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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
----------------------- ----------------------
Commission File Number: 001-31458
---------------------------------
NEWCASTLE INVESTMENT CORP.
--------------------------
(Exact name of registrant as specified in its charter)
Maryland 81-0559116
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1251 Avenue of the Americas, New York, NY 10020
----------------------------------------- -----
(Address of principal executive offices) (Zip Code)
(212) 798-6100
-----------------------------------------------------------
(Registrant's telephone number, including area code)
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act). Yes [ ] No [X]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.
Common stock, $0.01 par value per share: 23,488,517 outstanding as of May 9,
2003.
NEWCASTLE INVESTMENT CORP.
FORM 10-Q
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2003 (unaudited) and December 31, 2002 1
Consolidated Statements of Income (unaudited) for the three months ended March 31, 2003 and 2002 2
Consolidated Statements of Stockholders' Equity (unaudited) for the three months ended March 31, 2003 and 2002 3
Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2003 and 2002 4
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk 19
Item 4. Controls and Procedures 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities and Use of Proceeds 24
Item 3. Defaults upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 24
Item 6. Exhibits and Reports on Form 8-K 24
SIGNATURES 25
CERTIFICATIONS 26
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
- --------------------------------------------------------------------------------
MARCH 31, 2003
(UNAUDITED) DECEMBER 31, 2002
-------------- -----------------
ASSETS
Real estate securities, available for sale $ 1,590,122 $ 1,069,892
CBO III deposit -- 37,777
Operating real estate, net 118,931 113,652
Real estate held for sale 2,208 3,471
Mortgage loans, net 303,013 258,198
Other securities, available for sale 20,931 11,209
Cash and cash equivalents 75,765 45,463
Restricted cash 11,797 10,380
Deferred costs, net 7,300 6,489
Receivables and other assets 18,998 16,036
----------- -----------
$ 2,149,065 $ 1,572,567
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
CBO bonds payable $ 1,336,297 $ 868,497
Other bonds payable 37,584 37,389
Notes payable 65,272 62,952
Repurchase agreements 289,446 248,169
Derivative liabilities 49,522 54,095
Due to affiliates 1,768 9,161
Dividends payable 10,773 1,335
Accrued expenses and other liabilities 8,537 6,728
----------- -----------
1,799,199 1,288,326
----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 2,500,000
shares of Series B Cumulative Redeemable Preferred Stock, liquidation
preference $25.00 per share, issued and outstanding at March 31, 2003 62,500 --
Common stock, $0.01 par value, 500,000,000 shares authorized, 23,488,517 shares
issued and outstanding at March 31, 2003 and December 31, 2002 235 235
Additional paid-in capital 288,499 290,935
Dividends in excess of earnings (13,636) (13,966)
Accumulated other comprehensive income 12,268 7,037
----------- -----------
349,866 284,241
----------- -----------
$ 2,149,065 $ 1,572,567
=========== ===========
See notes to consolidated financial statements.
1
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except share data)
- --------------------------------------------------------------------------------
THREE MONTHS ENDED
-------------------------------
MARCH 31, 2003 MARCH 31, 2002
-------------- --------------
REVENUES
Interest income $ 25,032 $ 13,028
Rental and escalation income 5,797 4,811
Gain on settlement of investments 2,491 3,026
Management fee from affiliate -- 2,235
Incentive income from affiliate -- (12,810)
------------ ------------
33,320 10,290
------------ ------------
EXPENSES
Interest expense 14,863 8,408
Property operating expense 2,665 2,156
Loan servicing expense 402 88
General and administrative expense 950 591
Management fee to affiliate 1,305 3,598
Preferred incentive compensation to affiliate 1,330 (5,565)
Depreciation and amortization 711 850
------------ ------------
22,226 10,126
------------ ------------
Income before equity in earnings (losses) of
unconsolidated subsidiaries 11,094 164
Equity in earnings (losses) of unconsolidated subsidiaries -- (452)
------------ ------------
Income (loss) from continuing operations 11,094 (288)
Income from discontinued operations 9 1,159
------------ ------------
NET INCOME 11,103 871
Preferred dividends and related accretion (203) (638)
------------ ------------
INCOME AVAILABLE FOR COMMON STOCKHOLDERS $ 10,900 $ 233
============ ============
NET INCOME PER SHARE OF COMMON STOCK, BASIC $ 0.46 $ 0.01
============ ============
NET INCOME PER SHARE OF COMMON STOCK, DILUTED $ 0.46 $ 0.01
============ ============
Income (loss) from continuing operations per share of common stock, after preferred dividends and
related accretion, basic $ 0.46 $ (0.06)
============ ============
Income (loss) from continuing operations per share of common stock, after preferred dividends
and related accretion, diluted $ 0.46 $ (0.06)
============ ============
Income from discontinued operations per share of common stock, basic $ 0.00 $ 0.07
============ ============
Income from discontinued operations per share of common stock, diluted $ 0.00 $ 0.07
============ ============
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON STOCK OUTSTANDING, BASIC 23,488,517 16,488,517
============ ============
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON STOCK OUTSTANDING, DILUTED 23,619,909 16,488,517
============ ============
DIVIDENDS DECLARED PER COMMON SHARE $ 0.45 $ 0.60
============ ============
See notes to consolidated financial statements.
2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(dollars in thousands)
- --------------------------------------------------------------------------------
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------- --------------------- PD. IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
---------- ------- ----------- -------- ----------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2002 -- $ -- 23,488,517 $ 235 $ 290,935
Dividends declared -- -- -- -- --
Issuance of preferred stock 2,500,000 62,500 -- -- (2,436)
Comprehensive income:
Net income -- -- -- -- --
Unrealized gain on securities -- -- -- -- --
Realized (gain) on securities: reclassification adjustment -- -- -- -- --
Foreign currency translation -- -- -- -- --
Unrealized gain on derivatives designated as cash flow hedges -- -- -- -- --
Total comprehensive income
---------- ------- ----------- -------- ---------
Stockholders' equity - March 31, 2003 2,500,000 $62,500 23,488,517 $ 235 $ 288,499
========== ======= =========== ======== =========
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 16,488,517 $ 165 $ 309,356
Dividends declared -- -- --
Comprehensive income:
Net income -- -- --
Unrealized (loss) on securities -- -- --
Foreign currency translation -- -- --
Unrealized gain on derivatives designated as cash flow hedges -- -- --
Total comprehensive income
----------- -------- ---------
Stockholders' equity - March 31, 2002 16,488,517 $ 165 $ 309,356
=========== ======== =========
DIVIDENDS ACCUM. TOTAL
IN EXCESS OTHER STOCK-
OF COMP. HOLDERS'
EARNINGS INCOME EQUITY
---------- --------- ----------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2002 $ (13,966) $ 7,037 $ 284,241
Dividends declared (10,773) -- (10,773)
Issuance of preferred stock -- -- 60,064
Comprehensive income:
Net income 11,103 -- 11,103
Unrealized gain on securities -- 3,401 3,401
Realized (gain) on securities: reclassification adjustment -- (3,480) (3,480)
Foreign currency translation -- 1,740 1,740
Unrealized gain on derivatives designated as cash flow hedges -- 3,570 3,570
---------
Total comprehensive income 16,334
--------- -------- ---------
Stockholders' equity - March 31, 2003 $ (13,636) $ 12,268 $ 349,866
========= ======== =========
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 $ (7,767) $ 8,791 $ 310,545
Dividends declared (10,531) -- (10,531)
Comprehensive income:
Net income 871 -- 871
Unrealized (loss) on securities -- (9,071) (9,071)
Foreign currency translation -- (486) (486)
Unrealized gain on derivatives designated as cash flow hedges -- 1,064 1,064
---------
Total comprehensive income (7,622)
--------- -------- ---------
Stockholders' equity - March 31, 2002 $ (17,427) $ 298 $ 292,392
========= ======== =========
See notes to consolidated financial statements.
3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(dollars in thousands)
- --------------------------------------------------------------------------------
THREE MONTHS ENDED
-------------------------------
MARCH 31, 2003 MARCH 31, 2002
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 11,103 $ 871
Adjustments to reconcile net income to net cash provided by operating activities
(inclusive of amounts related to discontinued operations):
Depreciation and amortization 711 3,571
Accretion of discount and other amortization (3,354) (1,060)
Equity in (earnings) loss of unconsolidated subsidiaries -- 452
Accrued incentive (income) loss from affiliate -- 12,810
Non-cash incentive compensation to affiliate -- (6,413)
Deferred rent (151) (427)
Gain on settlement of investments (2,291) (3,105)
Change in:
Restricted cash (1,334) (926)
Receivables and other assets (3,259) (1,837)
Due to affiliates 433 3,819
Accrued expenses and other liabilities 2,264 (2,876)
--------- --------
Net cash provided by operating activities 4,122 4,879
--------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase and improvement of operating real estate -- (1,002)
Proceeds from sale of operating real estate 2,238 --
Purchase of mortgage loans (210,281) --
Repayments of loan and security principal 13,926 7,569
Proceeds from settlement of mortgage loans 162,554 289
Contributions to unconsolidated subsidiaries -- (5,029)
Distributions from unconsolidated subsidiaries -- 3,450
Purchase of real estate securities (513,395) (67,080)
Proceeds from sale of real estate securities 34,879 65,940
Deposit on real estate securities (4,922) (19,631)
Payment of deferred transaction costs -- (491)
Purchase of other securities (14,127) (108)
--------- --------
Net cash used in investing activities (529,128) (16,093)
--------- --------
See notes to consolidated financial statements. Continuing on Page 5
4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(dollars in thousands)
- --------------------------------------------------------------------------------
THREE MONTHS ENDED
-------------------------------
MARCH 31, 2003 MARCH 31, 2002
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings under repurchase agreements 199,716 --
Repayments of repurchase agreements (158,439) --
Repayments of notes payable (215) (1,027)
Issuance of CBO bonds payable 467,094 --
Repayments of other bonds payable (2,438) (4,038)
Draws under credit facility -- 20,000
Issuance of preferred stock 62,500 --
Costs related to issuance of preferred stock (2,436) --
Dividends paid (9,161) (8,882)
Payment of deferred financing costs (1,313) (419)
--------- --------
Net cash provided by financing activities 555,308 5,634
--------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 30,302 (5,580)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 45,463 31,360
--------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 75,765 $ 25,780
========= ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for interest expense $ 14,684 $ 13,411
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Common stock dividends declared but not paid $ 10,570 $ 9,893
Preferred stock dividends declared but not paid $ 203 $ 638
Deposit used in acquisition of real estate securities $ 44,409 $ --
See notes to consolidated financial statements.
