| CAPITAL LEASE FUNDING INC Item 1A Risk Factors |
| Set forth below and elsewhere in this annual report on Form 10-K and in other documents we file or furnish with the SEC are risks and uncertainties that could adversely affect our business and operations and cause actual results to differ materially from the results contemplated by any forward-looking statements made by us or on our behalf |
| Risks Related to Operations We may fail to continue to invest in net lease assets |
| Investment in additional net lease assets is critical to the success of our business strategy |
| The net lease market is highly competitive and we cannot assure you that we will be able to identify net lease opportunities that meet our underwriting and return criteria |
| This competition intensified during 2005, putting downward pressure on yields and spreads on both property acquisitions and our origination of loans for our portfolio |
| If we are unable to continue to invest in additional net lease assets that are acceptable to us, we may be unable to execute our business plan, which could have a material adverse effect on the market price of our stock |
| We may fail to invest in profitable assets |
| Our investment strategy contemplates investing in profitable assets, as determined by our returns on those assets less our related financing cost |
| We invest in long-term assets with generally fixed cash flows and generally seek to finance those assets with lower coupon long-term fixed rate debt, thus earning a profit or spread |
| We generally secure long-term financing for our assets after we agree to acquire them |
| Therefore, we price our assets at origination or acquisition based on our assumptions about our expected future financing cost |
| If our cost to finance our assets increases over our assumptions between the time we commit to purchase the asset and when we obtain long-term financing, the profit or spread we expected to earn on the asset and our overall portfolio will erode |
| Various factors could cause our financing cost to increase, including: • a decline in the credit rating of the underlying tenant; 15 _________________________________________________________________ • increases in long-term interest rates; • market dislocations caused by the failure or financial difficulties of a large financial institution or institutions; • ineffectiveness of our hedging strategies; • weakening economic conditions; and • United States military activity and terrorist activities |
| Our failure to invest in profitable assets would have a material adverse effect on our cash flows, results of operations and financial condition |
| We conduct a significant part of our business with Wachovia Bank, NA and its affiliates, and their continued business with us is not guaranteed |
| We rely on Wachovia Bank, NA and its affiliates in various aspects of our business |
| For example: • Wachovia Bank, NA and its affiliates provide us with short-term financing through a dlra250dtta0 million repurchase agreement and a dlra100dtta0 million real property acquisition facility |
| • Many of our real property acquisitions have been and we expect will continue to be financed with traditional mortgage debt obtained from Wachovia Bank |
| • Affiliates of Wachovia Bank, NA have performed investment banking services for us, including in connection with our initial public offering, our initial CDO transaction and our Series A preferred stock offering |
| • Wachovia Bank, NA acts as loan servicer of our net lease asset investments financed under our repurchase facility |
| These parties are not obligated to do business with us, and any adverse developments in their business or in our relationship with them could result in these parties choosing not to do business with us or a significant reduction in our business with them |
| Termination of our business with Wachovia Bank, NA or its affiliates or a significant reduction in our business with these parties could have a material adverse effect on our business, operating results and financial condition |
| If we lower our dividend, the market value of our common stock may decline |
| The level of our common stock dividend is established by our board of directors from time to time based on a variety of factors, including our cash available for distribution, our funds from operations and our maintenance of REIT status |
| Various factors could cause our board of directors to decrease our common stock dividend level, including tenant defaults resulting in a material reduction in our cash flows or a material loss resulting from an adverse change in one or more of the tenants underlying our investments |
| If we are required to lower our common stock dividend, the market value of common stock in our company could be adversely affected |
| An interruption in or breach of our information systems could impair our ability to acquire assets on a timely basis and may result in lost business |
| We rely heavily upon communications and electronic information systems to conduct our business |
| Any failure or interruption or breach in security of our information systems or the third-party information systems on which we rely could cause underwriting or other delays and could result in reduced efficiency in asset servicing |
| We cannot assure you that any failures or interruptions will not occur or, if they do occur that we or the third parties on whom we rely will adequately address them |
| The occurrence of any failures or interruptions could significantly harm our financial condition and operating results |
| Risks Related to Net Lease Assets An adverse change in the financial condition of one or more tenants underlying our net lease investments could have a material adverse impact on us |
| We make investments in net lease assets based on the financial strength of the underlying net lease tenant and our expectations of their continued payment of rent under the lease |
| We rely on rent payments under the lease for our cash flows |
| Therefore, adverse changes in the financial condition of the tenants or the certainty of their ability to pay rents could have a material adverse impact on us |
| For example: • The bankruptcy, insolvency or failure to make rental payments by a tenant to whom we have significant exposure could result in a material reduction of our cash flows and material losses to our company |
| 16 _________________________________________________________________ • The value of our net lease investments is primarily driven by the credit quality of the underlying tenant or tenants, and an adverse change in the subject tenant’s financial condition or a decline in the credit rating of such tenant may result in a decline in the value of our net lease investments and a charge to our income statement |
