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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to____________________
Commission File No. 1-10150
STARWOOD FINANCIAL TRUST
(Exact name of registrant as specified in its charter)
Maryland 95-6881527
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
1114 Avenue of the Americas 10036
27th Floor (Zip Code)
New York, NY 10036
(Address of principal executive offices)
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Registrant's telephone number, including area code: (212) 930-9400
Securities registered pursuant to Section 12(b) of the Act:
Title of each class: Name of Exchange on which registered:
-------------------- -------------------------------------
Class A Shares, $1.00 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES [ X ] NO [ ]
--- ---
As of November 9, 1998, there were 52,407,718 Class A Shares of Starwood
Financial Trust, $1.00 par value, outstanding.
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STARWOOD FINANCIAL TRUST
INDEX TO FORM 10-Q
Page
----
PART I. CONSOLIDATED FINANCIAL INFORMATION.......................... 3
ITEM 1. FINANCIAL STATEMENTS:
CONSOLIDATED BALANCE SHEETS AT SEPTEMBER 30, 1998 AND
DECEMBER 31, 1997...................................... 3
CONSOLIDATED STATEMENTS OF OPERATIONS - FOR THE THREE AND NINE
MONTH PERIODS ENDED SEPTEMBER 30, 1998 AND 1997........ 4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY -
FOR THE NINE MONTH PERIOD ENDED SEPTEMBER 30, 1998..... 5
CONSOLIDATED STATEMENTS OF CASH FLOWS - FOR THE THREE AND NINE
MONTH PERIODS ENDED SEPTEMBER 30, 1998 AND 1997........ 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS................... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................... 16
PART II. OTHER INFORMATION............................................ 20
ITEM 1. LEGAL PROCEEDINGS............................................ 20
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.................... 20
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.............................. 20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......... 20
ITEM 5. OTHER INFORMATION............................................ 20
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................. 20
SIGNATURES................................................... 21
2
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PART I - CONSOLIDATED FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
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STARWOOD FINANCIAL TRUST
CONSOLIDATED BALANCE SHEETS
(In thousands)
SEPTEMBER 30, DECEMBER 31,
1998 1997*
--------- -------
(unaudited)
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ASSETS
Loans and other investments, net (Note 5) $1,760,167 $ 90
Cash and cash equivalents 6,291 296
Marketable securities 6,117 11,085
Accrued interest and rent receivable 15,095 58
Deferred expenses and other assets 8,952 1,912
---------- -------
Total assets $1,796,622 $13,441
========== =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable, accrued expenses and other liabilities $ 10,843 $ 1,915
Debt obligations (Note 6) 1,014,672 -
---------- -------
Total liabilities 1,025,515 1,915
---------- -------
Minority interest - 5,175
---------- -------
Commitments and contingencies - -
Shareholders' equity:
Class A Shares, $1.00 par value, unlimited shares authorized,
52,407,718 (1) and 7,550,000 shares issued and outstanding
at September 30, 1998 and December 31, 1997, respectively 52,408 7,550
Class B Shares, $0.01 par value, unlimited shares authorized,
26,203,859(1) and 3,775,000 shares issued and outstanding
at September 30, 1998 and December 31, 1997, respectively 262 38
Net unrealized gains (losses) on "available-for-sale" investments (22) (162)
Additional paid in capital 701,107 -
Retained earnings (deficit) 17,352 (1,075)
---------- -------
Total shareholders' equity 771,107 6,351
---------- -------
Total liabilities and shareholders' equity $1,796,622 $13,441
========== =======
*RECLASSIFIED TO CONFORM TO 1998 PRESENTATION.
(1) As adjusted for one-for-six reverse stock split effective June 19, 1998 (Note 1)
The accompanying notes are an integral part of the financial statements.
3
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STARWOOD FINANCIAL TRUST
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
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FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- -------------------------
1998 1997 1998 1997
------- ----- ------- -----
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REVENUE:
Interest income $36,398 $ 246 $68,910 $ 704
Operating lease income 4,350 - 8,624 -
Other income 1,329 - 2,213 2
------- ----- ------- -----
Total revenue 42,077 246 79,747 706
------- ----- ------- -----
COSTS AND EXPENSES:
Interest expense 14,978 - 25,472 -
Operating lease depreciation 1,374 - 2,943 -
General and administrative 964 104 1,777 261
Advisory fees 2,826 - 4,817 -
Provision for possible credit losses 1,000 - 1,750 -
Stock option compensation expense (Note 9) - - 5,985 -
------- ----- ------- -----
Total costs and expenses 21,142 104 42,744 261
------- ----- ------- -----
Net income before minority interest 20,935 142 37,003 445
Minority interest - (140) (54) (420)
------- ----- ------- -----
Net income $20,935 $ 2 $36,949 $ 25
======= ===== ======= =====
Basic earnings per Class A Share(1) $ 0.40 $0.00 $ 0.96 $0.02
======= ===== ======= =====
Diluted earnings per Class A Share(1) $ 0.38 $0.00 $ 0.94 $0.01
======= ===== ======= =====
(1) As adjusted for one-for-six reverse stock split effective June 19, 1998 (Note 1)
The accompanying notes are an integral part of the financial statements.
4
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STARWOOD FINANCIAL TRUST
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(IN THOUSANDS)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
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NET
UNREALIZED
PAR VALUE GAINS ADDITIONAL RETAINED
CLASS A CLASS B (LOSSES) ON PAID-IN EARNINGS
SHARES SHARES INVESTMENTS CAPITAL (DEFICIT) TOTAL
--------- ------- ----------- ---------- --------- --------
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Balance at December 31, 1997* $ 7,550 $ 38 $(162) $ - $ (1,075) $ 6,351
Recapitalization Transactions (Note 4) 306,796 1,534 - 432,084 - 740,414
Issuance of options to the Advisor (Note 9) - - - 5,985 - 5,985
Effective exercise of options 18 - - 252 - 270
Change in net unrealized gains (losses)
on investments - - 140 - - 140
Dividends paid - - - - (18,522) (18,522)
Effects of reorganization(1) (Note 1) (261,956) (1,310) - 262,786 - (480)
Net income for the period - - - - 36,949 36,949
--------- ------- ----- -------- ------- --------
Balance as of September 30, 1998 $ 52,408 $ 262 $ (22) $701,107 $17,352 $771,107
========= ======= ===== ======== ======= ========
* RECLASSIFIED TO CONFORM TO 1998 PRESENTATION.
(1) As adjusted for 1-for-six reverse stock split effective June 19, 1998 (Note 1)
The accompanying notes are an integral part of the financial statements.