5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31 2003
(dollars in tables in thousands, except per share data)
- --------------------------------------------------------------------------------
1. GENERAL
Newcastle Investment Corp. (and subsidiaries, "Newcastle") is a Maryland
Corporation that was formed in June 2002 as a wholly owned subsidiary of
Newcastle Investment Holdings Corp. ("Holdings") for the purpose of separating
the real estate securities and certain of its credit leased real estate
businesses from Holdings' other investments. Newcastle conducts its business
through three primary segments: (i) real estate securities, (ii) operating real
estate, primarily credit leased real estate, and (iii) mortgage loans.
In July 2002, Holdings contributed to Newcastle certain assets and liabilities
in exchange for 16,488,517 shares of Newcastle's common stock. However, for
accounting purposes this transaction is presented as a reverse spin-off. Under a
reverse spin-off, Newcastle is treated as the continuing entity and the assets
that were retained by Holdings and not contributed to Newcastle are accounted
for as if they were distributed at their historical book basis through a
spin-off to Holdings. Newcastle's operations commenced on July 12, 2002. At
March 31, 2003, Holdings held approximately 70% of Newcastle's outstanding
shares of common stock.
In October 2002, Newcastle sold 7 million shares of its common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million. Subsequent to this offering, Newcastle had 23,488,517
shares of common stock outstanding.
Newcastle is organized and conducts its operations to qualify as a real estate
investment trust ("REIT") for federal income tax purposes. As such, Newcastle
will generally not be subject to federal income tax on that portion of its
income that is distributed to stockholders if it distributes at least 90% of its
REIT taxable income to its stockholders by prescribed dates and complies with
various other requirements.
Newcastle has entered into a management agreement (the "Management Agreement")
with Fortress Investment Group LLC (the "Manager"), an affiliate, under which
the Manager advises Newcastle on various aspects of its business and manages its
day-to-day operations, subject to the supervision of Newcastle's board of
directors. For its services, the Manager receives an annual management fee and
preferred incentive compensation, both as defined in the Management Agreement.
The Manager also manages Holdings and Fortress Investment Fund LLC ("Fund I").
The consolidated financial statements include the accounts of Newcastle and its
controlled subsidiaries, subsequent to the date of commencement of its
operations, and also include the accounts of its predecessor, Holdings, prior to
such date.
Holdings is a Maryland corporation that invests in real estate-related assets on
a global basis. Its primary businesses were (1) investing in real estate
securities, (2) investing in operating real estate, primarily credit leased real
estate, (3) investing in Fund I and (4) investing in distressed, sub-performing
and performing residential and commercial mortgage loans, or portfolios thereof,
and related properties acquired in foreclosure or by deed-in-lieu of
foreclosure.
Holdings' investments in real estate securities and a portion of its investments
in operating real estate were transferred to Newcastle. The operating real
estate and real estate loan operations treated as being distributed to Holdings
have been accounted for as discontinued operations, because they constituted a
component of an entity, while the other operations treated as being distributed
to Holdings, including the investment in Fund I, have not been accounted for as
such, because they did not constitute a component of an entity as defined in
SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets."
The accompanying consolidated financial statements and related notes of
Newcastle have been prepared in accordance with accounting principals generally
accepted in the United States for interim financial reporting and the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain
information and footnote disclosures normally included in financial statements
prepared under accounting principals generally accepted in the United States
have been condensed or omitted. In the opinion of management, all adjustments
considered necessary for a fair presentation of Newcastle's financial position,
results of operations and cash flows have been included and are of a normal and
recurring nature. The operating results presented for interim periods are not
necessarily indicative of the results that may be expected for any other interim
period or for the entire year. These financial statements should be read in
conjunction with Newcastle's December 31, 2002 consolidated financial statements
and notes thereto included in Newcastle's annual report on Form 10-K filed with
the Securities and Exchange Commission. Capitalized terms used herein, and not
otherwise defined, are defined in Newcastle's December 31, 2002 consolidated
financial statements.
6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2003
- --------------------------------------------------------------------------------
2. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through three primary segments: real estate
securities, operating real estate and mortgage loans.
Holdings conducted its business in four primary segments: real estate
securities, operating real estate, mortgage loans, and its investment in Fund I.
The real estate securities segment was retained by Newcastle. The operating real
estate segment, which comprised three portfolios of properties, was split as
follows: the Bell Canada (Canadian) and LIV (Belgian) portfolios were retained
by Newcastle while the GSA (U.S.) portfolio was distributed to Holdings. The
existing mortgage loans and Fund I segments were distributed to Holdings.
Summary financial data on Newcastle's segments is given below, together with a
reconciliation to the same data for Newcastle as a whole (including its
predecessor, through the date of the commencement of our operations, as
described in Note 1):
Real Estate Operating Mortgage
Securities Real Estate Loans Fund I Unallocated Total
------------ ----------- ------------ ------------ ----------- ------------
March 31, 2003 and the Three Months then Ended
Gross revenues $ 24,543 $ 5,816 $ 2,961 $ -- $ -- $ 33,320
Operating expenses (158) (2,993) (259) -- (3,242) (6,652)
----------- --------- ----------- ----------- -------- -----------
Operating income (loss) 24,385 2,823 2,702 -- (3,242) 26,668
Interest expense (12,141) (1,589) (1,133) -- -- (14,863)
Depreciation and amortization -- (711) -- -- -- (711)
----------- --------- ----------- ----------- -------- -----------
Income (loss) from continuing operations 12,244 523 1,569 -- (3,242) 11,094
Income from discontinued operations -- 9 -- -- -- 9
----------- --------- ----------- ----------- -------- -----------
Net Income (Loss) $ 12,244 $ 532 $ 1,569 $ -- $ (3,242) $ 11,103
=========== ========= =========== =========== ======== ===========
Revenue derived from non-US sources:
Canada $ -- $ 4,223 $ -- $ -- $ -- $ 4,223
=========== ========= =========== =========== ======== ===========
Belgium $ -- $ 1,922 $ -- $ -- $ -- $ 1,922
=========== ========= =========== =========== ======== ===========
Total assets $ 1,635,607 $ 134,454 $ 304,080 $ -- $ 74,924 $ 2,149,065
=========== ========= =========== =========== ======== ===========
Long-lived assets outside the US:
Canada $ -- $ 59,505 $ -- $ -- $ -- $ 59,505
=========== ========= =========== =========== ======== ===========
Belgium $ -- $ 74,949 $ -- $ -- $ -- $ 74,949
=========== ========= =========== =========== ======== ===========
December 31, 2002
Total assets $ 1,138,767 $ 128,831 $ 259,381 $ -- $ 45,588 $ 1,572,567
=========== ========= =========== =========== ======== ===========
Long-lived assets outside the US:
Canada $ -- $ 56,939 $ -- $ -- $ -- $ 56,939
=========== ========= =========== =========== ======== ===========
Belgium $ -- $ 71,892 $ -- $ -- $ -- $ 71,892
=========== ========= =========== =========== ======== ===========
Three Months Ended March 31, 2002
Gross revenues $ 15,946 $ 4,843 $ -- $ (10,597) $ 98 $ 10,290
Operating expenses (110) (2,243) -- 4,170 (2,685) (868)
----------- --------- ----------- ----------- -------- -----------
Operating income (loss) 15,836 2,600 -- (6,427) (2,587) 9,422
Interest expense (6,032) (1,241) -- -- (1,135) (8,408)
Depreciation and amortization -- (634) -- (164) (52) (850)
Equity in earnings (loss) of unconsolidated
subsidiaries -- -- -- (479) 27 (452)
----------- --------- ----------- ----------- -------- -----------
Income (loss) from continuing operations 9,804 725 -- (7,070) (3,747) (288)
Income (loss) from discontinued operations -- 1,178 (19) -- -- 1,159
----------- --------- ----------- ----------- -------- -----------
Net Income (Loss) $ 9,804 $ 1,903 $ (19) $ (7,070) $ (3,747) $ 871
=========== ========= =========== =========== ======== ===========
Revenue derived from non-US sources:
Canada $ -- $ 3,918 $ -- $ -- $ -- $ 3,918
=========== ========= =========== =========== ======== ===========
Belgium $ -- $ 1,680 $ -- $ -- $ -- $ 1,680
=========== ========= =========== =========== ======== ===========
Italy $ -- $ -- $ 88 $ -- $ -- $ 88
=========== ========= =========== =========== ======== ===========
7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2003
- --------------------------------------------------------------------------------
3. REAL ESTATE SECURITIES
The following is a summary of Newcastle's real estate securities at March 31,
2003, all of which are classified as available for sale and are therefore marked
to market through other comprehensive income pursuant to SFAS No. 115
"Accounting for Certain Investments in Debt and Equity Securities." Unrealized
losses that are considered other than temporary are recognized currently in
income. There were no such losses incurred during the three months ended March
31, 2003.
