| SUNSET FINANCIAL RESOURCES INC Item 1A Risk Factors You should carefully consider all of the risks described in this Form 10-K before making an investment decision |
| If any of the risks described in this Form 10-K actually occur, our business, assets, liquidity, operating results, prospects and financial condition could be materially adversely affected |
| Risks Related to Our Business and Operations We might not be able to operate our business or implement our operating and investment policies successfully |
| The results of our operations depend on many factors, including the availability of future opportunities for the acquisition of residential and commercial mortgage assets, the level and volatility of interest rates, readily accessible short-term and long-term funding alternatives in the financial markets and general economic conditions |
| Moreover, delays in investing the proceeds of any prepayments or repayments on our mortgage assets or the net proceeds of any future debt or equity offering may cause our performance to be weaker than other fully invested mortgage REITs pursuing comparable investment strategies |
| You will not have the opportunity to evaluate the manner in which we invest or the economic merits of particular assets to be acquired by us in the future prior to our investment |
| Furthermore, we face the risk that we might not successfully implement our operating and investment policies or operate our business as described in this Annual Report on Form 10-K for the year ended December 31, 2004 |
| An interruption or reduction in the securitization markets or change in terms offered by these markets could have a material adverse effect on our results of operations, financial condition and business prospects |
| An important source of our funding is securitizations of mortgage loans |
| The securitization market is dependent upon a number of factors, including general economic conditions, the interest rate environment, conditions in the securities market generally and conditions in the mortgage-backed securities market specifically |
| In addition, poor performance of any loans we may securitize in the future could harm our future access to the securitization market |
| Accordingly, a decline in the securitization market or in our ability to obtain attractive terms could have a material adverse effect on our results of operations, financial condition and business prospects |
| 13 ______________________________________________________________________ [38]Table of Contents Reverse repurchase agreements, which are our primary source of financing, involve the risk that the market value of the assets that we are required to repurchase may decline below the repurchase price of the assets we have sold |
| We currently use reverse repurchase agreements as our primary source of financing |
| Reverse repurchase agreements involve sales by us of portfolio assets, concurrently with an agreement by us to repurchase these assets at a later date at a fixed price |
| During the reverse repurchase agreement period, we continue to receive principal and interest payments on these assets |
| At the maturity of the repurchase agreement, we are required to repay the loan and correspondingly receive back our collateral |
| These types of transactions involve the risk that the market value of the assets we sold but are obligated to repurchase will decrease below the amount of our repurchase obligation under the agreement |
| Reductions in the market value of the portfolio assets sold pursuant to a reverse repurchase agreement below the amount of our repurchase obligation may require us to sell additional assets or borrow additional funds to meet our repurchase obligations |
| In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral agreement without delay |
| In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor |
| In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes |
| These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur |
| As a result, these transactions could adversely affect our results of operations and cash available for distribution to our stockholders |
| Failure to maintain adequate funding under warehouse facilities and reverse repurchase agreements may harm our results of operations |
| We fund asset acquisitions primarily through reverse repurchase agreements and securitizations |
| Our inability to enter into reverse repurchase agreements at attractive terms or our inability to find other attractive sources of funding could harm our operations and our overall performance |
| An increase in the cost of financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distributions to our stockholders |
| Our operations are highly leveraged, without limit as to the amount of debt we can incur and any debt incurred will increase our exposure to losses |
| Leverage can reduce the net income available for distributions to stockholders |
| If the interest income on the assets we purchase with borrowed funds fails to cover the cost of the borrowings and any related hedges, we will experience net interest losses and may experience net losses and erosion or elimination of your equity |
| If the value of the assets we pledge to secure loans declines, we will experience losses and may lose our REIT status |
| A substantial portion of our borrowings are in the form of collateralized borrowings |
| If the value of the assets pledged to secure our borrowings were to decline, we would be required to post additional collateral, reduce the amount borrowed or suffer forced sales of the collateral |
| If sales were made at prices lower than the carrying value of the collateral, we would experience additional losses |
