holders of record of our Class of B-1, B-2 and B-3 common stock, respectively, two holders of record of our Class B-4 common stock, 412 holders of record of our Class C common stock, 27 holders of record of our common stock, and three holders of record of our outstanding Series B-1, Series B-2 and Series B-3 preferred stock.
Dividends
During the years ended December 31, 2017 and 2016, we paid no dividends on any of our classes of common stock. For those same years, we paid cash dividends of $2.1 million in each of the years, to the holders of our preferred stock.
Under the Second Amended Certificate of Designation, our common stock is junior in rank to our Series B Preferred Stock with respect to the preferences as to dividends, distributions and payments upon liquidation. In the event that any dividends are declared with respect to the common stock, the holders of the Series B Preferred Stock as of the record date established by the board of directors for such dividends will be entitled to receive as additional dividends (in each case, the “Additional Dividends”) an amount (whether in the form of cash, securities or other property) equal to the amount (and in the same form) of the dividends that such holder would have received had the Series B Preferred Stock been converted into common stock as of the date immediately prior to the record date of such dividend, such Additional Dividends to be payable, out of funds legally available, on the payment date of the dividend established by the board of directors. In the event we are obligated to pay a one-time special dividend on our Class B common stock (the “Special Dividend”), the holders of the Series B Preferred Stock as of the record date established by the board of directors will be entitled to receive as additional dividends (the “Special Preferred Class B Dividends”) for each share of common stock that it would hold if it had converted all of its shares of Series B Preferred Stock into common stock the same amount that is received by holders of Class B common stock with respect to each share of Class B common stock (in each case, subject to appropriate adjustment in the event of any stock dividend, stock split, combination or other similar reorganization event affecting such shares), such Special Preferred Class B dividends to be payable, out of funds legally available, on the payment date for the Special Dividend (the “Special Preferred Class B Payment Date”).
Equity Compensation Plan Information
During the year ended December 31, 2017, we issued options for 116,830 shares of common stock to our employees under our First Amended and Restated 2010 IMH Financial Corporation Employee Stock Incentive Plan (“Equity Incentive Plan”) subject to certain vesting and other conditions. Additionally, we approved grants of 352,325 shares of restricted common stock under our Equity Incentive Plan, subject to certain vesting and other conditions and net of certain tax elections made by the grantees.
During the year ended December 31, 2017, we issued a total of 116,772 shares of common stock under our 2014 Non-Employee Director Compensation Plan (“Director Compensation Plan”) to our independent board members.
The following is information with respect to outstanding options, warrants and rights as of December 31, 2017:
Issuer Purchases of Equity Securities
While the Company does not have a formal share repurchase program, it may repurchase its shares from time to time through privately negotiated transactions. There were no shares repurchased under any publicly announced plans or repurchase programs during the year ended December 31, 2017.
During the year ended December 31, 2017, the Company redeemed 196,278 shares of the common stock of the Company held by Lawrence D. Bain, the Company’s Chief Executive Officer, which were part of an 850,000 restricted share grant awarded to Mr. Bain pursuant to a Restricted Stock Award Agreement entered into between the Company and Mr. Bain, dated as of June 1, 2015 (the “Award Agreement”). The Company paid Mr. Bain $0.3 million for the redeemed shares. The shares were redeemed by the Company, upon the approval of the Compensation Committee of the Board of Directors of the Company, pursuant to an election made by Mr. Bain under Section 83(b) of the Code and the Award Agreement pursuant to which the parties agreed to make arrangements for the satisfaction of tax withholding requirements associated with the stock award.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA.
The registrant is a Smaller Reporting Company and, therefore, is not required to provide the information under this item.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS.
The following discussion of our financial condition and results of operations should be read in conjunction with the sections of this Form 10-K entitled “Risk Factors,” “Special Note About Forward-Looking Statements,” “Business” and our audited financial statements and the related notes thereto and other detailed information as of December 31, 2017 and 2016 and for the years ended December 31, 2017 and 2016 included elsewhere in this Form 10-K. This discussion contains forward-looking statements reflecting current expectations about the future of our business that involve risks and uncertainties. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the section entitled “Risk Factors” included elsewhere in this Form 10-K. Unless specified otherwise and except where the context suggests otherwise, references in this section to the “Company,” “we,” “us,” and “our” refer to IMH Financial Corporation and its consolidated subsidiaries. Undue reliance should not be placed upon historical financial statements since they are not necessarily indicative of expected results of operations or financial condition for any future periods.
Overview of the Business
We are a real estate investment and finance company focusing on the commercial, hospitality, industrial and residential real estate markets. The Company intends to expand its hospitality footprint and use of the L’Auberge brand through the acquisition or management of other luxury boutique hotels.
Our current business focus is to re-establish the Company’s access to significant investment capital in order to improve the performance of our portfolio. By increasing the level and quality of the assets in our portfolio, we believe that the Company can grow and ultimately provide its shareholders with favorable risk-adjusted returns on its investments and ultimately provide enhanced opportunity for liquidity.
Recent Developments
Operations and Investments
As of December 31, 2017, we held mortgage and real estate assets with a carrying value of $84.3 million. Our REO held for sale are being marketed for disposition within the next twelve months.
During the year ended December 31, 2017, we sold our Sedona hotel operating assets for $92.0 million, net of transaction costs and other adjustments, which resulted in a net gain of $6.8 million, and generated net proceeds of $57.9 million, after repayment of $50.0 million in senior indebtedness. In addition to the Sedona hotels, we sold 8 properties (or portions thereof) during the year ended December 31, 2017 for $12.8 million, net of transaction costs and other adjustments, which resulted in a net gain of $3.9 million.
On October 2, 2017, we acquired MacArthur Place for a purchase price $36.0 million.
In connection with the acquisition of MacArthur Place, the Company entered into a loan agreement with MidFirst Bank in the amount of $32.3 million, of which approximately $19.4 million was utilized for the purchase of MacArthur Place, approximately $10.0 million is being set aside to fund planned hotel improvements, and the balance is to fund interest reserves and operating capital. The MacArthur Loan requires us to fund minimum equity of $17.4 million, the majority of which was funded at the time of purchase and the balance of which will be funded during the renovation period.
During the year ended December 31, 2017, the Company began to consolidate previously unconsolidated variable interest entities into its financial statements, the assets of which are comprised of real estate holdings, rights to develop water and receivables from other related entities, and liabilities which consist primarily of various amounts payable to related entities. The consolidation followed the termination of a court-appointed receivership which controlled the general partnership interest in those entities. As a result of the termination of that receivership, the Company was deemed to have received full possession, custody and control of the general partnership interests and thus control such partnerships. The assets and liabilities of the newly consolidated entities were recorded at their preliminary estimated fair values, with the portion attributable to non-Company interests reflected in non-controlling interest.
During the year ended December 31, 2017, we recommenced our mortgage lending operations and acquired two loans with an aggregate face value of $19.9 million. One loan has a maturity date of September 9, 2018 with a one-year extension option, bearing an annual interest rate of 9.75% plus one-month LIBOR. The other loan has a maturity date of October 9, 2019, with 3 one-year extensions, and an annual interest rate of 7.25% plus one-month LIBOR.
We also recorded recoveries of investment and credit losses of $6.5 million during the year ended December 31, 2017.
Capital Activity
On February 9, 2018, the Company issued 2,352,941 shares for its newly authorized Series B-3 Cumulative Convertible Preferred Stock to JPM Funding at a purchase price of $3.40 per share, for a total purchase price of $8.0 million. Dividends on the Series B-3 Preferred Stock are cumulative and accrue from the issue date and compound quarterly at the rate of 5.65% of the issue price per year, and are payable quarterly in arrears. The Company intends to use the proceeds from the sale of these shares for general corporate purposes.
Factors Affecting Our Financial Results
General Economic Conditions Affecting the Real Estate Industry
We have held certain REO assets for several years with the expectation that we would realize more significant appreciation in the values of those assets over time. While we have seen a stabilization of values and sporadic increased values of our REO assets, the increase in value has been less than anticipated. Moreover, due to our lack of available cash flow, our investment opportunities have been limited. We continue to examine all material aspects of our business for areas of improvement and recovery on our assets including recoveries against guarantors.
The lodging industry is seasonal in nature and depends upon location, type of property and competitive mix within the specific location. Based on our current hotel assets, revenues are typically lower in the first and third quarters of each year in comparison to the second and fourth quarters of the year.
While we have been successful in securing debt and equity financing in recent years to provide adequate funding for working capital purposes and have generated cash through asset sales and mortgage receivable collections, our ability to reinvest such proceeds in income-producing assets has been limited. We need to secure additional and affordable capital in order realize our income objectives. Based on (1) our cash and cash equivalents of $11.8 million at the end of 2017, (2) the additional $8.0 million in capital secured in early 2018, (3) revenues we expect from our hotel management activities, and (4) the expected proceeds from the continued sale of our legacy real estate assets, we have sufficient liquidity to fund current operations for a period of at least one year from the date of this Annual Report.
Revenues
We receive only a small amount of income from our lending activities. As a result of the December 2016 sale of our Minnesota multifamily project, the February 2017 sale of our Sedona hotel operations, and the June 2017 sale of our golf course operation, our operating property revenues substantially decreased in 2017. We expect that we will generate additional operating revenue in 2018 as a result of our October 2017 acquisition of MacArthur Place and through the possible acquisition or management of other hospitality properties.
We also recommenced our lending activities during 2017, and expect to continue originating or acquiring loans in 2018. For the near future, we expect to derive a substantial percentage of our revenue from REO dispositions than from interest and fee income from loans originated or acquired by us. As our liquidity position improves, we intend to continue to execute our investment strategy and expect that interest and fee income from our commercial real estate lending activities will increase.
Expenses
We incur various expenses related to the direct operations of our operating and non-operating properties; professional fees for consulting, valuation, legal and other expenses related to our loan and guarantor enforcement activities; general and administrative expenses such as compensation and benefits for non-operating property employees, rent, insurance, utilities and related costs; and interest and related costs relative to our financing and refinancing initiatives.
Impairment of Real Estate Owned. Our estimate of impairment charges on REO assets largely depends on whether the particular REO asset is held for development or held for sale. This classification depends on various factors, including our intent to sell the property immediately or further develop and sell the property over time, and whether a formal plan of disposition has been adopted, among other factors. Real estate held for sale is carried at the lower of carrying amount or fair value, less estimated selling costs, which is primarily based on supporting data from third-party valuation firms, market participant sources, and valid offers from
third parties. Reductions in the fair value of assets held for sale are recorded as impairment charges. Real estate held for development is carried at the transferred value upon foreclosure, less cumulative impairment charges. Impairment charges on real estate owned consist of charges to REO assets in cases where the estimated future undiscounted cash flows of the property is below current carrying value and the reduction in asset value is deemed to be other than temporary. Generally, asset values have stabilized in many of the areas where we hold real estate, however, our assets are reviewed for impairment individually. We have sold and intend to actively market and sell substantially all of our REO assets, individually or in bulk, over the next 12 months as a means of raising additional capital to pursue our investment objectives and fund core operations.
Results of Operations for the Years Ended December 31, 2017 and December 31, 2016
The following discussion compares historical results of operations on a GAAP basis for the fiscal years ended December 31, 2017 and 2016. Unless otherwise noted, all comparative performance data included below reflects year-over-year comparisons.
Operating Property Revenue. For year ended December 31, 2017, we recorded $3.7 million in operating property revenue as compared to $4.7 million for the year ended December 31, 2016, a decrease of $1.0 million or 21.7%. The year-over-year decrease in operating property revenue is primarily attributable to the sale of our multifamily residential operation in the fourth quarter of 2016 and the sale of our golf and restaurant operation in the second quarter of 2017. This decrease was offset by the revenues generated by our operation of MacArthur Place beginning in October 2017. The revenue attributable to our Sedona hotels, which were sold in the first quarter of 2017, is classified within discontinued operations in our consolidated statement of operations for the years ended December 31, 2017 and 2016.
Management Fees, Investment and Other Income. For the year ended December 31, 2017, management fees, investment and other income was $1.2 million, an increase of $0.8 million, or 212.8%, over the year ended December 31, 2016. The year-over-year increase is primarily attributable to the management fees we received for managing the Sedona hotels following their sale, and management fees earned under various partnership agreements.
Mortgage Loan Income. For the year ended December 31, 2017, income from mortgage loans was $0.9 million, an increase of $0.6 million from the year ended December 31, 2016. The year-over-year increase in mortgage loan income is primarily attributable to mortgage investments we made in June and November 2017 totaling $19.7 million with a weighted average interest rate of 9.7%, offset by the payoff and sale of loans in 2016.
Costs and Expenses
Operating Property Direct Expenses (exclusive of Interest and Depreciation). For the year ended December 31, 2017, operating property direct expenses were $4.3 million, an increase of $0.4 million, or 10.7%, from $3.9 million for the year ended December 31, 2016. Amounts for the year ended December 31, 2017 include direct operating costs of our golf and restaurant operation (through the date of sale) and MacArthur Place, as well as costs relating to our hospitality management subsidiary which are partially funded through related management fee income. As noted above, the operating expenses attributable to our Sedona hotels, which were
sold in the first quarter of 2017, are classified within discontinued operations in our consolidated statement of operations for the years ended December 31, 2017 and 2016. The year-over-year increase in operating property direct expenses is primarily attributed to the acquisition and operating costs associated with the MacArthur Place purchase in the fourth quarter of 2017 coupled with the start-up and operational costs of our hospitality management subsidiary, offset by a decrease in the operating costs of our golf and restaurant operation (which was sold late in the second quarter of 2017), and our multifamily residential operation (which was sold in the fourth quarter of 2016).
Expenses for Non-Operating Real Estate Owned. For the year ended December 31, 2017, expenses for non-operating real estate owned assets were $0.8 million, an increase of $0.5 million or 121.0%, from $0.4 million for the year ended December 31, 2016. The year-over-year increase is primarily attributable to an increase in real estate taxes and asset repair and maintenance costs resulting from our consolidation of certain partnerships in 2017.
Professional Fees. For the years ended December 31, 2017 and 2016, professional fees were $5.2 million and $4.4 million, respectively. The increase in professional fees is primarily attributed to costs incurred in connection with certain capital transactions, due diligence of prospective and acquired investments, as well as enforcement and recovery related legal fees.
General and Administrative Expenses. For the years ended December 31, 2017 and 2016, general and administrative expenses were $9.0 million and $7.6 million, respectively, an increase of $1.3 million or 17.2%. The increase in general and administrative costs is primarily attributed to grants of cash and stock-based executive bonus compensation as well as one-time costs incurred in connection with the sale of the Series B-2 Preferred Stock to JPM.
Interest Expense. For the year ended December 31, 2017, interest expense was $2.1 million as compared to $5.3 million for the year ended December 31, 2016, a decrease of $3.2 million, or 60.9%. The year-over-year decrease is attributed primarily to the payoff of a $22.1 million construction loan, a $9.0 million in related party indebtedness in the fourth quarter of 2016, and the payoff of the $50.0 million mortgage note in February 2017, offset by the interest expense in the fourth quarter attributable to the $32.3 million acquisition and construction loan from MidFirst Bank.
Depreciation and Amortization Expense. For the year ended December 31, 2017, depreciation and amortization expense was $0.4 million compared to $0.8 million for the year ended December 31, 2016. The year-over-year decrease is due primarily to the sales of our multifamily property in the fourth quarter of 2016 and the sale of the Sedona hotels in the first quarter of 2017.
(Gain) Loss on Disposal of Assets. We sold 10 REO assets (in whole or portions thereof) for $104.9 million (net of selling costs) resulting in a gain of $10.7 million (of which $6.8 million is included as a component of discontinued operations in the audited consolidated statement of operations) during the year ended December 31, 2017. During the year ended December 31, 2016, we sold 10 REO asset for $44.2 million (net of selling costs) for a net gain of $10.8 million and one mortgage note for $6.4 million (net of selling costs), resulting in a net gain of $0.2 million.
(Recovery of) Provision for Investment and Credit Losses. For the year ended December 31, 2017, we recorded recoveries of investment and credit losses of $6.5 million primarily resulting from the consolidation of various equity interests, and from cash, receivables, and/or other assets recovered from guarantors on certain legacy loans and insurance recoveries. We recorded recoveries of $0.2 million for the year ended December 31, 2016.
Impairment of Real Estate Owned. For the year ended December 31, 2017, we recorded impairment of real estate owned of $0.7 million based on the fair value analysis of our REO portfolio, and none for the year ended December 31, 2016.
Equity Loss of Unconsolidated Subsidiaries. For the years ended December 31, 2017 and 2016, we recorded net losses of unconsolidated subsidiaries of $0.2 million. These losses resulted from our portion of allocated operating expenses combined with a lack of revenue from such partnerships.
Discontinued Operations. As described in Note 17 of this Form 10-K, we sold our Sedona hotel assets on February 28, 2017 and, in accordance with GAAP, have presented the results of operations for such assets in net income (loss) from discontinued operations for the years ended December 31, 2017 and 2016. For the year ended December 31, 2017, our Sedona hotels contributed net income of $3.1 million, compared to a net loss of $1.3 million for the year ended December 31, 2016. In conjunction with the sale of the Sedona hotels, the $50.0 million note payable secured by the assets was repaid in full. This note payable has correspondingly been presented in the liabilities from discontinued operations as of December 31, 2016.
Operating Segments
Our operating segments reflect the distinct business activities from which revenues are earned and expenses incurred that is evaluated regularly by our executive management team in assessing performance and in deciding how to allocate resources. As of and for the years ended December 31, 2017 and 2016, the Company’s reportable segments consisted of the following:
Hospitality and Entertainment Operations - Consists of revenues less direct operating expenses, depreciation and amortization relating to our hotel, golf, spa, and food & beverage operations. This segment also reflects the carrying value of such assets and the related financing and operating obligations. As described elsewhere in this Form 10-K, we sold our Sedona hotels on February 28, 2017 and, in accordance with GAAP, have presented the results of operations for such assets in net income (loss) from discontinued operations for the years ended December 31, 2017 and 2016. While the Sedona hotels have been presented as discontinued operations in the accompanying consolidated financial statements, the Company intends to continue its active engagement in the Hospitality and Entertainment Operations segment through our hotel management group. Moreover, the Company acquired MacArthur Place in the fourth quarter of 2017 and is actively pursuing other hospitality assets.
Mortgage and REO - Legacy Portfolio and Other Operations - Consists of the collection, workout and sale of new and legacy mortgage loan investments and REO assets, including financing of such asset sales. This also encompasses the carrying costs of such assets and other related expenses. This segment also reflects the carrying value of such assets and the related financing and operating obligations. This segment has also historically included rental revenue, less direct property operating expenses (maintenance and repairs, real estate taxes, management fees, and other operating expenses), depreciation and amortization from commercial and residential real estate leasing operations, and the carrying value of such assets and the related financing and operating obligations.
Corporate and Other - Consists of our centralized general and administrative and corporate treasury activities. This segment also includes reclassifications and eliminations between the reportable operating segments and reflects the carrying value of corporate fixed assets and the related financing and operating obligations.
A summary of the financial results for each of our operating segments during the years ended December 31, 2017 and 2016 follows (in thousands):
Hospitality and Entertainment Operations
For the years ended December 31, 2017 and 2016, the hospitality and entertainment operations segment revenues were $4.6 million and $2.8 million, respectively. Net income from discontinued operations for the years ended December 31, 2017 includes the net of all revenues and expenses of the Sedona hotels, as well the gain on the sale of the Sedona hotels of $6.8 million.
For the years ended December 31, 2017 and 2016, the segment contributed 78.0% and 50.6%, respectively, of total consolidated revenues. The year-over-year increase in hospitality and entertainment operations revenues as a percentage of total consolidated revenues is attributable to the contribution of revenues from MacArthur Place and our golf course (sold in the second quarter of 2017), and the absence of other income-producing assets and sale of our multifamily project in late 2016.
During the years ended December 31, 2017 and 2016, the hospitality and entertainment operations segment constituted the majority of consolidated operating property direct expenses. Net operating income for the segment as a percentage of related revenue totaled (6.2)% and 1.3% for the years ended December 31, 2017 and 2016, respectively. The decrease in net operating income percentages for the year ended December 31, 2017, as compared to the same period in 2016, was primarily attributed to increased revenue offset by increased operating property direct expenses, which included approximately $1.0 million in acquisition costs relating to MacArthur Place and start-up costs associated with the Hotel Fund.
After interest expense, and depreciation and amortization, the hospitality and entertainment operations segment contributed $0.4 million and $21.0 thousand of the total consolidated net loss from continuing operations for the years ended December 31, 2017 and 2016, respectively.
As previously noted, we sold our Sedona hotel properties in the first quarter of 2017 and our golf operation in the second quarter of 2017. MacArthur Place was acquired in the fourth quarter of 2017. We anticipate the hospitality and entertainment industry segment’s revenue and expense contribution to be less in comparison to previous levels until further acquisitions are made.
Mortgage and REO - Legacy Portfolio and Other Operations
For the years ended December 31, 2017 and 2016, the Mortgage and REO - Legacy Portfolio and Other Operations segment contributed 18.1% and 48.9%, respectively, of total consolidated revenues. The year-over-year decrease in segment revenue as a percentage of total revenue for the year ended December 31, 2017 resulted primarily from the sale of our multifamily project in
December 2016, coupled with reduced mortgage loan and investment income due to real estate asset sales and payoffs of certain mortgage loans.
For the years ended December 31, 2017 and 2016, the Mortgage and REO - Legacy Portfolio and Other Operations segment recorded total consolidated (income) expenses, net of gain, of $(4.5) million and $(2.7) million, respectively. The year-over-year decrease in net expenses for the year ended December 31, 2017, as compared to the same period in 2016, was primarily due to (i) increased recoveries from guarantors as a result of our enforcement and collection efforts, (ii) gains from the sale of REO assets, (iii) decreases in operating property expenses and interest expense due to the sale of certain REO assets and the repayment of debt collateralized by those assets, and (iv) the cessation of depreciation and amortization expense pertaining to the sale of our multifamily project in the second quarter of 2016, partially offset by reduced revenue from operating real estate owned due to their sale. The segment recorded a recovery provision of $6.4 million for the year ended December 31, 2017 compared to $0.2 million provision for credit losses recognized for the year ended December 31, 2016.
After revenues, less interest, depreciation and amortization expenses, and (recoveries of) provision for credit losses, the Mortgage and REO - Legacy Portfolio and Other Operations segment contributed net income of $3.4 million and $5.3 million for the years ended December 31, 2017 and 2016, respectively.
Corporate and Other
Other than occasional, non-recurring miscellaneous revenue, the Corporate and Other segment did not generate any material revenues for the Company for the year ended December 31, 2016. For the year ended December 31, 2017, the Company generated $0.2 million primarily from management fees earned from the management of certain partnerships.
For the years ended December 31, 2017 and 2016, the Corporate and Other segment contributed $11.8 million and $11.7 million, respectively, to total consolidated expenses. The decrease in expenses for this segment is primarily attributable to a decrease in interest expense due to the reduction of our outstanding notes payable balances.
Real Estate Owned, Lending Activities, Loan and Borrower Attributes
Lending Activities
As of December 31, 2017, our loan portfolio consisted of four loans with a carrying value of $19.7 million. As of December 31, 2016, our loan portfolio consisted of three first mortgage loans with a carrying value of $0.4 million. As of December 31, 2017 and December 31, 2016, two of these loans, which constitute our last remaining legacy loans, are fully reserved and have a zero carrying value. During the years ended December 31, 2017, we purchased two mezzanine loans with a face value of $19.9 million for $19.3 million and underwriting expenses of $0.2 million. During the years ended December 31, 2017, a group of partnerships previously accounted for under the equity investment method was consolidated, and through this process, we eliminated one prior mortgage loan through intercompany consolidation. We received principal payoffs totaling $7.6 million during the year ended December 31, 2016 and none during the year ended December 31, 2017. As of December 31, 2017 and December 31, 2016, the valuation allowance represented 39.2% and 97.1%, respectively, of the total outstanding loan principal and interest balances.
Changes in the Loan Portfolio Profile
Loan Modifications
We did not have any loan modifications during the years ended December 31, 2017 or 2016. Although we have in the past modified certain loans in our portfolio by extending the maturity dates or changing the interest rates thereof, on a case by case basis, we do not have in place a specific loan modification program or initiative. Rather, we may seek to modify any loan, in our sole discretion, based on the applicable facts and circumstances, including, without limitation: (i) our expectation that the borrower may be capable of meeting its obligations under the loan, as modified; (ii) the borrower’s perceived motivation to meet its obligations under the loan, as modified; (iii) whether we perceive that the risks are greater to us if the loan is modified, on the one hand, or not modified, on the other hand, and foreclosed upon; (iv) whether the loan is expected to become fully performing within some period of time after any proposed modification; (v) the extent of existing equity in the collateral net of the loan, as modified; (vi) the creditworthiness of the guarantor of the loan; (vii) the particular borrower’s track record and financial condition; and (viii) market based factors regarding supply/demand variables bearing on the likely future performance of the collateral. In the future, as our loan portfolio grows, we may modify loans on the same basis as above without any reliance on any specific loan modification program or initiative.
Geographic Diversification
As of December 31, 2017, the collateral underlying our loan portfolio was located in California, Missouri, and Texas. Unless and until we resume meaningful lending activities, our ability to diversify the geographic aspect of our loan portfolio remains significantly limited.
While our lending activities have historically been focused primarily in the southwestern United States, we have no geographic limitations in our investment policy.
Interest Rate Information
Our loan portfolio includes loans that carry variable and fixed interest rates. All variable interest rate loans are indexed to the Prime rate or one month LIBOR with interest rate floors. At December 31, 2017 and 2016, the Prime rate was 4.50% and 3.75%, respectively. At December 31, 2017 and 2016, the LIBOR rate was 1.56% and 0.77%, respectively.
As of December 31, 2017, two of our four loans were performing, having a total principal balance $19.9 million, and a weighted average interest rate of 9.69%. At December 31, 2016, one of our three loans was performing and had a principal balance of $0.3 million and an interest rate of 11.0%.
Loan and Borrower Attributes
The collateral supporting our loans historically have consisted of fee simple real estate zoned for residential, commercial or industrial use. The real estate may be in any stage of development from unimproved land to finished buildings with occupants or tenants. From a collateral standpoint, we believe the level of risk decreases as the borrower obtains governmental approvals (i.e., entitlements) for development. When the ultimate goal is to build an existing structure that can be sold or rented, in general, fully entitled land that is already approved for construction is more valuable than a comparable piece of land that has received no entitlement approvals. Each municipality or other governmental agency has its own variation of the entitlement process; however,
in general, the functions tend to be relatively similar. In general, the closer to completion a construction project may be, the lower the level of risk that construction will be delayed.
In recent years, we have re-focused our lending investment strategy to loans secured by collateral with income producing real estate. In 2017, we acquired two mezzanine loans that are secured by the borrowers’ interest in the entities that own the underlying office buildings. These loans are adjustable rate mortgages with interest rate floors at origination.
We generally classify loans into categories based on the underlying collateral’s projected end-use for purposes of identifying and managing loan concentration and associated risks. As of December 31, 2017, the original projected end-use of the collateral under our loans was classified as 39.2% residential and 60.8% commercial. As of December 31, 2016, the original projected end-use of the collateral under our loans was classified as 97.1% residential and 2.9% mixed-use.
Changes in the Portfolio Profile - Scheduled Maturities
The outstanding principal and interest balance of our loan portfolio, net of the valuation allowance, as of December 31, 2017, has scheduled maturity dates as follows (dollar amounts in thousands):
Operating Properties, Real Estate Held for Sale and Other Real Estate Owned
At December 31, 2017, we held total REO assets of $64.6 million, of which $5.9 million were held for sale, $20.5 million were held as operating properties, and $38.3 million were classified as other real estate owned. At December 31, 2016, we held REO assets of $33.3 million, of which $17.8 million were held for sale, $88.7 million were held as operating properties (which is classified in Assets from discontinued operations in the accompanying consolidated balance sheet as of December 31, 2016), and $15.5 million were classified as other real estate owned. All our REO assets are located in California, Texas, Arizona, Minnesota, Utah and New Mexico.
We did not acquire any REO assets during the year ended December 31, 2016. During the year ended December 31, 2017, we acquired the remaining 10% interest in Lakeside JV resulting in its consolidation and reflected in other real estate owned in the accompanying consolidated balance sheets. In addition, we acquired a controlling interest in a group of seven partnerships with real estate assets located in New Mexico (collectively referred to as the “New Mexico Partnerships”), which were previously accounted for under the equity method of accounting. As a result of this transaction, we consolidated the New Mexico Partnerships, at which time we recorded the related real estate assets at their preliminary estimated fair values, which added $18.1 million to our other real estate owned.
We acquired MacArthur Place for $36.0 million, of which $19.6 million has been added to our operating properties and the balance to goodwill and other intangible assets. In connection with this business combination, the Company acquired certain other assets and assumed certain liabilities, which are not expected to have an adverse effect on our operating results, liquidity, or financial condition. The Company is in the process of renovating MacArthur Place. This renovation project is expected to be finished in the late third or early fourth quarter of 2018. When complete, we anticipate that this will be the only 5-star hotel in the city of Sonoma and one of the top destinations in the region. Renovation project costs are being funded using construction proceeds set aside from the MacArthur Loan, offering proceeds from the Hotel Fund in excess of the reimbursement of our initial investment, and to the extent necessary, Company funds.