Gross Unrealized Weighted Average
------------------ ------------------------------------
Term to
Current Face Amortized Carrying S&P Maturity
Portfolio I Amount Cost Basis Gains Losses Value Rating Coupon Yield (Years)
- ----------- ------------ ---------- ------- -------- ---------- ------ ------ ----- --------
CMBS $ 312,050 $ 276,345 $24,776 $ (3,553) $ 297,568 BB+ 6.77% 9.42% 6.90
Unsecured REIT debt 223,227 221,678 23,887 (35) 245,530 BBB 7.37% 7.60% 5.57
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Subtotal - Portfolio I 535,277 498,023 48,663 (3,588) 543,098 BB+ 7.02% 8.61% 6.35
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Portfolio II
- ------------
CMBS 301,964 288,706 17,648 (300) 306,054 BBB- 6.18% 7.15% 6.95
Unsecured REIT debt 113,292 112,430 11,749 -- 124,179 BBB- 7.81% 7.85% 7.61
Asset-backed securities 60,845 58,661 1,540 (1,627) 58,574 AA 7.22% 8.30% 7.45
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Subtotal - Portfolio II 476,101 459,797 30,937 (1,927) 488,807 BBB 6.70% 7.47% 7.17
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Portfolio III
- -------------
CMBS 281,103 296,318 277 (4,106) 292,489 BBB 6.04% 5.27% 7.61
Unsecured REIT debt 105,110 110,049 1,145 (1,333) 109,861 BBB- 7.04% 6.32% 8.87
Asset-backed securities 35,836 34,037 128 (397) 33,768 AA- 4.99% 6.06% 6.05
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Subtotal - Portfolio III 422,049 440,404 1,550 (5,836) 436,118 BBB 6.20% 5.59% 7.79
---------- ---------- ------- -------- ---------- ---- ---- ---- ----
Total Real Estate
Securities* $1,433,427 $1,398,224 $81,150 $(11,351) $1,468,023 BBB- 6.67% 7.28% 7.05
========== ========== ======= ======== ========== ==== ==== ==== ====
* Carrying value excludes restricted cash of $122.1 million included in Real
Estate Securities pending its reinvestment. At March 31, 2003, the total
current face amount of fixed rate securities was $1,291.5 million, and of
floating rate securities was $141.9 million.
8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2003
- --------------------------------------------------------------------------------
4. RECENT ACTIVITIES
In February 2003, Newcastle sold its entire position in conforming residential
mortgage loans (a portion of its mortgage loan portfolio) for gross proceeds of
approximately $162.6 million resulting in a gain of approximately $0.7 million.
As a result of the sale, the existing repurchase agreement allocated to the
conforming loans was satisfied for approximately $153.9 million. Simultaneously,
Newcastle purchased additional non-conforming residential mortgage loans at a
cost of approximately $210.2 million. In connection with this purchase, the
outstanding balance of the existing repurchase agreement was increased by a net
of $45.9 million, after the repayment described above.
In March 2003, Newcastle completed its third CBO financing ("CBO III") whereby a
portfolio of real estate securities was contributed to a consolidated subsidiary
which issued $472.0 million face amount of investment grade senior bonds and
$28.0 million face amount of non-investment grade subordinated bonds in a
private placement. At March 31, 2003, the subordinated bonds were retained by
Newcastle and the $466.9 million carrying amount of senior bonds, which bore
interest at a weighted average effective rate, including discount and cost
amortization, of 2.51%, had an expected weighted average life of approximately
8.95 years. One class of the senior bonds bears a floating interest rate.
Newcastle has obtained an interest rate swap and cap in order to hedge its
exposure to the risk of changes in market interest rates with respect to these
bonds, at an initial cost of approximately $1.3 million. CBO III's weighted
average effective interest rate, including the effect of such hedges, was 4.04%
at March 31, 2003.
In March 2003, Newcastle issued 2.5 million shares of its 9.75% Series B
Cumulative Redeemable Preferred Stock (the "Series B Preferred") in a public,
registered offering for net proceeds of approximately $60.1 million. The Series
B Preferred has a $25 per share liquidation preference, no maturity date, no
required redemption, and may not be redeemed prior to March 2008.
In March 2003, an affiliate of the Manager purchased an additional 50,000 shares
of Holdings' common stock from a third party. In April 2003, Holdings
repurchased 2,178 shares of Newcastle's common stock from an affiliate of the
Manager.
Options to purchase 2,000 shares of its common stock were automatically granted
by Newcastle to each of its two independent directors who were appointed
subsequent to Newcastle's initial public offering, in accordance with the terms
of the Newcastle Stock Option and Incentive Award Plan.
In April 2003, Newcastle purchased additional non-conforming residential
floating rate mortgage loans at a cost of approximately $148.3 million. The
purchase is 95% financed subject to a floating rate repurchase agreement, which
bears interest at LIBOR + 0.425% for a term commitment of six months.
At March 31, 2003, Due To Affiliates was comprised of $1.3 million of preferred
incentive compensation and $0.5 million of management fees and expense
reimbursements payable to the Manager.
One of Newcastle's Other Securities represents a $3.3 million residual interest
in a securitization of real estate securities. Newcastle has no funding or other
obligations with respect to this securitization, which contained approximately
$250 million of assets at March 31, 2003. Newcastle has not yet determined
whether this interest represents a "variable interest entity" pursuant to FASB
Interpretation No. 46 "Consolidation of Variable Interest Entities." Should such
a determination be made, Newcastle would consolidate the gross assets and
liabilities of the securitization beginning in the third quarter of 2003. This
would increase both the assets and liabilities of Newcastle, but would not
effect equity or net income.
9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2003
- --------------------------------------------------------------------------------
5. DERIVATIVE INSTRUMENTS
The following table summarizes the notional amounts and fair (carrying) values
of Newcastle's derivative financial instruments as of March 31, 2003.
Notional Amount Fair Value Longest Maturity
--------------- ---------- ----------------
Interest rate caps treated as hedges (A) $235,925 $ 5,525 October 2015
Interest rate swaps, treated as hedges (B) $699,254 ($45,912) March 2013
Non-hedge derivative obligations (B) (C) ($ 820) July 2038
(A) Included in Deferred Costs, Net.
(B) Included in Derivative Liabilities.
(C) Represents two essentially offsetting interest rate caps and two
essentially offsetting interest rate swaps, each with notional
amounts of $32.5 million, an interest rate cap with a notional
amount of $17.5 million, and an interest rate cap with a notional
amount of approximately $63.2 million.
6. EARNINGS PER SHARE
Newcastle is required to present both basic and diluted earnings per share
("EPS"). Basic EPS is calculated by dividing net income available for common
stockholders by the weighted average number of shares of common stock
outstanding during each period. Diluted EPS is calculated by dividing net income
available for common stockholders by the weighted average number of shares of
common stock outstanding plus the additional dilutive effect of common stock
equivalents during each period. Newcastle's common stock equivalents are its
stock options. Net income available for common stockholders is equal to net
income less preferred dividends, and also less accretion of the discount on
Holdings' Series A Preferred, which was fully redeemed in June 2002.
The following is a reconciliation of the weighted average number of shares of
common stock outstanding on a diluted basis.
THREE MONTHS ENDED
------------------------------
MARCH 31, 2003 MARCH 31, 2002
-------------- --------------
Weighted average number of shares of common
stock outstanding, basic 23,488,517 16,488,517
Dilutive effect of stock options, based
on the treasury stock method 131,392 --
---------- ----------
Weighted average number of shares of common
stock outstanding, diluted 23,619,909 16,488,517
========== ==========
Newcastle accounts for its stock options using the intrinsic value method
pursuant to Accounting Principles Board Opinion No. 25 "Accounting for Stock
Issued to Employees," whereby no compensation cost is recorded for options
issued to employees (including directors) when the strike price is at market. If
Newcastle had accounted for such options using the fair value method pursuant to
SFAS No. 123 "Accounting for Stock-Based Compensation, as amended by SFAS No.
148 "Accounting for Stock-Based Compensation - Transition and Disclosure," the
options issued in the first quarter to its directors would have been recorded as
compensation expense at their fair value, which was immaterial (less than
$5,000) on the date of grant.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following should be read in conjunction with the unaudited consolidated
financial statements and notes included herein.
GENERAL
We were formed in June 2002 as a wholly owned subsidiary of Newcastle Investment
Holdings Corp. (referred to as Holdings) for the purpose of separating the real
estate securities and certain of the credit leased real estate businesses from
Holdings' other investments. In July 2002, Holdings contributed to us certain
assets and liabilities in exchange for 16,488,517 shares of our common stock (as
adjusted for an October stock dividend).
Although we were formed as a wholly owned subsidiary of Holdings, for accounting
purposes this transaction is presented as a reverse spin-off. Under a reverse
spin-off, Newcastle Investment Corp. is treated as the continuing entity and the
assets that were retained by Holdings and not contributed to us are accounted
for as if they were distributed at their historical book basis through a
spin-off to Holdings. Our operations commenced on July 12, 2002.
The analysis in this section treats us as the successor to Holdings and
therefore includes historical information, through the date of the commencement
of our operations, regarding operations of Holdings which were distributed to
them and therefore are unrelated to our ongoing operations. Transactions
completed by Holdings related to investments retained by Holdings (not
contributed to us) are referred to as being completed by our predecessor.
In October 2002, we sold 7 million shares of our common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million. Subsequent to this offering, we had 23,488,517 shares
of common stock outstanding.