5
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STARWOOD FINANCIAL TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
FOR THE FOR THE
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------------
1998 1997 1998 1997
--------- -------- ----------- ---------
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Cash flows from operating activities:
Net income $ 20,935 $ 2 $ 36,949 $ 25
Adjustments to reconcile net income to cash flows provided
by operating activities:
Minority interest - 140 54 420
Non-cash expense for options issued to Advisor (Note 9) - - 5,985 -
Equity in earnings of unconsolidated joint ventures and subsidiaries (690) - (690) -
Depreciation and amortization 2,363 - 4,870 -
Amortization of discount/premium and deferred interest (5,837) - (14,158) -
Provision for possible credit losses 1,000 - 1,750 -
Changes in assets and liabilities:
Increase in accrued interest and rent receivable (2,059) - (7,586) -
Decrease in deferred expenses and other assets 329 9 3,270 -
Increase in accounts payable, accrued
expenses and other liabilities 4,179 24 9,146 59
--------- ------- ----------- --------
Cash flows provided by operating activities 20,220 175 39,590 504
--------- ------- ----------- --------
Cash flows from investing activities:
Net cash outflow for the Recapitalization Transactions (Notes 3 & 4) - - (334,916) -
New loan originations/acquisitions (517,564) (10,249) (723,664) (16,255)
Principal fundings on existing loan commitments (500) - (10,500) -
Investment in unconsolidated joint venture (Note 5) (47,252) - (47,252) -
Repayments of and principal collections from loans and
other investments 87,375 5,149 95,840 9,781
--------- ------- ----------- --------
Cash flows provided by (used in) investing activities (477,941) (5,100) (1,020,492) (6,474)
--------- ------- ----------- --------
Cash flows from financing activities:
Proceeds from issuance of Class B Shares - - 1,534 -
Net borrowings under revolving credit facilities 310,192 - 605,814 -
Net borrowings under term loans 171,172 - 374,936 -
Borrowings under repurchase agreements (3,385) - 33,921 -
Dividends paid (18,522) - (18,522) -
Payment for deferred financing costs (1,623) - (10,310) -
Costs incurred in reorganization - - (480) -
Proceeds from exercise of options (Note 4) - - 4 -
Proceeds from exercise of warrants (Note 4) - - - 4,924
--------- ------- ----------- --------
Cash flows provided by financing activities 457,834 - 986,897 4,924
--------- ------- ----------- --------
Increase (decrease) in cash and cash equivalents 113 (4,925) 5,995 (1,046)
Cash and cash equivalents at beginning of period 6,178 5,767 296 1,888
--------- ------- ----------- --------
Cash and cash equivalents at end of period $ 6,291 $ 842 $ 6,291 $ 842
========= ======= =========== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for interest $ 12,644 $ - $ 19,186 $ -
========= ======= =========== ========
The accompanying notes are an integral part of the financial statements.
6
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STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND BUSINESS
ORGANIZATION - Starwood Financial Trust (the "Company") was formed for the
purpose of originating and acquiring various types of mortgage and other real
estate-related financial investments. Through a series of transactions during
1994 and 1996, Starwood Mezzanine Investors, L.P. ("Starwood Mezzanine") and
certain affiliates of the general partner of Starwood Mezzanine (SAHI, Inc. and
SAHI Partners) acquired control of the Company.
On September 26, 1996, the Company became the sole general partner of APMT
Limited Partnership (the "Partnership") (see Note 4). As discussed in Note 4,
on March 18, 1998, all the outstanding interests in the Partnership not held by
the Company were exchanged for additional $1.00 par value Class A Shares (the
"Class A Shares") of the Company, the Company became the sole partner of the
Partnership and the Partnership was terminated.
Also as more fully described in Note 4, on March 18, 1998, the Company
entered into a series of transactions approved by the Company's shareholders
with Starwood Mezzanine and Starwood Opportunity Fund IV, L.P. ("SOF IV") (an
affiliate of the general partners of Starwood Mezzanine), which, among other
things, substantially recapitalized the Company and modified its investment
policy (Starwood Mezzanine, SOF IV, SAHI, Inc. and SAHI Partners are
collectively referred to as the "Starwood Investors").
Effective June 18, 1998, the Company (which had previously been organized
under California law) changed its domicile to Maryland by merging with a
newly-formed subsidiary organized under Maryland Law and issued new shares of
the subsidiary to its shareholders in exchange for the previous shares of the
Company. Concurrently, the Company consummated a one-for-six(1) reverse stock
split.
During 1993 through 1997, the Company failed to qualify as a real estate
investment trust ("REIT") under the Internal Revenue Code of 1986, as amended
(the "Code"). However, pursuant to a Closing Agreement with the Internal
Revenue Service (the "IRS") obtained in March 1998, the Company will be eligible
to and intends to elect to be taxed as a REIT for the taxable year beginning
January 1, 1998.
BUSINESS - The Company is a specialized finance company focused exclusively
on the commercial real estate industry and is a leading provider of flexible
mortgage, mezzanine and lease financing. The Company's mission is to maximize
risk-adjusted returns on equity by providing innovative and value-added
financing solutions to the real estate industry.
The Company originates and acquires investments in various types of
income-producing commercial real estate loans. The Company's investment program
emphasizes senior and junior commercial mortgage loans, including mezzanine
financing, higher-yielding senior mortgage loans and non-performing or
sub-performing loans. The Company anticipates that a portion of the investments
to be held in its portfolio on a long-term basis will be structured so that the
Company's investment is subordinate to third-party first mortgage debt but
senior to the real estate owner/operator's equity position.
NOTE 2 - BASIS OF PRESENTATION
The accompanying audited consolidated financial statements have been
prepared in conformity with the instructions to Form 10-Q and article 10, Rule
10-01 of Regulations S-X for interim financial statements. Accordingly, they do
not include all of the information and footnotes required by generally accepted
accounting principles ("GAAP") for complete financial statements. The
consolidated financial statements include the accounts of the Company and its
qualified REIT subsidiaries. Certain third-party mortgage servicing operations
are conducted through Starwood Operating, Inc. ("Starwood Operating"), a taxable
corporation, which is not consolidated with the Company for financial reporting
or income tax purposes. The Company owns all of the preferred stock and a 95%
economic interest in Starwood Operating, which is accounted for under the equity
method for financial reporting purposes.
In the opinion of management, the accompanying financial statements contain
all adjustments, consisting of normal and recurring accruals, necessary for a
fair presentation of the Company's financial condition at September 30, 1998 and
the results of its operations, changes in shareholders' equity and its cash
flows for the three and nine month periods ended September 30, 1998 and 1997.
Such operating results are not necessarily indicative of the results that may be
expected for any other interim periods or the entire year.
NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
LOANS AND OTHER INVESTMENTS, NET - As described in Note 5, loans and other
investments, net includes the following investments: senior mortgages, junior
mortgages, opportunistic mortgages, partnership loans, construction loans,
investments in real estate under operating leases, loan participations and
investments in certain real estate related marketable securities. In general,
management considers its loan and marketable real estate related securities
investments as held-to-maturity and, accordingly, reflects such items at
amortized historical cost.
_____________
Explanatory note:
(1) All share information contained herein is presented as adjusted for effects
of one-for-six reverse stock split effective June 19, 1998.
7
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CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash held in
banks or invested in money market funds with original maturity terms of less
than 90 days.