During the year ended December 31, 2017, we sold REO for $104.9 million (net of transaction costs and other adjustments), resulting in a net gain on disposal of $10.7 million. During the year ended December 31, 2016, we sold ten REO assets for $44.2 million (net of transaction costs and other adjustments), resulting in a total net gain of $10.8 million.
During the year ended December 31, 2017, we reclassified certain assets between REO held for sale and operating properties (including the reclassification of our Sedona hotel assets) or other REO, depending on when such assets met the held for sale criteria under GAAP. Other REO includes those assets which are generally available for sale but, for a variety of reasons, are not being actively marketed for sale as of the reporting date, or those which are not expected to be disposed of within 12 months. Other than these reclassifications, there were no material changes with respect to REO classifications or planned development during the year ended December 31, 2017 other than as a result of REO asset sales and capitalized development costs.
Costs and expenses related to operating, holding and maintaining our operating properties and REO assets are expensed as incurred and included in operating property direct expenses and expenses for non-operating real estate owned in the accompanying consolidated statements of operations, which totaled $9.2 million ($4.0 million of which is included in income from discontinued operations) and $26.4 million ($22.1 million of which is included in loss from discontinued operations) for the years ended December 31, 2017 and 2016, respectively. Costs related to the development or improvements of the Company’s real estate assets are generally capitalized and costs relating to holding the assets are generally charged to expense. Cash outlays for capitalized development costs totaled $3.8 million and $11.9 million during the years ended December 31, 2017 and 2016, respectively.
The nature and extent of future costs for our REO properties depends on the holding period of such assets, the level of development undertaken, our projected return on such holdings, our ability to raise funds required to develop such properties, the number of additional foreclosures, and other factors. While substantially all our assets are generally available for sale, we continue to evaluate various alternatives for the ultimate disposition of these investments, including partial or complete development of the properties prior to sale or disposal of the properties on an as-is basis.
REO Classification
As of December 31, 2017, 66% of our REO assets were planned for residential development, 2% was planned for mixed-use development, and 32% was planned for commercial or industrial use. As of December 31, 2016, 22% of our REO assets were planned for residential development, 1% was planned for mixed-use development, and 77% was planned for commercial or industrial use. We continue to evaluate our use and disposition options with respect to these assets. The real estate held for sale and other real estate owned consists of improved and unimproved residential lots, and completed commercial properties located in California, Texas, Arizona, Minnesota, Utah, and New Mexico.
Equity Investments
Variable Interest Entities
The determination of whether the assets and liabilities of a variable interest entity (“VIE”) are consolidated on our balance sheet (also referred to as on-balance sheet) or not consolidated on our balance sheet (also referred to as off-balance sheet) depends on the terms of the related transaction and our continuing involvement with the VIE. We are deemed the primary beneficiary and therefore consolidate VIEs for which we have both (a) the power, through voting rights or similar rights, to direct the activities that most significantly impact the VIE's economic performance, and (b) a variable interest (or variable interests) that (i) obligates us to absorb losses that could potentially be significant to the VIE, and/or (ii) provides us the right to receive residual returns of the VIE that could potentially be significant to the VIE. We determine whether we hold a variable interest in a VIE based on a consideration of the nature and form of our involvement with the VIE. We assess whether we are the primary beneficiary of a VIE on an ongoing basis.
Lakeside Investment
In the fourth quarter of 2015, the Company, through a wholly owned subsidiary, formed a joint venture, Lakeside DV, LLC (“Lakeside JV”), with a third party developer, Park City Development, LLC (“PCD”), for the purpose of acquiring, holding, and developing certain real property located in Park City, Utah. Under the Lakeside JV operating agreement, the Company agreed to contribute up to $4.2 million for a 90% interest in Lakeside JV, while PCD agreed to contribute up to $0.5 million for a 10% interest. Lakeside JV was initially accounted for under the equity method of accounting. During the year ended December 31, 2017, the Company purchased PCD’s interest in Lakeside JV for $0.7 million and terminated PCD as the manager. Accordingly, Lakeside JV became a consolidated entity of the Company in the first quarter of 2017.
As of December 31, 2017, the Company had made all required contributions to Lakeside JV. Equity balances are subject to a 12% preferred return, compounded quarterly. Cash flows are to be distributed first in proportion to the preferred equity investment, including the preferred return, then to the extent of additional capital contributions made by the members. Thereafter, cash flows are to be distributed at varying rates as certain return hurdles are achieved. At the time of initial investment, the Company elected to syndicate $1.7 million of its investment to several investors (“Syndicates”), some of which are related parties of the Company. Aside from a 2% management fee payable to the Company from Lakeside JV, cash flow distributions to the Syndicates are to be calculated and paid on the same basis as the cash flow distributions to the Company.
Notes Receivable from Certain Investors in Lakeside JV
During the year ended December 31, 2017, certain of the investors in the Lakeside JV executed promissory notes in favor of a subsidiary of the Company totaling $0.7 million. The notes receivable have an annual interest rate of 8% and mature at the earliest to occur of 1) the date on which the sale of the Lakeside property occurs, or 2) September 17, 2019. The promissory notes are secured by the investors’ respective interest and allocated proceeds of the Lakeside JV. Under applicable accounting guidance, the notes receivable have been netted against the non-controlling interest balance in the accompanying consolidated balance sheet.
Equity Interests Acquired through Guarantor Recoveries
In 2015, the Company acquired certain real estate assets and equity interests in a number of limited liability companies and limited partnerships with various real estate holdings and related assets as a result of our enforcement and collection efforts. Prior to September 29, 2017, certain of these entities were consolidated in the accompanying consolidated financial statements while others were accounted for under the equity method of accounting, depending on the extent of the Company’s financial interest in and level of control over each such entity.
Effective September 29, 2017, the Company began to consolidate the accounts of additional entities. The assets of these entities consist primarily of general and limited partnership interests in, and various receivables from (and liabilities to), several of the previously consolidated and unconsolidated entities that were administratively dissolved by court order in a receivership wind-up motion. As a result, the Company began to consolidate into its financial statements the accounts of various unconsolidated variable interest entities, whose assets are comprised of real estate holdings, rights to develop water and receivables from other related entities, and liabilities which consist primarily of various amounts payable to related entities.
The Company’s maximum exposure to loss consists of its combined equity in the corporate entities and partnerships which totaled $28.7 million as of December 31, 2017.
L’Auberge de Sonoma Hotel Fund
As of December 31, 2017, the Hotel Fund has sold Preferred Interests of $0.7 million, which is included in noncontrolling interests in the accompanying consolidated balance sheet. The Hotel Fund made no distributions during the year ended December 31, 2017. Based on the structure of the Hotel Fund, our ability to direct the activities that that most significantly impact the economic performance of the Hotel Fund, and the risk of absorbing losses or rights to receive benefits that could be potentially significant to the Hotel Fund, the Company is deemed to be the primary beneficiary of the Hotel Fund, and accordingly we have consolidated and expect to continue to consolidate the Hotel Fund in our consolidated financial statements.
Important Relationships between Capital Resources and Results of Operations
Valuation Allowance and Fair Value Measurement of Loans and Real Estate Held for Sale and Other REO
We perform a valuation analysis of our loans, REO held for sale, other REO, and equity investments not less frequently than on a quarterly basis. Evaluating the collectability of a real estate loan is a matter of judgment. We evaluate our real estate loans for impairment on an individual loan basis, except for loans that are cross-collateralized within the same borrowing groups. For cross-collateralized loans within the same borrowing groups, we perform both an individual loan evaluation as well as a consolidated loan evaluation to assess our overall exposure to those loans. In addition to this analysis, we also complete an analysis of our loans as a whole to assess our exposure for loans made in various reporting periods and in terms of geographic diversity. The fact that a loan may be temporarily past due does not result in a presumption that the loan is impaired. Rather, we consider all relevant circumstances to determine if, and the extent to which, a valuation allowance is required. During the loan evaluation, we consider the following matters, among others:
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an estimate of the net realizable value of any underlying collateral in relation to the outstanding mortgage balance, including accrued interest and related costs;
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the present value of cash flows we expect to receive;
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the date and reliability of any valuations;
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the financial condition of the borrower and any adverse factors that may affect its ability to pay its obligations in a timely manner;
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prevailing economic conditions;
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historical experience by market and in general; and
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evaluation of industry trends.
We perform an evaluation for impairment on all of our loans in default as of the applicable measurement date based on the fair value of the underlying collateral of the loans because our loans are considered collateral dependent, as allowed under applicable accounting guidance. Impairment for collateral dependent loans is measured at the balance sheet date based on the then fair value of the collateral in relation to contractual amounts due under the terms of the applicable loan. In the case of the loans that are not deemed to be collateral dependent, we measure impairment based on the present value of expected future cash flows. Further, the impairment, if any, must be measured based on the fair value of the collateral if foreclosure is probable. All of our loans in default are deemed to be collateral dependent.
Similarly, REO assets that are classified as held for sale or other REO are measured at the lower of carrying amount or fair value, less estimated cost to sell. REO assets that are classified as operating properties or held for development are considered “held and used” and are evaluated for impairment when circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development or operation and eventual disposition of the asset. If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less estimated cost to sell. If we elect to change the disposition strategy for our real estate held for development, and such assets were deemed to be held for sale, we may record additional impairment charges, and the amounts could be significant.
We assess the extent, reliability and quality of market participant inputs such as sales pricing, cost data, absorption, discount rates, and other assumptions, as well as the significance of such assumptions in deriving the valuation. We generally employ one of four valuation approaches (as applicable), or a combination of such approaches, in determining the fair value of the underlying collateral of each loan, REO held for sale and other REO asset: the development approach, the income capitalization approach, the sales comparison approach, or the receipt of recent offers on specific properties.
In determining fair value, we have adopted applicable accounting guidance which establishes a framework for measuring fair value in accordance with GAAP, clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurements. This accounting guidance applies whenever other accounting standards require or permit fair value measurement.
Under applicable accounting guidance, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability, or the “exit price,” in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are (a) independent of the reporting entity; that is, they are not related parties; (b) knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary; (c) able to transact for the asset or liability; and (d) willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.
Factors Affecting Valuation
The underlying collateral of our loans, REO held for sale, and other REO assets vary by stage of completion and consist of either raw land (also referred to as pre-entitled land), entitled land, partially developed land, or mostly developed/completed lots or projects. We typically engage independent third party valuation firms to obtain a valuation report when underwriting a mortgage loan, making an REO investment, or during periods of high volatility of real estate values when performing our fair value analysis. Thereafter, we do not generally obtain formal updates of such reports in a stabilized or improving market, unless there is an indication of potential impairment. As a result, while we continue to utilize third party valuations for selected assets on a periodic basis as circumstances warrant, we rely primarily on our asset management consultants and internal staff to gather available market participant data from independent sources to establish assumptions used to derive fair value of the collateral supporting our loans and real estate owned for a majority of our loan and REO assets.
Our fair value measurement is based on the highest and best use of each property which is generally consistent with our current use for each property subject to valuation. In addition, our assumptions are established based on assumptions that we believe market participants for those assets would also use. During the years ended December 31, 2017 and 2016, we performed both a macro analysis of market trends and economic estimates, as well as a detailed analysis on selected significant loan and REO assets. In addition, our fair value analysis includes a consideration of management’s pricing strategy in disposing of such assets.
Selection of Single Best Estimate of Value
The results of our valuation efforts generally provide a range of values for the collateral and REO assets valued rather than a single point estimate because of variances in the potential value indicated from the available sources of market participant information. The selection of a value from within a range of values depends upon general overall market conditions as well as specific market conditions for each property valued, its stage of entitlement or development and management’s strategy for disposing of the asset. In selecting the single best estimate of value, we consider the information in the valuation reports, credible purchase offers received, and agreements executed, as well as multiple observable and unobservable inputs and management’s intent.
Valuation Conclusions
Based on the results of our evaluation and analysis, we did not record any non-cash provision for credit losses on our loan portfolio during the years ended December 31, 2017 and 2016. However, we recorded net recoveries of prior investment and credit losses of $6.5 million and $0.2 million during the year ended December 31, 2017 and 2016, respectively, relating to the collection of cash, receivables and/or other assets from guarantors on certain legacy loans and insurance reimbursements. For the years ended December 31, 2017, we recorded impairment of real estate owned of $0.7 million and none for the year ended December 31, 2016.
As of December 31, 2017 and December 31, 2016, the valuation allowance totaled $12.7 million, representing and 39.2% and 97.1%, respectively, of the total outstanding loan principal and accrued interest balance. The reduction in the valuation allowance as a percentage of outstanding loan principal and accrued interest is attributed to the acquisition of new performing loans acquired during 2017.
With the existing valuation allowance recorded on our loans and impairments recorded on our REO assets as of December 31, 2017, we believe that, as of that date, the fair value of our loans and REO is adequate in relation to the net carrying value of the related assets and that no additional valuation allowance or impairment is considered necessary. While the above results reflect our assessment of fair value as of December 31, 2017 and 2016 based on currently available data, we will continue to evaluate our loan and REO assets in 2018 and beyond to determine the adequacy and appropriateness of the valuation allowance and impairment balances. Depending on market conditions, such updates may yield materially different values and potentially increase or decrease the valuation allowance for loans or impairment charges for REO assets.
Valuation of Operating Properties
REO assets that are classified as operating properties are considered “held and used” and are evaluated for impairment when, based on various criteria set forth in applicable accounting guidance, circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development and eventual disposition of the asset. If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less cost to sell.
The valuation of our REO assets to be held and used is based on our intent and ability to execute our disposition plan for each asset and the proceeds to be derived from such disposition, net of estimated selling costs, in relation to the carrying value of such assets. REO assets which we will likely dispose of without further development are valued on an “as is” basis based on current
valuations using comparable sales. If we have the intent and ability to develop the REO asset over future periods in order to realize a greater value, we perform a valuation on an “as developed” basis, net of estimated selling costs but without discounting of cash flows, to determine whether any impairment exists. We do not write up the carrying value of real estate assets held for development if the proceeds from disposition are expected to exceed the carrying value of such assets. Rather, any gain from the disposition of such assets is recorded at the time of sale.
If we elected to change the disposition strategy for our operating properties, and such assets were classified as held for sale, we might be required to record additional impairment charges, although such amounts are not expected to be significant based on the previous impairment adjustments recorded. We recorded no impairment of our operating properties during the years ended December 31, 2017 and 2016. We believe the estimated net realizable values of such properties equal or exceed the current carrying values of our investment in the properties as of December 31, 2017.
Leverage to Enhance Portfolio Yields
We have not historically employed a significant amount of leverage to enhance our investment yield. However, we have secured financing when deemed beneficial, if not necessary, and may employ additional leverage in the future as deemed appropriate.
Current and Anticipated Borrowings
Senior Indebtedness
In January 2015, the Company borrowed $50.0 million in a loan secured by our Sedona hotels. This loan was repaid in full in February 2017 upon sale of the Sedona hotels.
Exchange Notes
In April 2014, we completed an offering of a five-year, 4%, unsecured notes to certain of our shareholders in exchange for common stock held by such shareholders at an exchange price of $8.02 per share (“Exchange Offering”). Upon completion of the Exchange Offering, we issued Exchange Offering notes (“EO Notes”) with a face value of $10.2 million, which were recorded by the Company at fair value of $6.4 million based on the fair value and the imputed effective yield of such notes of 14.6% (as compared to the note rate of 4%) resulting in an initial debt discount on the EO Notes of $3.8 million, with a remaining balance of $1.2 million at December 31, 2017. This amount is reflected as a debt discount in the accompanying financial statements, and is being amortized as an adjustment to interest expense using the effective interest method over the term of the EO Notes. The amortized discount added to the principal balance of the EO Notes during the year ended December 31, 2017 totaled $0.8 million. Interest is payable quarterly in arrears each January, April, July, and October. The EO Notes mature on April 28, 2019, and may be prepaid in whole or in part without penalty at the option of the Company. Subject to certain minimum cash and profitability conditions, the Company would have been required to prepay fifty percent (50%) of the outstanding principal balance of the EO Notes on April 29, 2018. Such conditions have not been met and, accordingly, no such prepayment is required.
Land Purchase Financing
During 2015, the Company obtained seller-financing of $5.9 million in connection with the purchase of certain real estate located in New Mexico at a purchase price of $6.8 million. The note bears interest at the WSJ Prime Rate as of December 31, 2015 (recalculated annually) plus 2% through December 31, 2017, and the WSJ Prime Rate plus 3% thereafter. Interest only payments are due on December 31 of each year with the principal balance and any accrued unpaid interest due upon the earlier of 1) December 31, 2019, or 2) sale of the underlying collateral property. The note may be prepaid in whole or in part without penalty.
Special Assessment Obligations
As of December 31, 2017 and December 31, 2016, obligations arising from our allocated share of certain community facilities district special revenue bonds and special assessments had remaining balances of $0.1 million and $3.6 million, respectively. These obligations are described below.
One of the special assessment obligations had an outstanding balance of zero and $3.1 million as of December 31, 2017 and December 31, 2016, respectively, and had an amortization period that extended through April 30, 2030, with an annual interest rate ranging from 5% to 6%. We made principal payments of $0.2 million on this special assessment obligation during the year ended December 31, 2017. This special assessment obligation was secured by certain real estate held for sale consisting of 171
acres of unentitled land located in Buckeye, Arizona, which was sold in the fourth quarter in 2017. In conjunction with the sale, the buyer agreed to assume the remaining balance of $2.9 million of the special assessment obligation.
The other special assessment obligation had an outstanding balance of and $0.1 million and $0.5 million as of December 31, 2017 and December 31, 2016, respectively. The special assessment obligation has amortization period that extends through 2022, with annual interest rates ranging from 6% to 7.5% and secured by certain REO consisting of 1.5 acres of unentitled land located in Dakota County, Minnesota which had a carrying value of $0.1 million at December 31, 2017. We made principal payments of $0.2 million on this special assessment obligation during the year ended December 31, 2017. During the year ended December 31, 2017, a portion of the property was sold and the buyer agreed to assume the related special assessment obligation for such parcels totaling $0.2 million of the remaining balance.
The responsibility for the repayment of each of the foregoing special assessment obligations rests with the owner of the property and will transfer to the buyer of the related real estate upon sale. Accordingly, if the assets to which these obligations arise from are sold before the full amortization period of such obligations, the Company would be relieved of any further liability since the buyer would assume the remaining obligations. Nevertheless, these special assessment obligations are deemed to be obligations of the Company in accordance with GAAP because they are fixed in amount and for a fixed period of time.
Hotel Acquisition and Construction Loan
In connection with the acquisition of MacArthur Place, the Company borrowed $32.3 million from MidFirst Bank, of which approximately $19.4 million was utilized for the purchase of MacArthur Place, $10.0 million is being set aside to fund planned hotel improvements, and the balance to fund interest reserves and operating capital. The loan has an initial term of three years and, subject to certain conditions and the payment of certain fees, may be extended for two (2) one-year periods. The MacArthur Loan requires interest-only payments during the initial three-year term and bears floating interest equal to the 30-day LIBOR rate plus 3.75% subject to certain adjustments.
The MacArthur Loan is secured by a deed of trust on all MacArthur Place real property and improvements, and a security interest in all furniture, fixtures and equipment, licenses and permits, and MacArthur Place-related revenues. The Company has agreed to provide a construction completion guaranty with respect to the planned hotel improvement project which shall be released upon payment of all project costs and receipt of a certificate of occupancy. In addition, the Company has provided a loan repayment guaranty equal to 50.0% of the MacArthur Loan principal along with a guaranty of interest and operating deficits, as well as other customary non-recourse carve-out matters such as bankruptcy and environmental matters. Under the guarantees, the Company is required to maintain a minimum tangible net worth of $50.0 million and minimum liquidity of $5.0 million throughout the term of the loan. Preferred equity is included as a component of equity with respect to the minimum tangible net worth covenant.In addition, the MacArthur Loan requires MacArthur Place to establish various operating and reserve accounts at MidFirst Bank which are subject to a cash management agreement. In the event of default, MidFirst Bank has the ability to take control of such accounts for the allocation and distribution of proceeds in accordance with the cash management agreement.
Hotel Fund Offering
In November 2017, the Company sponsored and commenced the offering of up to $25.0 million of Preferred Interests in the Hotel Fund. The Company made initial contributions of $17.8 million through December 31, 2017 for its common member interest in the Hotel Fund. The net proceeds of this offering are being used (i) to redeem the Company’s initial contributions to the Hotel Fund and (ii) to fund certain renovations to MacArthur Place. The Company is expected to retain a 10.0% Preferred Interest in the Fund. The Hotel Fund intends to pursue a liquidity event in approximately four to six years.
Purchasers of the Preferred Interests (the “Preferred Members”) are entitled to a preferred distribution, payable monthly, accruing at a rate of 7.0% per annum on invested capital, cumulative and non-compounding (the “Preferred Distribution”). Prior to the sale or other disposition of the Property, if the Fund has insufficient operating cash flow to pay the Preferred Distribution in a given month, the Company will provide the funds necessary to pay the Preferred Distribution for such month. Such payment will be treated as an additional capital contribution and the Company’s capital account will be increased by such amount. In addition, on a quarterly basis, the Fund will distribute 10.0% of cash available for distribution, as defined in the Fund’s LLC Agreement, after payment of the Preferred Distribution, calculated for the most recently completed fiscal quarter to the Preferred Members pro rata in proportion to the weighted average Preferred Interests owned during the applicable quarterly period (the “Quarterly Excess Cash Distribution”). Additionally, upon the refinance or sale of all or a portion of the Property, Preferred Members may be entitled to receive certain additional preferred distributions (the “Additional Preferred Distribution”) that will result in an overall return of up to12.0% on the Preferred Interests. The Company will have no obligation to contribute the funds necessary to pay the Preferred Distribution or the Additional Preferred Distribution upon a capital transaction such as the sale or refinancing of the Property. Upon a capital transaction, the Company will distribute an additional 10.0% of any cash available after the payment of
the Additional Preferred Distribution to the Preferred Members pro rata in proportion to the Preferred Interests owned. We have sold preferred shares to unrelated outside investors totaling $0.7 million through December 31, 2017 and $4.2 million through March 29, 2018.
Other Potential Borrowings and Borrowing Limitations
Our investment policy, the assets in our portfolio and the decision to utilize leverage are periodically reviewed by our board of directors as part of their oversight of our operations. We may employ leverage, to the extent available and permitted, through borrowings to finance our assets or operations, to fund the origination and acquisition of our target assets and to increase potential returns to our shareholders. Although we are not required to maintain any particular leverage ratio, the amount of leverage we will deploy for particular target assets will depend upon our assessment of a variety of factors, which may include the anticipated liquidity and price volatility of the target assets in our portfolio, the potential for losses and extension risk in our portfolio, the gap between the duration of our assets and liabilities, including hedges, the availability and cost of financing the assets, our opinion of the creditworthiness of our financing counterparties, the health of the U.S. economy and commercial mortgage markets, our outlook for the level, slope, and volatility of interest rates, the credit quality of our target assets, the collateral underlying our target assets, and our outlook for asset spreads relative to the LIBOR curve. Our charter and bylaws do not limit the amount of indebtedness we can incur, and our board of directors has discretion to deviate from or change our indebtedness policy at any time. We intend to use leverage for the sole purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates.
Under the Second Amended Certificate of Designation, we may not undertake certain actions without the consent of the holders of at least 85% of the shares of Series B preferred stock outstanding, including entering into major contracts, entering into new lines of business, or selling REO assets other than within certain defined parameters. Further, certain actions, including breaching any of our material obligations to the holders of Series B preferred stock under the Second Amended Certificate of Designation, could result in a default under the terms of the Series B preferred stock, which could allow the Series B preferred stockholders to require us to redeem the Series B preferred stock. In addition, some of our new financing arrangements may include other restrictions that limit our ability to secure additional financing.
As a result of their substantial beneficial equity interest in us, the holders of our Series B Preferred Stock each have considerable influence over our corporate affairs which makes it difficult or impossible to enter into certain transactions without their consent.
Liquidity and Capital Resources
Financial Statement Presentation and Liquidity
Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. We believe that our cash and cash equivalents, coupled with the revenues generated by our operating properties and mortgage investments, as well as proceeds from the disposition of our remaining loans and real estate held for sale will allow us to fund current operations for a period of at least one year from the date these financial statements are issued.
In addition, our borrowings and equity issuances have allowed us the time and resources necessary to meet liquidity requirements, to dispose of assets in a reasonable manner and on terms that we believe are more favorable to us, and to help us continue to develop our investment strategy that started to be implement during 2017. While we have been successful in securing debt and equity financing to provide adequate funding for working capital purposes and have generated liquidity primarily through asset sales, there is no assurance that we will be successful in selling our remaining real estate assets at prices we seek in a timely manner or in obtaining additional financing, if needed, to sufficiently fund future operations or to implement our investment strategy.
The information in the following paragraphs constitutes forward-looking information and is subject to a number of risks and uncertainties, including those set forth under the heading entitled “Risk Factors,” which may cause our sources and requirements for liquidity to differ from these estimates. To the extent that the net proceeds from the sources of liquidity reflected in foregoing table are not realized in the amount or time-frame anticipated, the shortfall would reduce the timing and amount of our ability to undertake and consummate the discretionary acquisition of target assets by a corresponding amount.
Requirements for Liquidity
We require liquidity and capital resources for capitalized costs, expenses and general working capital needs, including maintenance, development costs and capital expenditures for our operating properties and non-operating REO assets, professional fees, general and administrative operating costs, loan enforcement costs, costs on borrowings, debt service payments on borrowings, dividends or distributions to shareholders, distributions to noncontrolling interests, other costs and expenses, as well as to acquire our target assets. We expect our primary sources of liquidity over the next twelve months to consist of our current cash, revenues from our operating properties, income from anticipated investment activities, proceeds from the disposition of our existing loan and REO assets held for sale, and proceeds from debt and equity financing initiatives. To the extent there is a shortfall in available cash, we would likely seek to reduce general and administrative costs, scale back projected investing activity costs, sell certain assets below our current asking prices, and/or seek possible additional financing. To the extent that we have excess liquidity at our disposal, we expect to fund a portion of such proceeds for new investments in our target assets. However, the extent and amount of such investment is contingent on numerous factors outside of our control.
At December 31, 2017, we had cash and cash equivalents of $11.8 million, as well as REO held for sale of $5.9 million and other REO assets of $38.3 million which, while not technically classified as held for sale, are generally available for sale. Subsequent to December 31, 2017, we generated $8.0 million from the issuance of preferred equity to be used for investment and working capital purposes. We also expect to generate Hotel Fund offering proceeds in 2018, and have an unused credit facility to fund a portion of anticipated renovation costs at MacArthur Place. As of March 29, 2018, we have sold $4.2 million in preferred shares to unrelated outside investors. We believe these resources are sufficient to cover our liquidity needs over the next twelve months from the issuance date of this Annual Report. However, our ability to reasonably estimate the proceeds from any of these asset sales is dependent on several factors that are outside our control including, but not limited to, real estate and credit market conditions, the actual timing of such sales and ultimate proceeds from the sale of assets, our ability to sell such assets at our asking prices or at prices in excess of the current carrying value of such real estate.
When our required cash uses are met, we expect to redeploy excess proceeds to acquire our target assets subject to approval of the investment committee, which will generate periodic liquidity from mortgage loan interest payments and cash flows from dispositions of these assets through sales. If we are unable to achieve our projected sources of liquidity from the sources anticipated above, we would be unable to purchase the desired level of target assets and it is unlikely that we would be able to meet our investment income projections.
For 2018, we expect to require $21.0 million to fund known operating uses of cash, $57.8 million to fund committed investing uses of cash and $14.2 million to fund known financing uses of cash. To the extent there is a shortfall in available cash to fund these uses, we would likely seek additional equity or debt capital, scale back projected investing activity costs, sell certain assets below our current asking prices, and/or reduce general and administrative costs. To the extent that we have excess liquidity at our
disposal, we expect to use such proceeds to make new investments in our target assets. However, the extent and amount of such investment is contingent on numerous factors outside of our control.
In the future, we also may require liquidity for the following items that are excluded from the above amounts:
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any required redemption of our Class C common stock or Series B Preferred Shares,
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special one-time dividends in respect of our Class B common stock, and/or
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repayment of exchange notes maturing in 2019
Our 2018 projected cash requirements are described in further detail below.
Operating Properties Direct Expenses
We will require liquidity to pay costs and expenses relating to our ownership and operation of MacArthur Place. We anticipate total direct expenses for that operation to be $8.7 million for the year ending December 31, 2018.
Debt Service Payments
We will require liquidity to pay principal and interest on our borrowings, notes payable, special assessment/CFD obligations and capital lease obligations. We expect to repay existing loan principal during 2018 in the amount of $5.9 million to coincide with the sale of related collateral. Based on anticipated debt balances, we expect to pay interest costs of $2.1 million during 2018 based on existing debt. During the year ended December 31, 2017, we repaid loan principal totaling $50.4 million and used cash for interest costs in the amount of $2.2 million.
Asset Management Carrying Costs, Maintenance and Development Costs for Non-Operating Real Estate Owned
We will require liquidity to pay costs and fees to preserve, protect and/or develop our real estate held for sale and development. Excluding our operating properties, based on our existing REO assets and anticipated dispositions, we expect to incur $0.1 million annually relating to the on-going operations and maintenance of such assets in 2018, a significant decrease from $0.8 million in 2017. However, the nature and extent of future costs for such properties depends on the timing of anticipated sales, the number of additional foreclosures and other factors.
During 2018, we also expect to incur development costs in the amount of $19.0 million in connection with the anticipated MacArthur Place renovation, well repairs on the New Mexico land holdings, capital improvement projects and other fixed asset purchases.