| • An adverse change in the financial condition of one or more tenants underlying our net lease investments or a decline in the credit rating of one or more tenants underlying our net lease investments could result in a margin call if the related asset is being financed on our short-term borrowing facilities, and could make it more difficult for us to arrange long-term financing for that asset |
| • We own the subordinate classes in our CDO financings |
| If the underlying tenant on any asset financed in our CDO fails to make rental payments, we may fail to satisfy coverage tests under the CDO, which could result in our cash flows from the assets in the CDO being redirected to senior class owners |
| We are subject to tenant credit concentrations that make us more susceptible to adverse events with respect to certain tenants |
| We are subject to the following tenant credit concentrations as of December 31, 2005: • approximately dlra196dtta7 million, or 16dtta3prca, of our assets in portfolio involve properties leased to the United States Government; • approximately dlra88dtta5 million, or 7dtta3prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, Lowe’s Companies Inc |
| ; • approximately dlra83dtta7 million, or 6dtta9prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, Aon Corporation; • approximately dlra77dtta1 million, or 6dtta4prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, Tiffany & Co |
| ; and • approximately dlra67dtta7 million, or 5dtta6prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, CVS Corporation |
| Any bankruptcy, insolvency or failure to make rental payments by, or any adverse change in the financial condition of, one or more of these tenants or any other tenant to whom we may have a significant credit concentration in the future, could result in a material reduction of our cash flows or material losses to our company |
| We are subject to tenant industry concentrations that make us more susceptible to adverse events with respect to certain industries |
| We are subject to the following industry concentrations as of December 31, 2005: • approximately dlra179dtta4 million, or 14dtta9prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the insurance industry (eg, Aon Corporation, Allstate Insurance Company, Farmers New World Life Insurance Company); • approximately dlra105dtta5 million, or 8dtta8prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the retail home improvements industry (eg, Lowe’s Companies, Inc |
| ); and • approximately dlra93dtta3 million, or 7dtta7prca, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the retail drug industry (eg, CVS Corporation, Walgreen Co |
| Any downturn in one or more of these industries or in any other industry in which we may have a significant credit concentration in the future could have a material adverse effect on our cash flows and operating results |
| We are subject to geographic concentrations that make us more susceptible to adverse events in these areas |
| We are subject to the following geographic concentrations as of December 31, 2005: • approximately dlra188dtta8 million, or 15dtta7prca, of our assets in portfolio are investments in properties located in the Chicago, Illinois metropolitan area; • approximately dlra176dtta2 million, or 14dtta6prca, of our assets in portfolio are investments in properties located in the Washington, DC metropolitan area; 17 _________________________________________________________________ • approximately dlra149dtta3 million, or 12dtta4prca, of our assets in portfolio are investments in properties located in the New York City and Northern New Jersey area; and • approximately dlra77dtta2 million, or 6dtta4prca, of our assets in portfolio are investments in properties located in the Southern California area |
| An economic downturn or other adverse events or conditions such as terrorist attacks or natural disasters in one or more of these areas, or any other area where we may have a significant credit concentration in the future, could have a material adverse effect on our financial condition and operating results |
| Our investments in assets backed by below investment grade credits have a greater risk of default |
| We invest in net lease assets where the underlying tenant’s credit rating is below investment grade (approximately dlra101dtta0 million, or 8dtta4prca, of our assets in portfolio as of December 31, 2005) |
| These investments will have a greater risk of default and bankruptcy than investments on properties net leased exclusively to investment grade tenants |
| Our investments in assets where we obtain “private” credit ratings expose us to certain risks |
| In order to effectively implement our financing strategy, we are required to have ratings for all of the underlying tenants on our loans and properties |
| When we invest in a loan or property where the underlying tenant does not have a publicly available credit rating, we rely on our own estimates of the tenant’s credit rating and later obtain a private rating from S&P or Moody’s to allow us to finance the asset as we had planned |
| If S&P or Moody’s disagrees with our ratings estimates, we may not be able to obtain our desired level of leverage and/or our financing costs may exceed those that we projected |
| This outcome could have an adverse impact on our returns on that asset and hence our operating results |
| Risks Related to Ownership of Real Estate Single tenant leases involve significant risks of tenant default |
| We focus our real estate acquisition activities on properties that are net leased to single tenants |
| Therefore, a default by the sole tenant is likely to cause a significant or complete reduction in the operating cash flow generated by the property leased to that tenant and a reduction in the value of that property |
| Bankruptcy laws will limit our remedies if a tenant becomes bankrupt and rejects our lease |
| We rely on rent payments under our lease with the tenant for the cash flows to fund our financing of the property and to generate the “spread,” or profit, we earn on the asset |
| In such a case, our remedies will be limited under the United States Bankruptcy Code |
| We may not be able to recover the premises promptly from the tenant and our claim for damages, which is limited to rent under the lease for the greater of one year or 15 percent (but not more than three years) of the remaining term, plus rent already due but unpaid, may not be sufficient to cover our debt service and any other expenses with respect to the property |