At March 31, 2003, Holdings held approximately 16.5 million or 70% of our
outstanding shares of common stock. On April 30, 2003, Holdings announced a
distribution of all such Newcastle stock to Holdings' stockholders, to be made
on or about May 19, 2003. Approximately 2.8 million of such shares will be
distributed by Holdings to an affiliate of the Manager; these shares are subject
to a lock up agreement with the underwriters of our initial public offering
until October 2003, after such time these shares may be sold subject to Rule 144
of the Securities Act, including the limitations thereunder.
We are organized and conduct our operations to qualify as a REIT for federal
income tax purposes. As such, we will generally not be subject to federal income
tax on that portion of our income that is distributed to stockholders if we
distribute at least 90% of our REIT taxable income to our stockholders by
prescribed dates and comply with various other requirements.
We conduct our business through three primary segments: (i) real estate
securities, (ii) operating real estate, primarily credit leased real estate,
including a portfolio of properties located in Canada, which we refer to as our
Bell Canada portfolio, and a portfolio of properties located in Belgium, which
we refer to as our LIV portfolio, and (iii) mortgage loans.
Our predecessor, Holdings, conducted its business through four primary segments:
(1) real estate securities, (2) operating real estate, primarily credit leased
real estate, (3) its investment in Fortress Investment Fund LLC ("Fund I") and
(4) mortgage loans. Holdings' investments in real estate securities and a
portion of its investments in operating real estate were contributed to us. The
operating real estate and mortgage loans operations distributed to Holdings have
been treated as discontinued operations, because they constituted a component of
an entity, while the other operations distributed to Holdings, including the
investment in Fund I, have not been treated as such, because they did not
constitute a component of an entity as defined in SFAS No. 144 "Accounting for
the Impairment or Disposal of Long-Lived Assets." Revenues attributable to each
segment are disclosed below (unaudited) (in thousands).
Real Estate Operating Mortgage
Securities Real Estate Loans Fund I Unallocated Total
----------- ----------- -------- -------- ----------- --------
For the three months ended March 31, 2003: $ 24,543 $ 5,816 $ 2,961 $ -- $ -- $ 33,320
For the three months ended March 31, 2002: $ 15,946 $ 4,843 $ -- $(10,597) $ 98 $ 10,290
11
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP"). The preparation of financial statements in conformity
with GAAP requires the use of estimates and assumptions that could affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities and the reported amounts of revenue and expenses. Actual results
could differ from these estimates. The following is a summary of our accounting
policies that are most effected by judgements, estimates and assumptions.
We have classified our real estate securities as available for sale. As such,
they are carried at fair value with net unrealized gains or losses reported as a
component of accumulated other comprehensive income. Fair value is based
primarily upon multiple broker quotations, which provide valuation estimates
based upon reasonable market order indications or a good faith estimate thereof.
These quotations are subject to significant variability based on market
conditions, such as interest rates and spreads. Changes in market conditions, as
well as changes in the assumptions or methodology used to determine fair value,
could result in a significant increase or decrease in our book equity. We must
also assess whether unrealized losses on securities, if any, reflect a decline
in value which is other than temporary and, accordingly, write the impaired
security down to its value through earnings. Significant judgement is required
in this analysis. To date, no such write-downs have been made.
Income on these securities is recognized using a level yield methodology based
upon a number of assumptions that are subject to uncertainties and
contingencies. Such assumptions include the expected disposal date of such
security and the rate and timing of principal and interest receipts (which may
be subject to prepayments, delinquencies and defaults). These uncertainties and
contingencies are difficult to predict and are subject to future events, and
economic and market conditions, which may alter the assumptions.
Similarly, our derivative instruments, held for hedging purposes, are carried at
fair value pursuant to Statement of Financial Accounting Standards ("SFAS") No.
133 "Accounting for Derivative Instruments and Hedging Activities," as amended.
Fair value is based on counterparty quotations. To the extent they qualify as
hedges under SFAS No. 133, net unrealized gains or losses are reported as a
component of accumulated other comprehensive income; otherwise, they are
reported as a component of current income. Fair values of such derivatives are
subject to significant variability based on many of the same factors as the
securities discussed above. The results of such variability could be a
significant increase or decrease in our book equity and/or earnings.
We purchase mortgage loans to be held for investment. We must periodically
evaluate each of these loans for possible impairment. Impairment is indicated
when it is deemed probable that we will be unable to collect all amounts due
according to the contractual terms of the loan. Upon determination of
impairment, we would establish a specific valuation allowance with a
corresponding charge to earnings. Significant judgment is required both in
determining impairment and in estimating the resulting loss allowance. To date,
we have determined that no loss allowances have been necessary on the loans in
our portfolio.
RESULTS OF OPERATIONS
COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2003 TO THE THREE MONTHS ENDED
MARCH 31, 2002
Interest income increased by $12.0 million or 92%, from $13.0 million to $25.0
million. This increase is primarily the result of the acquisition of real estate
securities used as collateral for the CBO II and CBO III financings.
Rental and escalation income increased by $1.0 million or 20%, from $4.8 million
to $5.8 million. This increase is primarily the result of foreign currency
fluctuations related to our Bell Canada and LIV portfolios. Escalation income
represents contractual increases in rental income to offset increases in
expenses or general price increases over a base amount.
Gain on settlement of investments decreased by $0.5 million, from $3.0 million
to $2.5 million, primarily as a result of a decrease in the volume of sales of
certain real estate securities. Sales of real estate securities are based on a
number of factors including credit, asset type and industry and can be expected
to increase or decrease from time to time. Periodic fluctuations in the volume
of sales of securities is dependent upon, among other things, management's
assessment of credit risk, asset concentration, portfolio balance and other
factors. The decreased volume of sales of securities during this period reflects
management's determination that the portfolio required less adjustment than in
prior periods.
Management fee and incentive income from affiliate related solely to our
predecessor's investment in Fund I.
12
Interest expense increased by $6.5 million or 77%, from $8.4 million to $14.9
million. This increase is primarily the result of interest on the CBO II
financing.
Property operating expense increased by $0.5 million or 24%, from $2.2 million
to $2.7 million, primarily as the result of foreign currency fluctuations
related to our Bell Canada and LIV portfolios.
Loan servicing expense increased by $0.3 million, from $0.1 million to $0.4
million, primarily as a result of the acquisition of the collateral for CBO II
and the acquisition of the mortgage loan portfolio.
General and administrative expense increased by $0.4 million, from $0.6 million
to $1.0 million, primarily as a result of increased costs related to being a
public company.
Management fee expense, excluding $2.2 million of management fee expense in 2002
relating to our predecessor's investment in Fund I, decreased by $0.1 million,
from $1.4 million to $1.3 million, primarily as a result of the distribution of
assets to Holdings which reduced our equity.
Preferred incentive compensation to affiliate, excluding an expense reversal of
$6.4 million in 2002 related to our predecessor's investment in Fund I,
increased by $0.5 million, from $0.8 million to $1.3 million, primarily as a
result of increased earnings.
Depreciation and amortization decreased by $0.2 million or 16%, from $0.9
million to $0.7 million, primarily as the result of the distribution to Holdings
of depreciable assets.
Equity in earnings of unconsolidated subsidiaries related solely to our
predecessor's activities.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measurement of our ability to meet potential cash requirements,
including ongoing commitments to repay borrowings, fund and maintain
investments, and other general business needs. Additionally, to maintain our
status as a REIT under the Internal Revenue Code, we must distribute annually at
least 90% of our taxable income. Our primary sources of funds for liquidity, in
addition to our initial public offering, consist of net cash provided by
operating activities, borrowings under loans and the issuance of debt
securities. Our loans and debt securities are generally secured directly by our
investment assets. As of March 31, 2003, our real estate securities purchased in
connection with our three CBO financings as well as our Bell Canada portfolio
were securitized, while our LIV portfolio, mortgage loan portfolio, and one of
our other securities served as collateral for loans.
Our ability to execute our business strategy, particularly the growth of our
investment portfolio, depends to a significant degree on our ability to obtain
additional capital. Our core business strategy is dependent upon our ability to
issue the match funded debt we use to finance our real estate securities at
spreads that provide a positive arbitrage. If spreads for CBO liabilities widen
or if demand for such liabilities ceases to exist, then our ability to execute
future CBO financings will be severely restricted.
We expect to meet our short-term liquidity requirements generally through our
cash flow provided by operations, as well as investment specific borrowings. In
addition, at March 31, 2003 we had an unrestricted cash balance of $75.8
million. Our cash flow provided by operations differs from our net income due to
four primary factors: (i) depreciation of our operating real estate, (ii)
accretion of discount on our real estate securities, discount on our debt
obligations, and deferred hedge gains and losses, (iii) straight-lined rental
income, and (iv) gains and losses. Proceeds from the sale of real estate
securities which serve as collateral for our CBO financings, including gains
thereon, are required to be retained in the CBO structure until the related
bonds are retired and are therefore not available to fund current cash needs.
Our operating real estate is financed long-term and primarily leased to credit
tenants with long-term leases and is therefore expected to generate generally
stable current cash flows. Our real estate securities are also financed
long-term and their credit status is continuously monitored; therefore, these
investments are also expected to generate a generally stable current return,
subject to interest rate fluctuations. See "Item 3. Quantitative and Qualitative
Disclosures About Market Risk -- Interest Rate Exposure" below. We consider our
ability to generate cash to be adequate and expect it to continue to be adequate
to meet operating requirements both in the short- and long-term.