General and Administrative Operating Costs
We will require liquidity to pay our general and administrative costs including compensation and benefits, rent, insurance, utilities and other related costs of operations. For the year ending December 31, 2018, we anticipate our general and administrative expenses will be $8.6 million, or $0.7 million per month, an increase from $9.0 million in 2017. The anticipated increase relates to our projected increase in hospitality management personnel and related costs in 2018 as we seek to expand our hospitality footprint.
Professional Fees
We expect professional fees will be $3.5 million in 2018, down from $5.2 million in 2017, as we reduce our guarantor enforcement activities.
Funding our Lending and Investment Activity
We require sufficient liquidity to acquire our target assets and fund mortgage loans. We anticipate that our existing cash coupled with our other liquidity sources described below will be sufficient to fund the payment of our operating expenses, debt service payments, loan fundings and other projected capitalized costs. Any excess cash may be used to invest in our target assets, although our ability to reasonably estimate the amount and timing of any such investments is subject to several factors including, but not limited to, the timing and our ability to generate additional liquidity from the sale of our assets, the timing and our ability to identify, underwrite and fund new investments, and our ability to obtain additional capital.
Dividends
Except for required preferred dividends, all dividends are made at the discretion of our board of directors and will depend on our earnings, our financial condition and other relevant factors. As described below, On February 9, 2018, the Company issued shares of Series B-3 Preferred Stock for a total purchase price of $8.0 million which accrue dividends from the issue date and compound quarterly at the rate of 5.65% per year. Dividends payable in cash to Preferred Shareholders are expected to total $3.5 million in 2018, which exceeds the $2.1 million we paid in 2017. The increase is attributed to the preferred equity issuances made subsequent to December 31, 2017.
Distributions to Noncontrolling Interests
The Preferred Members in the Hotel Fund are entitled to the Preferred Distribution accruing at a rate of 7.0% per annum on invested capital, cumulative and non-compounding, and payable monthly. Prior to the sale or other disposition of the hotel, if the Hotel Fund has insufficient operating cash flow to pay the Preferred Distribution in a given month, the Company is obligated to provide the funds necessary to pay the Preferred Distribution for such month. In addition, on a quarterly basis, the Fund will pay the Quarterly Excess Cash Distribution equal to 10.0% percent of cash available for distribution, if any, after payment of the Preferred Distribution.
In addition, distributions to non-controlling interests in the New Mexico partnerships or Lakeside joint ventures are contingent upon the sale of the related assets.
Because we are unable to reasonably estimate the actual amount of proceeds to be raised in the Hotel Fund in 2018 or the performance of MacArthur Place, we are also unable to reasonably estimate the distributions that will be made to the Preferred Members or to other non-controlling interests in 2018.
Sources of Liquidity
We expect our primary sources of liquidity in 2018 to consist of our current cash balances, revenues we earn from MacArthur Place operations and mortgage investment activities, proceeds from equity issuances, proceeds from the Hotel Fund offering, proceeds from borrowings, and proceeds from the disposition of our existing loan and REO assets held for sale. In addition to these sources, we expect to generate additional cash from our guarantor enforcement activities. We also may address our liquidity needs by periodically pursuing lines of credit and other credit facilities.
When our required cash uses are met, we expect to redeploy excess proceeds to acquire our target assets subject to approval of the investment committee, which will generate periodic liquidity from mortgage loan interest payments and cash flows from dispositions of these assets through sales. If we are unable to achieve our projected sources of liquidity from the sources anticipated above, we would be unable to purchase the desired level of target assets and it is unlikely that we would be able to meet our investment income projections.
Our 2018 projected cash sources are described in further detail below.
Cash and Cash Equivalents and Funds Held by Lender and Restricted Cash
At December 31, 2017, we had cash and cash equivalents of $11.8 million and restricted cash of $0.1 million.
Sale of Real Estate Owned and Loans
At December 31, 2017, we had REO held for sale of $5.9 million and other REO assets of $38.3 million which, while not technically classified as held for sale, are generally available for sale. We are or intend to actively market these assets for sale in 2018. Our ability to reasonably estimate the proceeds from any of these asset sales is dependent on several factors that are outside our control including, but not limited to, real estate and credit market conditions, the actual timing of such sales and ultimate proceeds from the sale of assets, our ability to sell such assets at our asking prices or at prices in excess of the current carrying value of such real estate. As a result, we are unable to reasonably estimate the amount of proceeds from asset sales that we will generate in 2018. During the year ended December 31, 2017, we generated proceeds from asset sales in the amount of $104.9 million.
Revenues from Operating Properties
We anticipate that revenues from operating properties will increase to $9.5 million in 2018, up from $4.3 million for the year ended December 31, 2017, resulting from a full year of operations of MacArthur Place.
Loan and Other Investment Income
We expect to realize investment income from loans we originate or purchase and other investments which may come in the form of origination and modification fees, interest income, recognizable profit participation, and accretion of discounts on such investments, as applicable. The amounts and proportion of such income is dependent on the amount and timing of the deployment of our capital into our various target assets.
We expect to generate additional liquidity from the maturity of existing loans and from deployment of cash into income-producing investments during 2018.
One of our current mortgage investments with a principal balance of $7.3 million is scheduled to mature in 2018. Also, based on existing and committed mortgage investments, we expect to recognize minimum mortgage income of $2.0 million during 2018. Our ability to reasonably estimate mortgage and investment income beyond that is dependent on multiple factors not all of which are within our control including, but not limited to, the timing and our ability to generate adequate liquidity from the sale of assets, the timing and our ability to identify, underwrite and fund new investments, and the ability to negotiate interest rates on loans or rates of return on investments.
Proceeds from Debt Issuance
We continue to seek financing to provide us with additional sources of funds to be used for working capital and investment activities. During the year ended December 31, 2017, the Company entered into a $32.3 million acquisition and construction loan agreement, $19.4 million of which was drawn in 2017 in connection with the purchase of MacArthur Place. We expect to draw upon the balance of that loan in 2018 to fund planned renovations at the property. We may also seek additional financing facilities in 2018 in pursuit of our business strategy.
Our ability to reasonably estimate total proceeds from debt issuance is dependent on multiple factors not all of which are within our control. As a result, we are unable to reasonably estimate the total amount of proceeds we will generate from debt issuance in 2018.
Proceeds from Guarantor Recoveries
We aggressively pursue enforcement action against borrowers and the related guarantors who have defaulted on their obligations to us. During the year ended December 31, 2017, we recorded recoveries of cash recoveries from guarantors of $0.1 million. Despite our ongoing enforcement activities, our ability to reasonably estimate guarantor recovery income is dependent on several factors, many of which are outside of our control including, but not limited to, the timing and our ability to obtain court approved judgments in our favor, the determination of whether the guarantor has sufficient assets to satisfy any or all of any judgments (if received), the value, and timing and our ability to secure collection of any assets. As a result, we are unable to reasonably estimate the amount of guarantor recovery income that we will generate in 2018.
Hotel Fund Raise
While the Company is aggressively marketing the Hotel Fund and is targeting an $18.0 million to $20.0 million capital raise in 2018, our ability to reasonably estimate the actual amount of the raise is dependent on multiple factors many of which are outside of our control including, but not limited to, outside investor interest in the Hotel Fund, the timing and velocity at which funds can be raised.
Equity Issuances
On February 9, 2018, the Company issued 2,352,941 Series B-3 Preferred Stock to JPM Funding at a purchase price of $3.40 per share, for a total purchase price of $8.0 million.
Cash Flows for the years ended December 31, 2017 and 2016
Cash Used In Operating Activities.
Cash used in operating activities was $9.4 million and $9.5 million for the years ended December 31, 2017 and 2016, respectively. Cash from operating activities includes the cash generated from hospitality income, management fees, mortgage interest and investment and other income, offset by amounts paid for operating expenses for operating properties, real estate owned, professional
fees, general and administrative costs, funding of other receivables, interest on borrowings and litigation settlement payments and related costs. The increase in cash used in operating activities from 2016 to 2017 is primarily attributed to various changes in operating assets and liabilities.
Cash Provided By Investing Activities.
Net cash provided by investing activities was $43.6 million and $44.8 million for the years ended December 31, 2017 and 2016, respectively. While we recognized increased proceeds from the disposal of assets, the slight decrease in cash from investing activities is attributed primarily to increased investments in operating properties and capitalized REO costs as well as investments in mortgage investments. Proceeds received from the sale of REO assets and mortgage loans totaled $104.9 million and $48.0 million for the years ended December 31, 2017 and 2016, respectively. Mortgage loan funding totaled $19.3 million during the years ended December 31, 2017, while mortgage loan collections totaled $7.6 million during the year ended December 31, 2016. Additionally, investments in operating properties totaled $0.5 million in 2017 while acquisitions of and capital investments in real estate owned decreased year over year totaling $3.8 million and $11.9 million during the years ended December 31, 2017 and 2016, respectively.
Cash Used In Financing Activities.
Net cash used in financing activities was $33.9 million and $31.4 million for the years ended December 31, 2017 and 2016, respectively. During the years ended December 31, 2017, we repaid notes in the aggregate amount of $50.4 million compared to $36.9 million, during the same period in 2016. We received proceeds from notes payable of $19.4 million and $9.2 million during the year ended December 31, 2017 and 2016, respectively. We also made dividend payments of $2.1 million for each of the years ended December 31, 2017 and 2016.
Contractual Obligations
In addition to our existing indebtedness described elsewhere in this Form 10-K, a summary of our significant outstanding contractual obligations that existed at December 31, 2017 follows:
Preferred Stock Requirements
During the year ended December 31, 2014, the Company issued 8.2 million shares of the Company’s Series B Preferred Stock to the Series B Investors in exchange for $26.4 million. Except for certain voting and transfer rights, the rights and obligations of holders of the Series B-1 Preferred Stock and Series B-2 Preferred Stock are substantially the same. The current holders of Series B Preferred Stock are collectively referred to herein as the “Series B Investors.”
In addition to various other rights and preferences belonging to the holders of the Series B Preferred Stock, the following provides a summary of certain financial obligations relating to the Series B Preferred Stock:
•
Dividends. Dividends on the Series B Preferred Stock are cumulative and accrue from the issue date and compound quarterly at the rate of 8% of the issue price per year, payable quarterly in arrears. Subject to certain dividend rights and restrictions, no dividend may be paid on any capital stock of the Company during any fiscal year unless all accrued dividends on the Series B Preferred Stock have been paid in full, except for dividends on shares of voting Common Stock. In the event that any dividends are declared with respect to the voting Common Stock or any junior ranking securities, the holders of the Series B Preferred Stock are entitled to receive as additional dividends the additional dividend amount. We paid dividends on the Series B Preferred Stock of $2.1 million for each of the years ended December 31, 2017 and 2016.
•
Redemption upon Demand. At any time after July 24, 2019, each holder of Series B Preferred Stock may require the Company to redeem, out of legally available funds, the shares of Series B Preferred Stock held by such holder at the a price (the “Redemption Price”) equal to the greater of (i) 150% of the sum of the original price per share of the Series B Preferred Stock plus all accrued and unpaid dividends or (ii) the sum of the tangible book value of the Company per share of voting Common Stock plus all accrued and unpaid dividends, as of the date of redemption. Based on the initial investment of $26.4 million, the Redemption Price would presently be $39.6 million, resulting in a redemption premium of $13.2 million. In accordance with applicable accounting standards, we have elected to amortize the redemption premium using the effective interest method as an imputed dividend over the five year holding term of the preferred stock. During year ended December 31, 2017, we recorded amortization of the redemption premium of $2.7 million as a deemed dividend.
•
Required Liquidation. Under the Second Amended Certificate of Designation authorizing the Series B Preferred Stock, if at any time we are not in compliance with certain of our obligations to the holders of the Series B Preferred Stock and we fail to pay (i) full dividends on the Series B Preferred Stock for two consecutive fiscal quarters or (ii) the Redemption Price within 180 days following the later of (x) demand therefore resulting from such non-compliance and (y) July 24, 2019, unless a certain percentage of the holders of the Series B Preferred Stock elect otherwise, we will be required to use our best efforts to commence a liquidation of the Company. In addition, the default by the Company or any of its subsidiaries under one or more debt agreements that remains uncured for a period of thirty (30) days entitles the Series B Investors to accelerate repayment of the Redemption Price.
Juniper Capital Partners, LLC and JCP Realty
On July 24, 2014, the Company entered into a consulting services agreement (the “JCP Consulting Agreement”) with JCP Realty Advisors, LLC (“JCP”), an affiliate of one of the Series B Investors and one of our directors, Jay Wolf, pursuant to which JCP has agreed to perform various services for the Company, including, but not limited to, advising the Company with respect to identifying, structuring, and analyzing investment opportunities, including assisting the Company to manage and liquidate assets, including non-performing assets. The initial term of the Consulting Agreement is three years and is automatically renewable for an additional two years unless notice of termination is provided by either party. The Company and JCP have come to substantial agreement on extending the term of the Consulting Agreement for successive one year periods provided that the annual base consulting fee will be reduced from $0.6 million to $0.5 million (subject to possible upward adjustment based on an annual review by our board of directors) and JCP will be entitled to receive a maximum 1.25% origination fee on any loans or investments in real estate, preferred equity or mezzanine securities that are originated or identified by JCP, subject to reduced fee based on the increasing size of the loan or investment.
JCP is also entitled to legacy fee payments derived from the disposition of certain assets held by the Company as of December 31, 2010, at an amount equal to 5.5% of the positive difference derived by subtracting (i) 110% of our December 31, 2010 valuation mark of that asset then owned by us from the (ii) the gross sales proceeds, if any, from sales of that asset (on a legacy asset by asset basis without any offset for losses realized on any individual asset sales). While the parties have agreed in principle that the terms of the amended agreement were effective as of July 25, 2017, the written amendment has not yet been executed by the parties.
During the year ended December 31, 2017 and 2016, we incurred base consulting fees to JCP of $0.5 million and $0.6 million, respectively. JCP earned legacy fees of $1.2 million and $0.1 million during the years ended December 31, 2017 and 2016, respectively.
Off-Balance Sheet Arrangements
General
We have equity interests in a number of joint ventures and limited partnerships previously recorded under the equity method with varying structures (which became consolidated entities effective September 29, 2017), as described in Note 5 of the accompanying consolidated financial statements. Most of the joint ventures and partnerships in which we have an interest are involved in the ownership and/or development of real estate. A venture or partnership will fund capital requirements or operational needs with cash from operations or financing proceeds, if possible. If additional capital is deemed necessary, a venture or partnership may request a contribution from the partners, and we will evaluate such request.
During the year ended December 31, 2016, a subsidiary of the Company executed promissory notes with certain of the previously unconsolidated partnerships (which the Company began consolidating during the year ended December 31, 2017) to loan up to $0.7 million for the funding of various costs of such partnerships. During the year ended December 31, 2017, the notes were amended to increase the collective lending facility to a maximum of $5.0 million to cover anticipated operating and capital expenditures. As of December 31, 2017, the total principal advanced under these notes was $1.9 million. The promissory notes earn interest at rates ranging from the JP Morgan Chase Prime rate plus 2.0% (6.50% at December 31, 2017) to 8.0% and have maturity dates which are the earliest to occur of 1) the date of transfer of the partnership’s real estate assets, 2) the date on which the current general partner resigns, withdraws or is removed as general partner, or 3) July 31, 2018. The promissory notes are cross collateralized and secured by real estate and other assets owned by such partnerships. These promissory notes and all related accrued interest receivable were eliminated in consolidation as of December 31, 2017.
Except as previously discussed, based on the nature of the activities conducted in these ventures, we cannot estimate with any degree of accuracy amounts that we may be required to fund in the short or long-term. However, we do not believe that additional funding of these ventures or partnerships will have a material adverse effect on our financial condition or results of operations.
Debt Guarantees
In certain instances, we have provided “non-recourse carve-out guarantees” on certain non-recourse loans to our subsidiaries. Certain of these loans had variable interest rates, which created exposure in the form of market risk due to interest rate changes. As of December 31, 2017, in connection with the MacArthur Loan, we agreed to provide a construction completion guaranty with respect to the planned MacArthur Hotel improvement project which shall be released upon payment of all project costs and receipt of a certificate of occupancy. In addition, we have provided a loan repayment guaranty of 50% of the MacArthur Loan principal along with a guaranty of interest and operating deficits, as well as other customary carve-out matters such as bankruptcy and environmental matters. Under the guarantees, the Company is required to maintain a minimum tangible net worth of $50.0 million and minimum liquidity of $5.0 million throughout the term of the loan. Preferred equity is included as a component of equity with respect to the minimum tangible net worth covenant.
Extension of Office Lease
During the year ended December 31, 2017, the Company executed an amendment to extend its office lease term for a period of five years ending September 30, 2022. The lease commits the Company to rents totaling $1.5 million over the five year term, net of certain concessions granted.
Critical Accounting Policies
Our financial statements and accompanying notes are prepared in accordance with GAAP. Preparing financial statements requires management to make estimates and assumptions that affect reported amounts and related disclosures. Management considers an
accounting policy and estimate to be critical if: (1) we must make assumptions that were uncertain when the estimate was made; and (2) changes in the estimate, or selection of a different estimate methodology could have a material effect on our consolidated results of operations or financial condition. Management has discussed the development and selection of its critical accounting policies and estimates with the Audit Committee of our Board of Directors.
While we believe that our estimates, assumptions, and judgments are reasonable, they are based on information available when the estimate or assumption was made. Actual results may differ significantly. Additionally, changes in our assumptions, estimates or assessments due to unforeseen events or otherwise could have a material impact on our financial position or results of operations.
See Footnote 2 “Significant Accounting Policies” for further information related our critical accounting policies and estimates, which are as follows:
•
Revenue Recognition - including how we measure revenues for mortgage investments and operating properties
•
Loan Loss Reserves - including information on how we measure impairment on senior, mezzanine, and other loans of these types;
•
Valuation of mortgage investments and REO assets - including information on how we evaluate the fair value of mortgage investments and REO assets and when we record impairment losses on such investments;
•
Intangibles and Long-Lived Assets - including how we evaluate the fair value of intangibles and long-lived assets and when we record impairment losses on intangibles and long-lived assets;
•
Goodwill - including how we evaluate the fair value of reporting units and when we record an impairment loss on goodwill;
•
Income Taxes - including information on how we determine our current year amounts payable or refundable, our estimate of deferred tax assets and liabilities, as well our provisional estimates of the current year impacts of the 2017 Tax Act;
•
Business Combinations - including the assumptions that we make to estimate the fair values of assets acquired and liabilities assumed related to discount rates, and the amount and timing of future cash flows, and
•
Fair Value - including information regarding our sensitivity analysis performed around these assumptions.
•
Gains and losses on disposal of real estate owned - including information about how we measure and recognize gains and losses from sale or other disposition of real estate owned.
•
Stock-based compensation - including information related to measurement and recognition of stock-based compensation expense.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The registrant is a Smaller Reporting Company and, therefore, is not required to provide the information under this item.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by this section is contained in the Consolidated Financial Statements of IMH Financial Corporation and Report of BDO USA, LLP, Independent Registered Public Accounting Firm, beginning on Page.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES.
Disclosure Controls and Procedures
An evaluation was performed under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of December 31, 2017. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that the design and operation of these disclosure controls and procedures were effective as of December 31, 2017.
Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 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. Our 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 U.S. GAAP. Also, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, management assessed the effectiveness of our internal control over financial reporting as of December 31, 2017, utilizing the 2013 framework established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework (2013). Based on their assessment, we determined that the Company’s internal control over financial reporting was effective as of December 31, 2017.
This report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting since the Company, as a smaller reporting company under the rules of the SEC, is not required to include such report.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
Information relating to the board of directors of the Company, including its audit committee and audit committee financial expert, procedures for recommending nominees to the Board of Directors, and compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the information set forth under the captions “Information Regarding Meetings and Committees of the Board of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive Proxy Statement for the 2018 Annual Meeting of Shareholders since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of the Company’s fiscal year pursuant to Regulation 14A.
The following is a list of the names, ages, principal occupations and positions with the Company of the executive officers of the Company. All executive officers of the Company have terms of office that run until the next succeeding annual meeting of the Board of Directors of IMH Financial Corporation following the Annual Meeting of Shareholders unless they are removed sooner by the Board.
Lawrence D. Bain has served as our chief executive officer and chairman of the board since joining us in July 2014. From August 2009 to July 2014, Mr. Bain served as managing partner of ITH Partners, LLC (“ITH Partners”), a private equity and consulting firm. Through ITH Partners, Mr. Bain provided strategic consulting services to the Company from September 2009 to July 2014 relating to, among other things, strategic business matters, asset management, asset dispositions, financing matters (including debt and equity issuances), corporate governance, insurance, and loan underwriting. From 2000 to 2009, Mr. Bain served as chief executive officer of TrueNorth Advisors, LLC, an investment-banking firm providing capital advisory services to small and mid-sized companies. From 2004 to 2009, Mr. Bain served as chief executive officer of ProLink Solutions, LLC, which designs, manufactures, maintains and sells global positioning satellite (GPS) golf course management systems and software to golf course owners and operators worldwide. Mr. Bain spent 20 years in the securities industry holding managing director positions at Stifel, Nicolaus & Company, Inc., Everen Securities, Dean Witter and EF Hutton. Mr. Bain is a graduate of the Ohio State University. The Company believes that Mr. Bain’s qualifications to serve on our Board of Directors include his extensive capital markets experience, his demonstrated strategic insight with respect to real estate finance and development companies, and his knowledge and understanding of the Company’s operations and industry.
Jonathan T. Brohard has served as our Executive Vice President & General Counsel since January 2015. Mr. Brohard also serves as our Chief Compliance Officer, Director of Human Resources and Corporate Secretary. From July 2011 until joining the Company in January 2015, Mr. Brohard was an equity shareholder at Polsinelli, PC, a national AmLaw 100 law firm, where he focused his practice on advising clients with respect to real estate acquisitions and real estate development matters, complex financing structures, including institutional debt and equity, private equity, joint ventures and syndications. Previously, from January 2010 to July 2011, Mr. Brohard served in various executive positions with American Spectrum Realty Management, a real estate investment and management company with more than 135 properties located across 22 states and more than 240 employees. From 2004 until 2010, Mr. Brohard also served as Executive Vice President of Atherton-Newport Investments, LLC, a real estate investment firm. Mr. Brohard received his B.S. in Finance, summa cum laude, at West Virginia University, and his law degree from the University of Virginia.
Samuel J. Montes has served as our Chief Financial Officer since April 2016. Mr. Montes joined IMH in April 2007 and since that time has served in the various capacities of Controller, Director of Financial Reporting and Compliance, Vice President of Finance and, most recently, Senior Vice President of Finance. Prior to joining IMH, Mr. Montes served as Senior Financial Analyst from September 2005 through March 2007 for Picerne Real Estate Group, a privately-owned, national real estate developer and manager of multi-family residential housing. From November 2004 through August 2005, Mr. Montes served as the Director of Finance for Childhelp USA, a national not-for-profit organization. Mr. Montes’ prior experience includes over 13 years with international public accounting firms, where he specialized in real estate, gaming and public sector clients. Mr. Montes has over 25 years of experience in finance and accounting, primarily in the real estate industry. Mr. Montes graduated from California State University of Los Angeles with a Bachelor of Science Degree in Business Administration with a focus in Accounting.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION.
Information relating to executive officer and trustee compensation will be contained in the Proxy Statement referred to above in Item 10, “Directors, Executive Officers and Corporate Governance,” under the caption “Executive Compensation” and such information is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
Information relating to security ownership of certain beneficial owners and management and related stockholder matters will be contained in the Proxy Statement referred to in Item 10, “Directors, Executive Officers and Corporate Governance,” under the caption “Principal Security Holders” and such information is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
Information relating to certain relationships and related transactions, and director independence will be contained in the Proxy Statement referred to in Item 10, “Directors, Executive Officers and Corporate Governance,” under the caption “Certain Relationships and Related Transactions” and such information is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Information relating to principal accounting fees and services will be contained in the Proxy Statement referred to in Item 10, “Directors, Executive Officers and Corporate Governance,” under the caption “Ratification of Selection of Independent Auditors” and such information is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a)
Financial Statements and Schedules
The financial statements of IMH Financial Corporation, the report of its independent registered public accounting firm, and Schedule II - Valuation and Qualifying Accounts are filed herein as set forth under Item 8 of this Form 10-K. All other financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included in the financial statements or notes thereto.
(b)
Exhibits
ITEM 16.
FORM 10-K SUMMARY.
None.
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.
KNOW ALL MEN BY THESE PRESENTS, that Lawrence D. Bain, whose signature appears below constitutes and appoints Samuel J. Montes his true and lawful attorney-in-fact and agent, for such person in any and all capacities, to sign any amendments to this report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or substitute or substitutes, may do or cause to be done by virtue hereof. 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
IMH FINANCIAL CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Stockholders and Board of Directors
IMH Financial Corporation
Scottsdale, Arizona
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of IMH Financial Corporation (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended, and the related notes and financial statement schedule listed in the accompanying index (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ BDO USA, LLP
We have served as the Company's auditor since 2006.
Phoenix, Arizona
March 29, 2018
IMH FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
IMH FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
IMH FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Years ended December 31, 2017 and 2016
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
IMH FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BUSINESS, BASIS OF PRESENTATION AND LIQUIDITY
Our Company
IMH Financial Corporation (the “Company”) is a real estate investment and finance company based in the southwestern United States engaged in various and diverse facets of the real estate lending and investment process, including origination, acquisition, underwriting, servicing, enforcement, development, marketing, and disposition. The Company’s focus is to invest in, manage and dispose of commercial real estate mortgage investments, hospitality assets, or other real estate assets, and to perform all functions reasonably related thereto, including developing, managing and either holding for investment or disposing of real property acquired through acquisition, foreclosure or other means. In addition, the Company intends to expand its hospitality footprint and use of the L’Auberge brand through the acquisition or management of other luxury boutique hotels.
We acquired certain operating properties through deed-in-lieu of foreclosure which have contributed significantly to our operating revenues and expenses in recent years. During the years ended December 31, 2017 and 2016, our operating properties consisted of two operating hotels and restaurants located in Sedona, Arizona (“Sedona Hotels”) (sold in February 2017), a golf course and restaurant operation located in Bullhead City, Arizona (sold in June 2017), and a multi-family housing complex in Apple Valley, Minnesota (sold in December 2016). As discussed in Note 9, in the fourth quarter of 2017, we purchased a 64-room operating hotel, spa and restaurant located in Sonoma, California, commonly known as MacArthur Place (“MacArthur Place”). Due to our limited lending activities since 2008, our operating properties contributed the majority of Company revenues in 2017 and 2016.
Our History and Structure
We were formed from the conversion of our predecessor entity, IMH Secured Loan Fund, LLC (the “Fund”), into a Delaware corporation. The Fund, which was organized in May 2003, commenced operations in August 2003, focusing on investments in senior short-term whole commercial real estate mortgage loans collateralized by first mortgages on real property. The Fund was externally managed by Investors Mortgage Holdings, Inc. (the “Manager”), which was incorporated in Arizona in June 1997 and is licensed as a mortgage banker by the State of Arizona. Through a series of private placements to accredited investors, the Fund raised $875 million of equity capital from May 2003 through December 2008. Due to the cumulative number of investors in the Fund, the Fund registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), on April 30, 2007 and began filing periodic reports with the Securities and Exchange Commission, (“SEC”). On June 18, 2010, following approval by members representing 89% of membership units of the Fund voting on the matter, the Fund became internally-managed through the acquisition of the Manager, and converted into a Delaware corporation in a series of transactions that we refer to as the Conversion Transactions.
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The accompanying consolidated financial statements include the accounts of IMH Financial Corporation and the following wholly-owned operating subsidiaries: 11333, Inc. (formerly known as Investors Mortgage Holdings, Inc.), an Arizona corporation, Investors Mortgage Holdings California, Inc., a California corporation, IMH Holdings, LLC, a Delaware limited liability company (“Holdings”), and various other wholly owned subsidiaries established in connection with the acquisition of real estate either through foreclosure or purchase and/or for borrowing purposes, as well as its majority owned or controlled real estate entities and its interests in variable interest entities (“VIEs”) in which the Company is determined to be the primary beneficiary. Holdings is a holding company for IMH Management Services, LLC, an Arizona limited liability company, which provides us and our affiliates with human resources and administrative services, including the supply of employees. Other entities in which we have invested and have the ability to exercise significant influence over operating and financial policies of the investee, but upon which we do not possess control, are accounted for by the equity method of accounting within the financial statements and they are therefore not consolidated.
The Company, through certain subsidiaries, obtained certain real estate assets and equity interests in a number of limited liability companies and limited partnerships with various real estate holdings and related assets as a result of certain loan and guarantor enforcement and collection efforts. Certain of these entities have been consolidated in the accompanying consolidated financial statements while others were accounted for under the equity method of accounting in periods prior to September 30, 2017, based on the extent of the Company’s controlling financial interest in each such entity. During the period ended September 30, 2017, the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BUSINESS, BASIS OF PRESENTATION AND LIQUIDITY - continued
Company consolidated those partnerships previously recorded under the equity method of accounting following the assignment of certain controlling interests in those partnerships. See Note 5 for a further discussion of the effects of the consolidation, our equity investments and VIEs.