| If we are forced to liquidate qualified REIT real estate assets to repay borrowings, there can be no assurance that we will be able to maintain compliance with the REIT provisions of the Internal Revenue Code regarding asset and source of income requirements |
| If we are unable to maintain our status as a REIT, our distributions will not be deductible by us, and our income will be subject to taxation, reducing our earnings available for distribution |
| Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or any of our lenders file for bankruptcy |
| Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay if we file for bankruptcy |
| Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that our lender files for bankruptcy |
| Thus, the use of repurchase agreements exposes our pledged assets to risk in the event of a bankruptcy filing by either our lender or us |
| 14 ______________________________________________________________________ [39]Table of Contents Future revisions to our policies can be made without stockholder consent creating uncertainty for investors that may increase the risk and change the nature of your investment |
| Our board of directors has established our operating and investment policies |
| Although our board of directors has no current intention to do so, these policies may be amended or revised at any time at the discretion of our board without a vote of our stockholders |
| A change in these policies may increase the risk and change the nature of your investment |
| Complying with REIT requirements may force us to liquidate otherwise attractive investments |
| In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75prca of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets |
| The remainder of our investment in securities generally cannot include more than 10prca of the outstanding voting securities of any one issuer or more than 10prca of the total value of the outstanding securities of any one issuer |
| In addition, generally, no more than 5prca of the value of our assets can consist of the securities of any one issuer |
| If we fail to comply with these requirements, we must dispose of a portion of our assets within 30 days after the end of the calendar quarter or otherwise comply with applicable relief provisions in order to avoid losing our REIT status and suffering adverse tax consequences |
| We use hedging strategies that involve risk and that may not be successful in insulating us from exposure to changing interest and prepayment rates |
| From time to time, we enter into hedging transactions primarily to protect ourselves from the effect of interest rate fluctuations on our floating rate borrowings and also to protect our portfolio of mortgage assets from interest rate fluctuations |
| Because the decision to engage in particular hedging activities depends upon market conditions, we cannot quantify the extent to which any particular hedging activity will be utilized in the future |
| These hedging activities include, among other derivative securities, short sales, purchases of treasury options, mortgage-backed securities and futures, interest rate swaps, swaptions, caps and floors and other transactions involving derivative securities |
| There can be no assurance that our hedging activities will have the desired beneficial impact on our results of operations or financial condition |
| Moreover, no hedging activity can completely insulate us from the risks associated with changes in interest rates |
| Our directors are responsible for reviewing the extent and effect of our hedging activities |
| The amount of income we may earn from our hedging instruments is subject to limitations under the REIT provisions of the Internal Revenue Code |
| These limitations may result in management electing to have us bear a level of interest rate risk that could otherwise be hedged when management believes, based on all relevant facts, that bearing such risk is advisable to maintain our status as a REIT Interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates, which could harm our results of operations |
| During periods of rising and volatile interest rates, there is a higher demand for hedging transactions as parties seek to mitigate the risks associated with the interest rate environment |
| A greater demand for hedging transactions makes entering into those transactions more expensive, even though the potential benefits of hedging remain relatively constant |
| To the extent more parties seek to hedge interest rate risk, we may incur greater expense to enter into such transactions, which could adversely affect our results of operations |
| Complying with REIT requirements may limit our ability to hedge effectively |
| The existing REIT provisions of the Internal Revenue Code substantially limit our ability to hedge our mortgage loan assets |
| Under these provisions, our annual income from qualified hedges, together with any other income not generated from qualified REIT real estate assets, is limited to less than 25prca of our gross income |
| In addition, we must limit our aggregate income from hedging and services from all sources, other than from qualified REIT real estate assets or qualified hedges, to less than 5prca of our annual gross income |
| As a result, we might in the future have to limit our use of advantageous hedging techniques |
| This could leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear |
| If we were to violate the 25prca or 5prca limitations, we might have to pay a penalty tax equal to the amount of our income in excess of those limitations, multiplied by a fraction intended to reflect our profitability |