NON-CASH ACTIVITY - During the nine month period ended September 30, 1998,
the Company had significant non-cash activity including: (i) conversion of units
in the Partnership (shown as "minority interest" in the consolidated financial
statements) to Class A Shares (see Note 4); (ii) issuance of options to the
Advisor to acquire Class A Shares of the Company (see Note 9); and (iii)
issuance of new Class A Shares in exchange for a portion of the acquisition of
loans and related investments as part of the Recapitalization Transactions (see
Note 4).
The cash portion of the Recapitalization Transactions is summarized as
follows (in thousands):
Acquisition of loans and other investments $(1,061,006)
Acquired accrued interest and rent receivable (7,451)
Par value of Class A Shares issued 302,223
Additional paid in capital on Class A Shares issued 431,318
- -----------
Net cash outflow for the Recapitalization Transactions $ (334,916)
- ===========
MARKETABLE SECURITIES: The Company has certain investments in securities
which are insured or guaranteed by an agency of the U.S. Government, such as
the Government National Mortgage Association (GNMA), Federal National Mortgage
Association (FNMA), and Federal Home Loan Mortgage (FHLMC). Although the
Company generally intends to hold such investments for long-term investment
purposes, it may, from time to time, sell any of its investments in these
securities as part of its overall management of its balance sheet.
Accordingly, the Company considers such investments as "available-for-sale" and
reflects such investments at fair market value with changes in fair market value
reflected as a component of shareholder equity.
REVENUE RECOGNITION - Interest income, including amortization of loan fees
and premiums or discounts, is recognized using the effective interest method.
Income under equity participation features is recognized when earned and
payable. Income from prepayment penalties is recognized when received.
PROVISION FOR POSSIBLE CREDIT LOSSES - The Company's accounting policies
require that an allowance for estimated credit losses be maintained at a level
that management, based upon an evaluation of known and inherent risks in the
portfolio, considers adequate to provide for possible credit losses. Further,
specific valuation allowances are established for impaired loans in the amount
by which the carrying value, before allowance for estimated losses, exceeds the
fair value of collateral less disposition costs on an individual loan basis.
Management considers a loan to be impaired when, based upon current information
and events, it believes that it is probable that the Company will be unable to
collect all amounts due according to the contractual terms of the loan agreement
on a timely basis. Management measures these impaired loans at the fair value
of the loans' underlying collateral less estimated disposition costs. Impaired
loans may be left on accrual status during the period the Company is pursuing
repayment of the loan. These loans are placed on non-accrual status at such
time that the loans either: (i) become 90 days delinquent; or (ii) management
determines the borrower is incapable of, or has ceased efforts toward, curing
the cause of the impairment. Impairment losses are recognized as direct
write-downs of the related loan with a corresponding charge to the provision for
possible credit losses. Charge-offs occur when loans, or a portion thereof, are
considered uncollectible and of such little value that further pursuit of
collection is not warranted. Management's periodic evaluation of the allowance
for possible credit losses is based upon an analysis of the portfolio,
historical and industry loss experience, economic conditions and trends,
collateral values and quality and other relevant factors.
INCOME TAXES - The Company did not qualify as a REIT from 1993 through
1997; however, it did not incur any material tax liabilities as a result of its
operations. See Note 8 to the consolidated financial statements for more
information.
As confirmed in a Closing Agreement with the IRS obtained in March 1998,
the Company is eligible and intends to elect to be taxed as a REIT for its
taxable year beginning January 1, 1998. As a REIT, the Company will be subject
to income taxation at corporate rates on its REIT taxable income; however, the
Company is allowed a deduction for the amount of dividends paid to its
shareholders, thereby subjecting the distributed net income of the Company to
taxation at the shareholder level only. For income tax purposes, the Company
reports revenue and expenses on the accrual method. Starwood Operating is not
consolidated for federal income tax purposes and is taxed as a corporation. For
financial reporting purposes, current and deferred taxes are provided for in the
portion of earnings recognized by the Company with respect to its interest in
Starwood Operating.
EARNINGS (loss) PER CLASS A SHARE - In February 1997, the Financial
Accounting Standards Boards ("FASB") issued Statement of Financial Accounting
Standards No. 128, "Earnings per Share" ("SFAS No. 128") effective for periods
ending after December 15, 1997. SFAS No. 128 simplifies the standard for
computing earnings per share and makes them comparable with international
earnings per share standards. The statement replaces primary earnings per share
with basic earnings per share ("Basic EPS") and fully diluted earnings per share
with diluted earnings per share ("Diluted EPS"). The Company adopted this
accounting standard effective December 31, 1997, as required. Prior periods
have been restated for comparative purposes in accordance with SFAS No. 128.
USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
8
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of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
NOTE 4 - TRANSACTIONS WITH AFFILIATES AND RECAPITALIZATION
TRANSACTIONS WITH AFFILIATES - The shares of the Company are of two
classes: Class A Shares (par value $1.00 per share) and Class B Shares (par
value $0.01 per share). There is no limit on the number of either Class A or
Class B Shares which the Company is authorized to issue. Class B Shares are
required to be issued by the Company in an amount equal to one-half of the
number of Class A Shares outstanding. Class A and Class B Shares are each
entitled to one vote per share with respect to the election of trustees and
other matters. Pursuant to the Company's Declaration of Trust, the Class B
Shares are convertible at the option of the Class B Shareholders into Class A
Shares on the basis of 49 Class B Shares for one Class A Share. However, the
current holder of Class B Shares has agreed with the Company that it will not
convert the Class B Shares into Class A Shares without the approval of a
majority of Trustees that are not affiliated with such holder. All
distributions of cash are made 99% to the Class A Shareholders and 1% to the
Class B Shareholders.
In November 1993, the Company was notified that SAHI, Inc. (one of the
Starwood Investors) had acquired all of the Company's 212,500 outstanding
Class B Shares. Subsequent to the acquisition of the Class B Shares, SAHI
Partners (another of the Starwood Investors) purchased the Class B Shares from
SAHI, Inc. and accumulated 40,683 Class A Shares, or 9.60% of the total then
outstanding Class A Shares.
On March 15, 1994, the Company announced that it had entered into an
agreement with SAHI and SAHI, Inc. for the sale of a warrant for the right to
purchase 833,333 Class A Shares at a price of $6.00 per share (the "Class A
Warrant") and 416,667 shares of Class B Shares at a price of $0.06 per share
(the "Class B Warrant"). SAHI and SAHI, Inc. purchased the warrants for
$101,000, which amount was applied against the purchase price for the initial
Class A and Class B Shares purchased pursuant to the warrants. On March 28,
1996, the Class A Warrant was assigned to Starwood Mezzanine.