| The success of our owned properties business will depend on our ability to obtain third-party management for the real properties we purchase |
| For many of our owned properties, we retain property owner obligations under the lease |
| These obligations range from structural repair of the building to common area maintenance |
| In most of these instances, we retain third party property managers to perform our obligations |
| A failure of these managers or us to perform could trigger the tenant’s right to terminate the lease or abate rent |
| In addition, if the managers or us fail to perform our obligations in a cost-effective manner, our net cash flows from the property and hence our operating results and cash flows could be adversely affected |
| Operating expenses of our properties could reduce our cash flow and funds available for future dividends |
| In these instances, our lease requires the tenant to reimburse us for all or a portion of these costs, either in the form of an expense reimbursement or increased rent |
| Our reimbursement may be limited to a fixed amount or a specified percentage annually |
| To the extent operating costs exceed our reimbursement, our cash flows and returns would be harmed and our ability to pay dividends may be harmed |
| We have greater exposure to operating costs when we invest in owned properties leased to the United States Government |
| Our leases with the United States Government are typical Government Services Administration, or GSA, type leases |
| These leases do not provide that the United States Government is wholly responsible for operating costs of the property, but include an operating cost component within the rent we receive that increases annually by an agreed upon percentage based 18 _________________________________________________________________ upon the Consumer Price Index, or CPI Thus, we have greater exposure to operating costs on our properties leased to the United States Government because if the operating costs of the property increase faster than CPI, we will bear those excess costs |
| Upon the expiration of leases on our properties, we may not be able to re-let all or a portion of that property, or the terms of re-letting (including the cost of concessions to tenants) may be less favorable to us than current lease terms |
| If we are unable to re-let promptly or if the rental rates upon re-letting are significantly lower than the current rates, our financial condition and operating results will be adversely affected |
| There can be no assurance that we will be able to retain tenants upon the expiration of their leases |
| It may be difficult for us to buy and sell real estate quickly |
| Real estate investments are relatively illiquid |
| Our ability to vary our portfolio by selling and buying properties in response to changes in economic and other conditions will be limited |
| In addition, the mortgage debt we put on the property and REIT tax requirements restrict our ability to quickly re-sell properties we have purchased |
| If we must sell a property, we cannot assure you that we will be able to dispose of the property in the time period we desire or that the sales price of the property will recoup or exceed our cost for the property |
| An uninsured loss or a loss that exceeds the insurance policy limits on our owned properties could subject us to lost capital or revenue on those properties |
| Our comprehensive loss insurance policies may include substantial deductibles and certain exclusions |
| For example, during 2005 we obtained earthquake insurance on one of our properties and our coverage included a customary deductible of five percent of our insurable value |
| If we are subject to an uninsured loss or a loss that is subject to a substantial deductible, we could lose part of our capital invested in, and anticipated revenue from, the property, which could harm our operating results and financial condition and our ability to pay dividends |
| Noncompliance with environmental laws could adversely affect our financial condition and operating results |
| The real properties we own are subject to various federal, state and local environmental laws |
| Under these laws, courts and government agencies have the authority to require the current owner of a contaminated property to clean up the property, even if the owner did not know of and was not responsible for the contamination |
| For example, liability can be imposed upon us based on activities of one of our tenants |
| Prior to acquisition of a property, we obtain Phase I environmental reports and, in some cases, a Phase II environmental report |
| However, these reports may not reveal all environmental conditions at a property and we may incur material environmental liabilities of which we are unaware |
| The costs incurred to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could adversely affect our financial condition and operating results |
| Our real estate investments are subject to risks particular to real property |
| As an owner of real property (including any real property we may acquire upon foreclosure), we are subject to various additional risks not otherwise discussed in these risk factor and generally incident to the ownership of the real estate |
| These risks may include those listed below: • civil unrest, acts of God, including earthquakes, floods and other natural disasters, which may result in uninsured losses, and acts of war or terrorism, including the consequences of the terrorist attacks, such as those that occurred on September 11, 2001; • adverse changes in national and local economic and market conditions; • the costs of complying or fines or damages as a result of non-compliance with the Americans with Disabilities Act; • changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; • the ongoing need for capital improvements, particularly in older structures; and • other circumstances beyond our control |
| Should any of these events occur, our financial condition and operating results could be adversely affected |
| As of December 31, 2005, our CMBS investments included dlra57dtta8 million of below investment grade bond classes |
| Generally, these classes represent subordinate classes of the securitization pool, meaning that we hold the “first loss” position or a near “first loss” position in the event of losses on the assets within the pool |
| We may not be able to recover our investment in these subordinated CMBS classes |
| In addition, the value of these subordinated investments may be adversely affected by decreases in the value of the underlying collateral, increases in market rates for similar collateral pools or economic downturns, and we may be required under GAAP to record an impairment loss on our investment if any of these developments occur |