| If we fail to satisfy the 25prca or 5prca limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for federal income tax purposes |
| We may not be able to achieve our leverage goals, which could cause us to experience losses or reduced profits |
| Our ability to achieve our investment objectives depends to a significant extent on our ability to borrow money in sufficient amounts and at rates lower than the interest rates earned on our mortgage loans and mortgage-backed securities |
| We 15 ______________________________________________________________________ [40]Table of Contents may not be able to achieve the degree of leverage we believe to be optimal due to decreases in the number of our mortgage assets we can borrow against, decreases in the market value of our mortgage assets, changes in the availability of financing in the market, conditions then applicable in the lending market and other factors |
| This may cause us to experience losses or reduced profits |
| Risks Related to Mortgage Assets and Our Acquisition Activities Interest rate fluctuations will affect the value of our mortgage assets, our net income and the market value of our net assets |
| Interest rates 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 |
| Interest rate fluctuations can adversely affect our income and the value of our common stock in many ways and present a variety of risks, including the risk that our borrowing rates exceed our asset yields |
| Our operating results depend in large part on differences between the income from our assets (net of credit losses) and our borrowing costs |
| We anticipate that, in most cases, the income from our assets will respond more slowly to interest rate fluctuations than the cost of our borrowings, creating a potential mismatch between asset yields and borrowing rates |
| Consequently, increases in the cost of our borrowings will tend to decrease our net income and market value of our net assets |
| Interest rate fluctuations resulting in our interest expense exceeding interest income on our assets would result in our incurring operating losses |
| Variances in the yield curve may adversely affect our net income and the market value of our net assets |
| The relationship between short-term and long-term interest rates is often referred to as the “yield curve |
| ” Ordinarily, short-term interest rates are lower than long-term interest rates |
| Over the past year short-term interest rates have risen disproportionately relative to long-term interest rates (a flattening of the yield curve), and our borrowing costs have therefore increased more rapidly than the interest income earned on our assets |
| Because our borrowings bear interest at short-term rates and our assets bear interest at medium-term to long-term rates, a flattening of the yield curve will tend to decrease our net income and market value of our net assets |
| Additionally, to the extent cash flows from long-term assets that return scheduled and unscheduled principal are reinvested, the spread between the yields of the new assets and available borrowing rates may decline and also may tend to decrease the net income and market value of our net assets |
| It is also possible that short-term interest rates may adjust relative to long-term interest rates such that the level of short-term rates exceeds the level of long-term rates (a yield curve inversion) |
| In this case, our borrowing costs may exceed our interest income and we could incur operating losses |
| Prepayment rates on our mortgage assets could increase, thus adversely affecting our yields |
| The value of our mortgage assets may be affected by prepayment rates |
| Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, prepayment rates cannot be predicted with certainty |
| In periods of declining mortgage interest rates, prepayments on mortgage assets generally increase |
| If general interest rates decline as well, the prepayment proceeds received during these periods are likely to be reinvested by us in assets yielding less than the yields on the investments that were prepaid |
| In addition, the market value of the mortgage assets may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates |
| Conversely, in periods of rising interest rates, prepayments on mortgage assets generally decrease, in which case we would not have the prepayment proceeds available to invest in assets with higher yields |
| Under certain interest rate and prepayment scenarios, we may fail to recoup fully our cost of acquisition of certain investments |
| In addition, prepayments of loans receivable may affect our “spread” on any pools of mortgage loans that we securitize |
| Prepayments of mortgage loans that have higher interest rates negatively impact the value of our retained interests to a greater extent than prepayments of loans that have lower interest rates |
| Prepayments in excess of our assumptions will cause a decline in the value of our retained interests primarily relating to the excess funds expected from our securitization transactions |
| We might experience reduced net interest income or a loss from holding fixed rate investments during periods of rising interest rates |
| We may fund our acquisition of fixed rate mortgage assets with short-term floating rate debt instruments |
| During periods of rising interest rates, our costs associated with borrowings used to fund the acquisition of fixed rate mortgage assets are subject to increases while the income we earn from these assets remains substantially fixed |
| This would reduce and could eliminate the net interest spread between the fixed rate mortgage assets that we purchase and our borrowings used to purchase them, which would reduce our net interest income and could cause us to suffer a loss |