We expect to meet our long-term liquidity requirements, specifically the
repayment of our debt obligations and our investment funding needs, through
additional borrowings, the issuance of debt and equity securities and the
liquidation or refinancing of our assets at maturity. We believe that the value
of these assets is, and will continue to be, sufficient to repay our debt
obligations at maturity under either scenario. Our ability to meet our long-term
liquidity requirements is subject to obtaining
13
additional equity and debt financing. Decisions by investors and lenders to
enter into such transactions with us will depend upon a number of factors, such
as our historical and projected financial performance, compliance with the terms
of our current credit arrangements, industry and market trends, the availability
of capital and our investors' and lenders' policies and rates applicable
thereto, and the relative attractiveness of alternative investment or lending
opportunities.
We expect that our cash on hand and our cash flow provided by operations will
satisfy our liquidity needs for our business plan with respect to our current
investment portfolio over the next twelve months. However, we currently expect
to seek additional capital in order to grow our investment portfolio.
With respect to our operating real estate, we expect to incur approximately $1.7
million of tenant improvements in connection with the inception of leases and
capital expenditures during the nine months ending December 31, 2003.
The following table presents certain information regarding Newcastle's debt
obligations as of March 31, 2003 (unaudited) (dollars in thousands):
Carrying Stated Weighted Average Effective Weighted Average
Amount Face Amount Interest Rate Maturity Interest Rate (B) Expected Life
----------- ----------- ------------- ----------- -------------------------- ----------------
CBO I Bonds $ 429,954 $ 437,500 See Below July 2038 5.42% 5.01 Years
CBO II Bonds 439,399 444,000 See Below April 2037 6.07% 7.11 Years
CBO III Bonds 466,944 472,000 See Below March 2038 4.04% 8.95 Years
----------- ----------- ---- ----------
Total CBO bonds 1,336,297 1,353,500 5.16% 7.07 Years
----------- ----------- ---- ----------
Bell Canada Securitization 37,584 38,385 See Below April 2012 7.01% 2.86 Years
LIV Mortgage 65,272 65,272 5.32% Nov. 2006 6.17% 3.50 Years
CMBS Repo 1,457 1,457 LIBOR+1.35% One Month 2.65% 1 Month
Mortgage Loan Repo (A) 287,989 287,989 LIBOR+0.40% May 2003 1.71% 2 Months
----------- -----------
Total repurchase agreements 289,446 289,446
----------- -----------
Total debt obligations $ 1,728,599 $ 1,746,603
=========== ===========
(A) The counterparty on this repo is Bear Stearns Mortgage Capital
Corporation.
(B) Including the effect of applicable hedges.
Our long-term debt obligations existing at March 31, 2003 (gross of
$18.0 million of discounts) are expected to mature as follows (unaudited) (in
millions):
Period from April 1, 2003 through December 31, 2003 $ 290.1
2004 2.1
2005 1.7
2006 60.8
2007 0.0
2008 0.0
Thereafter 1,391.9
----------
Total $ 1,746.6
In July 1999, we completed our first CBO financing, CBO I, whereby a portfolio
of real estate securities was contributed to a consolidated subsidiary which
issued $437.5 million face amount of investment grade senior bonds and $62.5
million face amount of non-investment grade subordinated bonds in a private
placement. At March 31, 2003, the subordinated bonds were retained by us, and
the $430.0 million carrying amount of senior bonds, which bore interest at a
weighted average effective rate, including discount and cost amortization, of
approximately 3.91%, had an expected weighted average life of approximately 5.01
years. Two classes of the senior bonds bear floating interest rates. We have
obtained an interest rate swap and cap in order to hedge our exposure to the
risk of changes in market interest rates with respect to these bonds, at an
initial cost of approximately $14.3 million. CBO I's weighted average effective
interest rate, including the effect of such hedges, was 5.42% at March 31, 2003.
In addition, in connection with the sale of two classes of bonds, we entered
into two interest rate swaps and three interest rate cap agreements that do not
qualify for hedge accounting.
In April 2002, we completed our second CBO financing, CBO II, whereby a
portfolio of real estate securities was contributed to a consolidated subsidiary
which issued $444.0 million face amount of investment grade senior bonds and
$56.0 million face amount of non-investment grade subordinated bonds, in a
private placement. The subordinated bonds have been retained by us. At March 31,
2003, the $439.4 million carrying amount of senior bonds, which bore interest at
a weighted average effective rate, including discount and cost amortization, of
approximately 3.07%, had an expected weighted average life of approximately 7.11
years. One class of the senior bonds bears a floating interest rate. We obtained
an interest rate swap and cap in order to hedge our exposure to the changes in
market interest rates with respect to this bond, at an initial cost of $1.2
million. CBO II's weighted average effective interest rate, including the effect
of such hedges, was 6.07% at March 31, 2003.
14
In November 2001, we sold the retained subordinated $17.5 million Class E Note
from CBO I to a third party for approximately $18.5 million. The Class E Note
bore interest at a fixed rate of 8.0% and had a stated maturity of June 2038.
The sale of the Class E Note represented an issuance of debt and was recorded as
additional CBO bonds payable. In April 2002, a wholly owned subsidiary
repurchased the Class E Note. The repurchase of the Class E Note represented a
repayment of debt and was recorded as a reduction of CBO bonds payable. The
Class E Note is included in the collateral for CBO II. The Class E Note is
eliminated in consolidation.
In March 2003, we completed our third CBO financing, CBO III, whereby a
portfolio of real estate securities was contributed to a consolidated subsidiary
which issued $472.0 million face amount of investment grade senior bonds and
$28.0 million face amount on non-investment grade subordinated bonds in a
private placement. At March 31, 2003, the subordinated bonds were retained by us
and the $466.9 million carrying amount of senior bonds, which bore interest at a
weighted average effective rate, including discount and cost amortization, of
2.51%, had an expected weighted average life of approximately 8.95 years. One
class of the senior bonds bears a floating interest rate. We have obtained an
interest rate swap and cap in order to hedge our exposure to the risk of changes
in market interest rates with respect to this bond, at an initial cost of
approximately $1.3 million. CBO III's weighted average effective interest rate,
including the effect of such hedges, was 4.04% at March 31, 2003.
In April 2002, we refinanced the Bell Canada portfolio through a securitization
transaction. At March 31, 2003, the CAD 55.1 million, or approximately $37.6
million, carrying amount of outstanding bonds, which bore interest at a weighted
average effective rate, including discount and cost amortization, of
approximately 7.01%, had an expected weighted average life of approximately 2.86
years. We have retained one class of the issued bonds. In connection with this
securitization, we guaranteed certain payments under an interest rate swap to be
entered into in 2007 if the bonds are not fully repaid by such date. We believe
the fair value of this guarantee is negligible at March 31, 2003.
In November 2002, we refinanced the LIV portfolio. At March 31, 2003, the EUR
59.8 million or approximately $65.3 million carrying amount of debt bore
interest at a weighted average effective rate, including cost amortization, of
6.17% and matures in November 2006.
We utilize repurchase agreements for short-term financing of investments. As of
March 31, 2003 we had a $1.5 million repurchase agreement outstanding, secured
by a CMBS investment, bearing interest at approximately 2.65% with a short-term
maturity.
In November 2002, we purchased a $260.2 million portfolio of floating rate
mortgage loans subject to $246.7 million of floating rate financing. In February
2003, we sold our entire position in conforming residential mortgage loans (a
portion of our mortgage loan portfolio) for gross proceeds of approximately
$162.6 million at a gain of approximately $0.7 million. As a result of the sale,
the existing repurchase agreement allocated to the conforming loans was
satisfied for approximately $153.9 million. Simultaneously, we purchased
additional non-conforming residential mortgage loans at a cost of approximately
$210.2 million. In connection with this purchase, the outstanding balance of the
existing repurchase agreement was increased by a net of $45.9 million, after the
repayment described above. At March 31, 2003, the $303.0 million carrying amount
of mortgage loans bore interest at a net weighted average effective rate of
approximately 3.24%, and the $289.4 million carrying amount of financing bore
interest at a weighted average effective rate of approximately 1.71%.
In April 2003, we purchased additional non-conforming residential floating rate
mortgage loans at a cost of approximately $148.3 million. The purchase was 95%
financed subject to a floating rate repurchase agreement, which bears interest
at LIBOR + 0.425% for a term commitment of six months.
In October 2002, we sold 7 million shares of our common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million. Subsequent to this offering, we have 23,488,517
shares of common stock outstanding.
In March 2003, we issued 2.5 million shares of our 9.75% Series B Cumulative
Redeemable Preferred Stock (the "Series B Preferred") in a public, registered
offering for net proceeds of approximately $60.1 million. The Series B Preferred
has a $25 per share liquidation preference, no maturity date, no required
redemption, and may not be redeemed prior to March 2008.
15
We declared a distribution of $0.45 per share of common stock to our
stockholders of record at the close of business on April 7, 2003, including
Holdings and an affiliate of the Manager, for the quarter ending March 31, 2003.
These dividends were paid in April 2003.
Net cash flow provided by operating activities decreased from $9.2 million for
the three months ended March 31, 2002 to $4.1 million for the three months ended
March 31, 2003. This change resulted from the acquisition and settlement of
Newcastle's investments as described above, including the distribution of
investments to Holdings.
Investing activities (used) ($529.1 million) and ($16.1 million) during the
three months ended March 31, 2003 and 2002, respectively. Investing activities
consisted primarily of investments made in certain real estate securities and
mortgage loans, net of proceeds from the settlement of investments as well as
the sale of properties.
Financing activities provided $555.3 million and $1.3 million during the three
months ended March 31, 2003 and 2002, respectively. The borrowings, debt and
equity issuances described above served as the primary sources of cash flow from
financing activities. Offsetting uses included the payment of related deferred
financing costs (including the purchase of hedging instruments), the payment of
dividends and the repayment of debt obligations as described above.