In accordance with ASC 205-20, Presentation of Financial Statements-Discontinued Operations, a component of an entity is reported in discontinued operations after meeting the criteria for held for sale classification if the disposition represents a strategic shift that has (or will have) a major effect on the entity's operations and financial results. While the Company intends to continue to remain active in the hospitality industry through the development and expansion of its hospitality management group during 2017 and through the pursuit of additional hotels to manage and/or acquire, the Company determined that the disposal of the Sedona hotels is required to be treated as discontinued operations accounting presentation under GAAP. As such, the historical financial results of the Sedona hotels and the related income tax effects have been presented as discontinued operations for all periods presented of the disposal group, and is reported as assets of discontinued operations and liabilities of discontinued operations in the accompanying consolidated balance sheets, and in net income (loss) from discontinued operations, net of tax in the accompanying consolidated statements of operations.
All significant intercompany accounts and transactions have been eliminated in consolidation.
Liquidity
As of December 31, 2017, our accumulated deficit aggregated $679.5 million primarily as a result of previous provisions for credit losses recorded relating to the decrease in the fair value of the collateral securing our legacy loan portfolio and impairment charges relating to the value of real estate owned (“REO”) assets acquired primarily through foreclosure, as well as on-going net operating losses resulting from the lack of income-producing assets, and the high cost of our previous debt financing. Beginning in 2008, we experienced significant defaults and foreclosures in our mortgage loan portfolio due primarily to the erosion of the U.S. and global real estate and credit markets during those periods. As a result, since that time we have been focused on enforcing our rights under our loan documents, working to repossess the collateral properties underlying those loans for purposes of disposing of or developing such assets, and pursuing recovery from guarantors under such loans.
Our liquidity plan has included obtaining additional financing, selling mortgage loans, and selling the majority of our legacy real estate assets. We secured various financings between 2011 and 2016 which, along with proceeds from asset sales, have been our primary sources of working capital. During the year ended December 31, 2017, we sold a number of our operating properties and REO assets, generating net cash of $57.9 million after payment of closing expenses and related indebtedness. In the implementation of our investment strategy to acquire income-producing assets, we utilized a majority of such funds to acquire MacArthur Place for $36.0 million and to make certain mortgage investments totaling $19.7 million as of December 31, 2017.
In connection with the acquisition of the MacArthur Place, the Company entered into a building loan agreement/disbursement schedule and related agreements (the “MacArthur Loan”) with MidFirst Bank in the amount of $32.3 million, of which approximately $19.4 million was utilized for the purchase of MacArthur Place, $10.0 million is being set aside to fund planned hotel improvements, and the balance is to fund interest reserves and operating capital. The Company began to undertake a significant renovation project of MacArthur Place in the fourth quarter of 2017 which is expected to continue until the third or fourth quarter of 2018.
The MacArthur Loan required the Company to fund minimum equity of $17.4 million, the majority of which was funded at the time of the Sonoma Hotel purchase and the remaining balance has since been funded. The Company was required to provide a loan repayment guaranty equal to 50% of the MacArthur Loan principal along with a guaranty of interest and operating deficits, as well as other customary non-recourse carve-out matters such as bankruptcy and environmental matters. Under the guarantees, the Company is required to maintain a minimum Tangible Net Worth, as defined, of $50.0 million and minimum liquidity of $5.0 million throughout the term of the MacArthur Loan. The Company was in compliance with such financial covenants as of December 31, 2017. In addition, the MacArthur Loan requires MacArthur Place to establish various operating and reserve accounts at MidFirst Bank which are subject to a cash management agreement. In the event of default, MidFirst Bank has the ability to take control of such accounts for the allocation and distribution of proceeds in accordance with the cash management agreement.
While the Company utilized its own equity (along with debt proceeds as described above) to fund the purchase of MacArthur Place, the Company sponsored and commenced an offering in the Hotel Fund in late November 2017 of up to $25.0 million of preferred limited liability company interests (the “Preferred Interests”) in the Hotel Fund pursuant to Regulation D and Regulation
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NOTE 1 - BUSINESS, BASIS OF PRESENTATION AND LIQUIDITY - continued
S promulgated under the Securities Act. The Company made initial contributions of $17.8 million through December 31, 2017 for the common member interest in the Hotel Fund. The net proceeds of the Offering are being used to (i) reimburse the Company’s initial investment in the Hotel Fund and (ii) fund certain renovations to MacArthur Place. The Company is expected to retain a 10.0% Preferred Interest in the Hotel Fund. The Hotel Fund has sold Preferred Interests to unrelated investors in the aggregate amount of $0.7 million through December 31, 2017 and $4.2 million through March 29, 2018. Since the Company is deemed the primary beneficiary of and controls the Hotel Fund, we have consolidated this entity.
As of December 31, 2017, we had cash and cash equivalents of $11.8 million, REO assets held for sale with a carrying value of $5.9 million and other REO assets with a carrying value of $38.3 million that we intend to dispose of within the next 12 months. We continue to evaluate potential disposition strategies for our remaining REO assets and to seek additional sources of debt and equity for investment and working capital purposes.
As described in Note 18, subsequent to December 31, 2017, the Company entered into a Series B-3 Cumulative Convertible Preferred Stock Subscription Agreement with its largest shareholder, JPMorgan Chase Funding Inc. (“JPM Funding”), pursuant to which JPM Funding agreed to purchase 2,352,941 shares of Series B-3 Cumulative Convertible Preferred Stock, $0.01 par value per share, of the Company (the “Series B-3 Preferred Stock”), at a purchase price of $3.40 per share, for a total purchase price of $8.0 million. The Company intends to use the proceeds from the sale of these shares for general corporate purposes. While several of the terms of the Second Amended Certificate of Designation remained consistent with the Restated Certificate of Designation and provide substantially all of the rights and preferences of the Series B-1 and Series B-2 Preferred Stock, except that dividends on the Series B-3 Preferred Stock accrue at the rate of 5.65% of the issue price per year, and are payable quarterly in arrears. See Note 18 for additional information relating to the Series B-3 Preferred Stock. In connection with this transaction, the Company issued a warrant to JPM Funding to acquire 600,000 shares of our common stock that is exercisable at any time on or after February 9, 2021 for a two (2) year period at an exercise price of $2.25 per share.
We require liquidity and capital resources for our general working capital needs, including maintenance, development costs and capital expenditures for our operating properties and non-operating REO assets, professional fees, general and administrative operating costs, loan enforcement costs, financing costs, debt service payments, dividends to our preferred shareholders, as well as to acquire our target assets. We expect our primary sources of liquidity over the next twelve months to consist of our current cash, mezzanine and mortgage loan interest income, revenues from ownership or management of hotels, proceeds from borrowings and equity issuances, and proceeds from the disposition of our existing REO assets held for sale. We believe that our cash and cash equivalents coupled with our operating and investing revenues, as well as proceeds that we anticipate receiving from the disposition of our real estate held for sale, and debt and equity financing will be sufficient to allow us to fund our operations for a period of one year from the date these consolidated financial statements are issued.
While we have been successful in securing financing through December 31, 2017 and through the date of this filing to provide adequate funding for working capital purposes, which has been supplemented by proceeds from the sale of certain REO assets, receipts of principal and interest on mortgage and related investments, there is no assurance that we will be successful in selling our remaining REO assets in a timely manner or in obtaining additional or replacement financing, if needed, to sufficiently fund future operations, repay existing debt, or to implement our investment strategy. Our failure to generate sustainable earning assets and to successfully liquidate a sufficient number of our loans and REO assets may have a material adverse effect on our business, results of operations and financial position.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Certain accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. The Company evaluates its estimates and assumptions on a regular basis. The Company uses historical experience and various other assumptions that are believed to be reasonable under the circumstances to form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may materially differ from these estimates and assumptions used in preparation of the consolidated financial statements.
Variable Interest Entities
The Company invests in partnerships and joint ventures that may or may not qualify as “variable interest entities” or “VIEs.”
Generally, an entity is determined to be a VIE when either (i) the equity investors (if any) as a group, lack one or more of the essential characteristics of a controlling financial interest, (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support or (iii) the equity investors have voting rights that are not proportionate to their economic interests and substantially all of the activities of the entity involve or are conducted on behalf of an investor that has disproportionately fewer voting rights. The Company consolidates entities that are VIEs for which the Company is determined to be the primary beneficiary. The primary beneficiary is the entity that has both (i) the power to direct the activities that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Entities are also considered VIEs where the Company is the general partner (or the equivalent) and the limited partners (or the equivalent) in such investments do not have “kick-out” rights or substantive participating rights. The Company reassesses whether it has a controlling financial interest in any such investments as circumstances warrant. For consolidated VIE’s, the net equity pertaining to unrelated equity owners is reported as noncontrolling interests.
In instances where the Company is not the primary beneficiary, or the entity does not constitute a VIE, the Company uses the equity method of accounting. Under the equity method of accounting, investments are initially recognized in the consolidated balance sheet at cost, or fair value in the case of legal assignments of such interests, and are subsequently adjusted to reflect the Company’s proportionate share of net earnings or losses of the entity, distributions received, contributions and certain other adjustments, as appropriate. When circumstances indicate there may have been a loss in value of an equity method investment, and the Company determines the loss in value is other than temporary, the Company recognizes an impairment charge to reflect the investment at fair value.
Noncontrolling Interests
Noncontrolling interests represent the portion of equity in the Company’s consolidated entities which is not attributable to the Company’s stockholders. Accordingly, noncontrolling interests are reported as a component of equity, separate from stockholders’ equity, in the accompanying consolidated balance sheets. The net earnings (loss) allocated to such parties are reported in loss attributable to noncontrolling interest income allocation in the accompanying consolidated statements of operations.
Comprehensive Income
Comprehensive income includes items that impact changes in shareholders’ equity but are not recorded in earnings. The Company did not have any such items during the years ended December 31, 2017 and 2016. Accordingly, comprehensive income (loss) is equal to net income (loss) for those periods.
Cash and Cash Equivalents
Cash and cash equivalents are held in depository accounts with financial institutions that are members of the Federal Deposit Insurance Corporation (“FDIC”). Cash balances with institutions may be in excess of federally insured limits or may be invested in time deposits that are not insured by the institution or the FDIC or any other government agency. The company has never
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NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES - continued
experienced any losses related to these balances. We consider all highly liquid investments purchased with an initial maturity of three months or less to be cash equivalents. As of December 31, 2017 and 2016, our cash and cash equivalents were invested primarily in money market accounts that invest primarily in U.S. government securities. Due to the short maturity period of the cash equivalents, the carrying amount of these instruments approximate their fair values.
Funds Held by Lender and Restricted Cash
Funds held by lender and restricted cash includes amounts maintained in escrow or other restricted accounts deposited into reserve accounts held by lenders for contractually specified purposes, which includes property taxes and insurance. In addition, restricted cash includes initial Hotel Fund investor contributions which are held in a separate account until the accreditation evaluation is completed, at which time such funds are released for general operating purposes.
In February 2017, certain senior lender-controlled reserve accounts held at December 31, 2016 in the amount of $2.1 million were released to us upon sale of the Sedona hotels, which were the underlying collateral. At year end, this balance consists of property tax and insurance reserves for the MacArthur Loan and Hotel Fund investor contributions totaling $0.1 million at December 31, 2017.
Revenue Recognition
Operating Property Revenue
Revenues for the hospitality and entertainment operations include hotel, spa, golf, ancillary guest services, and related food and beverage operations, which are recognized as services are provided. Food and beverage revenue is derived from the sale of prepared food and beverage and select retail items and is recognized at the time of sale. Revenue derived from gift card sales is recognized at the time the gift card is redeemed. Until the redemption of gift cards occurs, the outstanding balances on such cards are included in accrued expenses in the accompanying consolidated balance sheets. In addition, advance deposits received from customers for hotel rooms or for event facility rentals are recorded as deferred revenue in customer deposits and funds held for others in the accompanying consolidated balance sheets, and are recognized as income at the time service is provided for the related deposit. Sales taxes are presented on the net basis with sales tax charged on taxable transactions excluded from consolidated statement of operations and represented as a liability on the consolidated balance sheet.
Residential rental income includes monthly rents, non-refundable fees, security, pet and cleaning deposits and retained refundable security deposits at the Company’s apartment complex. Rents are recognized on the first of each month when there is a tenant occupying the unit either under an initial or renewed term of a lease on a straight-line basis, or under the month-to-month provision of the lease. Rent concessions (i.e. first month free rent) are spread evenly over the term of the lease agreement. Rental income is suspended upon the earlier of the tenant becoming two months delinquent in rents, or the commencement of eviction proceedings, which usually occur within 30 days of delinquency. Rental income is restarted and/or caught-up when the tenant becomes current on the account. Retained refundable security deposits are recorded as liabilities and are not recognized as income unless or upon the meeting of security deposit forfeiture criteria (i.e. lease breakage, property damage, unmet move-out requirements, etc.).
Rental income arising from operating leases for the easement or use of real property owned by the Company is recognized on a straight-line basis over the life of the lease.
Management Fee Revenue Recognition
Our revenues include base management and incentive management fees from management of hotels. Management fees are typically composed of a base fee, which typically is a percentage of the hotel revenues, plus an incentive fee, which is generally based on hotel profitability. We recognize base management fees as revenue when we earn them under the contracts. In interim periods and at year-end, we recognize incentive management fees that would be due as if the contracts were to terminate at that date, exclusive of any termination fees payable or receivable by us.
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Mortgage Investment Revenue Recognition
Interest on mortgage loans is recognized as revenue when earned using the interest method based on a 360 or 365 day year, in accordance with the related mortgage loan terms. We do not recognize interest income on loans once they are deemed to be impaired and placed in non-accrual status. Generally, a loan is placed in non-accrual status when it is past its scheduled maturity by more than 90 days, when it becomes delinquent as to interest due by more than 90 days or when the related fair value of the collateral is less than the total principal, accrued interest and related costs. We may determine that a loan, while delinquent in payment status, should not be placed in non-accrual status in instances where the fair value of the loan collateral significantly exceeds the principal and the accrued interest, as we expect that income recognized in such cases is probable of collection. Unless and until we have determined that the value of underlying collateral is insufficient to recover the total contractual amounts due under the loan term, generally our policy is to continue to accrue interest until the loan is more than 90 days delinquent with respect to accrued, uncollected interest or more than 90 days past scheduled maturity, whichever comes first. Mortgage loans classified as held for sale are recorded on the lower of carrying value or fair value less cost to sell.
We do not typically remove a loan from non-accrual status until (a) the borrower has brought the respective loan current as to the payment of past due interest, and (b) we are reasonably assured as to the collection of all contractual amounts due under the loan based on the value of the underlying collateral of the loan, the receipt of additional collateral required and the financial ability of the borrower to service our loan.
We do not generally reverse accrued interest on loans once they are deemed to be impaired and placed in non-accrual status. In conducting our periodic valuation analysis, we consider the total recorded investment for a particular loan, including outstanding principal, accrued interest, anticipated protective advances for estimated outstanding property taxes for the related property and estimated foreclosure costs, when computing the amount of valuation allowance required. As a result, our valuation allowance may increase based on interest income recognized in prior periods, but subsequently deemed to be uncollectible as a result of our valuation analysis.
We generally allocate cash receipts first to interest, except when such payments are specifically designated by the terms of the loan as a principal reduction. Loans with a principal or interest payment one or more days delinquent are in technical default and are subject to various fees and charges including default interest rates, penalty fees and reinstatement fees. Often these fees are negotiated in the normal course of business and, therefore, not subject to estimation. Accordingly, revenue for such fees is recognized over the remaining life of the loan as an adjustment to the interest income yield.
We defer fees for loan originations, processing and modifications, net of direct origination costs, at origination and amortize such fees as an adjustment to interest income using the effective interest method. Revenue for non-refundable commitment fees is recognized over the remaining life of the loan as an adjustment to the interest income yield.
We defer premiums or discounts arising from acquired loans at acquisition and amortize such premiums or discounts as an adjustment to interest income over the contractual term of the related loan using the effective interest method. We include the unamortized portion of the premium or discount as a part of the net carrying value of the loan on the consolidated balance sheets. Costs not directly paid to the seller of the loan are expensed as incurred and not amortized, except for any fees paid directly to the seller.
Recovery of Credit Losses
We record recovery of credit losses when either: 1) our fair value analysis indicates an increase in the value of our assets held for sale (but not above our basis); or 2) we collect recoveries against borrowers or guarantors of our loans. We generally pursue enforcement action against guarantors on loans in default. In those circumstances where we obtain a legal judgment against a particular guarantor, he may not have the financial resources to pay the judgment amount in full, or he may take other legal action to avoid payment to us, such as declaring bankruptcy. As a result, the collectability of such amounts is generally not determinable, and as such, we do not record the effects of such judgments until realization of the recovery is deemed probable and when all contingencies relating to recovery have been resolved, which is generally upon receipt of funds or others assets. Upon receipt of such amounts, we recognize the income in recovery of credit losses in the accompanying consolidated statements of operations.
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(Gain) Loss on Disposal of Assets
Gains from sales of real estate related assets are recognized in accordance with applicable accounting standards only when all of the following conditions are met: 1) the sale is consummated, 2) the buyer has demonstrated a commitment to pay and the collectability of the sales price is reasonably assured, 3) if financed, the receivable from the buyer is collateralized by the property and is subject to subordination only by an existing first mortgage and other liens on the property, and 4) the seller has transferred the usual risks and rewards of ownership to the buyer, and is not obligated to perform significant activities after the sale. If a sale of real estate does not meet the foregoing criteria, any potential gain relating to the sale is deferred until such time that the criteria is met.
Unconsolidated Entities
The Company has held ownership interests in several entities that do not meet the criteria under GAAP for consolidation. For these entities, the Company utilizes the equity method of accounting and records the net income and losses from those unconsolidated entities, as applicable, in equity method income (loss) from unconsolidated entities in the accompanying consolidated statements of operations. As of December 31, 2017, all entities have been consolidated.
Advertising and Marketing Costs
Advertising costs are charged to expense as incurred. For 2017 and 2016, our operations incurred advertising costs of $0.3 million (of which $0.2 million is included as a component of discontinued operations in the consolidated statement of operations) and $1.1 million (of which $0.9 million is included as a component of discontinued operations in the consolidated statement of operations), respectively. Advertising costs related to operations are included in operating property direct expenses and general and administrative expense in the accompanying consolidated statements of operations.
Valuation Allowance
A loan is deemed to be impaired when, based on current information and events, it is probable that we will be unable to ultimately collect all amounts due according to the contractual terms of the loan agreement and the amount of loss can be reasonably estimated.
Our mortgage loans, which are deemed to be collateral dependent, are subject to a valuation allowance based on our determination of the fair value of the subject collateral in relation to the outstanding mortgage balance, including accrued interest and related expected costs to foreclose and sell. We evaluate our mortgage loans for impairment losses on an individual loan basis, except for loans that are cross-collateralized within the same borrowing group. For cross-collateralized loans within the same borrowing group, we perform both an individual loan evaluation as well as a consolidated loan evaluation to assess our overall exposure for such loans. As such, we consider all relevant circumstances to determine impairment and the need for specific valuation allowances. In the event a loan is determined not to be collateral dependent, we measure the fair value of the loan based on the estimated future cash flows of the note discounted at the note’s contractual rate of interest.
Since our loan portfolio is considered collateral dependent, the extent to which our loans are considered collectible, with consideration given to personal guarantees provided under such loans, is largely dependent on the fair value of the underlying collateral.
Fair Value
In determining fair value, we have adopted applicable accounting guidance which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements under GAAP. Specifically, this guidance defines fair value based on exit price, or the price that would be received upon the sale of an asset or the transfer of a liability in an orderly transaction between market participants at the measurement date. Accounting Standards Codification (“ASC”) 820 also establishes a fair value hierarchy that prioritizes and ranks the level of market price observability used in measuring financial instruments. Market price observability is affected by a number of factors, including the type of financial instrument, the characteristics specific to the financial instrument, and the state of the marketplace, including the existence and transparency of transactions between market participants. Financial instruments with readily available quoted prices in active markets generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value.
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Financial instruments measured and reported at fair value are classified and disclosed based on the observability of inputs used in the determination, as follows:
Level 1-
Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access at the measurement date;
Level 2-
Valuations based on quoted market prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active or models for which all significant inputs are observable in the market either directly or indirectly; and
Level 3-
Valuations based on models that use inputs that are unobservable in the market and significant to the fair value measurement. These inputs require significant judgment or estimation by management of third parties when determining fair value and generally represent anything that does not meet the criteria of Levels 1 and 2.
The accounting guidance gives the highest priority to Level 1 inputs, and gives the lowest priority to Level 3 inputs. The value of a financial instrument within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value instrument.
We perform an evaluation for impairment for all loans in default as of the applicable measurement date based on the fair value of the collateral if we determine that foreclosure is probable. We generally measure impairment based on the fair value of the underlying collateral of the loans in default because those loans are considered collateral dependent. Impairment is measured at the balance sheet date based on the then fair value of the collateral, less costs to sell, in relation to contractual amounts due under the terms of the loan. In the case of loans that are not deemed to be collateral dependent, we measure impairment based on the present value of expected future cash flows. In addition, we perform a similar evaluation for impairment for all real estate held for sale as of the applicable measurement date based on the fair value of the real estate.
In the case of collateral dependent loans, REO held for sale, or other REO, the amount of any improvement in fair value attributable to the passage of time is recorded as a credit to (or recovery of) the provision for credit losses or impairment of REO held for sale or other REO with a corresponding reduction in the valuation allowance.
In connection with our assessment of fair value, we may utilize the services of one or more independent third-party valuation firms, other consultants or the Company’s internal asset management department to provide a range of values for selected properties. With respect to valuations received from third-party valuation firms, one of four valuation approaches, or a combination of such approaches, is used in determining the fair value of the underlying collateral of each loan or REO asset held for sale: (1) the development approach; (2) the income capitalization approach; (3) the sales comparison approach; or (4) the cost approach. The valuation approach taken depends on several factors including the type of property, the current status of entitlements and level of development (horizontal or vertical improvements) of the respective project, the likelihood of a bulk sale as opposed to individual unit sales, whether the property is currently or nearly ready to produce income, the current sales price of the property in relation to the cost of development and the availability and reliability of market participant data.
We generally select a fair value within a determinable range as provided by our asset management team, unless we or the borrower have received a bona fide written third-party offer on a specific loan’s underlying collateral, or REO asset. In determining a single best estimate of value from the range provided, we consider the macro- and micro-economic data provided by the third-party valuation specialists, supplemented by management’s knowledge of the specific property condition and development status, borrower status, level of interest by market participants, local economic conditions, and related factors.
As an alternative to using third-party valuations, we utilize bona fide written third-party offer amounts received, executed purchase and sale agreements, internally prepared discounted cash flow analysis, or internally prepared market comparable assessments, whichever may be determined to be most relevant.
We are also required by GAAP to disclose fair value information about financial instruments that are not otherwise reported at fair value in our consolidated balance sheet, to the extent it is practicable to estimate a fair value for those instruments. These disclosure requirements exclude certain financial instruments and all non-financial instruments. As of the dates of the balance sheets, the respective carrying value of all balance sheet financial instruments approximated their fair values. These financial
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instruments include cash and cash equivalents, funds held by lender and restricted cash, mortgage loans, other receivables, accounts payable, accrued interest, customer deposits and funds held for others, and notes payable. Other than notes payables, the fair values of these financial instruments are assumed to approximate carrying values because these instruments are short term in duration. Fair values of notes payable are assumed to approximate carrying values because the terms of such indebtedness are deemed to be at effective market rates and/or because of the short-term duration of such notes.
Loan Charge Offs
Loan charge offs generally occur under one of two scenarios: (i) the foreclosure of a loan and transfer of the related collateral to REO status, or (ii) we agree to accept a loan payoff in an amount less than the contractual amount due. Under either scenario, the loan charge-off is generally recorded through the valuation allowance.
When a loan is foreclosed and transferred to REO status, the asset is transferred to the applicable REO classification at its then current fair value, less estimated costs to sell. In addition, we record the related liabilities of the REO assumed in the foreclosure, such as outstanding property taxes or special assessment obligations. Our REO assets are classified as either held for development, operating (i.e., a long-lived asset) or held for sale.
A loan charged off is recorded as a charge to the valuation allowance at the time of foreclosure in connection with the transfer of the underlying collateral to REO status. The amount of the loan charge off is equal to the difference between a) the contractual amounts due under the loan plus related liabilities assumed, and b) the fair value of the collateral acquired through foreclosure, net of selling costs. At the time of foreclosure, the carrying value of the loan plus related liabilities assumed less the related valuation allowance is compared with the estimated fair value, less costs to sell, on the foreclosure date and the difference, if any, is included in the provision for credit losses (recovery) in the statement of operations. The valuation allowance is netted against the gross carrying value of the loan, and the net balance is recorded as the new basis in the REO assets. Once in REO status, the asset is evaluated for impairment based on accounting criteria for long-lived assets or on a fair value, as appropriate basis.
Except in limited circumstances, our mortgage loans are collateralized by first deeds of trust (mortgages) on real property and generally include a personal guarantee by the principals of the borrower and, often times, the loans are secured by additional collateral. Loans that we intend to sell, subsequent to origination or acquisition, are classified as loans held for sale, net of any applicable valuation allowance. Loans classified as held for sale are generally subject to a specific marketing strategy or a plan of sale. Loans held for sale are accounted for at the lower of cost or fair value on an individual basis. Direct costs related to selling such loans are deferred until the related loans are sold and are included in the determination of the gains or losses upon sale. Valuation adjustments related to loans held for sale are reported net of related principal and interest receivable in the consolidated balance sheets and are included in the provision for (recovery of) credit losses in the consolidated statements of operations.
Some of the loans we sell are non-performing and generate no cash flow from interest or principal payments. In those cases, a buyer is generally interested in the underlying real estate collateral. Accordingly, we use the criteria applied to our sales of real estate assets, as described above, in recording gains or losses from the sale of such loans. In addition, we also consider the applicable accounting guidance for derecognition of financial assets in connection with our loan sales. Since we do not retain servicing rights, nor do we have any rights or obligations to repurchase such loans, derecognition of such assets upon sale is appropriate.
Discounts on Acquired Loans
We account for mortgages acquired at a discount in accordance with applicable accounting guidance which requires that the amount representing the excess of cash flows estimated by us at acquisition of the note over the purchase price is to be accreted into interest income over the expected life of the loan (accretable discount) using the effective interest method. Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan using the effective interest method. If cash flow projections deteriorate subsequent to acquisition, or if the probability of the timing or amount to be collected is indeterminable, the decline is accounted for through the provision for credit loss. No accretion is recorded until such time that the timing and amount to be collected under such loans is determinable and probable as to collection.
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Real Estate Held for Sale
Real estate held for sale consists primarily of assets that have been acquired in satisfaction of a loan receivable, such as in the case of foreclosure. When a loan is foreclosed upon and the underlying collateral is transferred to REO status, an assessment of the fair value is made, and the asset is transferred to real estate held for sale at this amount less estimated costs to sell. We typically obtain a fair value report on REO assets within 90 days of the foreclosure of the related loan. Valuation adjustments required at the date of transfer are charged off against the valuation allowance.
Our classification of a particular REO asset as held for sale depends on various factors, including our intent to sell the property, the anticipated timing of such disposition and whether a formal plan of disposition has been adopted. If management undertakes a specific plan to dispose of real estate owned within twelve months and the real estate is transferred to held for sale status, the fair value of the real estate may be less than the estimated future undiscounted cash flows of the property when the real estate was held for sale, and that difference may be material.
Subsequent to transfer, real estate held for sale is carried at the lower of carrying amount (transferred value) or fair value, less estimated selling costs. Our real estate held for sale is carried at the transferred value, less cumulative impairment charges. Real estate held for sale requires periodic evaluation for impairment which is conducted at each reporting period. When circumstances indicate that there is a possibility of impairment, we will assess the future undiscounted cash flows of the property and determine whether they exceed the carrying amount of the asset. In the event these cash flows are insufficient, we determine the fair value of the asset and record an impairment charge equal to the difference between the fair value and the then-current carrying value. The impairment charge is recognized in the consolidated statement of operations.
Upon sale of REO assets, any difference between the net carrying value and net sales proceeds is charged or credited to operating results in the period of sale as a gain or loss on disposal of assets, assuming certain revenue recognition criteria are met. See revenue recognition policy above.
Operating Properties
Operating properties consist of both operating assets acquired through foreclosure and operating assets that have been purchased by the Company, which the Company has elected to hold for on-going operations. At December 31, 2017, our sole operating property consisted of MacArthur Place, a hospitality property in Sonoma, California. During the year ended December 31, 2017, we sold our hospitality properties in Sedona, Arizona, and an 18-hole golf course and clubhouse in Bullhead City, Arizona.
Other Real Estate Owned
Other REO includes those assets which are generally available for sale but, for a variety of reasons, are not currently being marketed for sale as of the reporting date, or those which are not expected to be disposed of within 12 months.
Property and Equipment
Property and equipment is recorded at cost, net of accumulated depreciation and amortization. Costs to develop, and improve or extend the life of property and equipment are capitalized, while costs for normal repairs and maintenance are expensed as incurred. Depreciation and amortization are computed on a straight line basis over the estimated useful life of the related assets, which range from five to 40 years. Gains or losses on the sale or retirement of assets are included in income when the assets are retired or sold provided there is reasonable assurance of the collectability of the sales price and any future activities to be performed by us relating to the assets sold are insignificant. Upon the acquisition of real estate, we assess the fair value of acquired assets (including land, buildings and improvements, identified intangibles, such as acquired above and below-market leases, acquired in-place leases and tenant relationships) and acquired liabilities and we allocate the purchase price based on these assessments.
Business Combinations
We allocate the purchase price of an acquisition to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values at the acquisition date. We recognize as goodwill the amount by which the purchase price of an acquired entity exceeds the net of the fair values assigned to the assets acquired and liabilities assumed. In determining the fair values of assets acquired and liabilities assumed, we use various recognized valuation methods including the income and market approaches.