| 16 ______________________________________________________________________ [41]Table of Contents We may be subject to the risks associated with inadequate or untimely services from loan-servicers, which may adversely affect our results of operations |
| We do not service our residential loans or our securitized residential loans |
| This allows us to increase the volume of the assets we purchase without incurring the expenses associated with servicing operations |
| However, as with any external service provider, we are subject to the risks associated with inadequate or untimely services |
| Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures |
| A substantial increase in our delinquency rate that results from improper servicing or mortgage loan performance in general could adversely affect our ability to securitize our mortgage loans in the future |
| Our investment strategy includes acquiring commercial mortgage assets which generally involve a greater risk of loss than residential mortgage assets |
| Commercial mortgage assets are considered to involve a higher degree of risk than residential mortgage assets because of a variety of factors, including generally larger loan balances, dependency for repayment on successful operation of the mortgaged property and non-owner tenant operators operating on the property, and loan terms that include balloon payments at stated maturity rather than periodic principal payments |
| We have risk of loss on our mortgage assets |
| The value of our residential and commercial mortgage assets may be affected adversely by a number of factors, including, but not limited to: • national, regional and local economic conditions; • changes or continued weakness in specific industry segments; • declining real estate property values; • geographic concentration of our mortgage loans and natural hazard risks affecting those regions; • with respect to commercial property, perceptions by prospective tenants, retailers and shoppers of the safety, convenience, services and attractiveness of the property; • with respect to commercial property, the willingness and ability of the property’s owner to provide capable management and adequate maintenance; • construction quality, age and design; • demographic factors; • retroactive changes to building or similar codes; and • increases in operating expenses (such as energy costs) |
| Our investment strategy includes investing in commercial mortgage bridge loans that are not secured by income producing real properties, which involves greater risks of loss |
| We have acquired entire commercial mortgage bridge loans and those in which we share ownership with other interest holders, secured by property which is not income-producing |
| The loans involve a higher degree of risk than long-term senior mortgage loans secured by income-producing real property |
| This increased risk is due to of a variety of factors, including difficulties in finding suitable long-term financing and loan terms that often require little or no amortization |
| We are subject to certain risks as the result of our commercial mortgage bridge loans that we own jointly with other interest holders |
| At December 31, 2005, our portfolio contained a commercial mortgage bridge loan that we own jointly with other interest holders |
| A commercial mortgage bridge loan that we own jointly with other interest holders entitles us, as a holder of an interest to participate in the economic benefits and losses of the loan in proportion to the interest we hold |
| With respect to this loan all holders of interests share joint title to the loan |
| Therefore, we are a joint owner of a commercial mortgage bridge loan with third parties |
| Under certain circumstances, such joint ownership of a commercial mortgage bridge loan may involve 17 ______________________________________________________________________ [42]Table of Contents risks not otherwise present with other methods of owning commercial mortgage bridge loans |
| Examples of these risks include the following: • entities with which we own the loan may become insolvent or bankrupt; • entities with whom we own the loan may have economic or other business interests or objectives that are inconsistent with our business interests or objectives, including inconsistent objectives relating to the foreclosure of property underlying a particular commercial mortgage bridge loan or the timing of the termination and liquidation of the joint business arrangement; • we may incur liabilities (including unexpected liabilities) as the result of actions taken by entities with whom we own the loan; or • entities with whom we own the loan may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives, including our policy with respect to qualifying and maintaining our qualification as a REIT If we have a right of first refusal or buy/sell right to buy out another owner’s interest in a commercial mortgage bridge loan, we may be unable to finance such a buy-out if it becomes exercisable or we may be required to purchase such interest at a time when it would not otherwise be in our best interest to do so |
| If our interest is subject to a buy/sell right, we may not have sufficient cash available, borrowing capacity or other capital resources to allow us to elect to purchase the interest of these co-owners subject to the buy/sell right, in which case we may be forced to sell our interest as the result of the exercise of such right when we would otherwise prefer to keep our interest |
| Finally, we may not be able to sell our interest in commercial mortgage bridge loans that we own jointly with other interest holders if we desire to exit for any reason or if our interest is likewise subject to a right of first refusal of the co-owners of the loan, our ability to sell such interest may be adversely impacted by such right |