See the consolidated statements of cash flows included in our consolidated
financial statements included herein for a reconciliation of our cash position
(including our predecessor's cash position prior to the commencement of our
operations) for the periods described herein.
CREDIT AND INTEREST RATE RISK
We are subject to credit and interest rate risk with respect to our investments
in real estate securities.
The commercial mortgage-backed securities (CMBS) we invest in are generally
junior in right of payment of interest and principal to one or more senior
classes, but benefit from the support of one or more subordinate classes of
securities or other form of credit support within a securitization transaction.
The unsecured REIT debt securities we invest in reflect comparable credit risk.
We believe, based on our due diligence process, that these securities offer
attractive risk-adjusted returns with long-term principal protection under a
variety of default and loss scenarios. While the expected yield on these
securities is sensitive to the performance of the underlying assets, the more
subordinated securities or other features of the securitization transaction, in
the case of mortgage backed securities, and the issuer's underlying equity and
subordinated debt, in the case of REIT securities, are designed to bear the
first risk of default and loss. We further minimize credit risk by actively
monitoring our real estate securities portfolio and the underlying credit
quality of our holdings and, where appropriate, repositioning our investments to
upgrade the credit quality and yield on our investments.
Our real estate securities portfolio is diversified by asset type, industry,
location and issuer. We expect that diversification will minimize the risk of
capital loss.
At March 31, 2003, our real estate securities which serve as collateral for our
CBO financings had an overall weighted average credit rating of approximately
BBB-, and approximately 76% of these securities had an investment grade rating
(BBB- or higher).
Our real estate securities are also subject to spread risk. The majority of such
securities are fixed rate securities valued based on a market credit spread to
U.S. Treasuries. In other words, their value is dependent on the yield demanded
on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our real estate securities portfolio would
tend to decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our real estate securities would tend to
increase. Such changes in the market value of our real estate securities
portfolio may effect our net equity, net income or cash flow directly through
their impact on unrealized gains or losses on available-for-sale securities, and
therefore our ability to realize gains on such securities, or indirectly through
their impact on our ability to borrow and access capital. See "Item 3.
Quantitative and Qualitative Disclosures About Market Risk - Credit Spread Curve
Exposure" below.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also affect the yield
required on our securities and therefore their value. This would have similar
effects on our real estate securities portfolio and our financial position and
operations to a change in spreads.
16
Returns on our real estate securities are sensitive to interest rate volatility.
We minimize exposure to interest rate fluctuation through the use of
match-funded financing structures and hedges. In particular, we finance our real
estate securities through the issuance of debt securities in the form of CBOs to
take advantage of the structural flexibility offered by CBO financings to buy
and sell certain investment positions to manage risk and, subject to certain
limitations, to optimize returns. We also utilize interest rate swaps and caps
to minimize this risk. As of March 31, 2003, a 100 basis point change in short
term interest rates would affect our earnings by no more than $2.9 million per
annum. See "Item 3. Quantitative and Qualitative Disclosures About Market Risk -
Interest Rate Exposure" below.
Interest rate changes may also impact our net book value as our real estate
securities and related hedge derivatives are marked-to-market each quarter.
Generally, as interest rates increase, the value of our fixed rate securities,
such as CMBS, decreases and as interest rates decrease, the value of such
securities will increase. We seek to hedge changes in value attributable to
changes in interest rates by entering into interest rate swaps and other
derivative instruments. In general, we would expect that over time, decreases in
the value of our real estate securities portfolio attributable to interest rate
changes will be offset to some degree by increases in the value of our swaps,
and vice versa. However, the relationship between spreads on securities and
spreads on swaps may vary from time to time, resulting in a net aggregate book
value increase or decline. Our real estate securities portfolio is largely
financed to maturity through long-term CBO financings that are not redeemable as
a result of book value changes. Accordingly, unless there is a material
impairment in value that would result in a payment not being received on a
security, changes in the book value of our real estate securities portfolio will
not directly affect our recurring earnings or our ability to pay a dividend.
Furthermore, our core business strategy is dependent upon our ability to issue
the match-funded debt we use to finance our real estate securities at spreads
that provide a positive arbitrage. If spreads for CBO liabilities widen or if
demand for such liabilities ceases to exist, then our ability to execute future
CBO financings will be severely restricted.
Similar to our real estate securities portfolio, we are subject to credit and
spread risk with respect to our mortgage loan portfolio.
Credit risk refers to each individual borrower's ability to make required
interest and principal payments on the scheduled due dates. Unlike our real
estate securities portfolio, our mortgage loan portfolio does not benefit from
the support of junior classes of securities, but rather bears the first risk of
default and loss. We believe that this credit risk is mitigated through our
extensive due diligence process, periodic reviews of the borrower's payment
history, delinquency status, and the relationship of the loan balance to the
underlying property value.
Our mortgage loan portfolio is diversified by geographic location and by
borrower. We believe that this diversification also helps to minimize the risk
of capital loss.
Our mortgage loan portfolio is also subject to spread risk. The majority of such
loans are floating rate securities valued based on a market credit spread to
LIBOR. The value of the loans is dependent upon the yield demanded by the market
based on their credit. The value of our portfolio would tend to decline should
the market require a higher yield on such loans, resulting in the use of a
higher spread over the benchmark rate (usually the applicable LIBOR yield). If
the value of our mortgage loan portfolio were to decline, it could affect our
ability to refinance such portfolio upon the maturity of the related repurchase
agreement.
Any credit or spread losses incurred with respect to our mortgage loan portfolio
would effect us in the same way as similar losses on our real estate securities
portfolio as described above.
OFF-BALANCE SHEET ARRANGEMENTS
As of March 31, 2003, we had the following material off-balance sheet
arrangements:
- - A $3.3 million equity interest in a securitization, described in Note 7 to
our consolidated financial statements included in our December 31, 2002
annual report on Form 10-K filed with the Securities and Exchange
Commission ("SEC").
- - A guarantee of certain payments under an interest rate swap which may be
entered into in 2007 in connection with the securitization of the Bell
Canada portfolio, if the bonds are not fully repaid by such date. We
believe the fair value of this guarantee is negligible at March 31, 2003.
In the first case, our potential loss is limited to the amount shown above which
is included in our consolidated balance sheet. At this time, we do not
anticipate a substantial risk of incurring a loss with respect to any of the
arrangements.
17
INFLATION
Substantially all of our office leases provide for separate escalations of real
estate taxes and operating expenses over a base amount, and/or increases in the
base rent based on changes in the Belgian Sante Index. We believe that
inflationary increases in expenses will generally be offset by the expense
reimbursements and contractual rent increases described above.
We believe that our risk of increases in the market interest rates on our
floating rate debt as a result of inflation is largely offset by our use of
match funding and hedging instruments as described above. See "Item 3.
Quantitative and Qualitative Disclosure About Market Risk -- Interest Rate
Exposure" below.
FUNDS FROM OPERATIONS
We believe Funds from Operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. We also believe that FFO is an appropriate supplemental disclosure
of operating performance for a REIT due to its widespread acceptance and use
within the REIT and analyst communities. FFO, for our purposes, represents net
income available for common shareholders (computed in accordance with GAAP),
excluding extraordinary items, plus real estate depreciation and amortization,
and after adjustments for unconsolidated subsidiaries, if any. We consider gains
and losses on resolution of our investments to be a normal part of our recurring
operations and therefore do not exclude such gains and losses when arriving at
FFO. Adjustments for unconsolidated subsidiaries, if any, are calculated to
reflect FFO on the same basis. FFO prior to the commencement of our operations
includes certain adjustments related to our predecessor's investment in Fund I,
as described in our December 31, 2002 annual report on Form 10-K filed with the
SEC. FFO does not represent cash generated from operating activities in
accordance with GAAP and therefore should not be considered an alternative to
net income as an indicator of our operating performance or as an alternative to
cash flow as a measure of liquidity and is not necessarily indicative of cash
available to fund cash needs. Our calculation of FFO may be different from the
calculation used by other companies and, therefore, comparability may be
limited.
Funds from Operations (FFO), is calculated as follows (unaudited) (in
thousands):
For the Three
Months Ended
March 31, 2003
--------------
Income available for common stockholders $10,900
Operating real estate depreciation 704
-------
Funds from Operations (FFO) $11,604
=======
Funds from operations was derived from the Company's segments as follows
(unaudited) (in thousands):
Average Invested Equity
Book Equity at for the Three Months Return on
March 31, 2003 Ended March 31, 2003 (1) FFO Equity (ROE) (2)
-------------- ------------------------ --------- ----------------
Real estate and other securities $ 230,792 $ 217,047 $ 12,244 22.6%
Operating real estate 40,488 39,871 1,236 12.4%
Mortgage loans 15,866 14,511 1,569 43.2%
Unallocated 61,138 26,828 (3,445) N/A
--------- --------- --------- -----
Total (1) 348,284 $ 298,257 $ 11,604 15.6%
========= ========= =====
Accumulated depreciation (10,686)
Accumulated other comprehensive income 12,268
---------
Net book equity $ 349,866
=========
(1) Book equity gross of accumulated depreciation and accumulated other
comprehensive income.
(2) FFO divided by average invested equity, annualized.
18
CAUTIONARY STATEMENTS
The information contained in this Quarterly Report on Form 10-Q is not a
complete description of our business or the risks associated with an investment
in our Company. We urge you to carefully review and consider the various
disclosures made by us in this report and in our other filings with the SEC,
including our December 31, 2002 annual report on Form 10-K filed with the SEC,
that discuss our business in greater detail.