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Further, we make assumptions within certain valuation techniques, including discount rates, royalty rates, and the amount and timing of future cash flows. We record the net assets and results of operations of an acquired entity in our consolidated financial statements from the acquisition date. We initially perform these valuations based upon preliminary estimates and assumptions by management or independent valuation specialists under our supervision, where appropriate, and make revisions as estimates and assumptions are finalized. We expense acquisition-related costs as we incur them. See Note 9 Business Combination for additional information.
Goodwill
We assess goodwill for potential impairment in the third quarter of each fiscal year, or during the year if an event or other circumstance indicates that we may not be able to recover the carrying amount of the net assets of the reporting unit. In evaluating goodwill for impairment, we first assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. Qualitative factors that we consider generally include macroeconomic and industry conditions, overall financial performance, and other relevant entity-specific events. If we bypass the qualitative assessment, or if we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then we perform a two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment we will recognize, if any.
In the first step of the two-step goodwill impairment test, we compare the estimated fair value of the reporting unit with its carrying value. If the estimated fair value of the reporting unit exceeds its carrying amount, no further analysis is required or performed. However, if the estimated fair value of the reporting unit is less than its carrying amount, we proceed to the second step and calculate the implied fair value of the reporting unit goodwill to determine whether any impairment loss is necessary. We calculate the implied fair value of the reporting unit goodwill by allocating the estimated fair value of the reporting unit to all of the unit’s assets and liabilities as if the unit had been acquired in a business combination. If the carrying value of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss in the amount of that excess. In allocating the estimated fair value of the reporting unit to all of the assets and liabilities of the reporting unit, we use available industry and market data, as well as our historical experience and knowledge of the industry.
We calculate the estimated fair value of a reporting unit using a combination of standard valuation methodologies, as applicable, which typically include the income and market approaches. For the income approach, we use internally developed discounted cash flow models that include the following assumptions, among others: projections of revenues, expenses, and related cash flows based on assumed long-term growth rates and demand trends; expected future investments to enhance overall unit value; and estimated discount rates. For the market approach, we use internal analyses based primarily on market comparables. We base these assumptions on our historical data and experience, third-party appraisals, industry projections, micro and macro general economic condition projections, and our expectations.
Intangibles and Long-Lived Assets
For real estate assets that are classified as held for sale, the Company records impairment losses if the fair value of the asset net of estimated selling costs is less than the carrying amount. Management reviews each long-lived asset for the existence of any indicators of impairment. If indicators of impairment are present, the Company calculates the expected undiscounted future cash flows to be derived from that asset. If the undiscounted cash flows are less than the carrying amount of the asset, the Company reduces the asset to its fair value, and records an impairment charge for the excess of the net book value over the estimated fair value.
We assess indefinite-lived intangible assets for potential impairment and continued indefinite use at the end of each fiscal year, or during the year if an event or other circumstance indicates that we may not be able to recover the carrying amount of the asset. Similar to goodwill, we may first assess qualitative factors to determine whether it is more likely than not that the fair value of the indefinite-lived intangible is less than its carrying amount. If the carrying value of the asset exceeds the fair value, we recognize an impairment loss in the amount of that excess.
We test definite-lived intangibles and long-lived asset groups for recoverability when changes in circumstances indicate that we may not be able to recover the carrying value; for example, when there are material adverse changes in projected revenues or expenses, significant underperformance relative to historical or projected operating results, or significant negative industry or economic trends. We also test recoverability when management has committed to a plan to sell or otherwise dispose of an asset
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group and we expect to complete the plan within a year. We evaluate recoverability of an asset group by comparing its carrying value to the future net undiscounted cash flows that we expect the asset group will generate. If the comparison indicates that we will not be able to recover the carrying value of an asset group, we recognize an impairment loss for the amount by which the carrying value exceeds the estimated fair value. When we recognize an impairment loss for assets to be held and used, we depreciate the adjusted carrying amount of those assets over their remaining useful life.
We calculate the estimated fair value of an intangible asset or asset group using the income approach or the market approach. We generally utilize similar assumptions and methodology for the income approach applied in the assessment of goodwill. For the market approach, we use internal analyses based primarily on market comparables and assumptions about market capitalization rates, growth rates, and inflation.
Segment Reporting
Our operations are organized and managed according to a number of factors, including line of business categories and geographic locations. As our business has evolved from that of a lender to an owner and operator of various types of real properties, our reportable segments have also changed in order to more effectively manage and assess operating performance. As permitted under applicable accounting guidance, certain operations have been aggregated into operating segments having similar economic characteristics and products. The Company’s reportable segments include the following: Mortgage and REO-Legacy Portfolio and Other Operations, Hospitality and Entertainment Operations, and Corporate and Other.
Statement of Cash Flows
Changes in funds held by lender and restricted cash activity is reflected in cash flows from operating, investing or financing activities depending on the nature and use of such funds for those respective years.
Stock Based Compensation
The Company accounts for its equity-based compensation awards using the fair value method, which requires an estimate of fair value of the award at the time of grant. The Company recognizes the compensation expense related to the time-based vesting criteria on a straight-line basis over the requisite service period. Accruals of compensation cost for an award with a performance condition shall be based on the probable outcome of that performance condition. Therefore, compensation cost shall be accrued if it is probable that the performance condition will be achieved and shall not be accrued if it is not probable that the performance condition will be achieved.
Redeemable Convertible Preferred Stock
The Company’s Series B-1 and B-2 Cumulative Convertible Preferred Stock is convertible into common stock on a one-to-one basis, and is redeemable five years from the issuance date at the option of the holder for a redemption price of 150% of the original purchase price of the preferred stock. As described in Note 18, subsequent to December 31, 2017, we issued shares of Series B-3 Cumulative Convertible Preferred Stock with similar terms but with a redemption price of 145% of the original purchase price of that preferred stock. The preferred stock is reported in the mezzanine equity section of the accompanying consolidated balance sheets. Since the preferred stock does not have a mandatory redemption date (rather it is at the option of the holder), under applicable accounting guidance, the Company elected to amortize the redemption premium over the five year redemption period using the effective interest method and recording this as a deemed dividend, rather than recording the entire accretion of the redemption premium as a deemed dividend upon issuance of the preferred stock. In accordance with applicable accounting guidance, the Company assesses whether the preferred stock is redeemable at each reporting period.
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A roll forward of the balance of redeemable convertible preferred stock for the years ended December 31, 2017 and 2016 follows (in thousands):
Earnings per Share
Basic net income (loss) per share is computed by dividing net income (loss) reduced by preferred stock dividends and amounts allocated to certain non-vested share-based payment awards, if applicable, by the weighted-average number of common shares outstanding during the period.
Income Taxes
We recognize deferred tax assets and liabilities and record a deferred income tax (benefit) provision when there are differences between assets and liabilities measured for financial reporting and for income tax purposes. We regularly review our deferred tax assets to assess our potential realization and establish a valuation allowance for such assets when we believe it is more likely than not that we will not recognize some portion of the deferred tax asset. Generally, we record any change in the valuation allowance in income tax expense. Income tax expense includes (i) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in the valuation allowance and (ii) current tax expense, which represents the amount of taxes currently payable to or receivable from a taxing authority plus amounts accrued for income tax contingencies (including both penalty and interest). Income tax expense excludes the tax effects related to adjustments recorded to accumulated other comprehensive income (loss) as well as the tax effects of cumulative effects of changes in accounting principles.
In evaluating our ability to realize our deferred tax assets, we consider all available positive and negative evidence regarding the ultimate realizability of our deferred tax assets, including past operating results and our forecast of future taxable income. In addition, general uncertainty surrounding future economic and business conditions have increased the likelihood of volatility in our future earnings. Further, to date we have not demonstrated the ability to be profitable. Accordingly, we have recorded a full valuation allowance against our net deferred tax assets.
Reclassifications
Certain reclassifications have been made to 2016 amounts to conform to the current year presentation. In February 2017, the Company entered into an agreement to sell the Sedona hotels to a third party, at which time such assets met the criteria for held for sale classification. Due to the material nature of the Sedona hotel operations, the disposition of this asset group was deemed to represent a strategic shift that would have a major effect on our current operations and financial results under GAAP. Accordingly, this also caused the reclassification of the respective assets, liabilities, revenues and expenses related to the Sedona hotels to be presented as Assets from discontinued operations and Liabilities from discontinued operations in the consolidated balance sheets, and Income (Loss) from discontinued operations, net of tax in the consolidated statements of operations, respectively. See Note 17 for a summary of discontinued operations. The balance of Mortgage Loans Held for Sale, Net as of December 31, 2016 was reclassified to Mortgage Loans, Net in the consolidated balance sheets to conform with the Company’s determination that such assets did not meet the applicable accounting criteria of held for sale as of that date.
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Discontinued Operations
In determining whether a group of assets disposed (or to be disposed) of should be presented as a discontinued operation, the Company makes a determination of whether the criteria for held-for-sale classification is met and whether the disposition represents a strategic shift that has (or will have) a major effect on our operations and financial results. If these determinations can be made affirmatively, the results of operations of the group of assets being disposed of (as well as any gain or loss on the disposal transaction) are aggregated for separate presentation apart from continuing operating results of the Company in the consolidated financial statements.
Recent Accounting Pronouncements
Changes to GAAP are established by the Financial Accounting Standards Board (“FASB”) in the form of accounting standards updates (“ASUs”) to the FASB’s Accounting Standards Codification (“ASC”). The Company considers the applicability and impact of all ASUs.
Adopted Accounting Standards
In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvement to Employee Share Based Payment Accounting (“ASU 2016-09”), which affects entities that issue share-based payment awards to their employees. ASU 2016-09 is designed to simplify several aspects of accounting for share-based payment award transactions including the income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows and forfeiture rate calculations. The Company elected to change our policy surrounding forfeitures, and beginning January 1, 2017, the Company no longer estimates the number of awards expected to be forfeited but rather accounts for them as they occur. The adoption of ASU 2016-09 has been evaluated and did not have a material impact on the Company’s consolidated financial statements and related disclosures.
Accounting Standards Not Yet Adopted
Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). The Financial Accounting Standards Board issued ASU 2014-09, and several related ASUs, which supersede the revenue recognition requirements in Topic 605, as well as most industry-specific guidance, and provide a principles-based, comprehensive framework in Topic 606, Revenue Recognition. ASU 2014-09 also provides for enhanced disclosure requirements. We will use the modified retrospective transition method when we adopt ASU 2014-09 in our 2018 first quarter. Based on our preliminary assessment, the impact that ASU 2014-09 will have on our financial statements and disclosures relating to our recognition of room revenue, ancillary guest services revenue, food and beverage revenue, banquet, events and corporate group revenue, spa services revenue, and management fees revenue is expected to remain substantially unchanged. Interest income is not within the scope of this standard. The company is in the process of finalizing the disclosure requirements and will have this completed by the first quarter of 2018.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), which requires all equity investments to be measured at fair value with changes in the fair value recognized through net income (other than those accounted for under equity method of accounting or those that result in consolidation of the investee). The amendments in this update also require an entity to present separately in other comprehensive income, the portion of the total change in the fair value of a liability resulting from a change in the instrument­ specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. In addition, the amendments in this update require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The Company is currently evaluating the impact that this new guidance will have on its consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU 2016-02, Leases. This new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with
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certain practical expedients available. The Company is currently evaluating the impact that this new guidance will have on its consolidated financial statements and related disclosures.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses. The ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. Additionally, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. For public companies, this update will be effective for interim and annual periods beginning after December 15, 2019. We have not yet determined the impact the adoption of ASU 2016-13 will have on the Company’s consolidated financial statements and related disclosures.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which is intended to address diversity in practice related to how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments in ASU 2016-15 address eight specific cash flow issues as well as application of the predominance principle (dependence on predominant source or use of receipt or payment) and are effective for public business entities for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years with early adoption permitted. ASU 2016-15 requires retrospective adoption unless it is impracticable to apply, in which case it is to be applied prospectively as of the earliest date practicable. The Company is currently evaluating the impact that this new guidance will have on its consolidated financial statements and related disclosures.
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASU 2016-18”), which provides guidance on the presentation of restricted cash and restricted cash equivalents in the statement of cash flows. In accordance with ASU 2016-18, restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning­ of­ period and end­ of­ period amounts shown on the statements of cash flows. The amendments of ASU 2016-18 are effective for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the impact this amendment will have on its consolidated financial statements and related disclosures.
In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-01”), which clarifies the definition of a business by adding guidance to assist entities in evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. For public companies, ASU 2017-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those periods. We have not yet determined the impact the adoption of ASU 2017-01 will have on the Company’s consolidated financial statements and related disclosures.
In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718) . The ASU provides clarification on when modification accounting should be used for changes to the terms or conditions of a share-based payment award. ASU 2017-09 does not change the accounting for modifications but clarifies that modification accounting guidance should only be applied if there is a change to the value, vesting conditions or award classification and would not be required if the changes are considered non-substantive. The amendments of this ASU are effective for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the impact this amendment will have on its consolidated financial statements and related disclosures.
In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): I. Accounting for Certain Financial Instruments with Down Round Features; II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception, (“ASU 2017-11”). Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of the pricing of future equity offerings. Current accounting guidance creates cost and complexity for entities that issue financial instruments (such as warrants and convertible instruments) with down round features that require fair value measurement of the entire instrument or conversion option. Part II of this update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity, because of the existence of extensive pending content in the FASB Accounting Standards Codification. This pending content is the result of the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain
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nonpublic entities and certain mandatorily redeemable noncontrolling interests. The amendments in Part II of this update do not have an accounting effect. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. The Company is currently assessing the potential impact of adopting ASU 2017-11 on its consolidated financial statements and related disclosures.
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NOTE 3 - MORTGAGE LOANS, NET
Lending Activities
During the year ended December 31, 2017, the Company purchased two mezzanine loans from a related party (as described in Note 16) at a discount for $19.3 million, with a face value of $19.9 million. The loans are collateralized by a pledge of 100% of the equity interests in the entity owning the collateral for underlying assets of the respective loans. One loan had an original maturity date of September 9, 2016 with three one-year extensions. The borrower has exercised the first two extension options to extend the maturity date to September 9, 2018. The loan has an annual interest rate of 9.75% plus one-month LIBOR (11.23% at December 31, 2017). The second loan has a maturity date of October 9, 2019 with three one-year extensions, and bears an annual interest rate of 7.25% plus one-month LIBOR (8.73% at December 31, 2017). The respective discount for each loan is being amortized over the term of that loan using the effective interest method.
As further discussed in Note 5, effective September 29, 2017, the Company consolidated certain partnerships which had previously been accounted for as equity investments. As a result of the consolidation of such partnerships, one mortgage loan with a principal and interest balance of $0.4 million due from one of the partnerships has been eliminated in consolidation.
A roll-forward of loan activity for the years ended December 31, 2017 and 2016 follows (in thousands):
As of December 31, 2017, the Company had four loans outstanding with an aggregate average principal and interest balance of $8.2 million. Two of these loans were performing loans with an average outstanding principal and accrued interest balance of $10.0 million, bearing a weighted average interest rate of 9.7% as of December 31, 2017. As of December 31, 2016, the Company had three loans with an aggregate average principal and interest balance of $4.4 million, one of which was performing with an outstanding principal and accrued interest balance of $0.4 million and bearing an interest rate of 11.0%. As of December 31, 2017 and December 31, 2016, the Company had two non-performing loans which have been fully reserved and have a zero carrying value. During the year ended December 31, 2017 and 2016 we recorded mortgage interest income of $0.9 million and $0.3 million, respectively. As of December 31, 2017 and 2016, the valuation allowance was $12.7 million and represented 39.2% and 97.1%, respectively, of the total outstanding loan principal and interest balances.
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Geographic Diversification
Our mortgage loans consist of loans where the primary collateral is located in California, Missouri, New Mexico, and Texas. As of December 31, 2017 and 2016, the geographical concentration of our loan balances by state was as follows (dollar amounts in thousands):
Interest Rate Information
Our loan portfolio includes loans that carry variable and fixed interest rates. All variable interest rate loans are indexed to the Prime Rate or LIBOR. At December 31, 2017 and December 31, 2016, the Prime Rate was 4.50% and 3.75%, respectively. At December 31, 2017 and December 31, 2016, the one-month LIBOR was 1.56% and 0.77%, respectively.
At December 31, 2017, we had four loans with principal and interest balances totaling $32.4 million and interest rates ranging from 8.7% to 12.0%. Of this total, two loans with principal and interest balances totaling $12.7 million and a weighted average interest rate of 12.0% were non-performing loans and fully reserved, while two loans with principal and interest balances totaling $19.7 million and a weighted average interest rate of 9.7% were performing. Since a significant percentage of our loan principal balance is in default, the extent of mortgage income recognized on our loans is limited to only those loans that are performing.
At December 31, 2016, we had three loans with principal and interest balances totaling $13.1 million and interest rates ranging from 11.0% to 12.0%. Of this total, two loans with principal and interest balances totaling $12.7 million and a weighted average interest rate of 12.0% were non-performing loans and fully reserved, while one loan with principal and interest balances totaling $0.4 million and an interest rate of 11.0% was performing.
Changes in the Portfolio Profile - Scheduled Maturities
The outstanding principal and interest balances of mortgage investments, net of the valuation allowance, as of December 31, 2017 and 2016, have scheduled maturity dates within the next several quarters as follows (dollar amounts in thousands):
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From time to time, we may modify certain terms of a loan or extend a loan’s maturity date in an effort to preserve our collateral. Accordingly, repayment dates of the loans may vary from their currently scheduled maturity date. If the maturity date of a loan is not extended, we classify and report the loan as matured. We did not modify any loans during the years ended December 31, 2017 or 2016.
We do not expect payoffs to materialize for nonperforming loans past their maturity dates. We may find it necessary to foreclose, modify, extend, make protective advances or sell such loans in order to protect our collateral, maximize our return or generate additional liquidity.
There were no mortgage loan payoffs during the year ended December 31, 2017. During the year ended December 31, 2016, we collected mortgage loan payoffs totaling $7.6 million. This amount represented the negotiated payoffs of two of our performing loans at a collective discount of $0.2 million. The discounted payoffs on these loans did not represent troubled debt restructuring because the loans were fully performing and the Company initiated the discounted payoffs in order to generate liquidity. We recorded an adjustment as of December 31, 2015 to provide for this discount.
Summary of Existing Loans in Default
At December 31, 2017 and 2016, two of our remaining legacy loans with outstanding principal and interest balances totaling $12.7 million were in default and past their respective scheduled maturity dates and are fully reserved. There were no other changes to loans in default during the year ended December 31, 2017.
We are evaluating the best course of action with respect to the loans in default which could lead to foreclosure or other disposition, but we have not completed foreclosure on any such loans during the year ended or subsequent to December 31, 2017. The timing of foreclosure on the remaining loans is dependent on several factors, including applicable states statutes, potential bankruptcy filings by the borrowers, the nature and extent of other liens secured by the underlying real estate.
Concentration by Category based on Collateral Development Status
We have historically classified loans into categories for purposes of identifying and managing loan concentrations. The following table summarizes, as of December 31, 2017 and 2016, respectively, loan principal and interest balances by concentration category (dollars in thousands):
Unless loans are modified and additional loan amounts are advanced to allow a borrower’s project to progress to the next phase of the project’s development, the classifications of our loans generally do not change during the loan term. Thus, in the absence of funding new loans, we do not expect material changes between loan categories with the exception of changes resulting from foreclosures or loan sales.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - MORTGAGE LOANS, NET - continued
We also classify loans into categories based on the underlying collateral’s projected end-use for purposes of identifying and managing loan concentration and associated risks. As of December 31, 2017 and 2016, respectively, outstanding principal and interest loan balances by expected end-use of the underlying collateral, were as follows (dollars in thousands):
Borrower and Borrower Group Concentrations
Our investment policy generally provides that aggregate loans outstanding to a borrower or affiliated borrowers should not exceed 20% of the total of the Company’s investment portfolio. Following the origination of a loan, however, the aggregate loans outstanding to a borrower or affiliated borrowers may exceed those thresholds as a result of foreclosures, limited lending activities, and changes in the size and composition of our overall portfolio.
As of December 31, 2017, we had four outstanding loans, of which there were two performing loans whose aggregate principal and interest carrying value totaled $19.7 million, representing 100% of our total loan portfolio net carrying value. As of December 31, 2016, we had three outstanding loans. One loan, the only performing loan, had an outstanding principal and interest carrying value, net of allowance, of $0.4 million, which represented 100% of our total loan portfolio net carrying value. Due to the limited size of our mortgage portfolio, during the year ended December 31, 2017, two individual loans with aggregate principal balances totaling $19.5 million collectively accounted for 96.9% of total mortgage income for the year. Similarly, during the year ended December 31, 2016, three individual loans with average aggregate principal balances totaling $3.5 million accounted for 99.2% of total mortgage loan income for the year.
Loan Sales and Payoffs
We did not sell any mortgage loans during the year ended December 31, 2017. During the year ended December 31, 2016, the Company sold one loan with a carrying value of $3.1 million for a net loss of $0.1 million. During the year ended December 31, 2017, we did not collect any mortgage principal payments. During the year ended December 31, 2016, we collected mortgage loan payoffs totaling $7.6 million.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - OPERATING PROPERTIES, REAL ESTATE HELD FOR SALE AND OTHER REAL ESTATE OWNED
As of December 31, 2017, we held total REO assets of $64.6 million, of which $5.9 million were held for sale, $20.5 million were held as operating properties, and $38.3 million were classified as other real estate owned. At December 31, 2016, we held total REO assets of $122.1 million, of which $17.8 million was held for sale, $88.7 million were held as operating properties (which have been reclassified as assets of discontinued operations on the accompanying consolidated balance sheets), and $15.5 million were classified as other real estate owned.
A summary of operating properties and REO assets owned as of December 31, 2017 and December 31, 2016, respectively, by method of acquisition, is as follows (in thousands):
A summary of operating properties and REO assets owned as of December 31, 2017 and 2016, respectively, by state, is as follows (dollars in thousands):
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - OPERATING PROPERTIES, REAL ESTATE HELD FOR SALE AND OTHER REAL ESTATE OWNED - continued
Following is a roll-forward of REO activity for the years ended December 31, 2017 and 2016 (dollars in thousands):
In October 2017, the Company, through the Hotel Fund, acquired MacArthur Place for a purchase price of $36.0 million. The purchase price was allocated to applicable tangible and intangible assets and liabilities based on their relative fair value, with the excess attributed to goodwill. Of the $36.0 million purchase price, $19.6 million was allocated to operating properties. Since we
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - OPERATING PROPERTIES, REAL ESTATE HELD FOR SALE AND OTHER REAL ESTATE OWNED - continued
are deemed to be the primary beneficiary and maintain control of the Hotel Fund, we have consolidated this entity in accordance with GAAP.
During the year ended December 31, 2017, we acquired the remaining interest of Park City Development, LLC in Lakeside JV. Following the acquisition of that interest, we were deemed to be the primary beneficiary and obtained control of the entity and changed our accounting for the investment from an unconsolidated equity method investment to a consolidated investment, at which time we recorded the gross values of related real estate, other assets and liabilities. During the year ended December 31, 2017, we obtained control over various interests in which we were deemed to be the primary beneficiary in a group of seven partnerships with real estate assets located in New Mexico (collectively referred to as the “New Mexico Partnerships”), which were previously accounted for under the equity method of accounting. As a result, we have consolidated the New Mexico Partnerships and recorded the related assets and liabilities on a gross basis at their estimated fair values.
REO Sales
We have developed formal plans to actively market REO assets designated as held for sale with the expectation that they will sell within a 12 month time frame as of the reporting date. We intend to dispose of the majority of our other REO assets but those assets did not meet one or more of the GAAP criteria in order to be classified as held for sale as of the reporting date (for example, not presently listed with a broker). We are also periodically approached on an unsolicited basis by third parties expressing an interest in purchasing REO assets that may not be classified as held for sale.
During the year ended December 31, 2017, the Company sold REO from 10 projects (in whole or portions thereof), for $104.9 million (net of transaction costs and other non-cash adjustments) resulting in a total net gain on sale of $10.7 million, of which $6.8 million is included as a component of discontinued operations in the consolidated statement of operations. During the year ended December 31, 2016, we sold 10 REO assets (or portions thereof) for $44.2 million (net of transaction costs and other non-cash adjustments), resulting in a total net gain of $10.8 million.
REO Planned Development and Operations
Costs and expenses related to operating, holding and maintaining our operating properties and REO assets are expensed as incurred and included in operating property direct expenses, and expenses for non-operating real estate owned in the accompanying consolidated statements of operations. For the years ended December 31, 2017 and 2016, these costs and expenses were $9.2 million ($4.0 million of which is included in income from discontinued operations) and $26.4 million ($22.1 million of which is included in loss from discontinued operations), respectively. Costs related to the development or improvements of the Company’s real estate assets are generally capitalized and costs relating to holding the assets are generally charged to expense. Cash outlays for capitalized development costs totaled $3.8 million and $11.9 million for the years ended December 31, 2017 and 2016, respectively.
REO Valuation Considerations
Our fair value assessment procedures are more fully described in Note 6. Certain properties are expected to have minimal development activity until a decision is made whether or not to sell the property. The undiscounted cash flow from these properties is based on current comparable sales for the asset in its current condition, less costs to sell and holding costs. Other properties are expected to be developed more extensively to maximize sale proceeds. The undiscounted cash flow from these properties are based on a build-out scenario that considers both the cash inflows and the cash outflows over the duration of the development, which often includes an estimate for required financing.
In the absence of available financing, our estimates of undiscounted cash flows assume that we will pay development costs from the disposition of current assets or the raising of additional capital. However, the level of planned development for our individual properties is dependent on several factors, including the current entitlement status of such properties, the cost to develop such properties, our financial resources, the ability to recover development costs, and competitive conditions. Generally, vacant, unentitled land is being held for future sale to an investor or developer with no planned development expenditures by us. In certain instances, we may choose to further develop fully or partially entitled land to maximize interest to developers and our return on investment.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - OPERATING PROPERTIES, REAL ESTATE HELD FOR SALE AND OTHER REAL ESTATE OWNED - continued
Based on our assessment of impairment of operating properties for the year ended December 31, 2017 we did not record any impairment charges.
Based on our assessment of impairment of REO assets held for sale and other REO for the year ended December 31, 2017, we recorded impairment charges of $0.7 million primarily to adjust the fair value of our other REO to reflect current market conditions and management’s plan of disposition. We did not record any impairment charges during the year ended December 31, 2016. See Note 6 for valuation testing results over our REO held for sale and other REO.
Reclassification of Assets from Operating Properties to REO Held for Sale
In the first quarter of 2017, we reclassified our two Sedona hotels from operating properties to REO held for sale as a result of management’s decision and actions to dispose of such assets. The properties were sold in February 2017. As of December 31, 2016, the Sedona hotel represented 60.6% of the Company’s total assets and constituted an individually significant component of the Company’s business. The Sedona assets contributed to net income, net of tax of $3.1 million for the year ended December 31, 2017, and $1.3 million in net loss, net of tax for the year ended December 31, 2016.
The operations and gain on sale of the Sedona hotels is reported as discontinued operations in the accompanying consolidated financial statements. See Note 17, Discontinued Operations, for additional information.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENTS IN JOINT VENTURES AND PARTNERSHIPS
Park City, Utah Lakeside Investment
During 2015, the Company, through a consolidated subsidiary, Lakeside DV Holdings, LLC (“LDV Holdings”), entered into a joint venture with a third party developer, Park City Development, LLC (“PCD”) for the purpose of acquiring, holding and developing certain real property located in Park City, Utah (“Lakeside JV”). The intent of Lakeside JV was to sell townhome, single family residential and hotel lots. Under the Lakeside JV limited liability company agreement, the Company agreed to contribute up to $4.2 million for a 90% interest and PCD agreed to contribute up to $0.5 million for a 10% interest. Equity balances in Lakeside JV were subject to a 12% preferred return, compounded quarterly. PCD’s principal provided a limited performance guaranty to the Company in the case of certain defaults by PCD.
In January 2017, the Company purchased PCD’s 10% interest in Lakeside JV for $0.7 million and terminated PCD as manager. Upon purchase of PCD’s interest, Lakeside JV became a consolidated entity of the Company in the first quarter of 2017. The Company’s investment in Lakeside JV was previously accounted for under the equity method. No gain or loss was recorded for this transaction as the consideration paid plus the reported amounts of previously held interests approximated the fair value of Lakeside JV. As of December 31, 2017, the Company had made all required contributions to Lakeside JV.
Upon formation of Lakeside JV, the Company syndicated $1.7 million of its $4.2 million investment to several investors (“Syndicates”) by selling preferred equity interests in LDV Holdings. The syndicated investment was made up of $1.4 million from various related parties and $0.3 million from an unrelated party. Of the $1.4 million invested by related parties, $1.1 million was invested by one of the Company’s directors and preferred shareholders (see Note 16), $0.2 million was invested by two members of the Company’s board of directors, and $0.1 million was invested by a partner from one of the Company’s outside law firms. The Company has no obligation to return the initial investment to the Syndicates.
LDV Holdings’ cash flows are to be distributed first to its members in proportion to the preferred equity investment, including the preferred return, then to the extent of additional capital contributions made by its members. Thereafter, cash flows are to be distributed to members at varying rates as certain return hurdles are achieved. Other than a 2% management fee to be paid to the Company, cash flows distributions from LDV Holdings to the Syndicates are to effectively mirror the distributions to LDV Holdings from Lakeside JV. The investment by the Syndicates in LDV Holdings is included in non-controlling interests, a component of shareholders’ equity in the accompanying consolidated balance sheets.