| We may experience losses on our mortgage loans |
| We originate mortgage loans as part of our investment strategy |
| As a holder of mortgage loans, we are subject to risks of tenant defaults, borrower defaults, bankruptcies, fraud, losses and special hazard losses that may not be covered by standard hazard insurance |
| In the event of any default under our mortgage loans, we will bear the risk of loss of principal to the extent of any deficiency between the value of the mortgage collateral and the principal amount of the mortgage loan plus all interest and other costs payable on the loan |
| The typical net lease requires casualty insurance (which may be provided through self insurance) to be maintained on the underlying property (generally by the borrower or the tenant), with such coverages and in such amounts as are customarily insured against with respect to similar properties, for fire, vandalism and malicious mischief, extended coverage perils, physical loss perils, commercial general liability, flood (when the underlying property is located in whole or in material part in a designated flood plain area) and worker injury |
| There are, however, certain types of losses (such as from earthquakes or wars) that may be either uninsurable or not economically insurable |
| Should an uninsured loss occur, we could lose some or all of our investment in the net lease property |
| We could be subject to the risks incident to ownership of real property if the tenants underlying our net lease loans fail to make their lease payments |
| Our net lease loans are generally non-recourse to the property owner, and, in the event of default, we are entirely dependent on the loan collateral |
| Rent payment by the underlying tenant is the primary source of payment of these loans |
| To the extent the tenant does not make its lease payments, repayment of the net lease loan will depend upon the liquidation value of the underlying real property |
| The liquidation value of a commercial property may be adversely affected by risks generally incident to interests in real property, including changes in general or local economic conditions and/or specific industry segments, declines in real estate values, increases in interest rates, real estate tax rates and other operating expenses including energy costs, changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, and other factors which are beyond our or our borrower’s control |
| There can be no assurance that our remedies with respect to the loan collateral will provide us with a recovery adequate to recover our investment |
| Our collateral rights under our 10-year credit tenant loan program are limited |
| As part of our 10-year credit tenant loan program, we split a loan secured by a mortgage on real estate and an assignment of the lease on the property into two notes, a real estate note (which we generally sell promptly following origination), and a corporate credit note (which we retain in our portfolio) |
| The corporate credit note has a junior claim on the real estate mortgage |
| Further, while the corporate credit note has a first priority claim on the lease assignment in a tenant bankruptcy, our claim for damages will be limited to an amount defined under the Bankruptcy Code (the greater of one year’s rent or 15prca (but not more than three years) of rent over the remaining lease term, plus rent already due but unpaid) |
| Therefore, in the event of a default on the loan, our collateral rights on our corporate credit notes will be more limited than the collateral rights we have under our mortgage loans |
| Our mezzanine investments have a greater risk of loss than mortgage loans |
| We make mezzanine and other generally subordinate investments |
| These investments involve a higher degree of risk than our first mortgage loans |
| While we expect most of these investments will be secured, we expect our right to payment and security interest will be subordinated to one or more senior lenders |
| Therefore, we may be limited in our rights to collect scheduled payments on these investments and to recover any of our investment through a foreclosure of collateral |
| Our mezzanine investments may also include an interest only payment schedule, with the principal amount remaining outstanding and at risk until the maturity of the obligation |
| In this case, a borrower’s ability to repay its obligation may be dependent upon a liquidity event, such as a sale or refinancing of the property |
| 20 _________________________________________________________________ Development loans involve greater risk of loss than loans secured by income producing properties |
| We make investments in development loans that involve a higher degree of risk than long-term senior mortgage loans secured by income-producing real property, due to a variety of factors |
| These factors include the subordinate status of our loan investment, dependence for repayment on successful completion and operation of the project, difficulties in estimating construction or rehabilitation costs, loan terms that often require little or no amortization, and the possibility that a foreclosure by the holder of the senior loan could result in a substantial decrease in the value of our collateral |
| Accordingly, in the event of a borrower default, we may not recover some or all of our investment in our development loans |
| Fluctuating interest rates may adversely affect the quantity of net lease loan assets we can originate |
| Higher interest rates may reduce overall demand for net lease loans and accordingly reduce our origination of loan assets, which could have a material adverse effect on our financial condition and operating results |
| Unscheduled principal payments on our loans could adversely affect our financial condition and operating results |
| The rate and timing of unscheduled payments of principal on our net lease loans is impossible to predict accurately and will be affected by a variety of factors, including the level of prevailing interest rates, restrictions on voluntary prepayments contained in the loans, the availability of credit generally and other economic, demographic, geographic, tax and legal factors |
| In general, however, if prevailing interest rates fall significantly below the interest rate on a loan, the borrower is more likely to prepay the then higher-rate loan than if prevailing rates remain at or above the interest rate on the loan |
| While our loan documents generally prohibit prepayment without a premium to preserve our yield, this premium may not be required or may not be recoverable under various circumstances, including in the event of a casualty or condemnation of the related property or a loan default |