On September 26, 1996, the Company became sole general partner of the
Partnership by contributing $400,000 in cash in exchange for an 8.05% interest
in the Partnership, which was evidenced by 66,667 partnership units. Starwood
Mezzanine became the 91.95% limited partner by contributing to the Partnership
its entire interest in the participation certificates in the Warwick Hotel
mortgage note, valued by the Company at approximately $4.6 million as of
September 30, 1996. Starwood Mezzanine's interest in the Partnership was
evidenced by 761,491 units, which were convertible into cash, Class A Shares or
a combination of both pursuant to an exchange rights agreement. In addition,
Starwood Mezzanine had the right to require the Company to register for public
sale, any or all of the Class A Shares in the Partnership issued to it upon the
exercise of the Class A Warrant or upon exchange of the units issued to Starwood
Mezzanine. As described below, the units were converted to Class A Shares in the
first quarter of 1998.
On January 22, 1997, Starwood Mezzanine exercised its rights under the
Class A Warrant to acquire 833,333 Class A Shares. After its exercise of the
Class A Warrant, Starwood Mezzanine beneficially owned 833,333 Class A Shares
and 761,491 units. In addition, SAHI, Inc. exercised its rights under the
Class B Warrant to acquire 416,667 Class B Shares. After its exercise of the
Class B Warrant, SAHI Inc. beneficially owned 1,009,911 Class B Shares and
40,683 Class A Shares. Upon exercise of the Class A and Class B Warrant, SAHI,
SAHI, Inc. and Starwood Mezzanine jointly owned 70% of the outstanding Class A
Shares and, with the voting interest of the Class B Shares, controlled 80% of
the voting interest of the Company. The Company increased its capital by
$5,025,000, and the resulting funds were used to purchase qualified short-term
government securities.
During the quarter ended March 31, 1998, the Company consummated certain
transactions and entered into agreements which significantly recapitalized and
expanded the capital resources of the Company as well as modified future
operations including those described herein below in "Recapitalization
Transactions."
RECAPITALIZATION TRANSACTIONS - Prior to the consummation of the
Recapitalization Transactions: (i) Starwood Mezzanine and SAHI Inc. owned 70%
and 100% of the outstanding Class A Shares and Class B Shares of the Company,
respectively, through which they together controlled approximately 80% of the
voting interests in the Company; and (ii) Starwood Mezzanine owned 761,491 units
which represented the remaining 91.95% of the Partnership not held by the
Company that were convertible into either cash, an additional 761,491 Class A
Shares of the Company, or a combination of the two, as determined by the
Company.
On March 18, 1998, each outstanding unit held by Starwood Mezzanine was
exchanged for one Class A Share of the Company and, concurrently, the
Partnership was liquidated through a distribution of its net assets to the
Company, its then sole partner.
Simultaneously, Starwood Mezzanine and SOF IV consummated the transactions
contemplated by the contribution agreement ("Contribution Agreement") among
Starwood Mezzanine, SOF IV and the Company to substantially recapitalize and
increase the size of the Company's assets and operations (collectively, the
''Recapitalization Transactions''). Pursuant to the Contribution Agreement,
Starwood Mezzanine contributed various loans and other investments to the
Company in exchange for 9,191,333 Class A Shares and $25.5 million in cash, as
adjusted. SOF IV contributed loans and other investments, $17.9 million in cash
and certain letters of intent in exchange for 41,179,133 Class A Shares of the
Company and a cash payment of $324.3 million. Concurrently, the holders of the
Class B Shares who are affiliates of the general partners of Starwood Mezzanine
and SOF IV acquired 25,565,979 additional Class B Shares sufficient to maintain
existing voting preferences as required by the Company's Amended and Restated
Declaration of Trust (the "Declaration of Trust"). Immediately after these
transactions, the Starwood Investors owned an aggregate of approximately 99.3%
of the outstanding Class A Shares of the Company and 100% of the Class B Shares.
9
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Assets acquired from Starwood Mezzanine have been reflected using step
acquisition accounting at predecessor basis adjusted to fair market value to
the extent of post-transaction third-party ownership. Assets acquired from SOF
IV have been reflected at their fair market value.
The following summary pro forma information includes the effects of the
following transactions consummated in March 1998: (i) the Recapitalization
Transactions; (ii) the exchange of each outstanding unit held by holders other
than the Company for one Class A Share; (iii) the liquidation and termination of
the Partnership; and (iv) the borrowings necessary to consummate the
aforementioned transactions. The pro forma operating data for the nine month
periods ended September 30, 1998 and 1997 are presented as if the transactions
had been completed on January 1, 1998 and 1997, respectively.
PRO FORMA
CONDENSED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR NET INCOME PER CLASS A SHARE)
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FOR THE NINE
MONTH PERIOD ENDED
SEPTEMBER 30,
--------------------
1998 1997
---- ----
(UNAUDITED)
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REVENUE:
Interest income $ 88,280 $43,721
Operating lease income 11,850 11,561
Other income 2,489 16,905
-------- -------
Total revenue 102,619 72,187
-------- -------
COSTS AND EXPENSES:
Interest expense 31,333 -
Operating lease depreciation 4,332 4,332
General and administrative 2,223 2,776
Advisory fees 10,045 10,062
Provision for possible credit losses 1,750 1,750
-------- -------
Total costs and expenses 49,683 18,920
-------- -------
Pro forma net income $ 52,936 $53,267
======== =======
Pro forma basic net income per Class A Share $ 1.00 $ 1.01
======== =======
Weighted average number of Class A Shares outstanding 52,408 52,344
======== =======
</TABLE>
The pro forma operating data for the nine month period ended September 30,
1998 excludes a charge of approximately $6.0 million or $0.11 per Class A Share,
as adjusted, relating to the value of options to acquire Class A Shares issued
to the Advisor concurrently with the consummation of the Recapitalization
Transactions, as such charge is considered largely non-recurring in nature.
However, future charges may be taken to the extent of additional option grants,
which are at the discretion of the Board of Trustees.
While other real estate-related investments are assumed to have taken place
as of the beginning of each period, mortgage note receivable acquisitions or
originations are not reflected in these pro forma numbers until the actual
origination or acquisition date by Mezzanine or SOF IV. Consequently, since
many of the mortgage acquisitions or originations did not occur until after
September 30, 1997, the revenue from these assets is not included in the 1997
pro forma results. Pro forma other income for the nine months ended September
30, 1997 includes approximately $14.0 million related to the early repayment of
an improvement note held by Starwood Mezzanine. No interest expense has been
reflected in the pro forma operating data for the nine month period ended
September 30, 1997 since the aggregate capital contributed in the
Recapitalization Transactions exceeded the pro forma weighted average for the
real estate loans and related investments actually outstanding during the
period. The pro forma financial information is not necessarily indicative of
what the consolidated results of operations of the Company would have been as of
and for the periods indicated, nor does it purport to represent the results of
operations for future periods.
ADVISORY AGREEMENT - In connection with the Recapitalization Transactions,
the Company and Starwood Financial Advisors, L.L.C. (the "Advisor") entered into
an Advisory Agreement (the "Advisory Agreement") pursuant to which the Advisor
manages the investment affairs of the Company, subject to the Company's purpose
and investment policy, the investment restrictions and the directives of the
Board of Trustees. The services provided by the Advisor include the following:
identifying investment opportunities for the Company; advising the Company with
respect to and effecting acquisitions and dispositions of the Company's
investments; monitoring, managing and servicing the Company's loan portfolio;
and arranging debt financing for the Company. The Advisor will not act in a
manner that is inconsistent with the express direction of the Board of Trustees
and reports to the Board of Trustees and the officers of the Company with
respect to its activities.