| Competition might prevent us from acquiring new mortgage assets at favorable yields, which would harm our results of operations |
| Our net income depends on our ability to acquire new mortgage assets at favorable spreads over our borrowing costs |
| In acquiring mortgage assets, we compete with other REITs, investment banking firms, savings and loan associations, banks, insurance companies, mortgage companies, mutual funds and other lenders and entities that purchase mortgage assets, many of which have greater financial resources than we do |
| As a result, we may not be able to acquire sufficient mortgage assets at favorable spreads over our borrowing costs, which would harm our results of operations |
| We may not be successful in identifying suitable new acquisitions that meet our criteria, which may impede our growth and negatively affect our results of operations |
| Our ability to expand through acquisitions of loan portfolios is integral to our business strategy and requires us to identify suitable acquisition candidates or investment opportunities that meet our criteria and are compatible with our growth strategy |
| We may not be successful in identifying suitable assets that meet our acquisition criteria or in consummating acquisitions on suitable terms |
| Failure to identify or consummate new acquisitions will reduce the number of acquisitions we complete and slow our growth, which could in turn adversely affect our stock price |
| Our mortgage assets may be concentrated in specific geographic regions and any adverse market or economic conditions in those regions may have a disproportionately adverse effect on the ability of our customers to make their loan payments |
| Our mortgage assets in our portfolio are and may continue to be concentrated in specific geographic regions |
| Adverse market or economic conditions in a particular region may disproportionately increase the risk that borrowers in that region are unable to make their mortgage payments |
| In addition, the market value of the real estate securing those mortgage loans could be adversely affected by adverse market and economic conditions in that region |
| Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in that geographic region could adversely affect both our net interest income from assets in our portfolio as well as our ability to sell and securitize loans, which would significantly harm our revenues and results of operations |
| We may be required to repurchase mortgage loans that we have sold or to indemnify holders of our mortgage-backed securities |
| If any of the mortgage loans that we securitize do not comply with the representations and warranties that we make about the characteristics of the loans, the borrowers and the properties securing the loans, we may be required to repurchase 18 ______________________________________________________________________ [43]Table of Contents those loans that we have securitized, or replace them with substitute loans or cash |
| If this occurs, we may have to bear any associated losses directly |
| In addition, we may be required to indemnify the purchasers of such loans for losses or expenses incurred as a result of a breach of a representation or warranty made by us |
| Repurchased loans typically require an allocation of working capital to carry on our books, and our ability to borrow against such assets is limited, which could limit the amount by which we can leverage our equity |
| Any significant repurchases or indemnification payments could significantly harm our cash flow and results of operations |
| New legislation may restrict our ability to acquire and sell mortgage loans, negatively impeding our revenues |
| In recent years, federal and several state and local laws, rules and regulations have been adopted, or are under consideration, that are intended to eliminate certain lending practices, often referred to as “predatory” lending practices, that are considered to be abusive |
| Many of these laws, rules and regulations restrict commonly accepted lending activities and impose additional costly and burdensome compliance requirements |
| These laws, rules and regulations impose certain restrictions on loans on which certain points and fees or the annual percentage rate, or APR, meets or exceeds specified thresholds |
| Some of these restrictions expose a lender to risks of litigation and regulatory sanction regardless of how carefully a loan is underwritten |
| In addition, an increasing number of these laws, rules and regulations seek to impose liability for violations on the purchasers of mortgage loans, regardless of whether a purchaser knew of or participated in the violation |
| Accordingly, as a purchaser of mortgage loans, in certain states we may be subject to liability for any loans that do not comply with these laws, rules and regulations |
| In addition, the third parties that purchase or provide financing for our loans will not want and will not be contractually required, to purchase or finance loans that do not comply with these laws, rules and regulations |
| The difficulty of managing the compliance risks presented by these laws, rules and regulations may decrease the availability of warehouse financing and the overall demand for the purchase of our loans |
| These laws, rules and regulations will increase our cost of doing business as we will be required to develop systems and procedures to ensure that we do not violate any aspect of these requirements |
| Our goal is to avoid purchasing loans that meet or exceed the APR or “points and fees” threshold of these laws, rules and regulations |