| Unscheduled principal prepayments could adversely affect our financial condition and operating results to the extent we are unable to reinvest the funds we receive at an equivalent or higher yield rate, if at all |
| In addition, a large amount of prepayments, especially prepayments on loans with interest rates that are high relative to the rest of our portfolio, will likely decrease the net income we anticipate receiving from our assets |
| We may be required to repurchase assets that we have sold or to indemnify holders of our CDOs |
| If any of the assets we originate or acquire and sell or pledge to obtain long-term financing do not comply with representations and warranties that we make about certain characteristics of the assets, the borrowers and the underlying properties, we may be required to repurchase those assets or replace them with substitute assets |
| In addition, in the case of assets that we have sold, we may be required to indemnify persons for losses or expenses incurred as a result of a breach of a representation or warranty |
| Repurchased assets may require a significant allocation of working capital to carry on our books, and our ability to borrow against such assets may be limited |
| Any significant repurchases or indemnification payments could materially and adversely affect our financial condition and operating results |
| The success of our net lease loan business will depend upon our ability to service effectively, or to obtain effective third-party servicing for, the loans we invest in |
| We have entered into a servicing arrangement with Wachovia Bank, NA for servicing of our net lease loans |
| We may in the future undertake to retain the servicing of our loan assets in a taxable subsidiary of ours |
| We cannot assure you that our third-party contractor or we will be able to service the loans according to industry standards |
| Failure to service the loans properly could harm our financial condition and operating results |
| Maintenance of our Investment Company Act of 1940 exemption imposes limits on our operations |
| We intend to continue to conduct our business in a manner that allows us to avoid registration as an investment company under the Investment Company Act of 1940 (the “1940 Act”) |
| Under Section 3(c)(5)(C) of the 1940 Act, entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate” are not treated as investment companies |
| The position of the SEC staff generally requires us to maintain at least 55prca of our assets directly in qualifying real estate interests in order for us to rely on this exemption (the “55prca Requirement”) |
| To constitute a qualifying real estate interest under this 55prca Requirement, a real estate interest must meet various criteria |
| Mortgage securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55prca Requirement |
| Our ownership of these mortgage securities, therefore, is limited by the provisions of the 1940 Act and SEC staff interpretations |
| We cannot assure you that efforts to pursue our investment strategy will not be adversely affected by operation of the 1940 Act |
| 21 _________________________________________________________________ Risks Related to Lease Enhancements Our lease enhancement mechanisms may fail |
| We have developed certain lease enhancement mechanisms designed to reduce the risks inherent in our net lease investments |
| These lease enhancement mechanisms include: • casualty and condemnation insurance policies that protect us from any right the tenant may have to terminate the underlying net lease or abate rent as a result of a casualty or condemnation; and • borrower reserve funds that protect us from any rights the tenant may have to terminate the underlying net lease or abate rent as a result of the failure of the property owner to maintain and repair the property or related common areas |
| These lease enhancement mechanisms may not protect us against all losses |
| For example, our casualty and condemnation policies typically contain exclusions relating to war, insurrection, rebellion, revolution or civil riot and radioactive matter, earthquakes (in earthquake zones) and takings (other than by condemnation) by reason of danger to public health, public safety or the environment |
| In addition, amounts in the borrower reserve fund may be insufficient to cover the cost of maintenance or repairs, and the borrower may fail to perform such maintenance or repairs at its own expense |
| The failure of our lease enhancement mechanisms may result in the loss of our capital invested in, and profits anticipated from, our investment, and could adversely affect our financial condition and operating results |
| We depend on our insurance carriers to provide and honor lease enhancements |
| We presently obtain specialized lease enhancement insurance policies from two carriers |
| The limited number of insurance carriers available to provide lease enhancements restricts our ability to replace such insurers |
| Any of the following developments with respect to our carriers may have a material adverse effect on our financial condition and operating results: • a deterioration in our relationship with one or both of our carriers; • a bankruptcy or other material adverse financial development with respect to one or both of our carriers; and • a dispute as to policy coverage with one or both of our carriers |
| We may fail to analyze leases adequately or apply appropriate lease enhancement mechanisms |
| In determining whether a lease enhancement mechanism is appropriate, we examine the costs and benefits of the lease enhancement mechanism in light of our analysis of the risks associated with the underlying net lease |
| As a result of this analysis, we may decline to apply a lease enhancement mechanism that would otherwise protect us |
| Our failure to analyze leases adequately or apply appropriate lease enhancement mechanisms could cause a decline in the value of our net lease asset and adversely affect our financial condition and operating results |
| Risks Related to Borrowings Leveraging our portfolio is an important component of our strategy and subjects us to increased risk of loss |
| A key component of our strategy is to borrow against, or leverage, our assets to allow us to invest in a greater number of assets and enhance our asset returns |
| However, leverage also subjects us to increased risk of loss |
| The use of leverage may result in increased losses to us in the following ways: • We will rely on the cash flows from the assets financed to fund our debt service requirements |