During 2017, certain of Syndicates executed promissory notes in favor of a subsidiary of the Company totaling $0.7 million. The notes receivable have an annual interest rate of 8% and mature at the earliest to occur of 1) the date on which the sale of the Lakeside JV property occurs, or 2) September 17, 2019. The promissory notes are secured by the investors’ respective interest and allocated proceeds of LDV Holdings. Under applicable accounting guidance, the notes receivable have been netted against the non-controlling interest balance in the accompanying consolidated balance sheet.
In the Company’s estimation, the fair value of the unimproved real estate holdings of Lakeside JV exceeded our investment basis as of December 31, 2017 and 2016. The Company’s maximum exposure to loss in the Lakeside JV as of December 31, 2017 was $2.7 million. The risk of loss on the balance of the investment is borne by the Syndicates.
During the year ended December 31, 2016, Lakeside JV recorded a loss of $0.2 million which is reflected in the loss on the equity method investment in the accompanying consolidated statements of operations, of which $0.1 million was allocable to the Syndicates and is reflected in income attributable to noncontrolling interest income allocation in the accompanying consolidated statements of operations.
Equity Interests Acquired through Guarantor Recoveries
In 2015, the Company acquired certain real estate assets and equity interests in a number of limited liability companies and limited partnerships with various real estate holdings and related assets in satisfaction of an outstanding receivable from a court-appointed receiver advanced in connection with certain enforcement and collection efforts against the guarantor of a former borrower. Prior to September 29, 2017, certain of these entities were consolidated in the our consolidated financial statements while others were accounted for under the equity method of accounting, depending on the extent of the Company’s financial interest in and level of control over each such entity.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENT IN JOINT VENTURES AND PARTNERSHIPS - continued
Effective September 29, 2017, the Company consolidated the accounts of various corporate entities, the full ownership of which was initially granted to the Company under a previous judgment award against a guarantor under certain legacy mortgage loans. The value of the corporate entities was not recorded as a recovery at the time of award since the ownership of those entities remained under the control of a court-appointed receiver from the date the judgment was awarded. The assets of the corporate entities consist primarily of general and limited partnership interests in, and various receivables from (and liabilities to), several of the previously consolidated and unconsolidated entities, as well amounts for other entities pertaining to the guarantor that were administratively dissolved by court order in a receivership wind-up motion. As a result, the Company began to consolidate into its financial statements the accounts of various unconsolidated variable interest entities, whose assets are comprised of real estate holdings, rights to develop water and receivables from other related entities, and liabilities which consisted primarily of various amounts payable to related entities.
The consolidation of the aforementioned entities occurred as a result of the termination of a court-appointed receivership over the corporate entities which maintained the general partner interests and thereby controlled the activities of such entities through that date. During the year ended December 31, 2017, the receiver assigned and delivered to the Company the stock certificates of the corporate entities, including the underlying interest in partnerships. As a result, as of that date, the Company received full possession, custody and control of its awarded interests in the corporate entities and related interest in partnerships. The Company’s ownership interests in the consolidated entities range from 3.8% to 100.0% and were determined to be variable interest entities. The Company determined the partnerships are deemed to be variable interest entities and that through its general and limited partnership interests, the Company is the primary beneficiary of such entities because 1) it has the power to direct the activities of the entities that most significantly impact the economic performance of such entities, and 2) with the financial assistance provided to such entities, the Company has the risk of absorbing losses or rights to receive benefits that could be potentially significant to the entities; as such, they should be consolidated. Intercompany receivables and liabilities have been eliminated in consolidation in the accompanying consolidated financial statements.
In April 2017, the court-appointed receiver over the general partner of one of the partnerships made a capital call of all partners to fund various operating and capital requirements. While the Company met its obligation under this request, none of the remaining partners did so, at which point the Company funded those portions as well totaling $1.1 million to the partnership. As a result of the other partners’ failure to make the required contributions, the general partner declared a default by such limited partners under the terms of the partnership agreement and assigned those limited partner interests to the Company’s limited partner subsidiary. Upon transfer of the general partner interest to the Company at termination of the receivership on September 29, 2017, the Company gained full authority to act on behalf of the partnership. Accordingly, we recorded the effects of the ownership of those additional limited partner interests upon consolidation.
Financial data presented for previous periods have not been restated to reflect the consolidation of the entities. The assets and liabilities of the newly consolidated entities were recorded at their preliminary estimated fair values. As a result of the assignment of the corporate entity and related general partner interests and recording of assets and liabilities at fair value for the affected entities, and after elimination of intercompany balances, the Company recorded the elimination of the investment in unconsolidated entities of $4.0 million, and recorded a decrease in mortgage loans of $0.4 million, a decrease in other receivables of $2.4 million, an increase in other real estate owned of $17.8 million, an increase in other assets of $1.1 million, an increase in liabilities of $0.2 million, and non-controlling interests of $6.5 million at consolidation. In addition, the Company recorded net recovery income of $6.1 million at consolidation.
In 2016, a subsidiary of the Company entered into a series of promissory notes and related agreements with five of the partnerships to advance a total of up to $0.7 million for the purposes of funding various operating costs and well infrastructure development costs in connection with a damaged well affecting the partnerships. The partnership notes are secured by the assets of the respective partnerships, bear interest rates ranging from the JP Morgan Chase Prime rate plus 2.0% (6.50% at December 31, 2017) to 8.0% and mature no later than July 31, 2018. During the year ended December 31, 2017, the notes were amended to increase the maximum loan amount to $1.0 million per entity, or $5.0 million in total, and to cross-collateralize the notes. During the year ended December 31, 2017, a total of $1.5 million was advanced to the five partnerships under the terms of the note agreements. The outstanding principal and interest of such notes totaled $2.0 million as of December 31, 2017. As a result of the consolidation of the related entities, the notes receivable and notes payable and related interest amounts have been eliminated in consolidation.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENT IN JOINT VENTURES AND PARTNERSHIPS - continued
The Company’s consolidated financial statements include the assets, liabilities and results of operations of VIEs for which the Company is deemed to be the primary beneficiary. The other equity holders’ interests are reflected in net income (loss) attributable to noncontrolling interests in the accompanying consolidated statements of operations and noncontrolling interest in the accompanying consolidated balance sheets. For certain of the consolidated entities, the Company previously recorded only its proportionate interest in related assets and liabilities at that time such interests were initially awarded, rather than recording the gross assets and liabilities and non-controlling interest portion. For the applicable entities, it was determined that the Company should have recorded additional other REO assets and a corresponding non-controlling interest in the amount of $3.2 million since these entities were consolidated. We have recorded out of period adjustments to reflect the proper amount of assets, liabilities and non-controlling interests as of December 31, 2017. The Company concluded that these out of period adjustments were not material to any of the prior period consolidated balance sheets and they had no impact on prior period consolidated statements of operations and cash flows.
L’Auberge de Sonoma Hotel Fund
As described in Note 9, in October 2017, the Company, through various subsidiaries, acquired MacArthur Place for a purchase price of $36.0 million. The acquisition of MacArthur Place was funded using $19.4 million in loan proceeds from MidFirst Bank (see Note 7 for description of loan terms) and the balance was contributed by the Company through the Hotel Fund. In November 2017, the Company commenced an offering of up to $25.0 million of preferred interests in the Hotel Fund. The net proceeds of this offering will be used to (i) redeem the Company’s initial contributions to the Hotel Fund and (ii) fund certain renovations to MacArthur Place.
Purchasers of the preferred interests (the “Preferred Members”) are entitled to a preferred distribution, payable monthly, accruing at a rate of 7.0% per annum on invested capital, cumulative and non-compounding (the “Preferred Distribution”). Prior to the sale or other disposition of the Property, if the Fund has insufficient operating cash flow to pay the Preferred Distribution in a given month, the Company will provide the funds necessary to pay the Preferred Distribution for such month. Such payment by the Company will be treated as an additional capital contribution and the Company’s capital account will be increased by such amount. Moreover, we, as sponsor have agreed to fund, in the form of common capital contributions, up to 6.0% of gross proceeds as selling commissions and up to 1.0% of gross proceeds as nonaccountable expense reimbursements to broker-dealers based on the capital raised by them for the Hotel Fund. These portions of our common equity in the Hotel Fund are subordinate to the distribution of capital to Preferred Investors in the event of a capital transaction. Additionally, upon the refinance or sale of all or a portion of MacArthur Place, Preferred Members may be entitled to receive certain additional preferred distributions (the “Additional Preferred Distribution”) that will result in an overall return of up to12.0% on the Preferred Interests. Upon a capital transaction, the Fund will distribute 10.0% of any cash available after the payment of the Additional Preferred Distribution to the Preferred Members pro rata in proportion to the Preferred Interests owned. Any amounts in excess of this shall be retained by the Company. The Fund intends to pursue a liquidity event, with a focus on the sale of all or substantially all of the Fund’s assets, approximately four to six years following commencement of the Offering.
As of December 31, 2017, the Hotel Fund sold preferred interests in the aggregate amount of $0.7 million, which is included in noncontrolling interests in the accompanying consolidated balance sheet. The Hotel Fund did not make any distributions during the year ended December 31, 2017. Based on the structure of the Hotel Fund, our ability to direct the activities that that most significantly impact the economic performance of the Hotel Fund, and the risk of absorbing losses or rights to receive benefits that could be potentially significant to the Hotel Fund, the Company is deemed to be the primary beneficiary of the Hotel Fund, and accordingly we have consolidated and expect to continue to consolidate the Hotel Fund in our consolidated financial statements.
The following table summarizes the carrying amounts of the above referenced entities’ assets and liabilities included in the Company’s consolidated balance sheets at December 31, 2017 and December 31, 2016 (in thousands, net of intercompany eliminations):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENT IN JOINT VENTURES AND PARTNERSHIPS - continued
The Company’s maximum exposure to loss consists of its combined equity in those entities which totaled $28.7 million as of December 31, 2017.
Summarized Financial Information of Unconsolidated Entities (unaudited)
As of December 31, 2017, we no longer hold investments that are recorded on the equity method as a result of the aforementioned consolidation.
Prior to consolidation, during the years ended December 31, 2017 and 2016, the equity loss recorded on our equity method investments in the accompanying consolidated statements of operations was $0.2 million and $0.2 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 - FAIR VALUE
Valuation Allowance and Fair Value Measurement of Loans, Real Estate Held for Sale, and Other REO
We perform a valuation analysis of our loans, REO held for sale, other REO and equity investments not less frequently than on a quarterly basis. Evaluating the collectability of a real estate loan is a matter of judgment. We evaluate our real estate loans for impairment on an individual loan basis, except for loans that are cross-collateralized within the same borrowing groups. For cross-collateralized loans within the same borrowing groups, we perform both an individual loan evaluation as well as a consolidated loan evaluation to assess our overall exposure from those loans. In addition to this analysis, we also complete an analysis of our loans as a whole to assess our exposure from loans made in various reporting periods and in terms of geographic diversity. The fact that a loan may be temporarily past due does not necessarily result in a presumption that the loan is impaired. Rather, we consider all relevant circumstances to determine if, and the extent to which, a valuation allowance is required. During the loan evaluation process, we consider the following matters, among others:
•
an estimate of the net realizable value of any underlying collateral in relation to the outstanding mortgage balance, including accrued interest and related costs;
•
the present value of cash flows we expect to receive;
•
the date and reliability of any valuations;
•
the financial condition of the borrower and any adverse factors that may affect its ability to pay its obligations in a timely manner;
•
prevailing economic conditions;
•
historical experience by market and in general; and
•
an evaluation of industry trends.
Impairment for collateral dependent loans is measured at the balance sheet date based on the then fair value of the collateral in relation to contractual amounts due under the terms of the applicable loan if foreclosure is probable. In the case of the loans that are not deemed to be collateral dependent, we measure impairment based on the present value of expected future cash flows.
REO assets that are classified as held for sale and other REO are measured at the lower of carrying amount or fair value, less estimated cost to sell. REO assets that are classified as operating properties are considered “held and used” and are evaluated for impairment when circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development or operation and eventual disposition of the asset. If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less estimated cost to sell. If we elect to change the disposition strategy for our operating properties or properties to be held and used, and such assets were deemed to be held for sale, we may record additional impairment charges, and the amounts could be significant.
We assess the extent, reliability and quality of market participant inputs such as sales pricing, cost data, absorption, discount rates, and other assumptions, as well as the significance of such assumptions in deriving the valuation. We generally employ one of four valuation approaches (as applicable), or a combination of such approaches, in determining the fair value of the underlying collateral of each loan, REO held for sale and other REO asset: (i) the development approach; (ii) the income capitalization approach; (iii) the sales comparison approach; or (iv) the receipt of recent offers on specific properties. The valuation approach taken depends on several factors including:
•
the type of property;
•
the current status of entitlement and level of development (horizontal or vertical improvements) of the respective project;
•
the likelihood of a bulk sale as opposed to individual unit sales;
•
whether the property is currently or near ready to produce income;
•
the current sales price of property in relation to cost of development;
•
the availability and reliability of market participant data; and
•
the date of an offer received in relation to the reporting period.
With respect to properties or loans for which we (or the borrower) have received a bona fide written third-party offer (or entered into a purchase and sale agreement) to buy the related property, we generally utilize the offer or agreement amount even where the amount is outside our current valuation range, as offers and purchase agreements are considered lower (Level 2) inputs. An
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 - FAIR VALUE - continued
offer or agreement is only considered for valuation purposes if we deem it to be valid, reasonable, negotiable, and we believe the counterparty has the financial wherewithal to execute the transaction. When deemed appropriate, the offers received may be discounted to allow for potential changes in our on-going negotiations.
Factors Affecting Valuation
The underlying collateral of our loans, REO held for sale and other REO assets vary by stage of completion, which consists of either raw land (also referred to as pre-entitled land), entitled land, partially developed land, or mostly developed/completed lots or projects. While we continue to utilize third party valuations for selected assets on a periodic basis as circumstances warrant, we rely primarily on our outside asset management consultants and internal staff to gather available market participant data from independent sources to establish assumptions used to derive fair value of the collateral supporting our loans and real estate owned for a majority of our loan and REO assets.
Our fair value measurement is based on the highest and best use of each property which is generally consistent with our current use for such property. In addition, our assumptions are based on assumptions that we believe market participants for those assets would also use. During the years ended December 31, 2017 and 2016, we performed both a macro analysis of market trends and economic estimates, as well as a detailed analysis on selected significant REO assets. In addition, our fair value analysis included a consideration of management’s pricing strategy in disposing of such assets.
The following is a summary of the procedures performed in connection with our fair value analysis as of and for the years ended December 31, 2017 and 2016:
1.
We reviewed the status of each of our loans to ascertain the likelihood of collecting or recovering all amounts due under the terms of the loans at maturity based on current real estate and credit market conditions.
2.
We reviewed the status of each of our REO assets to determine whether such assets continue to be properly classified as held for sale, operating properties or other REO as of the reporting date.
3.
For the years ended December 31, 2017 and 2016, we performed an internal analysis to evaluate fair value for the balance of the portfolio not covered by third-party valuation reports or existing offers or purchase and sale agreements. Our internal analysis of fair value included a review and update of current market participant activity, overall market conditions, the current status of the property, our direct knowledge of local market activity affecting the property, as well as other market indicators obtained through our asset management group and various third parties to determine whether there were any indications of a material increase or decrease in the value of the underlying collateral or REO asset since our previous analysis for such assets. Our asset-specific analysis focused on the higher valued assets of our total loan collateral and REO portfolio. We considered the results of our analysis and the potential valuation implication to the balance of the portfolio based on similar asset types and geographic location.
4.
In connection with the consolidation of the New Mexico partnerships described in Note 5, we estimated the preliminary fair value of assets and liabilities. The fair value of assets, which are primarily comprised of land and/or related rights to develop water, was based on recently prepared valuation reports and other available market data with respect to the land and water development rights, with consideration given to, and value adjusted for, management’s disposition strategy for such assets. The gross value was reduced by the estimated amount of selling costs, repair cost estimates to ready such assets for sale, and contingent liabilities due upon sale. The fair value of liabilities was based on the anticipated settlement amount of such liabilities.
5.
For properties for which we or our borrower has received a bona fide written third-party offer or entered into a purchase and sale agreement to buy our loan or REO asset, we generally utilized the offer or agreement amount in those cases where that amount falls outside our current valuation conclusion. Such offers or agreements are only considered if we deem them to be valid, reasonable and negotiable, and we believe the counter-party has the financial wherewithal to execute the transaction.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 - FAIR VALUE - continued
Following is a table summarizing the methods used by management in estimating fair value as of December 31, 2017 and 2016:
As of December 31, 2017 and 2016, the highest and best use for the majority of our real estate collateral, REO held for sale and other REO was deemed to be held for investment and/or future development, rather than being subject to immediate development. A summary of the valuation approaches taken and key assumptions that we utilized to derive fair value, is as follows:
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NOTE 6 - FAIR VALUE - continued
•
For properties that included either unentitled or entitled raw land lacking any vertical or horizontal improvements, given the limited opportunities to exploit real estate and credit markets, the development approach was deemed to be unsupportable because market participant data was insufficient or other assumptions were not readily available. In such cases, the “highest and best use” standard required such property to be classified as “held for investment” purposes until market conditions provide observable development activity to support a valuation model for the development of the planned site. As a result, we utilized a sales comparison approach using available data to determine fair value.
•
For properties containing partially or fully developed lots, the development approach is generally utilized, with assumptions made for pricing trends, absorption projections, holding costs, and the relative risk given these assumptions. There were no properties for which the development approach was utilized as of December 31, 2017 and 2016.
Selection of Single Best Estimate of Value
The results of our valuation efforts generally provide a range of values for the collateral valued or REO assets rather than a single point estimate because of variances in the potential value indicated from the available sources of market participant information. The selection of a value from within a range of values depends upon general overall market conditions as well as specific market conditions for each property valued and its stage of entitlement or development. In selecting the single best estimate of value, we consider the information in the valuation reports, credible purchase offers received and agreements executed, as well as multiple observable and unobservable inputs.
Valuation Conclusions
Based on the results of our evaluation and analysis, we did not record any non-cash provision for credit losses on our loan portfolio during the years ended December 31, 2017 and 2016. However, we recorded other net (recoveries of) provision for investment and credit losses totaling $(6.5) million and $0.2 million for the year ended December 31, 2017 and 2016, respectively, resulting from (i) the receipt of cash and/or other assets from guarantors on certain legacy loans, (ii) insurance recoveries, and (iii) additional provisions for credit losses.
The Company recorded a loss on impairment of REO of $0.7 million during the year ended December 31, 2017 to reflect current market conditions and management’s decision to implement a more aggressive pricing strategy to sell the related REO. There were no impairment losses recorded during the year ended December 31, 2016 in the categories for which net mortgage loans and REO held for sale were measured at fair value on a non-recurring basis based upon the lowest level of significant input to the valuation as of December 31, 2016.
As of December 31, 2017 and 2016, the valuation allowance totaled $12.7 million, representing 39.2% and 97.1%, respectively, of the total outstanding loan principal and accrued interest balances. With the existing valuation allowance recorded as of December 31, 2017, we believe that, as of that date, the fair value of our loans, REO assets held for sale, and other REO is adequate in relation to the net carrying value of the related assets and that no additional valuation allowance or impairment is considered necessary. While the above results reflect management’s assessment of fair value as of December 31, 2017 based on currently available data, we will continue to evaluate our loans and REO assets to determine the appropriateness of the carrying value of
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NOTE 6 - FAIR VALUE - continued
such assets. Depending on market conditions, such updates may yield materially different values and potentially increase or decrease the valuation allowance for loans or impairment charges for REO assets.
Valuation Categories
A summary of our assets measured at fair value on a nonrecurring basis as of December 31, 2017 for which losses were recorded during the year ended December 31, 2017 follows (in thousands):
Generally, all of our mortgage loans, REO held for sale and other REO are valued using significant unobservable inputs (Level 3) obtained through updated analysis prepared by our asset management staff, except for such assets for which third party offers or executed purchase and sale agreements were used, which are considered Level 2 inputs. Changes in the use of Level 3 valuations are based solely on whether we utilized third party offers or internal assessment for valuation purposes.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7 - NOTES PAYABLE AND SPECIAL ASSESSMENT OBLIGATIONS
As of December 31, 2017 and 2016, our debt, notes payable and special assessment obligations consisted of the following (in thousands):
* This note was paid off in connection with the sale of the Sedona assets in February 2017 and has been reclassified into Liabilities of discontinued operations as of December 31, 2016 in the accompanying consolidated balance sheet.
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NOTE 7 - NOTES PAYABLE AND SPECIAL ASSESSMENT OBLIGATIONS - continued
Interest expense for the years ended December 31, 2017 and 2016 was $3.1 million and $9.5 million, respectively, of which $1.1 million and $4.2 million, respectively, is included in income from discontinued operations in the accompanying consolidated statements of operations.
Senior Indebtedness
Sedona Operating Hotel
In January 2015, the Company borrowed $50.0 million from Calmwater Capital 3, LLC. This loan was repaid in full in February 2017.
MacArthur Place
In October 2017, we borrowed $32.3 million from MidFirst Bank in connection with our purchase of MacArthur Place (the “MacArthur Loan”), of which $19.4 million was utilized for the purchase of MacArthur Place, approximately $10.0 million is being set aside to fund planned hotel improvements, and the balance is to fund interest reserves and operating capital. The loan bears floating interest equal to the 30-day LIBOR rate (1.56% at December 31, 2017) plus 3.75%, which may be reduced by up to 0.50% if certain conditions are met. The loan has an initial term of three years subject to the right of the Company to extend the maturity date for two one-year periods, provided that the loan is in good standing and upon satisfaction of certain other conditions, including payment of an extension fee equal to 0.35% of outstanding principal per extension. The Company is required to make interest-only payments during the initial three year term. During the year ended December 31, 2017, the Company made interest draws totaling $0.2 million against the loan. The Company incurred deferred financing fees of $0.5 million which are being amortized over the term of the loan using the effective interest method.
The MacArthur Loan is secured by a deed of trust on all MacArthur Place real property and improvements, and a security interest in all furniture, fixtures and equipment, licenses and permits, and MacArthur Place related revenues. The Company agreed to provide a construction completion guaranty with respect to the planned improvement project which shall be released upon payment of all project costs and receipt of a certificate of occupancy. In addition, the Company provided a loan repayment guaranty equal to 50% of the loan principal along with a guaranty of interest and operating deficits, as well as other customary carve-out matters such as bankruptcy and environmental matters. Under the guarantees, the Company is required to maintain a minimum tangible net worth of $50.0 million and minimum liquidity of $5.0 million throughout the term of the loan. Preferred equity is included as a component of equity with respect to the minimum tangible net worth covenant. The Company was in compliance with these covenants and guarantees at December 31, 2017. In addition, the Company is required to establish various operating and reserve accounts at MidFirst Bank which are subject to a cash management agreement. In the event of default, MidFirst Bank has the ability to take control of such accounts for the allocation and distribution of proceeds in accordance with the cash management agreement.
Land Purchase Financing
During 2015, the Company obtained seller-financing of $5.9 million in connection with the purchase of certain New Mexico real estate for $6.8 million. The note bears interest at the prime rate as published by The Wall Street Journal (the “WSJ Prime Rate”) (recalculated annually) plus 2% through December 31, 2017, and the WSJ Prime Rate plus 3% thereafter. Interest only payments are due on December 31 of each year with the principal balance and any accrued unpaid interest due at maturity on December 31, 2019. The note may be prepaid in whole or in part without penalty.
Exchange Notes
In April 2014, we completed an offering of a five-year, 4%, unsecured notes to certain of our shareholders in exchange for common stock held by such shareholders at an exchange price of $8.02 per share (“Exchange Offering”). Upon completion of the Exchange Offering, we issued Exchange Offering notes (“EO Notes”) with a face value of $10.2 million, which were recorded by the Company at fair value of $6.4 million based on the fair value and the imputed effective yield of such notes of 14.6% (as compared to the note rate of 4%) resulting in an initial debt discount on the EO Notes of $3.8 million, with a balance of $1.2 million at December 31, 2017. This amount is reflected as a debt discount in the accompanying financial statements, and is being amortized as an adjustment to interest expense using the effective interest method over the term of the EO Notes. The amortized discount added to the principal balance of the EO Notes during the years ended December 31, 2017 and 2016 totaled $0.8 million and $0.7 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7 - NOTES PAYABLE AND SPECIAL ASSESSMENT OBLIGATIONS - continued
Interest is payable quarterly in arrears each January, April, July, and October. The EO Notes mature on April 28, 2019, and may be prepaid in whole or in part without penalty at the option of the Company. Subject to certain minimum cash and profitability conditions, the Company would be required to prepay fifty percent (50%) of the outstanding principal balance of the EO Notes on April 29, 2018. Such conditions were not met and no prepayment is required.
Notes Payable and Special Assessment Obligations, Assets Held for Sale
As of December 31, 2017 and 2016, obligations arising from our allocated share of certain community facilities district special revenue bonds and special assessments had remaining balances of $0.1 million and $3.6 million, respectively. These obligations are described below.
One of the special assessment obligations had an outstanding balance of zero and $3.1 million as of December 31, 2017 and 2016, respectively, and has an amortization period that extends through April 30, 2030, with an annual interest rate ranging from 5% to 6%. This special assessment obligation was secured by certain real estate consisting of 171 acres of unentitled land located in Buckeye, Arizona which was sold in the fourth quarter of 2017. We made principal payments of $0.2 million on this special assessment obligation during the year ended December 31, 2017. In conjunction with the sale of the related property, the buyer agreed to assume the remaining $2.9 million special assessment obligation.
The other special assessment obligations are comprised of a series of special assessments that collectively had an outstanding balance of $0.1 million and $0.5 million as of December 31, 2017 and 2016, respectively. These special assessment obligations have amortization periods that extend through 2022, with annual interest rates ranging from 6% to 7.5% and secured by certain real estate classified as REO held for sale consisting of 1.5 acres of unentitled land located in Dakota County, Minnesota which had a carrying value of $0.1 million at December 31, 2017. We made principal payments of $0.2 million on this special assessment obligation during the year ended December 31, 2017. During the year ended December 31, 2017, a portion of the related property was sold. In conjunction with the sale, the buyer agreed to assume $0.2 million of the special assessment obligation.
The responsibility for the repayment of each of the foregoing special assessment obligations rests with the owner of the property and will transfer to the buyer of the related real estate upon sale. Accordingly, if the assets to which these obligations arise from are sold before the full amortization period of such obligations, the Company would be relieved of any further liability since the buyer would assume the remaining obligations. Nevertheless, these special assessment obligations are deemed to be obligations of the Company in accordance with GAAP because they are fixed in amount and for a fixed period of time.
Our notes payable and special assessment obligations have the following scheduled maturities as of December 31, 2017 (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8 - SEGMENT INFORMATION
Operating segments are defined as components of an enterprise that engage in business activity from which revenues are earned and expenses incurred for which discrete financial information is available that is evaluated regularly by our chief operating decision makers in deciding how to allocate resources and in assessing performance.
Hospitality and Entertainment Operations - Consists of revenues less direct operating expenses, depreciation and amortization relating to our hotel, golf, spa, and food & beverage operations. This segment also reflects the carrying value of such assets and the related financing and operating obligations. As described elsewhere in this Form 10-K, we sold our Sedona hotels on February 28, 2017 and, in accordance with GAAP, have presented the results of operations for such assets in net income (loss) from discontinued operations for the years ended December 31, 2017 and 2016. While the Sedona hotels have been presented as discontinued operations in the accompanying consolidated financial statements, the Company intends to continue its active engagement in the Hospitality and Entertainment Operations segment through our hotel management group. Moreover, the Company acquired MacArthur Place in the fourth quarter of 2017 and is actively pursuing other hospitality assets.
Mortgage and REO - Legacy Portfolio and Other Operations - Consists of the collection, workout and sale of new and legacy mortgage loan investments and REO assets, including financing of such asset sales. This also encompasses the carrying costs of such assets and other related expenses. This segment also reflects the carrying value of such assets and the related financing and operating obligations. This segment has also historically included rental revenue, less direct property operating expenses (maintenance and repairs, real estate taxes, management fees, and other operating expenses), depreciation and amortization from commercial and residential real estate leasing operations, and the carrying value of such assets and the related financing and operating obligations.
Corporate and Other - Consists of our centralized general and administrative and corporate treasury activities. This segment also includes reclassifications and eliminations between the reportable operating segments and reflects the carrying value of corporate fixed assets and the related financing and operating obligations.
The information presented in our reportable segments tables that follow are based in part on internal allocations which involve management judgment. Substantially all revenues recorded are from external customers. There is no material intersegment activity.
Consolidated financial information for our reportable operating segments, excluding assets from discontinued operations, as of December 31, 2017 and 2016 and for the years then ended is summarized as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8 - SEGMENT INFORMATION - continued
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NOTE 8 - SEGMENT INFORMATION - continued
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NOTE 9 - BUSINESS COMBINATION
In October 2017, the Company acquired MacArthur Place for a purchase price of $36.0 million. This acquisition was funded through a combination of Company equity and a loan from MidFirst Bank. Simultaneously with the acquisition of MacArthur Place, a hotel management subsidiary of the Company entered into a a five year management agreement to provide hotel and resort management services in exchange for monthly and annual management fees at commercially standard terms. This acquisition was made in connection with the Company’s strategy to expand its footprint in the luxury boutique hotel operations and hotel management industry. The purchase price was allocated to the identifiable tangible and intangible assets acquired and liabilities assumed based on their relative fair values. The goodwill of $15.4 million arising from the acquisition resulted largely from expected synergies from combining operations of MacArthur Place and the Company’s hotel management experience, the value of the historic and demographic attributes of MacArthur Place and intangible assets that do not qualify for separate recognition. The goodwill balance was assigned to the Company’s Hospitality and Entertainment segment. Goodwill recognized is expected to be deductible for income tax purposes.