| If we elect to relax our self-imposed restrictions on purchasing loans, subject to these laws, rules and regulations, we will be subject to greater risks for actual or perceived non-compliance with the laws, rules and regulations, including demands for indemnification or loan repurchases from the parties to whom we broker or sell loans, class action lawsuits, increased defenses to foreclosure of individual loans in default, individual claims for significant monetary damages, and administrative enforcement actions |
| Any of the foregoing could significantly harm our business, cash flow, financial condition, liquidity and results of operations |
| Failure to maintain an exemption from the Investment Company Act would harm our results of operations |
| We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended |
| If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as described in this prospectus |
| The Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on, and interests in, real estate |
| Under the current interpretation of the SEC staff, in order to qualify for this exemption, we must maintain at least 55prca of our assets directly in these qualifying real estate interests |
| Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55prca requirement |
| Therefore, our ownership of these mortgage-backed securities is limited by the provisions of the Investment Company Act |
| In satisfying the 55prca requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates |
| If the SEC or its staff adopts a contrary interpretation of such treatment, we could be required to sell a substantial amount of our mortgage-backed securities under potentially adverse market conditions |
| Further, in our attempts to ensure that we at all times qualify for the exemption under the Investment Company Act, we might be precluded from acquiring mortgage-backed securities if their yield is higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption |
| 19 ______________________________________________________________________ [44]Table of Contents One-action rules may harm the value of the security interest |
| Several states have laws that prohibit more than one action to enforce a mortgage obligation, and some courts have construed the term “action” broadly |
| In such jurisdictions, if the judicial action is not conducted according to law, there may be no other recourse in enforcing a mortgage obligation, thereby decreasing the value of the security interest |
| If we fail to remain qualified as a REIT, our distributions will not be deductible by us, and our income will be subject to taxation, reducing our earnings available for distribution |
| We intend to remain qualified as a REIT under the Internal Revenue Code, which will afford us significant tax advantages |
| The requirements for this qualification, however, are highly technical and complex and even a technical or inadvertent mistake could jeopardize our REIT status |
| If we fail to meet these requirements and lose our REIT qualification, our distributions will not be deductible by us and we will have to pay a corporate level tax on our income |
| This would substantially reduce our earnings, our cash available to pay distributions and your yield on your investment in our common stock |
| In addition, such a tax liability might cause us to borrow funds, liquidate some of our investments or take other steps which could negatively affect our operating results |
| Moreover, if our REIT status is terminated because of our failure to meet a technical REIT requirement or if we voluntarily revoke our election, we would not qualify as a REIT for the year in which we lost or revoked our REIT election and we would generally be disqualified from electing treatment as a REIT for the four taxable years following the year in which our REIT status was lost |
| We may be unable to comply with the strict income distribution requirements applicable to REITs or compliance with such requirements could adversely affect our financial condition |
| To obtain the favorable treatment associated with qualifying as a REIT, we must distribute to our stockholders with respect to each year at least 90prca of our REIT taxable income |
| In addition, we are subject to a tax on the undistributed portion of our income at regular corporate rates and also may be subject to a non-deductible 4prca excise tax on this undistributed income |
| We could be required to either sell assets or borrow funds on a short-term basis to meet the distribution requirements that are necessary to achieve the tax benefits associated with qualifying as a REIT, even if conditions are not favorable for borrowing, which could adversely affect our financial condition |
| Our ability to satisfy the income and asset tests applicable to REITs depends on the nature of our assets, the sources of our income, and factual determinations, including the value of the real property underlying our loans |
| As a REIT, 75prca of our assets must consist of specified real estate related assets and other specified types of investments, and 75prca of our gross income must be earned from real estate related sources and other specified types of income |
| If the value of the real estate securing each of our loans, determined at the date of acquisition of the loans, is less than the highest outstanding balance of the loan for a particular taxable year, then a portion of that loan will not be a qualifying real estate asset and a portion of the interest income will not be qualifying real estate income |