| Therefore, in the event of a tenant default on its rent payments, our losses are expected to increase as we will need to fund our debt service requirements from other sources |
| • To the extent we have financed our assets under our variable rate short-term borrowing facilities, our debt service requirements will increase as short-term rates rise |
| Therefore, if short-term interest rates rise in excess of the yields on our assets financed, we will be subject to losses |
| • Our lenders will have a first priority claim on the collateral we pledge and the right to foreclose on the collateral |
| Therefore, if we default on our debt service obligations, we would be at risk of losing some or all of our assets |
| • Our short-term borrowing facilities are fully recourse lending arrangements |
| Therefore, if we default on our debt service obligations, our lenders will have general recourse to our company’s assets, rather than limited recourse to just the assets financed |
| 22 _________________________________________________________________ We may not be able to secure long-term financing for our assets |
| We secure long-term financing of our assets to enable us to invest in a greater number of assets and enhance our asset returns |
| Our ability to implement our long-term financing strategy is subject to the following risks: • We may not be able to achieve our desired leverage level due to decreases in the market value of our assets, increases in interest rates and other factors |
| • We are subject to conditions in the mortgage, CDO and other long-term financing markets which are beyond our control, including the liquidity of these markets and maintenance of attractive credit spreads |
| • In the event of an adverse change in the financial condition of our underlying net lease tenant, it may not be possible or it may be uneconomical for us to obtain long-term financing for the subject asset |
| Our inability to implement our long-term financing strategy may cause us to experience lower leveraged returns on our assets than would otherwise be the case, and could have a material adverse effect on our operating results |
| Hedging transactions may not effectively protect us against anticipated risks and may subject us to certain other risks and costs |
| Our current policy is to enter into hedging transactions primarily to protect us from the effect of interest rate fluctuations on our portfolio of net lease assets from the date on which we commit a rate or price to a borrower or seller and until the date our cost to finance the asset on a long-term basis is fixed |
| Our hedging policy exposes us to certain risks, among them the following: • No hedging activity can completely insulate us from the risks associated with changes in interest rates and, therefore, our hedging strategy may not have the desired beneficial impact on our results of operations or financial condition |
| • There will be many market risks against which we may not be able to hedge effectively, including changes in the spreads of corporate bonds, CMBS or CDOs over the underlying US Treasury rates |
| • We may or may not hedge any risks with respect to certain of our asset investments |
| • Our hedging strategy may serve to reduce the returns which we could possibly achieve if we did not hedge certain risks |
| • Because we intend to structure our hedging transactions in a manner that does not jeopardize our status as a REIT, we will be limited in the type of hedging transactions that we may use |
| • Hedging costs increase as the period covered by the hedging increases and during periods of rising and volatile interest rates |
| We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising |
| We may fail to qualify for hedge accounting treatment |
| We record derivative and hedge transactions in accordance with United States generally accepted accounting principles, specifically Statement of Financial Accounting Standards Nodtta 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) |
| Under these standards, we may fail to qualify for hedge accounting treatment for a number of reasons, including, if we use instruments that do not meet the SFAS 133 definition of a derivative (such as short sales), we fail to satisfy SFAS 133 hedge documentation and hedge effectiveness assessment requirements or our instruments are not highly effective |
| If we fail to qualify for hedge accounting treatment, our operating results may suffer because any losses on the derivatives we enter into would be charged to our income statement without any offset from the change in fair value of the related hedged transaction |
| We expect to borrow money under short-term borrowing facilities to fund our net lease asset investments |
| These facilities are uncommitted as the lender must agree to each asset financed |
| We cannot assure you that we will be able to finance assets on these facilities at any given time |
| Our short-term financings may expose us to interest rate risks and margin calls |
| Our borrowings under our short-term borrowing facilities are currently at variable rates and will be adjusted monthly relative to market interest rates |
| Increases in short-term rates will cause our borrowing rates to rise and our net income to 23 _________________________________________________________________ decrease |
| If interest rates on our borrowings rise in excess of the yields on our assets financed, we will be subject to losses on those assets |
| The amount available to us under our short-term borrowing facilities depends in large part on the lender’s valuation of the assets that secure our financings |
| The facilities provide the lender the right, under certain circumstances, to re-evaluate the collateral that secures our outstanding borrowings |
| In the event the lender determines that the value of the collateral has decreased (for example, in connection with a decline in the credit rating of the underlying tenant), it has the right to initiate a margin call |
| A margin call would require us to provide the lender with additional collateral or to repay a portion of the outstanding borrowings at a time when we may not have a sufficient portfolio of assets or cash to satisfy the margin call |
| Any failure by us to meet a margin call could cause us to default on our short-term borrowing facilities and otherwise have a material adverse effect on our financial condition and operating results |
| The use of CDO financings with coverage tests may have a negative impact on our operating results and cash flows |
| We have purchased, and expect to purchase in the future, subordinate classes of bonds in our CDO financings |