Beginning on the 90th day after the consummation of the Recapitalization
Transactions, the Company commenced paying to the Advisor a quarterly base
10
<PAGE>
management fee of 0.3125% (1.25% per annum) of the "Book Equity Value" of the
Company (as defined in the Advisory Agreement), determined as of the last day
of each quarter, but estimated and paid in advance subject to recomputation.
In addition, beginning on the 90th day after the consummation of the
Recapitalization Transactions, the Company commenced paying the Advisor a
quarterly incentive fee of 5.00% of the Company's "Adjusted Net Income" (as
defined in the Advisory Agreement) during each quarter that the Adjusted Net
Income for such quarter (restated and annualized as a rate of return on the
Company's Book Equity Value for such quarter) equals or exceeds a benchmark rate
defined in the Advisory Agreement. Approximately $1.1 million and $1.3 million
of incentive fees to the Advisor have been incurred in the three month and nine
month periods ended September 30, 1998, respectively. The Advisor may also be
reimbursed for certain expenses it incurs on behalf of the Company. No such
expenses have been incurred through September 30, 1998.
The Advisory Agreement has an initial term of three years, subject to
automatic renewal for one-year periods unless the Company has been liquidated or
a Termination Event (as defined in the Advisory Agreement and which generally
includes violations of the Advisory Agreement by the Advisor, a bankruptcy event
of the Advisor or the imposition of a material liability on the Company as a
result of the Advisor's bad faith, willful misconduct, gross negligence or
reckless disregard of duties) has occurred and is continuing. In addition, the
Advisor may terminate the Advisory Agreement on 60 days' notice to the Company
and the Company may terminate the Advisory Agreement upon 60 days' written
notice if a Termination Event has occurred or if the decision to terminate is
based on an affirmative vote of the holders of two thirds or more of the voting
shares of the Company at the time outstanding.
11
<PAGE>
NOTE 5 - LOANS AND OTHER INVESTMENTS - (IN THOUSANDS)
The following is a summary description of the Company's loans and other
investments:
<TABLE>
<CAPTION>
CURRENT COMPANY'S
NUMBER OF ORIGINAL PRINCIPAL CARRYING VALUE AS OF
UNDERLYING BORROWERS COMMITMENT BALANCES SEPTEMBER 30, DECEMBER 31,
TYPE OF LOAN/BORROWER PROPERTY TYPE IN CLASS AMOUNT OUTSTANDING 1998 1997
--------------------- ------------- --------- ---------- ----------- -------- ----
(UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
Senior Mortgages Office/Hotel/ 12 $751,954 $657,543 $ 655,529 -
Mixed Use/
Apartment
Subordinated Mortgages Office/Hotel/ 15 542,172 501,581 516,379 -
Resort/
Residential/
Land
Opportunistic Mortgages Office/Hotel/ 3 166,644 125,402 82,986 -
Apartment
Partnership Loans/Unsecured Office/Hotel 5 128,049 115,549 112,557 -
Notes
Construction Loans Assisted 2 92,390 91,906 97,057 -
Living/Resorts
Real Estate Under Hotels 1 N/A(3) N/A(3) 192,787 -
Operating Leases
Loan Participations Various 2 15,841 15,841 11,700 -
Investments in Strategic
Origination Ventures (4) Various 7 50,400 50,400 47,806 -
Other Real Estate-Related Real estate
Investments related securities N/A N/A N/A 45,116 $90
---------- ---
Subtotal Investments 1,761,917 90
Provision for Possible (1,750) -
Credit Losses ---------- ---
Total Loans and Other $1,760,167 $90
Investments, net ========== ===
<CAPTION>
ORIGINAL INTEREST INTEREST
MATURITY ACCRUAL PAYMENT PRINCIPAL PARTICIPATION
TYPE OF LOAN/BORROWER DATES RATES RATES AMORTIZATION FEATURES
--------------------- ----- ----- ----- ------------ --------
<S> <C> <C> <C> <C> <C>
Senior Mortgages 1999 to 2010 Fixed: 7.28 to 16.00% Fixed: 7.28 to 10.82% Yes(1) Yes(2)
Variable: LIBOR + Variable: LIBOR +
1.25 to 3.25% 1.25 to 3.25%
Subordinated Mortgages 1999 to 2007 9.53 to 17.00% 9.53 to 15.25% Yes(1) Yes(2)
Variable: LIBOR + Variable: LIBOR +
4.00 to 5.80% 4.00 to 5.80%
Opportunistic Mortgages 1999 and 2007 6.00 to 7.00% 6.00 to 7.00% Yes(1) Yes(2)
<PAGE>
Partnership Loans/Unsecured 2002 to 2013 8.50 to 15.00% 8.50 to 15.00% No Yes(2)
Notes Variable: LIBOR + Variable: LIBOR +
5.37% 5.37%
Construction Loans 1999 and 2004 12.00 to 12.50% 10.00 to 12.50% No No
Real Estate Under N/A(3) N/A(3) N/A(3) N/A(3) N/A(3)
Operating Leases
Loan Participations 1999 Fixed: 7.13% Fixed: 5.45 to 6.40% No No
Variable: LIBOR + Variable: LIBOR +
0.58 to 1.75% 0.58 to 1.75%
Investments in Strategic
Origination Ventures (4) 1999 to 2018 Fixed: 8.14 to 9.45% Fixed: 8.14 to 9.45% Yes No
Variable: LIBOR + Variable: LIBOR +
3.75 to 4.50% 3.75 to 4.50%
Other Real Estate-Related
Investments 2002 and 2007 12.00 to 12.75% 12.00 to 12.75% No No
Subtotal Investments
Provision for Possible
Credit Losses
Total Loans and Other
Investments, net
</TABLE>
EXPLANATORY NOTES
- -----------------
(1) The loans require fixed payments of principal and interest resulting in
partial principal amortization over the term of the loan with the remaining
principal due at maturity. In addition, one of the loans permits
additional annual prepayments of principal of up to $1.3 million without
penalty at the borrower's option.
(2) Under some of these loans, the lender receives additional payments
representing additional interest for participation in available cash flow
from operations of the property and the proceeds, in excess of a base
amount, arising from a sale or refinancing of the property.
(3) The lease is a triple net operating lease covering 17 hotels under which
the lessee pays all costs associated with the operation of the hotels,
including real estate taxes, insurance, utilities, services and capital
expenditures. The initial term of the lease expires on December 31, 2020,
and can be extended for up to three five-year terms at the lessee's option.
Rent payments under the lease consist of base rent and additional rent
based on the amount by which the aggregate operating revenue for any given
year exceeds the aggregate operating revenue for the 12 months ended
September 30, 1996. The carrying amount is presented net of accumulated
depreciation.