The following table summarizes the consideration paid for MacArthur Place and the allocation of amounts of the assets acquired and liabilities assumed recognized at the acquisition date (in thousands):
The Company acquired tangible assets of land, building, related site improvements, and furniture, fixtures, and equipment. We estimated the fair value of the land using a market comparison approach, adjusted for qualitative and quantitative factors unique to MacArthur Place. We estimated the fair value of the building, related site improvements, and furniture, fixtures, and equipment using the cost approach which utilizes estimated replacement and market costs to estimate fair value. The Company also acquired intangible assets consisting of trade name, customer relationships and goodwill. The estimated fair value of the trade name and customer relationships were valued using the income approach, discounted to present value, on an after-tax basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9 - BUSINESS COMBINATION - continued
The actual amount of MacArthur Place’s revenue and earnings (losses) included in the Company’s consolidated statement of operations for the year ended December 31, 2017, and the unaudited pro forma revenue and earnings (losses) of the combined entity assuming the acquisition had occurred on January 1, 2016 are as follows (in thousands):
The 2017 supplemental pro forma loss was adjusted to exclude $0.7 million of acquisition-related costs incurred during the year ended December 31, 2017. The 2016 supplemental pro forma losses was adjusted to include $0.7 million of acquisition-related costs incurred during the year ended December 31, 2016. Revenues and expenses related to property operations classified as discontinued operations have been excluded.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - INTANGIBLE ASSETS AND GOODWILL
In connection with the purchase of MacArthur Place, we allocated a portion of the total purchase price to certain intangible assets and goodwill. Of the total $16.4 million allocated to purchased intangibles, $0.1 million, $0.8 million, and $15.4 million were allocated to trade name and other, customer relationships, and goodwill, respectively.
The changes in the carrying amount of intangibles and goodwill allocated to our Hospitality and Entertainment Operations segment for the year ended December 31, 2017 is as follows (in thousands):
A summary of our intangible assets and goodwill as of December 31, 2017 and 2016 is as follows (in thousands):
Trade name and other, and customer relationships have weighted-average useful lives from the date of purchase of 7.0 years and 3.0 years, respectively. Goodwill and our liquor license are not subject to amortization due to the indeterminable life of such assets, but rather are subject to annual impairment analysis. Amortization expense relating to our purchased intangible assets was $32.0 thousand for the year ended December 31, 2017. We performed an impairment assessment on goodwill and intangible assets and based on this assessment no impairment charges were recorded for the year ended December 31, 2017. See Note 6 for further information regarding our valuation analysis for operating properties.
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NOTE 10 - INTANGIBLE ASSETS AND GOODWILL - continued
As of December 31, 2017, expected amortization expense for our purchased amortizing intangible assets for each of the next five years and thereafter is as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11 - PROPERTY AND EQUIPMENT
Our operating properties carrying values consist of land and certain depreciable assets such as buildings, improvements, and furniture and equipment assets. A summary of these assets, at cost less accumulated depreciation and amortization, as of December 31, 2017 and 2016, follows (in thousands):
* The 2016 amounts pertain to the Sedona Hotels which were sold in February 2017 and have been reclassified to assets of discontinued operations as of December 31, 2016 in the accompanying consolidated balance sheet.
In addition to these assets, the Company owns other property and equipment related primarily to our corporate activities, which consisted of the following at December 31, 2017 and 2016 (in thousands):
Depreciation and amortization on REO and corporate property and equipment is computed on a straight-line basis over the estimated useful life of the related assets, which range from 5 to 40 years. Depreciation and amortization expense recorded for our depreciable assets totaled $0.6 million and $4.0 million for the years ended December 31, 2017 and 2016, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12 - LEASE COMMITMENTS
Operating Leases
During the year ended December 31, 2017, the Company executed an amendment to extend its office lease term for a period of five years ending on September 30, 2022. The lease commits the Company to rents totaling $1.5 million over the five year term, net of certain concessions granted. Additionally, we are obligated under various operating leases for certain office and other equipment, storage, parking, and other leased space (some of which relate to MacArthur Place operations) for periods ranging from month-to-month to five years, with renewal options available for certain leases at our option. As of December 31, 2017, future minimum lease payments required under these various lease agreements are as follows (in thousands):
Rent expense was $0.2 million for each of the years ended December 31, 2017 and 2016, and is included in general and administrative expenses in the accompanying consolidated statement of operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - INCOME TAXES
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code by, among other things, reducing the federal corporate income tax rate and business deductions. In general, the Tax Act reduces the U.S. corporate income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018.
Under FASB ASC 740, the effects of changes in tax rates and laws are recognized in the period in which the new legislation is enacted. As a result of the reduction in the U.S. corporate income tax rate, the Company re-measured its ending net deferred tax assets at December 31, 2017 at the rate at which they are expected to reverse in the future and recognized a reduction in deferred tax assets of $66.4 million, which was offset by a similar reduction in valuation allowance. The Company is still analyzing certain aspects of the Tax Act, which could potentially affect the measurement of deferred tax balances or give rise to new deferred tax amounts.
In accordance with SAB 118, we have recognized the provisional tax impacts related to the re-measurement of our deferred tax assets and liabilities and included these amounts in our consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from these provisional amounts, due to, among other things, additional analysis, changes in interpretations and assumptions we have made, additional regulatory guidance that may be issued, and actions we may take as a result of the Tax Act.
The Company recorded no tax benefit or expense during the years ended December 31, 2017 and 2016. A reconciliation of the expected income tax expense (benefit) at the statutory federal income tax rate of 35% to the Company’s actual provision for income taxes and the effective tax rate for the years ended December 31, 2017 and 2016, respectively, is as follows (amounts in thousands):
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NOTE 13 - INCOME TAXES - continued
Deferred income tax assets and liabilities result from differences between the timing of the recognition of assets and liabilities for financial reporting purposes and for income tax return purposes. These assets and liabilities are measured using the enacted tax rates and laws that are currently in effect. The significant components of deferred tax assets and liabilities in the consolidated balance sheets for continuing operations as of December 31, 2017 and 2016, respectively, were as follows (in thousands):
* amounts for the year ended December 31, 2016 restated to include amounts from continuing operations only
Upon the execution of the Conversion Transactions (which included a recapitalization of the Fund), we became a corporation and subject to Federal and state income tax. Under GAAP, a change in tax status from a non-taxable entity to a taxable entity requires recording deferred taxes as of the date of change in tax status. For tax purposes, the Conversion Transactions were a contribution of assets at historical tax basis for holders of the Fund that are subject to federal income tax and at fair market value for holders that are not subject to federal income tax.
The temporary differences that gave rise to deferred tax assets and liabilities upon recapitalization of the Company were primarily related to the valuation allowance for loans held for sale and certain impairments of REO assets which were recorded on our books but deferred for tax reporting purposes. We had approximately $55.6 million of built-in unrealized tax losses in our portfolio of loans and REO assets, as well as other deferred tax assets, and approximately $439.1 million of federal and $246.7 million of state net operating loss (“NOL”) carryforwards as of December 31, 2017, which have begun to expire. As of December 31, 2016, we had approximately $67.1 million of built-in unrealized tax losses and approximately $424.7 million of federal and $244.8 million of state NOL carryforwards, which began to expire in 2017. The decrease in our valuation allowance during the years ended December 31, 2017 was primarily a result of the reduction in the deferred tax asset balances due to the reduction in the federal corporate income tax rate from a maximum of 35% to 21%.
We evaluated the deferred tax assets to determine if it was more likely than not that it would be realized and concluded that a valuation allowance was required for the net deferred tax assets. In making the determination of the amount of valuation allowance, we evaluated both positive and negative evidence including our recent historical financial performance, forecasts of our future income, tax planning strategies and assessments of current and future economic and business conditions.
Utilization of the NOL carryforwards may be subject to a substantial annual limitation due to an “ownership change” that may have occurred or that could occur in the future, pursuant to Section 382 of the Internal Revenue Code of 1986, as amended (“Code”), as well as similar state provisions. These ownership changes may limit the amount of NOL carryforwards that can be utilized annually to offset future taxable income. In general, an “ownership change” under Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50% of the outstanding stock of a company by certain stockholders or public groups.
In 2017, the Company conducted an analysis to assess whether an ownership change has occurred since the Company’s formation. Based on the results of this analysis, the Company believes it has not experienced a Section 382 ownership change since the Company’s formation. If such an ownership change were to occur, utilization of the NOL carryforwards would be subject to an annual limitation under Section 382. The annual limitation, which is determined by first multiplying the value of the Company’s stock at the time of the ownership change by the applicable long-term, tax-exempt rate, could be subject to additional adjustments.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - INCOME TAXES - continued
Any limitation may result in the expiration of a portion of the NOL carryforwards before utilization. Due to the existence of the valuation allowance provided against our deferred tax assets, future changes in the Company’s unrecognized tax benefits would not impact its effective tax rate. Any carryforwards that might expire prior to utilization as a result of a limitation under Section 382 would be removed from deferred tax assets with a corresponding reduction of the valuation allowance.
The Company has not identified any uncertain tax positions and does not believe it will have any material changes in the next 12 months. Interest and penalties accrued, if any, relating to uncertain tax positions will be recognized as a component of the income tax provision. However, since there are no uncertain tax positions, we have not recorded any accrued interest or penalties.
The Company is subject to U.S. federal and state taxes in the normal course of business, and its income tax returns are subject to examination by the relevant tax authorities. Tax years 2014-2016 are still open for examination by Federal tax authorities and tax years 2013-2016 are generally open for examination by state tax authorities. The Company has not utilized net operating loss carryforwards which were generated in the tax years 2010-2013, so the statute of limitations for these years remains open for purposes of adjusting the amounts of the losses carried forward from those years.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - STOCKHOLDERS’ EQUITY AND EARNINGS PER SHARE
Our capital structure consisted of the following at December 31, 2017 and 2016:
Common Stock
Shares of Common Stock, Class B Common Stock, Class C Common Stock, and Class D Common Stock share proportionately in our earnings and losses attributable to common shareholders. There are no shares of Class D Common Stock outstanding as of December 31, 2017 or 2016.
Class B, C, and D Common Stock
Holders of Class B, C, and D Common Stock generally have the same relative powers and preferences as the common stockholders, except for certain transfer restrictions, as follows:
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Class B Common Stock - The Class B common stock, which was issued in exchange for membership units of the Fund, the stock of the Manager or membership units of Holdings, is held by a custodian and divided into four separate series of Class B common stock. The Class B-1, B-2 and B-3 common stock are not eligible for conversion into common stock until, and subject to transfer restrictions that lapse upon, predetermined intervals of six, nine or 12 months following the earlier of (1) consummation of an initial public offering or (2) the 90th day following notice given by the board of directors not to pursue an initial public offering, in the case of each of the Class B-1, Class B-2 and Class B-3 common stock, respectively. If, at any time after the five-month anniversary of the consummation of an initial public offering, the closing price of the Company’s common stock is greater than 125% of the offering price in an initial public offering for 20 consecutive trading days, all shares of Class B-1, Class B-2 and Class B-3 common stock will be convertible into shares of our common stock and will not be subject to restrictions on transfer under the Company’s certificate of incorporation. Each share of Class B-4 common stock will be convertible to one share of Common Stock upon the four-year anniversary of the consummation of the Conversion Transactions. The transfer restrictions will terminate earlier if (1) any time after five months from the first day of trading on a national securities exchange, either the market capitalization (based on the closing price of the Company’s common stock) or the Company’s book value will have exceeded $730.4 million (subject to upward adjustment by the amount of any net proceeds from new capital raised in an initial public offering or otherwise, and to downward adjustment by the amount of any dividends or distributions paid on membership units of the Fund or the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - STOCKHOLDERS’ EQUITY AND EARNINGS PER SHARE - continued
Company’s securities after the Conversion Transactions), or (2) after entering into an employment agreement approved by the Company’s compensation committee, the holder of Class B common stock is terminated without cause, as this term is defined in their employment agreements as approved by the Company’s compensation committee. In addition, unless the Company has both (i) raised an aggregate of at least $50 million in one or more transactions through the issuance of new equity securities, new indebtedness with a maturity of no less than one year, or any combination thereof, and (ii) completed a listing on a national securities exchange, then, in the event of a liquidation of the Company, no portion of the proceeds from the liquidation will be payable to the shares of Class B-4 common stock until such proceeds exceed $730.4 million. All shares of Class B common stock automatically convert into Common Stock upon consummation of a change of control as defined in the certificate of incorporation. To provide additional incentive for holders of Class B common stock to remain longer-term investors, we agreed to pay, subject to the availability of legally distributable funds, a Special Dividend to Class B stockholders of $0.95 a share to all stockholders who have retained continuous ownership of their shares through the 12 month period following an initial public offering.
•
Class C Common Stock - There is one series of Class C common stock which is also held by the custodian and will either be redeemed for cash or converted into shares of Class B common stock. Following the consummation of an initial public offering, we may, in our sole discretion, use up to 30% of the net proceeds from the offering (up to an aggregate of $50 million) to effect a pro rata redemption of Class C common stock (based upon the number of shares of Class C common stock held by each stockholder) at the initial public offering price, less selling commissions and discounts paid or allowed to the underwriters in the initial public offering. It is expected that the amount the stockholders of Class C common stock will receive per share will be less than the amount of their original investment in the Fund per unit. Any shares of Class C common stock that are not so redeemed will automatically convert into shares of Class B common stock as follows: 25% of the outstanding shares of Class C common stock will convert into shares of Class B-1 common stock, 25% will convert into shares of Class B-2 common stock and 50% will convert into shares of Class B-3 common stock.
•
Class D Common Stock - If any holder of Class B common stock submits a notice of conversion to the custodian, but represents to the custodian that the holder has not complied with the applicable transfer restrictions, all shares of Class B common stock held by the holder will be automatically converted into Class D common stock and will not be entitled to the Special Dividend and will not be convertible into common stock until the 12-month anniversary of an IPO and, then, only if the holder submits a representation to the custodian that the applicable holder has complied with the applicable transfer restrictions in the 90 days prior to such representation and is not currently in violation. If any shares of Class B common stock owned by a particular holder are automatically converted into shares of Class D common stock, as discussed above, then each share of Class C common stock owned by the holder will convert into one share of Class D common stock.
Preferred Stock
In 2014, the Company issued a total of 8.2 million shares of the Company’s Series B-1 and B-2 Cumulative Convertible Preferred Stock (“Series B Preferred Stock”) to certain investor groups in exchange for $26.4 million (the “Preferred Investment”). The current holders of Series B Preferred Stock are collectively referred to herein as the “Series B Investors.” Except for certain voting and transfer rights, the rights and obligations of the Series B-1 Preferred Stock and Series B-2 Preferred Stock are substantially the same.
The description below provides a summary of certain material terms of the Series B Preferred Stock:
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Dividends. Dividends on the Series B Preferred Stock are cumulative and accrue from the issue date and compound quarterly at the rate of 8% of the issue price per year, payable quarterly in arrears. Subject to certain dividend rights and restrictions, no dividend may be paid on any capital stock of the Company during any fiscal year unless all accrued dividends on the Series B Preferred Stock have been paid in full, except for dividends on shares of voting Common Stock. In the event that any dividends are declared with respect to the voting Common Stock or any junior ranking securities, the holders of the Series B Preferred Stock are entitled to receive additional dividends over the stated 8% dividend rate - see additional descriptions below. During year ended December 31, 2017 and 2016, we recorded Preferred Investment dividends of $2.1 million and $2.1 million, respectively, or $0.13 and $0.13 per preferred share, respectively and there were no arrearages at December 31, 2017.
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Redemption upon Demand. At any time after July 24, 2019, or at any time in the event certain defaults have occurred if at least 85% of the holders choose, each holder of Series B Preferred Stock may require the Company to redeem, out of legally available funds, the shares of Series B Preferred Stock held by such holder at the a price (the “Redemption Price”) equal to the greater of (i) 150% of the sum of the original price per share of the Series B Preferred Stock plus all accrued and unpaid dividends or (ii) the sum of the tangible book value of the Company per share of voting Common Stock plus all accrued and unpaid dividends, as of the date of redemption. Such events of default may include default on debt or non-appealable judgments against the Company in excess of certain balances, failure to comply timely with the Company’s reporting obligations under the Exchange Act, or proceedings or investigations against the Company relating to any alleged noncompliance with certain regulations.
Based on the initial Preferred Investment of $26.4 million, the Redemption Price would presently be $39.6 million, resulting in a redemption premium of $13.2 million. In accordance with applicable accounting standards, Series B preferred stock is classified as temporary equity on the balance sheet and we have elected to amortize the redemption premium using the effective interest method as an imputed dividend over the five years holding term of the preferred stock. During years ended December 31, 2017 and 2016, we recorded amortization of the redemption premium of $2.7 million and $2.5 million, respectively, as deemed dividends to preferred shareholders.
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Optional Redemption. If at any time a holder holds less than 15% of the number of shares of Series B Preferred Stock originally issued to it (subject to adjustment), the Company may elect to redeem all shares of Series B Preferred Stock held by such holder at a price equal to the greater of (i) 150% of the sum of (x) the original price per share, plus (y) any accrued and unpaid dividends, whether or not declared, until redeemed, and (ii) the sum of (x) the per share book value per share as of the date of such redemption, plus (y) any accrued and unpaid dividends, whether or not declared, until redeemed, with a 30-day notice given by the Company.
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Liquidation Preference. Upon a “deemed liquidation event” of the Company, before any payment or distribution is made to or set apart for the holders of any junior ranking securities, the holders of shares of Series B Preferred Stock will be entitled to receive a liquidation preference of 150% of the sum of original issue price plus all accrued and unpaid dividends, subject to other provisions.
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Conversion. Each share of Series B Preferred Stock is convertible at any time by any holder thereof into a number of shares of Common Stock initially equal to the sum of the original price per share of Series B Preferred Stock plus all accrued and unpaid dividends, divided by the conversion price then in effect. The initial conversion price is equal to the original price per share of Series B Preferred Stock, subject to adjustment. However, all issued and outstanding shares of Series B Preferred Stock will automatically convert into shares of Common Stock at the conversion price then in effect upon the closing of a sale of shares of Common Stock at a price equal to or greater than 2.25 times the original price per share of the Series B Preferred Stock, subject to adjustment, in a firm commitment underwritten public offering and the listing of the Common Stock on a national securities exchange resulting in at least $75.0 million of gross proceeds. At December 31, 2017, the 8.2 million shares of Series B Preferred Stock are convertible into 8.2 million shares of Common Stock.
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Voting Rights. Holders of Series B Preferred Stock are entitled to vote on an as-converted basis on all matters on which holders of voting Common Stock are entitled to vote. For so long as each initial purchaser of the Series B Preferred Stock holds 50% or more of the number of shares of Series B Preferred Stock it was issued on the original issuance date of the Series B Preferred Stock, the holders of such stock, each voting as a single class, are each entitled to vote for the election of one member of the board of directors (Series B Directors). In addition, for so long as either of the initial purchaser of the Series B Preferred Stock holds 50% or more of the number of shares of Series B-1 Preferred Stock or Series B-2 Preferred Stock, respectively, issued to such person on the original issuance date of the Series B Preferred Stock, the holders of the Series B-1 Preferred Stock and Series B-2 Preferred Stock, by majority vote of the holders of each such series of Series B Preferred Stock, are entitled to vote for the election of one additional independent member of the board of directors.
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Investment Committee. The Series B Directors, along with the Company’s Chief Executive Officer (if then serving as a director of the Company), serve as members of the Investment Committee of the Company’s board of directors (the "Investment Committee"). The Investment Committee assists the board of directors with the evaluation of the Company’s investment policies and strategies.
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Required Liquidation. Under the Restated Certificate of Designation authorizing the Series B Preferred Stock (the “Restated Certificate of Designation”), if at any time we are not in compliance with certain of our obligations to the holders of the Series B Preferred Stock and we fail to pay (i) full dividends on the Series B Preferred Stock for two consecutive fiscal quarters or (ii) the Redemption Price within 180 days following the later of (x) demand therefore resulting from such non-compliance and (y) July 24, 2019, unless a certain percentage of the holders of the Series B Preferred Stock elect otherwise, we will be required to use our best efforts to commence a liquidation of the Company.
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Other Restrictive Covenants. The Restated Certificate of Designation also contains certain restrictive covenants, which require the consent of a certain percentage of the holders of the Series B Preferred Stock as a condition to us taking certain actions, including without limitation the following: limit the amount of our operating expense or capital expenditure in excess of budgeted amounts; sell, encumber or otherwise transfer certain assets, unless approved in our annual budget subject to certain exceptions; dissolve, liquidate or consolidate our business; enter into any agreement or plan of merger or consolidation; engage in any business activity not related to the ownership and operation of mortgage loans or real property; hire or terminate certain key personnel or consultants; bankruptcy of a subsidiary; default on debt over certain thresholds that entitle the creditor to accelerate repayment; judgments against the Company over $2.0 million that are not timely cured or appealed; failure to file timely with the SEC; or commencement of legal proceedings or investigations in conjunction with noncompliance with regulations. Under the Restated Certificate of Designation for the Series B Preferred Shares, we cannot exceed 103% of the aggregate line item expenditures in our annual operating budget approved by the Series B Investors without their prior written approval. We were in breach of this covenant for the year ended December 31, 2017. However, subsequent to December 31, 2017, we obtained a waiver of this breach from the Series B Investors.
On April 11, 2017, JPM Funding purchased all of the Company’s outstanding Series B-2 Preferred Shares from SRE Monarch pursuant to a Preferred Stock Purchase Agreement among the Company, JPM Funding and SRE Monarch (“Series B-2 Purchase Agreement”). Pursuant to the Series B-2 Purchase Agreement, the Company paid SRE Monarch all accrued and unpaid dividends on the Series B-2 Preferred Shares and $0.3 million in expenses. In connection with this transaction, the Company’s board of directors approved for filing with Secretary of State of the State of Delaware, an Amended and Restated Certificate of Designation of the Cumulative Convertible Series B-1 Preferred Stock and Cumulative Convertible Series B-2 Preferred Stock (“Restated Certificate of Designation”) pursuant to which JPM Funding replaced SRE Monarch as the holder of the Series B-2 Preferred Stock and, in general, succeeded to the rights of SRE Monarch thereunder. Concurrent with the execution of the Series B-2 Purchase Agreement, the Company, JCP Realty Partners, LLC, Juniper NVM, LLC, and JPM Funding entered into an Investment Agreement (“Series B Investment Agreement”) pursuant to which the Company made certain representations and covenants, including, but not limited to, a covenant that the Company take all commercially reasonable actions as are reasonably necessary for the Company to be eligible to rely on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act of 1940, as amended, commonly referred to as the “Real Estate Exemption,” and to remain eligible to rely on that exemption at all times thereafter. Furthermore, under the Series B-2 Purchase Agreement, the Company was obligated not to take any action, the result of which would reasonably be expected to cause the Company to become ineligible for the Real Estate Exemption without the prior written consent of JPM Funding. The Amended and Restated Certificate of Designation contains numerous provisions relating to dividend preferences, redemption rights, liquidation preferences and requirements, conversion rights, voting rights, investment committee participation and other restrictive covenants with respect to the Series B Preferred Stock.
See Note 18 regarding rights and preferences relating to issuance of Series B-3 Preferred Stock subsequent to December 31, 2017.
Treasury Stock
During the year ended December 31, 2017, we redeemed 196,278 shares of the common stock of the Company, which were part of an 850,000 restricted share grant awarded to the Company’s Chief Executive Officer pursuant to a restricted stock award agreement entered into in 2015 (the “Award Agreement”). The shares were redeemed by the Company pursuant to an election made by our Chief Executive Officer under Section 83(b) of the Code and the Award Agreement pursuant to which the parties agreed to make arrangements for the satisfaction of tax withholding requirements associated with the stock award. The Company paid $0.3 million for the redeemed shares, of which $0.2 million was determined to represent the fair value of the stock redeemed, with the difference of $0.1 million treated as compensation expense.
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Share-Based Compensation
Our First Amended and Restated 2010 IMH Financial Corporation Employee Stock Incentive Plan (“Equity Incentive Plan”) provides for awards of stock options, stock appreciation rights, restricted stock units and other performance based awards to our officers, employees, directors and certain consultants. The maximum number of shares of common stock available to be issued under such awards was not to exceed 2,700,000 common shares, subject to increase to 3,300,000 shares after an initial public offering.
The 2014 IMH Financial Corporation Non-Employee Director Compensation Plan (the “Director Plan”) provides for the issuance of up to 300,000 shares of common stock. Pursuant to the Director Plan, eligible directors are entitled to the compensation set forth below for their service as a member of the board of directors and its committees. The Director Plan provides for, among other things, an annual grant of restricted common stock in an amount equal to $20,000 based on the fair market value of such shares as determined under the Director Plan. These annual awards vest in full over twelve months and are issuable following the annual appointment of the board position. Only those directors who meet the independence standards under the rules of the New York Stock Exchange and the Securities and Exchange Commission are eligible to participate. Unless sooner terminated by the board of directors, the Director Plan will terminate on August 6, 2024.
During the year ended December 31, 2017, the Company issued 527,383 shares of common stock pursuant to previous restricted stock awards. During the year ended December 31, 2017, the Company granted 262,309 shares of restricted stock to certain executives of the Company, net of certain elections made by the executives under Section 83(b) of the Code and the award agreements, vesting in three equal parts on each of January 1, 2018, January 1, 2019, and January 1, 2020. We granted 116,830 options to employees pursuant to our Equity Incentive Plan during the year ended December 31, 2017. Those options have an exercise price of $1.13 per share, vest over a three year term, and have an estimated fair value of $0.70 per option. During the year ended December 31, 2017, no options were forfeited.
During the second quarter of 2017, we approved the issuance of 73,128 shares of previously approved restricted common stock to our employees pursuant to the Equity Incentive Plan, of which 22,279 were issued during the year ended December 31, 2017. These restricted shares were included in the Company’s board approved grant of 86,207 restricted shares for the year ended December 31, 2016. Of the 86,207 shares authorized, 9,942 shares were forfeited due to subsequent employee terminations, and 3,137 shares were withheld by the Company pursuant to an election made by certain employees under Section 83(b) of the Code.
During the second quarter of 2017, the Company issued 100,000 shares of restricted common stock as part of the Executive Employment Agreement with Samuel Montes, the Company’s Chief Financial Officer. The agreement provides for the issuance of 50,000 shares upon the execution of the employment agreement and an additional 50,000 shares upon the filing of the Company’s 2016 Form 10-K. The restricted shares vest ratably on each anniversary of the Montes Employment Agreement over a three year period beginning on April 1, 2017. Pursuant to an election made by Mr. Montes under Section 83(b) of the Code and the award agreement, the Company reduced the issuance to 79,324 shares in order to satisfy the tax withholding requirements associated with the stock award.
During the year ended December 31, 2017, the Company approved the issuance of 425,453 shares of restricted Company common stock pursuant to restricted stock award agreements, net of certain election made under Section 83(b) of the Code and the award agreement. All shares are scheduled to vest upon the earlier of a) ratably over the three year period of the related employment contracts; b) a change in control; or c) termination without cause or death. The holders of the restricted shares will have the voting and dividend rights of common stockholders as of the award date.
In addition, during 2017, the Company approved and issued 116,772 shares of restricted common stock to our non-employee independent directors pursuant to the Director Plan, all of which vested in 2017 since these were grants for 2015 and 2016. The fair value of the restricted stock on the date it was issuable was estimated at $1.74 per share as of June 30, 2015 and $1.13 per share as of June 30, 2016, based on stock valuations obtained for those periods. The value of such stock was recorded as compensation expense ratably over the respective service periods. There were 45,976 shares granted for the 2015 service period and 70,796 shares granted for the 2016 service period.
We account for the issuance of common stock, stock options and warrants in accordance with applicable accounting guidance. The compensation expense for such awards are determined based on the fair value of a share of the common stock, as determined by an independent consultant as our stock is not traded on an open exchange, and using valuation models and techniques, as
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appropriate. The options generally have a contractual term of ten years. Certain stock option grants vested ratably on the first, second and third anniversaries of the date of grant, while other stock options vested ratably on a monthly basis over three years from the date of grant. The fair value of stock-based awards is estimated on the date of grant using the Black-Scholes valuation model. For employee options, we use the simplified method to estimate the period of time that options granted are expected to be outstanding. Expected volatility is based on the historical volatility of our peer companies’ stock for the length of time corresponding to the expected term of the option. The expected dividend yield is based on our historical and projected dividend payments. The risk-free interest rate is based on the U.S. treasury yield curve on the grant date for the expected term of the option.
In order to estimate the fair value of the securities subject to these transactions pursuant to applicable accounting standards, we utilize information provided by an independent third-party valuation firm incorporating financial and other information, including prospective financial information, provided by us, as well as information obtained from various public, financial, and industry sources. Based on this analysis, management estimated the fair value of the restricted stock awards issued or granted for the years ended December 31, 2017 and 2016 was $1.13 and $1.13 per share, respectively.