| The terms of the CDO securities issued by us include and will include coverage tests that are used primarily to determine whether and to what extent principal and interest proceeds on the underlying assets may be used to pay principal of and interest on the subordinate classes of bonds in the CDO In the event the coverage tests are not satisfied, interest and principal that would otherwise be payable on the subordinate classes may be re-directed to pay principal on the senior bond classes |
| Therefore, failure to satisfy the coverage tests could adversely affect our operating results and cash flows |
| Risks Related to Business Strategy and Policies We face significant competition that could harm our business |
| We are subject to significant competition in each of our business segments |
| We compete with specialty finance companies, insurance companies, investment banks, savings and loan associations, banks, mortgage bankers, mutual funds, institutional investors, pension funds, hedge funds, other lenders, governmental bodies and individuals and other entities, including REITs |
| We may face new competitors and, due to our focus on net lease properties located throughout the United States, and because many of our competitors are locally and/or regionally focused, we may not encounter the same competitors in each region of the United States |
| Many of our competitors will have greater financial and other resources and may have other advantages over our company |
| Our competitors may be willing to accept lower returns on their investments, may have access to lower cost capital and may succeed in buying the assets that we target for acquisition |
| We may incur costs on unsuccessful acquisitions that we will not be able to recover |
| Our failure to compete successfully could have a material adverse effect on our financial condition and operating results |
| Our network of independent mortgage brokers and investment sale brokers may sell investment opportunities to our competitors |
| An important source of our investments comes from independent mortgage brokers and investment sale brokers |
| These brokers are not contractually obligated to do business with us |
| Further, our competitors also have relationships with many of these brokers and actively compete with us in our efforts to obtain investments from these brokers |
| As a result, we may lose potential transactions to our competitors, which could negatively affect the volume and pricing of our investments, which would have a material adverse effect on our financial condition and operating results |
| Our ability to grow our business will be limited by our ability to attract debt or equity financing, and we may have difficulty accessing capital on attractive terms |
| We expect to fund future investments primarily from debt or equity capital |
| Therefore, we are dependent upon our ability to attract debt or equity financing from public or institutional lenders |
| The capital markets have been, and in the future may be, adversely affected by various events beyond our control, such as the United States’ military involvement in the Middle East and elsewhere, the terrorist attacks on September 11, 2001, the ongoing War on Terrorism by the United States and the bankruptcy of major companies, such as Enron Corp |
| Events such as an escalation in the War on Terrorism, new terrorist attacks, or additional bankruptcies in the future, as well as other events beyond our control, could adversely affect the availability and cost of capital for our business |
| As a REIT, we will also be dependent upon the availability and cost of capital in the REIT markets specifically, which can be impacted by various factors such as interest rate levels, the strength of real estate markets and investors’ appetite for REIT investments |
| We cannot assure you that we will be successful in attracting sufficient debt or equity financing to fund future investments, or at an acceptable cost |
| Future offerings of debt and equity may adversely affect the market price of our common stock |
| During 2005, we raised additional capital through the issuance of preferred stock and trust preferred securities |
| We expect to continue to increase our capital resources by making additional offerings of equity and debt securities in the future, which would include classes of preferred stock, common stock and senior or subordinated notes |
| All debt securities and other 24 _________________________________________________________________ borrowings, as well as all classes of preferred stock, will be senior to our common stock in a liquidation of our company |
| Additional equity offerings could dilute our stockholders’ equity, reduce the market price of shares of our common stock, or be of preferred stock having a distribution preference that may limit our ability to make distributions on our common stock |
| Our ability to estimate the amount, timing or nature of additional offerings is limited as these factors will depend upon market conditions and other factors |
| As of December 31, 2005, our company had 21 employees |
| As our asset base continues to grow, we may experience a significant strain on our management, operational, financial and other resources |
| Our ability to manage growth effectively will require us to continue to improve our operational and financial systems, expand our employee base and train and manage our employees and develop additional management expertise |
| Management of growth is especially challenging for us due to our limited financial resources |
| Temporary investment in short-term investments may adversely affect our results |
| Our results of operations may be adversely affected during the period in which we are implementing our investment and leveraging strategies or during any period after which we have received the proceeds of a financing or asset sale but have not invested the proceeds |
| During this time, we may be invested in short-term investments, including CMBS or CDO bonds, corporate bonds, commercial paper, money market funds and US agency debt |
| The concentration of our company’s common stock could have an adverse impact on the value of your investment |
| As of December 31, 2005, approximately 47dtta8prca of our common stock was owned by six unrelated institutional investors (based on SEC filings made by these investors) |
| This concentration of ownership could have an adverse impact on the value of your investment, including as a result of the following: • Trading volume in our stock may be limited, which will reduce the liquidity of your investment |
| • The sale of a significant number of our shares in the open market by a significant stockholder or otherwise could adversely affect our stock price |