(4) Information for this investment classification, except for the Company's
carrying value, represents terms of loans in an unconsolidated joint
venture. See narrative discussion of venture in this note.
12
<PAGE>
NOTE 5 - LOANS AND OTHER INVESTMENTS
During the three months ended September 30, 1998 and the period from March
18, 1998 (the date of the consummation of the Recapitalization Transaction) to
September 30, 1998, the Company and its affiliated ventures originated or
acquired an aggregate of $517.6 million and $723.7 million in loans and related
investments, respectively, and received principal repayments of $87.4 million
and $95.8 million for those periods, respectively.
In addition, on July 24, 1998, the Company entered into a strategic
origination venture with a publicly traded finance company to originate loans
secured by specialty real estate. Under its terms, the venture is expected
to be ultimately capitalized 70.0% with third-party debt and 30.0% with
capital contributions from the Company and its venture partner. The Company
will contribute up to $72.0 million in preferred equity in exchange for a
12.00% preferred return and 50% of the residual profits in excess of the
aggregate of its preferred return and a 12.00% return to the subordinate
joint venture partner. Pending the closing of third-party senior debt
financing, the Company plans to advance senior equity to the venture at a
preferred return at a fixed margin over LIBOR. Since July 24, 1998, the
venture has funded approximately $50.4 million of loans. Of the total loan
amounts, the Company funded an aggregate of $47.3 million, representing its
interim funding of the venture's senior debt and its share of the venture's
preferred equity.
The Company has reflected provisions for possible credit losses of $1.0 and
$1.75 million in its results of operations during the three month and nine month
periods ended September 30, 1998, respectively. There was no other activity in
the Company's reserve balances during these periods. These provisions
represent portfolio reserves based on management's evaluation of general market
conditions, the Company's and industry loss experience, likelihood of
delinquencies or defaults and the underlying collateral. No direct impairment
reserves on specific loans were considered necessary. Management may transfer
reserves between general and specific reserves as considered necessary.
NOTE 6 - DEBT OBLIGATIONS
The Company had no outstanding long term debt obligations as of December
31, 1997. As of September 30, 1998, the Company has obligations under various
arrangements with financial institutions as follows (in thousands):
<TABLE>
<CAPTION>
MAXIMUM PRINCIPAL
AMOUNT BALANCE AS OF INTEREST MATURITY
AVAILABLE SEPTEMBER 30, 1998 RATE DATE
--------- ------------------ ---- ----
<S> <C> <C> <C> <C>
REVOLVING CREDIT FACILITIES:
Line of credit $675,000 $ 605,814 LIBOR + 150bp March 2001
Line of credit 500,000 - LIBOR + 100-125bp August 2000
----------
Total revolving credit facilities 605,814
----------
TERM LOANS:
Secured by real estate under operating lease 125,000 LIBOR + 150bp March 1999
Secured by senior mortgage investment 94,380 LIBOR + 100bp August 2000
Secured by senior and subordinate mortgage investments 114,791 LIBOR + 100bp August 2000
Secured by senior mortgage investment 40,765 LIBOR + 100bp May 1999
----------
Total term loans 374,936
----------
OTHER DEBT OBLIGATIONS: 33,922 Various Various
----------
TOTAL DEBT OBLIGATIONS $1,014,672
==========
</TABLE>
Availability of amounts under the revolving credit facilities are based on
a percentage borrowing base calculation. An aggregate of $10.3 million in loan
fees were incurred under the Company's debt obligations. These fees are
amortized over the related loan terms.
Note 7 - Risk Management and Use of Financial Instruments
RISK MANAGEMENT - In the normal course of its ongoing business operations,
the Company encounters economic risk. There are three main components of
economic risk: interest rate risk, credit risk and market risk. The Company is
subject to interest rate risk to the degree that its interest-bearing
liabilities mature or reprice at different speeds, or different bases, than its
interest earning assets. Credit risk is the risk of default on the Company's
loan portfolio that results from a property's or borrower's inability or
unwillingness to make contractually required payments. Market risk reflects
changes in the value of loans held for sale, securities available for sale and
purchased mortgage servicing rights due to changes in interest rates or other
market factors, including the rate of prepayments of principal and the value of
the collateral underlying loans and the valuation of real estate held by the
Company.
USE OF DERIVATIVE FINANCIAL INSTRUMENTS - The Company's use of derivative
financial instruments is primarily limited to the utilization of interest rate
13
<PAGE>
agreements or other instruments to manage interest rate exposure. The principal
objective of such arrangements is to minimize the risks and/or costs associated
with the Company's operating and financial structure as well as to hedge
specific anticipated transactions. The counterparties to these contractual
arrangements are major financial institutions with which the Company and its
affiliates also have other financial relationships. The Company is
potentially exposed to credit loss in the event of nonperformance by
these counterparties. However, because of their high credit ratings,
the Company does not anticipate that any of the counterparties will fail
to meet their obligations. Prior to the Recapitalization Transactions,
the Company did not significantly utilize derivative financial instruments.
In anticipation of and since the completion of the Recapitalization
Transactions, the Company has entered into LIBOR interest rate caps struck at
9.00% in the notional amounts of $125.0 million and $300.0 million expiring in
March 1999 and 2001, respectively. The Company also entered into LIBOR interest
rate caps struck at 7.50% in the notional amounts of $40.4 million and $38.3
million expiring in January and June 2001, respectively, on amounts borrowed
under additional term loans. Further, the Company has also entered into
approximately $206.8 million of interest rate swaps to effectively fix the
interest rate on a portion of the Company's floating-rate obligations.
The Company is currently pursuing certain anticipated long-term fixed rate
borrowings and has entered into certain derivative instruments based on U.S.
Treasury securities to hedge the potential effects of interest rate movements on
these transactions. As of September 30, 1998, the Company had entered into an
aggregate notional amount of approximately $232.0 million under such agreements.
NOTE 8 - INCOME TAXES
Although originally formed to qualify as a REIT under the Code for the
purpose of making and acquiring various types of mortgage and other loans,
during 1993 through 1997, the Company failed to qualify as a REIT. As confirmed
by a Closing Agreement with the Internal Revenue Service (the "IRS") obtained in
March 1998, the Company will be eligible to and intends to elect to be taxed as
a REIT for the tax year commencing on January 1, 1998. The Company did not
incur any material tax liabilities as a result of its operations during such
years.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and income tax purposes as well as operating loss and tax credit carry
forwards. A valuation allowance is recorded if, based on the weight of
available evidence, it is more likely than not that some portion or all of the
deferred income tax asset will not be realized. Given the limited nature of the
Company's operations and assets and liabilities from 1993 through 1997, the only
deferred tax assets are net operating loss carry forwards ("NOL's") which arose
during such periods. Since the Company intends to elect to be treated as a REIT
for its tax year beginning January 1, 1998, it is anticipated that such NOL's
will expire unutilized. Accordingly, no net value, after consideration of a
100% valuation allowance, has been reflected in these financial statements as of
September 30, 1998 and December 31, 1997.