| Accordingly, in order to determine the extent to which our loans constitute qualifying assets for purposes of the REIT asset tests and the extent to which the interest earned on our loan constitutes qualifying income for purposes of the REIT income tests, we need to determine the value of the underlying real estate collateral at the time we acquire each loan |
| Although we seek to be prudent in making these determinations, there can be no assurance that the IRS might not disagree with our determinations and assert that a lower value is applicable, which could negatively impact our ability to qualify as a REIT These considerations also might restrict the types of loans that we can make in the future |
| In addition, the need to comply with those requirements may cause us to acquire other assets that qualify as real estate that are not part of our overall business strategy and might not otherwise be the best investment alternative for us |
| The tax on prohibited transactions limits our ability to engage in transactions, including certain methods of securitizing mortgage loans, that would be treated as sales for federal income tax purposes |
| A REIT’s net income from prohibited transactions is subject to a 100prca tax |
| In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held primarily for sale to customers in the ordinary course of business |
| We might be subject to this tax if we were to sell or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes |
| Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial for us |
| 20 ______________________________________________________________________ [45]Table of Contents Even if we qualify as a REIT, the income earned by a taxable REIT subsidiary will be subject to federal income tax |
| We formed a taxable REIT subsidiary on November 14, 2003 and may in the future own one or more additional taxable REIT subsidiaries |
| We expect that these entities will earn income that might otherwise jeopardize our status as a REIT A taxable REIT subsidiary is taxed as a regular C corporation, and the income from the activities described above, and other income earned by our taxable REIT subsidiaries will therefore be subject to a corporate level tax, notwithstanding that we qualify as a REIT The REIT qualification rules impose limitations on the types of investments and activities that we may undertake which may preclude us from pursuing the most economically beneficial investment alternatives |
| In order to qualify as a REIT, we must satisfy certain income and asset tests, which require that a specified percentage of our income and assets be comprised of certain types of income and assets |
| Satisfying these requirements might limit our ability to undertake investments and activities that would otherwise be beneficial to us |
| For example, hedging instruments are not qualifying assets for purposes of the REIT asset tests, and income from hedging instruments is not qualifying income for purposes of the 75prca income test |
| Moreover, only income from hedging instruments that reduce the interest rate risk with respect to debt incurred by us to acquire or carry real estate assets is qualifying income for purposes of the 95prca income test |
| Therefore, in order to maintain our qualification as a REIT, we may choose not to engage in certain hedging transactions, even though such transactions might otherwise be beneficial for us |
| The “taxable mortgage pool” rules limit the manner in which we effect securitizations |
| There is a significant likelihood that our securitizations would be considered to result in the creation of taxable mortgage pools |
| As a REIT, so long as we own 100prca of the equity interests in the taxable mortgage pool, we are not adversely affected by the characterization of our securitizations as taxable mortgage pools (assuming that we do not have any stockholders who might cause a corporate income tax to be imposed upon us by reason of our owning a taxable mortgage pool) |
| We are precluded, however, from selling to outside investors equity interests in our securitizations or from selling any debt securities issued in connection with the securitization that might be considered to be equity interests for tax purposes |
| These limitations preclude us from using certain techniques to maximize our returns from securitization transactions |
| Recent change in taxation of corporate distributions may adversely affect the value of our shares |
| The Jobs and Growth Tax Relief Reconciliation Act of 2003 that was signed into law on May 28, 2003, among other things, generally reduces to 15prca the maximum marginal rate of tax payable by domestic non-corporate taxpayers on distributions received from a regular C corporation |
| This reduced tax rate, however, will not apply to distributions made to individuals by a REIT on its stock, except for certain limited amounts |
| While the earnings of a REIT that are distributed to its stockholders will still generally be subject to less federal income taxation than earnings of a non-REIT C corporation that are distributed to its stockholders net of corporate-level income tax, this legislation could cause individual investors to view the stock of regular C corporations as more attractive relative to the stock of a REIT than was the case prior to the enactment of the legislation |
| This may be the case because the distributions from regular C corporations would generally be taxed at a lower rate while distributions from REITs will generally be taxed at the same rate as the individual’s other ordinary income |
| We cannot predict what effect, if any, the enactment of this legislation may have on the value of the stock of REITs in general or on our common stock in particular, either in terms of price or relative to other investments |