For stock options issued during the years ended December 31, 2017 and 2016, the fair value was estimated at the date of grant using the Black-Scholes option-pricing model based on the exercise price of the award and other assumptions relating to expected dividend yield, expected stock price volatility, risk-free interest rate, and expected life of options granted which were as follows:
A summary of stock option and restricted stock activity as of and for the years ended December 31, 2017 and 2016, is presented below:
As of December 31, 2017, there were 1,055,497 stock options outstanding, of which 854,667 were fully vested, 2,000,000 fully vested stock warrants outstanding and 791,510 of unvested restricted stock grants outstanding. Vested restricted stock grants have been issued and are included in outstanding common stock.
Net stock-based compensation expense relating to the stock-based awards was $0.7 million and $0.8 million for the years ended December 31, 2017 and 2016, respectively, net of the effect for Section 83(b) elections. No stock options or warrants were exercised and we did not receive any cash from option or warrant exercises during the years ended December 31, 2017 or 2016. As of
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December 31, 2017, there was $0.4 million of unrecognized compensation cost related to the time-based restricted stock that is expected to be recognized as a charge to earnings over a weighted-average vesting period of 0.41 years.
Net Income (Loss) Per Share
The Company has adopted the two-class computation method, and thus includes all participating securities in the computation of basic shares for the periods in which the Company has net income available to common shareholders. A participating security is defined as an unvested share-based payment award containing non-forfeitable rights to dividends regardless of whether or not the awards ultimately vest or expire. Net losses are not allocated to participating securities unless the holder has a contractual obligation to share in the losses.
The following table presents a reconciliation of net loss to net loss attributable to common shareholders used in the basic and diluted earnings per share calculations for the years ended December 31, 2017 and 2016 (amounts in thousands, except for per share data):
The following securities were not included in the computation of diluted net loss per share as their effect would have been anti-dilutive (presented on a weighted average balance):
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Dividends
During the years ended December 31, 2017 and 2016, we did not declare or pay any common dividends. As described above, for each of the years ended December 31, 2017 and 2016, we recorded Preferred Investment cash dividends of $2.1 million. For the years ended December 31, 2017 and 2016, we recorded the amortization of the Preferred Investment redemption premium of $2.7 million and $2.5 million, respectively, as a deemed dividend. We have not established a minimum dividend level and we may not be able to make dividend payments in the future. All dividends will be made at the discretion of our board of directors and will depend on our earnings, our financial condition and such other factors as our board of directors may deem relevant from time to time, subject to the availability of legally available funds.
Under the Second Amended Certificate of Designation, all shares of capital stock of the Corporation must be junior in rank to all shares of Series B Preferred Stock with respect to the preferences as to dividends, distributions and payments upon liquidation. In the event that any dividends are declared with respect to the voting Common Stock or any junior stock, the holders of the Series B Preferred Stock as of the record date established by the board of directors for such dividends are entitled to receive as additional dividends (in each case, the “Additional Dividends”) an amount (whether in the form of cash, securities or other property) equal to the amount (and in the same form) of the dividends that such holder would have received had the Series B Preferred Stock been converted into Common Stock as of the date immediately prior to the record date of such dividend, such Additional Dividends to be payable, out of funds legally available therefor, on the payment date of the dividend established by the board of directors. The record date for any such Additional Dividends will be the record date for the applicable dividend, and any such Additional Dividends will be payable to the persons in whose name the Series B Preferred Stock is registered at the close of business on the applicable record date. In the event we are obligated to pay a one-time special dividend on our Class B common stock, the holders of the Series B Preferred Stock as of the record date established by the board of directors therefor will be entitled to receive as additional dividends (the “Special Preferred Class B Dividends”) for each share of Common Stock that it would hold if it had converted all of its shares of Series B Preferred Stock into Common Stock the same amount that is received by holders of Class B Common Stock with respect to each share of Class B Common Stock (in each case, with respect to the Common Stock and Class B Common Stock, subject to appropriate adjustment in the event of any stock dividend, stock split, combination or other similar reorganization event affecting such shares), such Special Preferred Class B Dividends to be payable, out of funds legally available therefor, on the payment date for the Special Dividend (the “Special Preferred Class B Payment Date”). The record date for any Special Preferred Class B Dividends will be the record date for the Special Dividend, and any such Special Preferred Class B Dividends will be payable to the persons in whose name the Series B Preferred Stock is registered at the close of business on the applicable record date.
See Note 18 regarding dividends relating to issuance of Series B-3 Preferred Stock subsequent to December 31, 2017.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15 - COMMITMENTS AND CONTINGENCIES
Construction and Related Guarantees
As described in Note 7, the Company agreed to provide MidFirst Bank with a loan repayment guaranty equal to 50% of the principal amount of the MacArthur Loan and a construction completion guaranty with respect to the planned renovations of MacArthur Place. The construction completion guaranty will be released upon payment of all project costs and receipt of a certificate of occupancy. The MidFirst Bank loan documents also require that the loan remain “in balance” throughout its term such that the sum of all remaining undisbursed loan funds and the amounts expended by the borrower will be sufficient to complete the approved construction budget and loan interest. If the loan becomes out of balance, the Company must fund the difference from its own equity. While the final construction budget has yet to be submitted to MidFirst Bank for approval, it is anticipated that the renovation costs may exceed the loan amount initially set aside for construction purposes. Management expects that any excess costs not funded by loan funds will be funded using offering proceeds from the Hotel Fund in excess of the reimbursement of our initial investment, and to the extent necessary, Company funds.
Well Repair Commitment
As described in Note 5, certain of the New Mexico Partnerships hold ownership of rights to develop water on various parcels in Sandoval County, New Mexico. In order to preserve those rights, the related partnerships have agreed with the relevant New Mexico governmental authorities to undertake a remediation plan to replace the infrastructure of two existing deep well groundwater wells on one of the parcels as a more permanent solution. Under the terms of certain secured promissory notes with the related entities described in Note 16, the Company has agreed to fund the infrastructure development costs which are expected to range from $2.0 million to $4.0 million. The Company incurred well development costs of $0.9 million during the year ended December 31, 2017.
Development Services Agreements
We entered into a development services agreement with an unrelated third party with respect to the development of a multifamily project in Apple Valley, Minnesota. This project was sold in late 2016. Under the terms of the development services agreement, we were required to pay our joint venturer certain services fees and a share of profits upon sale, as well as certain breakage fees if we elected not to proceed with any one of three phases of the project. We paid our joint venturer a total of $0.3 million in predevelopment fees during the year ended December 31, 2016. During the years ended December 31, 2017 and 2016, we paid breakage fees of $0.2 million and $0.5 million, respectively, which amounts are included in calculating the gain on disposal of assets in the accompanying consolidated statement of operations. We also paid $0.6 million in profit participation relating to the sale of the project during the year ended December 31, 2016, which amount was included in noncontrolling interest in the accompanying consolidated statement of stockholders’ equity.
Guarantor Recovery
We have pursued and periodically receive favorable judgments against guarantors in connection with their personal guarantees of certain legacy loans on which we previously foreclosed. Similarly, we have filed claims against certain insurance providers or other parties for reimbursement of amounts due under such policies. Due to the uncertainty of the nature and extent of the available assets of these guarantors to pay the judgment amounts or amounts collectible under insurance claims, we do not record recoveries for any amounts due under such judgments or claims, except to the extent we have received assets without contingencies. Nevertheless, these matters may be subject to appeal.
As disclosed in Note 5, during the year ended December 31, 2017, we recorded cash, receivables and/or other asset recoveries of $6.5 million from guarantor settlements, insurance recoveries, assignment of partnership interests and other settlements. During the year ended December 31, 2016, we recorded recoveries of $0.6 million from guarantor settlements, insurance recoveries and other settlements.
We continue to pursue, investigate and evaluate the assets available of guarantors to collect all amounts due under judgments received in our favor. However, to the extent that such amounts are not determinable, they have not been recognized as recovery income in the accompanying consolidated statements of operations. Further recoveries under this and other judgments received
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in our favor will be recognized when realization of the recovery is deemed probable and when all contingencies relating to recovery have been resolved.
Employee Benefit Plan
The Company, through its human resource provider, participates in a 401(k) retirement savings plan that allows for eligible participants to defer compensation, subject to certain limitations imposed by the Code. The Company may provide a discretionary matching contribution of up to 4% of each participant’s eligible compensation. During each of the years ended December 31, 2017 and 2016, the Company’s matching contributions was $0.1 million, which is included in general and administrative expenses in the accompanying consolidated statement of operations.
Legal Matters
We may be a party to litigation as the plaintiff or defendant in the ordinary course of business. While various asserted and unasserted claims may exist, resolution of these matters cannot be predicted with certainty. We establish reserves for legal claims when payments associated with the claims become probable and the payments can be reasonably estimated. Given the uncertainty of predicting the outcome of litigation and regulatory matters, it is generally difficult to predict what the eventual outcome will be, and when the matter will be resolved. The actual costs of resolving legal claims may be higher or lower than any amounts reserved for the claims.
Partnership Claims
In May 2015, Justin Ranch 123 LLP (“Justin 123”), an Arizona limited liability partnership for which a wholly-owned subsidiary of the Company serves as general partner, sold certain real estate assets in an arms-length transaction approved by a court-appointed receiver. During the first quarter of 2016, a limited partner of Justin 123 filed a complaint in United States District Court for Arizona against the Company, certain of our subsidiaries, our CEO in his individual capacity, and the court-appointed receiver, alleging that the defendants were in violation of their fiduciary duties to the limited partner. The plaintiff is seeking an unspecified amount of consequential damages and losses, and removal of the Company’s subsidiary as general partner. Subsequently, the complaint was amended to dismiss without prejudice all claims against the receiver and our CEO. The Court dismissed that second amended complaint in March 2017. A motion seeking permission to file a third amended complaint was filed in May 2017. The Company opposed that motion. The Court has not yet ruled. Management believes the plaintiff’s claims are without merit and intends to vigorously defend against this claim.
In August 2016, a limited liability company member of Carinos Properties, LLC and Unit 6 Partners, LLC, filed a complaint in the United States District Court for the District of Arizona alleging the Company breached its fiduciary duty to plaintiff under ERISA with respect to certain property we own in New Mexico. Damages were not specified. Management believes plaintiff’s claims are without merit and intends to vigorously defend against this claim.
On April 20, 2017, a subsidiary of the Company filed an action against a limited partner in Recorp New Mexico Limited Partnership LLC (“RNMA I”) with the United States District Court, District of Arizona (“USDC”) seeking declaratory relief that the partner’s limited partnership interest in RNMA I has been properly conveyed to the IMH subsidiary. The USDC dismissed the action and the Company subsidiary appealed to the United States Court of Appeals, Ninth Circuit (“Ninth Circuit”). The limited partner had disputed the effectiveness of the transfer of his limited partnership interest and the similar transfer of other limited partnership interests in RNMA I to the Company. This limited partner has initiated litigation in the state trial court seeking to resolve this dispute in another forum (“State Court”). This matter has been stayed at the Ninth Circuit level pending the litigation described below. Based on the advice of counsel, management believes the transfer of the limited partnership interests by the then-acting general partner was done in accordance with the rights granted to the general partner under the relevant organizational documents, and we believe that it is more likely than not that the court in the above referenced matter will agree with that conclusion. However, if the State Court were to rule that the limited partner interest transfers were ineffective, this could result in the recording of noncontrolling interests in that partnership of approximately $3.1 million as of December 31, 2017. The ultimate outcome of this litigation cannot presently be determined with certainty and no amounts have been accrued for this matter in the consolidated financial statements.
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In September 2017, the State Court ordered the termination of the receivership over Stockholder, LLC, a wholly-owned subsidiary of the Company (“Stockholder”). Stockholder is the owner of all of the shares of stock in certain corporations that act as the general partner / limited liability company manager of several entities that own land and/or certain water interests in New Mexico.
In December 2017, the State Court entered an interim “stay” order in the Company’s case against judgment debtor David P. Maniatis and his affiliates (“Maniatis”) enjoining the Company from taking any further collection action against Maniatis, pending an accounting of all previous debt collection activities and a trial on certain limited issues involving the calculation of interest and penalties on the original defaulted debt guaranteed by Maniatis. The stay order also temporarily inhibits the Company from effecting the sale or transfer of all or any part of the property previously acquired by the Company through litigation involving Maniatis, including approximately 7,000 acres of land and related water interests in New Mexico, and 111 acres of land in Texas.
The potential range of loss in this matter, if any, is indeterminable. The ultimate outcome of this litigation cannot presently be determined and no amounts have been accrued for in these consolidated financial statements.
Intercreditor Agreement Claim
The Company and certain of our subsidiaries are defendants in a case that is in the Arizona District Court. The case arose from claims by another creditor of the Justin 123 receivership discussed above, alleging breach of contract and other related claims stemming from a Partial Settlement and Intercreditor Agreement entered into among the major creditors, including the claimant and certain of our subsidiaries. The suit seeks damages totaling $0.3 million, plus attorney fees and punitive damages. The Company believes that the claims are without merit and intends to vigorously defend its position. The ultimate outcome of this litigation cannot presently be determined. The Company believes that any liability it may ultimately incur would not have a material adverse effect on its financial condition or its result of operations.
11333, Inc. Claim
In 2008, a subsidiary of the Company suffered a loss due to hurricane damage sustained to a property it owned in Galveston, TX. This property did not have insurance coverage at the time of loss. In March of 2011, the Company’s subsidiary filed a claim under an errors and omissions policy with its insurer, Lloyd’s of London (“Lloyd’s”), for failure to maintain adequate insurance on the property. The claim was denied by Lloyd’s and the Company filed a lawsuit with respect to this policy in the United States District Court of Arizona (the “Court”) against Lloyd’s and the Company’s insurance broker, HUB International Insurance Co. (“HUB”). On April 5, 2017, the Court denied the Company’s motion for summary judgment and granted the defendants’ motions for summary judgment, which the Company has appealed. Lloyd’s and HUB have recently filed motions seeking reimbursement of attorney fees in the amount of up to $1.2 million and the Company has filed opposing motions. The parties are currently awaiting the Court’s decision and the ninth circuit court stayed the deadline for 11333, Inc.’s appeal proceedings until a decision is made by the Court related to the motion for award of attorney fees. The Company believes that the claims are without merit and intends to vigorously defend its position. The ultimate outcome of this litigation cannot presently be determined and no amounts have been accrued for in these consolidated financial statements.
Hotel Fund Obligations
As discussed in Note 5, if the Hotel Fund has insufficient operating cash flow to pay the Preferred Distribution in a given month, the Company will provide the funds necessary to pay the Preferred Distribution for such month. Such payment will be treated as an additional capital contribution and the Company’s capital account will be increased by such amount. Moreover, we, as the sponsor, have agreed to fund, in the form of common capital contributions, up to 6.0% of gross proceeds as selling commissions and up to 1.0% of gross proceeds as nonaccountable expense reimbursements to broker-dealers based on the capital raised by them for the Hotel Fund. These portions of our common equity in the Hotel Fund are subordinate to the distribution of capital to Preferred Investors in the event of a capital transaction. The timing and amount of such required shortfall funding is indeterminable and could be material to the Company’s operations and liquidity.
Other
We are subject to oversight by various state and federal regulatory authorities, including, but not limited to, the Arizona Corporation Commission, the Arizona Department of Financial Institutions (Banking), and the SEC. Our income tax returns have not been examined by taxing authorities and all statutorily open years remain subject to examination.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - RELATED PARTY TRANSACTIONS AND COMMITMENTS
Notes Payable to Related Parties
As described further in Note 7, the Company borrowed $5.0 million from SRE Monarch pursuant to the SRE Note. SRE Monarch is a related party of Seth Singerman, one of the Company’s former directors and an affiliate of one of our preferred equity holders at that time. The SRE Note bore interest at a per annum base rate of 16%. During the year ended December 31, 2016, we incurred contractual interest totaling $0.8 million.
The SRE Note was amended on various occasions to extend the maturity date to December 22, 2016, at which time we paid all accrued interest at the date of each amendment, as well as various extension fees totaling $0.4 million during the year ended December 31, 2016. The SRE Note was repaid in full in December 2016.
Revolving Line of Credit with Related Party
As described further in Note 7, a subsidiary of the Company executed and drew upon the SRE Revolver with SRE Monarch in the amount of $4.0 million. The SRE Revolver bore interest at a per annum base rate of 5%. During the year ended December 31, 2016, we incurred contractual interest totaling $0.1 million.
The SRE Revolver was amended on various occasions to extend the revolver’s maturity date to December 22, 2016, at which time we paid all accrued interest at the date of each amendment, as well as various extension fees totaling $0.4 million during the year ended December 31, 2016. All accrued interest and principal of the SRE Revolver was repaid in full in December 2016. No principal or interest amounts were paid in 2017. Under the terms of the SRE Revolver, we also were obligated to pay SRE Monarch an amount equal to 5% of the net proceeds received upon sale of the land that served as collateral under the credit facility. In the first quarter of 2017, we paid SRE Monarch $0.2 million in connection with this obligation.
Contractual Agreements
CEO Legacy Fees
Under the terms of his employment agreement, our CEO is entitled to, among other things, legacy fee payments derived from the value of the disposition of certain legacy assets held by the Company as of December 31, 2010, if such assets are sold at values in excess of 110% of their carrying value as of December 31, 2010. Our CEO earned legacy fees of $0.7 million and $35.0 thousand during the years ended December 31, 2017 and 2016, respectively.
Chief Financial Officer Employment Agreement
The Company entered into an Executive Employment Agreement, dated April 11, 2017, with Samuel Montes (the “Montes Employment Agreement”) to serve as the Company’s Chief Financial Officer. Under this agreement, Mr. Montes earns an annual base salary of $0.3 million and is also entitled to receive 11.5% of an executive bonus pool as additional incentive-based compensation with a guaranteed minimum payment of $50,000 for 2016. Mr. Montes has also been granted 100,000 shares of restricted Company common stock which vest ratably on each anniversary of the Montes Employment Agreement over a three year period beginning in April 2017.
If the Montes Employment Agreement is terminated by the Company without “Cause” or by Mr. Montes for “Good Reason,” as those terms are defined in the Montes Employment Agreement, Mr. Montes will be entitled to receive a severance payment equal to 50% of the annual base salary payable in equal installments over a six month period plus the accrued but unpaid portion of Mr. Montes’ 11.5% interest in the executive bonus pool. All unvested stock grants and other equity grants vest upon such termination without cause.
The Montes Employment Agreement imposes various restrictive covenants on Mr. Montes, including restrictions with regards to the solicitation of Company clients, customers, vendors and employees, as well as restrictions on Mr. Montes’ ability to compete with the Company both during the term of the agreement and for 12 months after the termination of his employment.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - RELATED PARTY TRANSACTIONS AND COMMITMENTS - continued
Juniper Capital Partners, LLC and Related Entities
In July 2014, the Company entered into a consulting services agreement (the “Consulting Agreement”) with JCP Realty Advisors, LLC (“JCP”), an affiliate of Juniper Capital Partners, LLC (“Juniper Capital”), one of the Series B Investors, pursuant to which JCP agreed to perform various services for the Company, including, but not limited to, (a) advising the Company with respect to identifying, structuring, and analyzing investment opportunities and (b) assisting the Company in managing and liquidating assets, including non-performing assets. The initial term of the Consulting Agreement was three years and was automatically renewable for an additional two years unless notice of termination was provided by either party. The Company and JCP have agreed to extend the term of the Consulting Agreement for successive one year periods provided that the annual base consulting fee has been reduced from $0.6 million to $0.5 million (subject to possible upward adjustment based on an annual review by our board of directors) and JCP will be entitled to receive a maximum 1.25% origination fee on any loans or investments in real estate, preferred equity or mezzanine securities that are originated or identified by JCP, subject to reduced fee based on the increasing size of the loan or investment. JCP is also entitled to legacy fee payments derived from the disposition of certain assets held by the Company as of December 31, 2010 to persons or opportunities arising through the efforts of JCP, equal to 5.5% of the positive difference derived by subtracting (i) 110% of our December 31, 2010 valuation mark of that asset from the (ii) the gross sales proceeds from the sale of that asset (on a legacy asset by asset basis without any offset for losses realized on any individual asset sales). While the parties agreed in principle that the terms of the amended agreement were to be effective as of July 25, 2017, the written amendment was executed by the parties subsequent to December 31, 2017.
During the year ended December 31, 2017 and 2016, we incurred base consulting fees to JCP of $0.5 million and $0.6 million, respectively. JCP earned legacy fees of $1.2 million and $0.1 million during the years ended December 31, 2017 and 2016, respectively.
SRE Fee Agreement
The Company and SRE were parties to an agreement pursuant to which the Company agreed to make certain payments to SRE in the event that the Company or any of its affiliates made or entered into any loan or investment in preferred equity or mezzanine securities and such loan or investment arose from an opportunity identified by SRE. No fees to SRE under this agreement were incurred during the years ended December 31, 2017 or 2016. In April 2017, the parties terminated the agreement.
Investment in Lakeside JV
During 2015, the Company syndicated $1.7 million of its equity investment in Lakeside JV to several investors, including $1.1 million to one of the Company’s directors and preferred shareholders, $0.2 million to two other members of the Company’s board of directors, and $0.1 million to a partner of one of the Company’s outside law firms. The Company incurred legal or other professional fees totaling $0.6 million and $0.9 million to that law firm during the years ended December 31, 2017 and 2016. The Company had outstanding payables to that law firm totaling $36.8 thousand and $0.2 million as of December 31, 2017 and December 31, 2016, respectively.
Notes Receivable from Certain Investors in Lakeside JV
During the year ended December 31, 2017, certain of the investors in the Lakeside JV executed promissory notes in favor of a subsidiary of the Company totaling $0.7 million. The notes receivable have an annual interest rate of 8% and mature at the earliest to occur of 1) the date on which the sale of the Lakeside property occurs, or 2) September 17, 2019. The promissory notes are secured by the investors’ respective interest and allocated proceeds of the Lakeside JV. Under applicable accounting guidance, the notes receivable have been netted against the non-controlling interest balance in the accompanying consolidated balance sheet.
Notes Receivable from Certain Partnerships
During the year ended December 31, 2016, a subsidiary of the Company executed promissory notes with certain of the previously unconsolidated partnerships (which the Company began consolidating beginning in the third quarter of 2017 to loan up to $0.7 million for the funding of various costs of such partnerships. During the year ended December 31, 2017, the notes were amended to increase the collective lending facility to a maximum of $5.0 million to cover anticipated operating and capital expenditures. As of December 31, 2017, the total principal advanced under these notes was $1.9 million. The promissory notes earn interest at rates ranging from the JP Morgan Chase Prime rate plus 2.0% (6.50% at December 31, 2017) to 8.0% and have maturity dates
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - RELATED PARTY TRANSACTIONS AND COMMITMENTS - continued
which are the earliest to occur of: (1) the date of transfer of the partnership’s real estate assets; (2) the date on which the current general partner resigns, withdraws or is removed as general partner; or (3) July 31, 2018. The promissory notes are cross collateralized and secured by real estate and other assets owned by such partnerships. These promissory notes and the related accrued interest receivable were eliminated in consolidation during the year ended December 31, 2017.
Purchase of Mezzanine Mortgage Loan Receivable
During the year ended December 31, 2017, the Company purchased two mezzanine loans in the aggregate face amount of $19.9 million from an affiliate of JPM Funding, for $19.3 million. The loans are collateralized by a pledge of 100% of the equity interests in the entities owning the underlying collateral of the respective loans. One loan had an original maturity date of September 9, 2016 with three one-year extensions. The borrower has exercised the first two extension options to extend the maturity date to September 9, 2018. The first loan has an annual interest rate of 9.75% plus one-month LIBOR (11.23% at December 31, 2017). The second loan has a maturity date of October 9, 2019 with three one-year extensions, and bears an annual interest rate of 7.25% plus one-month LIBOR (8.73% at December 31, 2017). The respective discount for each loan is being amortized over the term of that loan using the effective interest method.
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - DISCONTINUED OPERATIONS.
On February 28, 2017, we sold the Sedona Hotels in a combined cash transaction to DiamondRock Hospitality Company (“DiamondRock”) for $97.0 million resulting in a gain on sale of $6.8 million (net of selling costs). The Company was not actively seeking to dispose of these assets and this sale resulted from an unsolicited offer we received from DiamondRock. In considering the offer, the Company determined that the price point was favorable to the Company based on review of available market data and elected to proceed with the transaction. In accordance with ASC 205-20, Presentation of Financial Statements-Discontinued Operations, a component of an entity is reported in discontinued operations after meeting the criteria for held for sale classification if the disposition represents a strategic shift that has (or will have) a major effect on the entity's operations and financial results. While the Company has remained active in the hospitality industry through the active pursuit of hospitality acquisition and management opportunities, the Company determined that the disposal of the Sedona hotels is required to be treated as discontinued operations accounting presentation under GAAP.
As such, the historical financial results of the Sedona Hotels and the related income tax effects have been presented as discontinued operations for all periods presented of the disposal group and is reported in the balance sheet as assets of discontinued operations, liabilities of discontinued operations and net income (loss) of discontinued operations in the consolidated statements of operations through the date of sale (February 28, 2017).
Balance Sheet
The following table summarizes the carrying amounts of the major classes of assets and liabilities for discontinued operations in the consolidated balance sheets as of December 31, 2016:
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - DISCONTINUED OPERATIONS - continued
Results of Operations
The following table summarizes the results of operations classified as discontinued operations, net of tax, for the years ended December 31, 2017 and 2016. The table below for the years ended December 31, 2017 reflects the financial results for Sedona assets operations from January 1, 2017 through February 28, 2017.
Interest expense
The Company allocated interest expense, including amortization of deferred financing fees, to discontinued operations based on the senior mortgage debt that was paid with the proceeds from the sale of the Sedona hotels. The total allocated interest expense for the years ended December 31, 2017 and 2016 is as follows:
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - DISCONTINUED OPERATIONS - continued
Cash Flow Information
The following table presents the total operating and investing cash flows and depreciation, amortization, capital expenditures, and significant operating and investing non-cash items of the discontinued operations for the years ended December 31, 2017 and 2016:
IMH FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - SUBSEQUENT EVENTS
JPM Funding Capital Transactions
On February 9, 2018, the Company entered into a Series B-3 Cumulative Convertible Preferred Stock Subscription Agreement (the “Subscription Agreement”) with JPM Funding. Pursuant to the Subscription Agreement, JPM Funding agreed to purchase 2,352,941 shares (the “JPM Series B-3 Shares”) of Series B-3 Cumulative Convertible Preferred Stock, $0.01 par value per share, of the Company (the “Series B-3 Preferred Stock”, and together with the Series B-1 Cumulative Convertible Preferred Stock, $0.01 par value per share, of the Company (the “Series B-1 Preferred Stock”) and the Series B-2 Cumulative Convertible Preferred Stock, $0.01 par value per share, of the Company (the “Series B-2 Preferred Stock”), referred to herein as the “Series B Preferred Stock”), at a purchase price of $3.40 per share, for a total purchase price of $8.0 million. The Subscription Agreement contains various representations, warranties and other obligations and terms that are commonly contained in a subscription agreement of this nature. The Company intends to use the proceeds from the sale of these shares for general corporate purposes. In connection with this transaction, the Company’s board of directors approved for filing with Secretary of State of the State of Delaware, the Second Amended and Restated Certificate of Designation of Series B-1 Cumulative Convertible Preferred Stock, Series B-2 Cumulative Convertible Preferred Stock and Series B-3 Cumulative Convertible Preferred Stock of the Company (the “Second Amended Certificate of Designation”).
Dividends on the Series B-3 Preferred Stock are cumulative and accrue from the issue date and compound quarterly at the rate of 5.65% of the issue price per year, and are payable quarterly in arrears.
Holders of the Series B-3 Preferred Stock will be entitled to receive a liquidation preference of 145% of the sum of the original price per share of Series B-3 Preferred Stock plus all accrued and unpaid dividends upon in accordance with the Second Amended Certificate of Designation.
Concurrent with the execution of the Subscription Agreement, the Company, Juniper, and JPM Funding entered into an Amended and Restated Investment Agreement (the “Restated Investment Agreement”) pursuant to which the Company made certain representations and agreed to abide by certain covenants, including, but not limited to covenants relating to exemptions from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act").
On February 9, 2018, the Company issued to JPM Funding a warrant to acquire up to 600,000 shares of the Company’s common stock (the “JPM Warrant”) in accordance with the terms of the Subscription Agreement. The JPM Warrant is exercisable at any time on or after February 9, 2021 for a two (2) year period, and has an exercise price of $2.25 per share. The JPM Warrant provides for certain adjustments that may be made to the exercise price and the number of shares issuable upon exercise due to customary anti-dilution provisions based on future corporate events. The JPM Warrant is exercisable in cash, and subject to certain conditions may also be exercised on a cashless basis.
Loan Origination
Bungalows on Jomax
In January 2018, IMH originated a construction loan for up to $13.1M, bearing interest at LIBOR plus 8.47% with an initial maturity date of January 18, 2020. Upon execution, IMH earned loan fees and origination fees totaling $0.2 million. Funding of the loan does not commence until the borrower meets it equity requirement in the project of $9.7 million, which is expected to be met in the second or third quarter of 2018.
Hotel Fund
The Hotel Fund has sold $4.2 million in preferred interests to unrelated outside investors as of March 29, 2018.
IMH FINANCIAL CORPORATION
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
For the years ended December 31, 2017 and 2016 (in thousands):
(1)
The amount listed in the column heading “Transferred to Other Accounts” represents net charge offs during the year, which were transferred to a real estate owned status at the date of foreclosure of the related loans or were recognized upon sale of the related loan.