NOTE 9 - 1996 SHARE INCENTIVE PLAN
The Company amended and restated its stock option plan to provide a means
of incentive compensation for officers, other key employees and trustees. Stock
options, restricted stock awards and other performance awards may be granted
under the Starwood Financial Trust 1996 Share Incentive Plan (the ''Plan'').
Under the amended Plan, up to a maximum of 9.0% of the outstanding Class A
Shares on a fully-diluted basis, as adjusted for subsequent issuances of Class A
Shares, are reserved for issuance under the Plan. All grants of shares under the
Plan, other than automatic grants to non-employee trustees, will be at the sole
discretion of the Board of Trustees or a specifically designated sub-committee
of such trustees. Approximately 2,493,843 options to purchase Class A Shares at
$15.00 per share that are immediately exercisable were granted to the Advisor
under the Plan upon consummation of the Recapitalization Transactions and
additional grants may be made to the Advisor or employees of the Company in the
future. During the first and second quarter of 1998, the Company issued options
to acquire an aggregate of 10,000 Class A Shares to certain trustees at exercise
prices equal to the market price at the date of grant.
The Company has elected to use the intrinsic method for accounting for
options issued to direct employees or trustees, as allowed under Statement of
Financial Accounting Standards No. 123 Accounting for Stock Based Compensation
("SFAS 123") and, accordingly, recognized no compensation charge in connection
with these options. The Company utilizes the option value method as required by
SFAS 123 to account for options issued to the Advisor. An independent financial
advisory firm estimated the value of these options at date of grant to be
approximately $2.40 per share using a Black-Scholes valuation model. In the
absence of comparable historical market information for the Company, the
advisory firm utilized assumptions consistent with activity of a comparable peer
group of companies including an estimated option life of five years, a 27.5%
volatility rate and an estimated annual dividend rate of 8.5%. The resulting
charge to earnings was calculated as the number of options allocated to the
Advisor multiplied by the estimated value at consummation. A charge of
approximately $6.0 million has been reflected in the Company's first quarter
1998 financial results. Future charges may be taken to the extent of additional
option grants, which are at the discretion of the Board of Trustees.
14
<PAGE>
NOTE 10 - EARNINGS PER SHARE
Basic EPS is computed based on the income applicable to Class A Shares
(which is net income reduced by 1% allocated to Class B Shares) divided by the
weighted-average number of Class A Shares outstanding during the period.
Diluted EPS is based on the net earnings applicable to Class A Shares plus
dividends on Class B Shares which are convertible into Class A Shares, divided
by the weighted average number of Class A Shares and dilutive potential Class A
Shares that were outstanding during the period. Dilutive potential Class A
Shares include the Class B Shares, which are convertible into Class A Shares at
a rate of 49 Class B Shares for one Class A Share, and potentially dilutive
options to purchase Class A Shares issued to the Advisor and the trustees of the
Company. Basic and diluted earnings per Class A Share are based upon the
following weighted average shares outstanding during each of the three and nine
month periods ended September 30, 1998 and 1997, respectively.
<TABLE>
<CAPTION>
(In thousands)
Three months ended Nine months ended
September 30, September 30,
--------------------- ---------------------
1998 1997 1998 1997
------ ----- ------ -----
<S> <C> <C> <C> <C>
Weighted average Class A Shares outstanding
for basic earnings per Class A Share 52,390 1,258 37,968 1,193
Add effect of assumed shares issued under
Treasury stock method for stock options 560 542 405 20
Add effects of conversion of Class B
Shares (1 for 49 ratio) 1,704 762 1,086 761
------ ----- ------ -----
Weighted average Class A Shares
outstanding for diluted earnings
per Class A Share 54,654 2,562 39,459 1,974
====== ===== ====== =====
</TABLE>
As previously indicated, effective June 19, 1998, the Company consummated a
one-for-six reverse stock split for its Class A and Class B Shares. Historical
earnings per share have been retroactively restated to reflect the reverse split
for comparative purposes.
NOTE 11 - COMPREHENSIVE INCOME
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income" ("SFAS No. 130") effective for fiscal years beginning after December 15,
1997. The statement changes the reporting of certain items currently reported
as changes in the shareholder's equity section of the balance sheet and
establishes standards for the reporting and display of comprehensive income and
its components in a full set of general-purpose financial statements. SFAS No.
130 requires that all components of comprehensive income shall be reported in
the financial statements in the period in which they are recognized.
Furthermore, a total amount for comprehensive income shall be displayed in the
financial statement where the components of other comprehensive income are
reported. The Company was not previously required to present comprehensive
income or its components under generally accepted accounting principles. The
Company has adopted this standard effective January 1, 1998. Total
comprehensive income was $21.0 million and $13,000 for the three month periods
ended September 30, 1998 and 1997 and $36.9 million and $31,000 for the nine
month periods ended June 30, 1998 and 1997, respectively. The primary component
of comprehensive income other than net income was the change in value of certain
investments in marketable securities classified as available-for-sale.
NOTE 12 - DIVIDENDS
In order to maintain its election to qualify as a real estate investment
trust, the Company must distribute, at minimum, an amount equal to 95% of its
taxable income and must distribute 100% an amount equal to its taxable income to
not pay any corporate federal income taxes. Accordingly, the Company
anticipates it will distribute all of its taxable income to its shareholders.
Because taxable income differs from cash flow from operations due to non-cash
revenues or expenses, in certain circumstances, the Company may be required to
borrow to make sufficient dividend payments to meet this anticipated dividend
threshold.
Total dividends declared by the Company aggregated $0.0 and $18.3 million
or $0.00 and $0.35 per Class A Share for the three month and nine month periods
ended September 30, 1998, respectively. On October 2, 1998, the Company
declared a dividend of approximately $20.1 million or $0.38 per Class A Share
applicable to the third quarter and payable to shareholders of record on
October 15, 1998. The exact amount of future quarterly dividends to Class A
Shareholders will be determined by the Board of Trustees based on the Company's
actual and expected operations for the fiscal year and the Company's overall
liquidity position.
15
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company is a specialized finance company focused exclusively on the
commercial real estate industry, and is a leading provider of flexible,
structured mortgage, mezzanine and lease financing.
Prior to the Recapitalization Transactions (described in Note 4 to the
Company's consolidated financial statements), the Company's primary source of
cash during 1997 was from income earned on its interest in the participation
certificates in the Warwick Hotel mortgage note and certain investments in
government or government-sponsored securities, as well as short term cash
investments. On October 1, 1997, the Warwick Hotel note was repaid and the $4.5
million of proceeds were invested in government securities.
On September 26, 1996, the Company became sole general partner of the
Partnership (see Notes 1 and 4 to the Company's consolidated financial
statements) by contributing $400,000 in cash in exchange for a 8.05% interest in
the Partnership evidenced by 66,667(1) units. Starwood Mezzanine became the
91.95% limited partner by contributing to the Partnership its entire interest in
the participation certificates in the Warwick Hotel mortgage note valued by the
Company at approximately $4.6 million at the time of contribution. Starwood
Mezzanine's units were converted into Class A Shares on March 18, 1998 on a
one-for-one basis and the Partnership was dissolved.