This report contains certain "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Such forward-looking
statements relate to, among other things, the operating performance of our
investments and financing needs. Forward-looking statements are generally
identifiable by use of forward-looking terminology such as "may," "will,"
"should," "potential," "intend," "expect," "endeavor," "seek," "anticipate,"
"estimate," "overestimate," "underestimate," "believe," "could," "project,"
"predict," "continue" or other similar words or expressions. Forward-looking
statements are based on certain assumptions, discuss future expectations,
describe future plans and strategies, contain projections of results of
operations or of financial condition or state other forward-looking information.
Our ability to predict results or the actual effect of future plans or
strategies is inherently uncertain. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, our actual results and performance could differ materially from
those set forth in the forward-looking statements. These forward-looking
statements involve risks, uncertainties and other factors that may cause our
actual results in future periods to differ materially from forecasted results.
Factors which could have a material adverse effect on our operations and future
prospects include, but are not limited to, changes in economic conditions
generally and the real estate and bond markets specifically; changes in interest
rates and/or credit spreads, as well as the success of our hedging strategy in
relation to such changes; impairments in the value of the collateral underlying
our real estate securities; legislative/regulatory changes; completion of
pending investments; continued ability to source new investments; the
availability and cost of capital for future investments; competition within the
finance and real estate industries; and other risks detailed from time to time
in our SEC reports. Readers are cautioned not to place undue reliance on any of
these forward-looking statements, which reflect our management's views as of the
date of this report. The factors noted above could cause our actual results to
differ significantly from those contained in any forward-looking statement. For
a discussion of our critical accounting policies see "Item 3. Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Critical Accounting Policies."
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. We are under no duty to update any of the
forward-looking statements after the date of this report to conform these
statements to actual results.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates,
credit spreads, foreign currency exchange rates, commodity prices and equity
prices. The primary market risks that we are exposed to are interest rate risk,
credit spread risk and foreign currency exchange rate risk. These risks are
highly sensitive to many factors, including governmental monetary and tax
policies, domestic and international economic and political considerations and
other factors beyond our control. All of our market risk sensitive assets,
liabilities and related derivative positions are for non-trading purposes only.
INTEREST RATE EXPOSURE
Our primary interest rate exposures relate to our mortgage loans, real estate
securities and floating-rate debt obligations, as well as our interest rate
swaps and caps. Changes in the general level of interest rates can effect our
net interest income, which is the difference between the interest income earned
on interest-earning assets and the interest expense incurred in connection with
our interest-bearing liabilities. Changes in the level of interest rates also
can effect, among other things, our ability to acquire mortgage loans and
securities, the value of our mortgage loans and real estate securities, and our
ability to realize gains from the settlement of such assets.
While we have not experienced any significant credit losses, in the event of a
significant rising interest rate environment and/or economic downturn, loan and
collateral defaults may increase and result in credit losses that would
adversely affect our liquidity and operating results.
19
Interest rates are highly sensitive to many factors, including governmental
monetary and tax policies, domestic and international economic and political
conditions, and other factors beyond our control. Our general financing strategy
focuses on the use of match-funded structures. This means that we seek to match
the maturities of our debt obligations with the maturities of our investments to
minimize the risk that we have to refinance our liabilities prior to the
maturities of our assets, and to reduce the impact of changing interest rates on
earnings. In addition, we generally match-fund interest rates with like-kind
debt (i.e., fixed rate assets are financed with fixed rate debt and floating
rate assets are financed with floating rate debt), directly or through the use
of interest rate swaps, caps, or other financial instruments, or through a
combination of these strategies.
Interest rate swaps are agreements in which a series of interest rate flows are
exchanged with a third party (counterparty) over a prescribed period. The
notional amount on which swaps are based is not exchanged. In general, our swaps
are "pay fixed" swaps involving the exchange of floating rate interest payments
from the counterparty for fixed rate payments from us. This can effectively
convert a floating rate debt obligation into a fixed rate debt obligation.
Similarly, an interest rate cap or floor agreement is a contract in which we
purchase a cap or floor contract on a notional face amount. We will make an
up-front payment to the counterparty for which the counterparty agrees to make
future payments to us should the reference rate (typically one- or three-month
LIBOR) rise above (cap agreements) or fall below (floor agreements) the "strike"
rate specified in the contract. Should the reference rate rise above the
contractual strike rate in a cap, we will earn cap income; should the reference
rate fall below the contractual strike rate in a floor, we will earn floor
income. Payments on an annualized basis will equal the contractual notional face
amount multiplied by the difference between the actual reference rate and the
contracted strike rate.
While a REIT may utilize these types of derivative instruments to hedge interest
rate risk on its liabilities or for other purposes, such derivative instruments
could generate income that is not qualified income for purposes of maintaining
REIT status. As a consequence, we may only engage in such instruments to hedge
such risks within the constraints of maintaining our standing as a REIT. We do
not enter into derivative contracts for speculative purposes nor as a hedge
against changes in credit risk.
The above strategies are specifically designed to reduce our exposure, on
specific transactions or on a portfolio basis, to changes in cash flows as a
result of interest rate movements in the market. In this regard, we utilize
securitization structures, particularly CBOs, as well as other match-funded
financing structures. Our financing strategy is dependent on our ability to
place the match-funded debt we use to finance our real estate securities at
spreads that provide a positive arbitrage. If spreads for CBO liabilities widen
or if demand for such liabilities ceases to exist, then our ability to execute
future CBO financings will be severely restricted.
While our strategy is to utilize interest rate swaps, caps and match-funded
financing in order to limit the effects of changes in interest rates on our
operations, there can be no assurance that our profitability will not be
adversely affected during any period as a result of changing interest rates. As
of March 31, 2003, a 100 basis point change in short term interest rates would
effect our earnings by no more than $2.9 million per annum.
Our hedging transactions using derivative instruments also involve certain
additional risks such as counterparty credit risk, the enforceability of hedging
contracts and the risk that unanticipated and significant changes in interest
rates will cause a significant loss of basis in the contract. The counterparties
to our derivative arrangements are major financial institutions with high credit
ratings with which we and our affiliates may also have other financial
relationships. As a result, we do not anticipate that any of these
counterparties will fail to meet their obligations. There can be no assurance
that we will be able to adequately protect against the foregoing risks and will
ultimately realize an economic benefit that exceeds the related amounts incurred
in connection with engaging in such hedging strategies.
Interest rate changes may also impact our net book value as our real estate
securities and related hedge derivatives are marked-to-market each quarter.
Generally, as interest rates increase, the value of our fixed rate securities,
such as CMBS, decreases and as interest rates decrease, the value of such
securities will increase. We seek to hedge changes in value attributable to
changes in interest rates by entering into interest rate swaps and other
derivative instruments. In general, we would expect that over time, decreases in
the value of our real estate securities portfolio attributable to interest rate
changes will be offset to some degree by increases in the value of our swaps,
and vice versa. However, the relationship between spreads on securities and
spreads on swaps may vary from time to time, resulting in a net aggregate book
value increase or decline. Our real estate securities portfolio is largely
financed to maturity through long-term CBO financings that are not redeemable as
a result of book value changes. Accordingly, unless there is a material
impairment in value that would result in a payment not being received on a
security, changes in the book value of our real estate securities portfolio will
not directly affect our recurring earnings or our ability to pay a dividend.
20
CREDIT SPREAD CURVE EXPOSURE
Our real estate securities are also subject to spread risk. The majority of such
securities are fixed rate securities valued based on a market credit spread to
U.S. Treasuries. In other words, their value is dependent on the yield demanded
on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our real estate securities portfolio would
tend to decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our real estate securities portfolio would
tend to increase. Such changes in the market value of our real estate securities
portfolio may effect our net equity, net income or cash flow directly through
their impact on unrealized gains or losses on available-for-sale securities, and
therefore our ability to realize gains on such securities, or indirectly through
their impact on our ability to borrow and access capital.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also effect the yield
required on our securities and therefore their value. This would have similar
effects on our real estate securities portfolio and our financial position and
operations to a change in spreads.
As of March 31, 2003, a 25 basis point movement in credit spreads would impact
our net book value by approximately $19 million.
CURRENCY RATE EXPOSURE
Our primary foreign currency exchange rate exposures relate to our operating
real estate and related leases. Our principal direct currency exposures are to
the Euro and the Canadian Dollar. Changes in the currency rates can adversely
impact the fair values and earnings streams of our international holdings. We
have attempted to mitigate this impact in part by utilizing local
currency-denominated financing on our foreign investments to partially hedge, in
effect, these assets.
We have material investments in a portfolio of Belgian properties, the LIV
portfolio, and a portfolio of Canadian properties, the Bell Canada portfolio.
These properties are financed utilizing debt denominated in their respective
local currencies (the Euro and the Canadian Dollar). The net equity invested in
these portfolios, approximately $8.2 million and $20.0 million, respectively, at
March 31, 2003, is exposed to foreign currency exchange risk.
FAIR VALUES
For certain of our financial instruments, fair values are not readily available
since there are no active trading markets as characterized by current exchanges
between willing parties. Accordingly, fair values can only be derived or
estimated for these investments using various valuation techniques, such as
computing the present value of estimated future cash flows using discount rates
commensurate with the risks involved. However, the determination of estimated
future cash flows is inherently subjective and imprecise. We note that minor
changes in assumptions or estimation methodologies can have a material effect on
these derived or estimated fair values, and that the fair values reflected below
are indicative of the interest rate and currency rate environments as of March
31, 2003 and do not take into consideration the effects of subsequent interest
rate, credit spread or currency rate fluctuations.
We note that the values of our investments in real estate securities and in
derivative instruments, primarily interest rate hedges on our debt obligations,
are sensitive to changes in market interest rates, interest rate spreads, credit
spreads and other market factors. The value of these investments can vary, and
has varied, materially from period to period. Historically, the values of our
real estate securities have tended to vary inversely with those of our
derivative instruments.