| • Although none of these investors on its own controls a majority of our common stock, these owners could determine to act together and given their significant concentration may be able to take actions that are not in your best interest |
| Our board of directors may change our investment and operational policies without stockholder consent |
| Our board of directors determines our investment and operational policies and may amend or revise our policies, including our policies with respect to our REIT status, investment objectives, acquisitions, growth, operations, indebtedness, capitalization and distributions, or approve transactions that deviate from these policies without a vote of or notice to our stockholders |
| Investment and operational policy changes could adversely affect the market price of stock in our company and our ability to make distributions to our stockholders |
| The federal income tax laws governing REITs are complex, and our failure to qualify as a REIT under the federal tax laws will result in adverse tax consequences |
| We intend to operate in a manner that will allow us to qualify as a REIT under the federal income tax laws |
| The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited |
| Accordingly, we cannot be certain that we will be successful in qualifying as a REIT At any time, new laws, interpretations, or court decisions may change the federal tax laws or the federal income tax consequences of our qualification as a REIT If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income |
| Our taxable income would be determined without deducting any distributions to our stockholders |
| We might need to borrow money or sell assets in order to pay any such tax |
| If we cease to qualify as a REIT, we no longer would be required to distribute most of our taxable income to our stockholders |
| Unless the federal income tax laws excused our failure to qualify as a REIT, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT Our ownership limitations may restrict or prevent you from engaging in certain transfers of our stock |
| In order to maintain our REIT qualification, no more than 50prca in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal income tax laws to include various kinds of entities) during the last half of any taxable year |
| “Individuals” for this purpose include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts |
| In order to preserve our REIT qualification, our charter generally prohibits any 25 _________________________________________________________________ person from directly or indirectly owning more than 9dtta9prca in value or in number of shares, whichever is more restrictive, of any class or series of the outstanding shares of our capital stock |
| If anyone transfers shares in a way that would violate our ownership limits, or prevent us from continuing to qualify as a REIT under the federal income tax laws, we will consider the transfer to be null and void from the outset and the intended transferee of those shares will be deemed never to have owned the shares or those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate our ownership limits |
| Anyone who acquires shares in violation of our ownership limits or the other restrictions on transfer in our charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of our stock falls between the date of purchase and the date of redemption or sale |
| Provisions of our charter and Maryland law may limit the ability of a third-party to acquire control of our company |
| Our charter contains restrictions on stock ownership and transfer |
| As described above, our charter contains stock ownership limits |
| These limits may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for stock of our company or otherwise be in the best interest of our stockholders |
| Our charter authorizes our board of directors to amend the charter to increase or decrease the aggregate number of shares of stock we have authority to issue, without any action by the stockholders |
| Issuances of additional shares of stock may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for stock of our company or otherwise be in the best interest of our stockholders |
| Other provisions of our charter and bylaws may delay or prevent a transaction or change of control |
| Our charter and bylaws also contain other provisions that may delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders |
| For example, our charter and bylaws provide that: a two-thirds vote of stockholders is required to remove a director, vacancies on our board may only be filled by the remaining directors, the number of directors may be fixed only by the directors, our bylaws may only be amended by our directors and a majority of shares is required to call a special stockholders meeting |
| Increased market interest rates may reduce the value of our stock |
| We believe that investors consider the dividend distribution rate on shares of REIT stock, expressed as a percentage of the market price of the shares, relative to market interest rates as an important factor in deciding whether to buy or sell the shares |
| If market interest rates go up, prospective purchasers of REIT stock may expect a higher dividend distribution rate |
| Higher interest rates would also likely increase our borrowing costs and might decrease cash available for distribution |
| Thus, higher market interest rates could cause the market price of stock in our company to decline |
| The market price of our stock may vary substantially |
| Various factors can affect the market price of our stock including the following: • actual or anticipated variations in our quarterly results of operations; • the extent of institutional investor interest in our company; • the reputation of REITs generally and the attractiveness of their equity securities in comparison to other equity securities, including securities issued by other real estate companies, and fixed income securities; • changes in expectations of future financial performance or changes in estimates of securities analysts; • fluctuations in stock market prices and volumes; and • announcements by us or our competitors of acquisitions, investments or strategic alliances |
| We depend on our key personnel |
| We depend on the efforts and expertise of our senior management team |
| Although we have entered into employment agreements with most members of our senior management, there is no guarantee that any of them will remain employed with 26 _________________________________________________________________ our company |
| If any member of our senior management team were to die, become disabled or otherwise leave our employ, we may not be able to replace him with a person of equal skill, ability and industry expertise |