21
We held the following interest rate risk sensitive instruments at March
31, 2003 (unaudited) (dollars in thousands):
Weighted
Carrying Principal Balance or Average Effective Maturity
Amount Notional Amount Interest Rate Date Fair Value
------ --------------- ------------- ---- ----------
ASSETS:
Real estate securities, available
for sale (A) $1,590,122 $1,555,527 7.28% Various $1,590,122
Other securities, available for
sale (B) 20,931 32,700 N/A (B) 20,931
Mortgage loans (C) 303,013 299,244 3.24% Various 303,013
Interest rate caps, treated as
hedges (D) 5,525 235,925 N/A (D) 5,525
LIABILITIES:
CBO bonds payable (E) 1,336,297 1,353,500 5.16% (E) 1,360,103
Other bonds payable (F) 37,584 38,385 7.01% April 2012 36,678
Notes payable (F) 65,272 65,272 6.17% Nov 2006 64,952
Repurchase agreements (G) 289,446 289,446 1.71% Short-term 289,446
Interest rate swaps, treated as
hedges (H) 45,912 699,254 N/A (H) 45,912
Non-hedge derivative obligations (I) 820 (I) N/A (I) 820
(A) These securities serve as collateral for our CBO financings and contain
various terms, including floating and fixed rates, self-amortizing and interest
only. The fair value of these securities is estimated by obtaining third party
broker quotations, if available and practicable, or counterparty quotations.
(B) These four securities with carrying amounts of $3.9 million, $3.3 million,
$6.0 million and $7.7 million, respectively, mature in November 2007, August
2030, July 2021 and January 2024, respectively. The former two represent
subordinate and residual interests in securitizations; the latter two represent
asset-backed securities. The fair values of the former two securities, for which
quoted market prices are not readily available, are estimated by means of a
price/yield analysis based on our expected disposition strategies for such
assets. The fair value of the latter two securities were obtained from third
party broker quotations.
(C) This portfolio of mortgage loans bears a floating rate of interest. We
believe that for similar financial investments with comparable credit risks, the
effective rate on this portfolio approximates the market rate. Accordingly, the
carrying amount of this portfolio is believed to approximate fair value.
(D) These three agreements have notional balances of $209.3 million, $18.0
million and $8.6 million, respectively, mature in March 2009, October 2015 and
June 2015, respectively, and cap 1-month LIBOR at 6.50%, 3-month LIBOR at 8.00%
and 3-month LIBOR at 7.00%, respectively. The fair value of these agreements is
estimated by obtaining counterparty quotations.
(E) For those bonds bearing floating rates at spreads over market indices,
representing approximately $1,134.7 million of the carrying amount of the CBO
bonds payable, we believe that for similar financial instruments with comparable
credit risks, the effective rates approximate market rates. Accordingly, the
carrying amount outstanding on these bonds is believed to approximate fair
value. For those bonds bearing fixed interest rates, values were obtained by
discounting expected future payments by a rate calculated by imputing a spread
over a market index on the date of borrowing. The weighted average stated
maturity of the CBO bonds payable is August 2036. The CBO bonds payable amortize
principal prior to maturity based on collateral receipts, subject to
reinvestment requirements.
(F) The Bell Canada Securitization and LIV Mortgage were valued by discounting
expected future payments by a rate calculated by imputing a spread over a market
index on the date of borrowing. They both amortize principal periodically with a
balloon payment at maturity.
22
(G) These agreements bear floating rates of interest and we believe that for
similar financial instruments with comparable credit risks, the effective rates
approximate market rates. Accordingly, the carrying amounts outstanding are
believed to approximate fair value. These agreements pay interest only prior to
maturity.
(H) These three agreements have notional balances of $133.2 million, $290.0
million and $276.1 million, respectively, mature in July 2005, April 2011 and
March 2013, respectively, and swap 1-month LIBOR for 6.1755%, 3-month LIBOR for
5.9325% and 3-month LIBOR for 3.865%, respectively. The fair value of these
agreements is estimated by obtaining counterparty quotations.
(I) These are two essentially offsetting interest rate caps and two essentially
offsetting interest rate swaps, each with notional amounts of $32.5 million, an
interest rate cap with a notional balance of $17.5 million, and an interest rate
cap with a notional balance of approximately $63.2 million. The maturity date of
the purchased swap is July 2009; the maturity date of the sold swap is July
2014, the maturity date of the $32.5 million caps is July 2038, the maturity
date of the $17.5 million cap is July 2009, and the maturity date of the $63.2
million cap is August 2004. They have been valued by reference to counterparty
quotations.
We held the following currency rate risk sensitive balances at March 31, 2003
(unaudited) (dollars in thousands, except exchange rates):
Current Effect of a 5% Effect of a 5%
Carrying Local Exchange Negative Change in Negative Change in
Amount Currency Rate to USD Euro Rate CAD Rate
------ -------- ----------- --------- --------
Assets:
LIV portfolio $ 70,158 Euro 0.91617 (3,508) N/A
Bell Canada portfolio 50,981 CAD 1.46720 N/A $(2,549)
LIV other, net 3,287 Euro 0.91617 (164) N/A
Bell Canada other, net 6,641 CAD 1.46720 N/A (332)
Liabilities:
LIV mortgage 65,272 Euro 0.91617 3,264 N/A
Bell Canada bonds 37,584 CAD 1.46720 N/A 1,879
-------- -------
Total $ (408) $(1,002)
======== =======
USD refers to U.S. dollars; CAD refers to Canadian dollars.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. The Company's Chief
Executive Officer and Chief Financial Officer have evaluated the effectiveness
of the Company's disclosure controls and procedures (as such term is defined in
Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act")) as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"). Based on such evaluation,
such officers have concluded that, as of the Evaluation Date, the Company's
disclosure controls and procedures are effective in alerting them on a timely
basis to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Company's reports
filed or submitted under the Exchange Act.
(b) Changes in Internal Controls. Since the Evaluation Date, there have not been
any significant changes in the Company's internal controls or in other factors
that could significantly affect such controls.
23
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is not party to any material legal proceedings.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Pursuant to a registration statement declared effective by the Securities and
Exchange Commission on October 9, 2002 (File No. 333-90578), the Company issued
and sold 7 million shares of its common stock, par value $0.01 per share, in a
public offering underwritten by Bear Stearns & Co. Inc., Lehman Brothers, Banc
of America Securities LLC and Friedman, Billings Ramsey & Co., Inc. The
aggregate offering price for these shares was $91 million. The aggregate
underwriting discounts and commissions were approximately $6 million.
The Company also incurred a total of approximately $5 million of other expenses
in connection with the offering. None of these expenses were direct or indirect
payments to any directors, officers or partners of the Company or their
associates or to persons owning 10 percent or more of any class of the Company's
securities. Of the approximately $80 million of net proceeds to the Company
(after deducting the underwriters' discount and commission and other offering
expenses) approximately $14 million was used to pay a portion of the purchase
price for a portfolio of mortgage loans from an affiliate of Bear Stearns & Co.
Inc., approximately $52 million was used to purchase a portfolio of real estate
securities from an affiliate of Bear Stearns & Co. Inc. for the Company's third
CBO financing, and approximately $14 million was used to purchase additional
securities.
On March 20, 2003, Newcastle CDO II, Limited and Newcastle CDO II Corp. issued
$472 million face amount of collateralized bond obligations in a transaction
exempt from the registration requirements of the Securities Act pursuant to Rule
144A and Regulation S thereunder to qualified institutional buyers and persons
outside the United States.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
On April 22, 2003, the Company announced the appointment of Debra A. Hess as
Chief Financial Officer of the Company, replacing Michael I. Wirth. Mr. Wirth
was appointed director of finance for Fortress Investment Group LLC.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits filed with this Form 10-Q:
3.1 Articles of Amendment and Restatement (incorporated by reference to the
Registrant's Registration Statement on Form S-11 (File No. 333-90578), Exhibit
3.1).
3.2 By-laws (incorporated by reference to the Registrant's Registration
Statement on Form S-11 (File No. 333-90578), Exhibit 3.2).
3.3 Articles Supplementary Relating to the Series B Preferred Stock (filed
herewith).
4.1 Rights Agreement between the Registrant and American Stock Transfer and
Trust Company, as Rights Agent, dated October 16, 2002 (incorporated by
reference to the Registrant's Quarterly Report on Form 10-Q for the period ended
September 30, 2002, Exhibit 4.1).
10.1 Amended and Restated Management and Advisory Agreement by and among the
Registrant and Fortress Investment Group LLC, dated March 4, 2003 (incorporated
by reference to the Registrant's Registration Statement on Form S-11 (File No.
333-103598), Exhibit 10.1).
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K filed by the registrant during its fiscal quarter ended
March 31, 2003:
Form 8-K filed with the Securities and Exchange Commission on April 30, 2003,
regarding the Registrant's results of operations for the quarter ended March 31,
2003.
24
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized:
NEWCASTLE INVESTMENT CORP.
By: /s/ Wesley R. Edens
--------------------
Wesley R. Edens
Chairman of the Board
May 12, 2003
By: /s/ Debra A. Hess
-------------------
Debra A. Hess
Chief Financial Officer
May 12, 2003
25
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
I, Wesley R. Edens, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Newcastle Investment
Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d - 14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
May 12, 2003 /s/ Wesley R. Edens
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(Date) Wesley R. Edens
Chief Executive Officer
26
CERTIFICATION OF CHIEF FINANCIAL OFFICER
I, Debra A. Hess, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Newcastle Investment
Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d - 14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
May 12, 2003 /s/ Debra A. Hess
------------ -----------------
(Date) Debra A. Hess
Chief Financial Officer
27