On January 22, 1997, Starwood Mezzanine exercised its rights under a
warrant (see Note 4) to acquire 833,333 Class A Shares. In addition, SAHI,
Inc. exercised its rights under the warrant (see Note 4) to acquire 416,667
Class B Shares. As a result of the exercise of the warrants, the Company's
capital increased by $5,025,000, and the resulting funds were used to
purchase short-term government securities.
As more fully discussed in Note 4 to the Company's consolidated financial
statements, on March 18, 1998, the Company entered into a series of transactions
approved by the Company's shareholders which, among other things, substantially
recapitalized the Company and modified its investment policy. Effective June
18, 1998, the Company (which was organized under California law) changed its
domicile to Maryland by merging with a newly formed subsidiary organized under
Maryland Law and issued new shares of the subsidiary to its shareholders in
exchange for the previous shares of the Company. Concurrently, the Company
consummated a one-for-six reverse stock split.
As more fully discussed in Note 8 to the Company's consolidated financial
statements, for fiscal years 1993 to 1997 the Company did not qualify as a REIT;
however, the Company intends to elect to qualify as a REIT under the Code for
its 1998 taxable year and, as such, anticipates distributing annually
approximately 100% of its taxable income, subject to certain adjustments. Cash
for such distributions is expected to be generated from the Company's
operations. The Company's operations for any period may be affected by a number
of factors, including the investment assets held, the financial and operating
performance of the collateral underlying secured loans or the business of the
borrowers with respect to unsecured loans, or the economic or interest rate
environment generally.
RESULTS OF OPERATIONS
THREE MONTH PERIOD ENDED SEPTEMBER 30, 1998 COMPARED TO 1997
During the three months ended September 30, 1998, total revenue increased
by approximately $41.8 million as compared to total revenue for the three months
ended September 30, 1997. This increase is a result of the interest generated
by the loans and other investments contributed in the Recapitalization
Transactions, as well as approximately $517.6 million of other loan investments
newly originated or acquired by the Company during 1998 and an additional $0.5
million funded under existing loan commitments. The Company received principal
repayments of $87.4 million during the three months ended September 30, 1998.
Included in other income for the three month period ended September 30, 1998 are
fees associated with the repayment of two first mortgage loans aggregating
approximately $1.2 million.
The increase in the Company's total costs and expenses during the three
months ended September 30, 1998 compared to the three months ended September 30,
1997 is primarily due to interest expense on the borrowings under the revolving
credit facilities and other borrowings used to fund the Company's loan
origination/acquisition activities, as well as general and administrative costs
associated with the implementation of the Company's new business plan and
advisory fee expenses under the Advisory Agreement.
The Company believes that because of the significant expansion of the scope
of its operations as a result of the Recapitalization Transactions, which
occurred on March 18, 1998, prior periods are not necessarily indicative of the
Company's future operating results or financial condition.
_____________
Explanatory note:
(1) All share information contained herein is presented as adjusted for effects
of one-for-six reverse stock split effective June 19, 1998.
16
<PAGE>
NINE MONTH PERIOD ENDED SEPTEMBER 30, 1998 COMPARED TO 1997
During the nine months ended September 30, 1998, total revenue increased by
approximately $79.0 million as compared to total revenue for the nine months
ended September 30, 1997. This increase is a result of the interest generated
by the loans and other investments contributed in the Recapitalization
Transactions, as well as approximately $723.7 million of other loan investments
newly originated or acquired by the Company during 1998 and an additional $10.5
million funded under existing loan commitments. The Company received principal
repayments of $95.8 million for the nine months ended September 30, 1998.
Included in other income for the nine month period ended September 30, 1998 are
fees associated with the repayment of two first mortgage loans of approximately
$1.2 million and a gain of approximately $0.9 million resulting from the
repayment of a $2.8 million loan participation which had been acquired at a
discount.
The increase in the Company's total costs and expenses during the nine
months ended September 30, 1998 compared to the nine months ended September 30,
1997 is primarily due to the expense associated with the issuance of
approximately 2,493,843 options to the Advisor (see Note 9 to the Company's
consolidated financial statements) as well as the interest expense on the
borrowings under the revolving credit facilities and other borrowings used to
fund the Company's new loan origination/acquisition activities, as well as
general and administrative costs associated with the implementation of the
Company's new business plan and advisory fee expenses under the Advisory
Agreement.
The minority interest expense represents Starwood Mezzanine's share of the
net income generated by the Partnership before the Partnership's dissolution on
March 18, 1998.
The Company believes that as a result of the Recapitalization Transactions,
which occurred on March 18, 1998, the nine month period ended September 30, 1998
and the comparable prior periods are not necessarily indicative of the Company's
future operating results or financial condition.
INTEREST RATE RISK MANAGEMENT
As part of its business, the Company is exposed to interest rate risks.
Management has implemented an interest rate risk management policy based on
match funding, with the objective that floating-rate assets be financed
by floating-rate liabilities and fixed-rate assets be financed by fixed-rate
liabilities.
The Company's operating results will depend in part on the difference
between the interest and related income earned on its assets and the interest
expense incurred in connection with its interest-bearing liabilities.
Competition from other providers of mezzanine capital may lead to a decrease in
the interest rate earned on the Company's interest-bearing assets, which the
Company may not be able to offset by obtaining lower interest costs on its
borrowings. Changes in the general level of interest rates prevailing in the
financial markets may affect the spread between the Company's interest-earning
assets and interest-bearing liabilities. Any significant compression of the
spreads between interest-earning assets and interest-bearing liabilities could
have a material adverse effect on the Company. In addition, an increase in
interest rates could, among other things, reduce the value of the Company's
interest-bearing assets and its ability to realize gains from the sale of such
assets, and a decrease in the interest rates could reduce the average life of
the Company's interest-earning 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 the control of the Company. The
Company employs match funding based hedging strategies to limit the effects of
changes in interest rates on its operations, including engaging in interest rate
swaps, caps, floors and other interest rate exchange contracts. There can be no
assurance that the profitability of the Company will not be adversely affected
during any period as a result of changing interest rates. In addition, hedging
transactions using derivative instruments involve certain additional risks such
as counter-party credit risk, legal enforceability of hedging contracts and the
risk that unanticipated and significant changes in interest rates will cause a
significant loss of basis in the contract. With regard to loss of basis in a
hedging contract, indices upon which contracts are priced may be more or less
variable than the indices upon which the hedged assets or liabilities are
priced, thereby making the hedge less effective. There can be no assurance that
the Company will be able to adequately protect against the foregoing risks and
that the Company will ultimately realize an economic benefit from any hedging
contract it enters into.
LIQUIDITY AND CAPITAL RESOURCES
The Company requires capital to fund its loan and other investment
origination/acquisition activities and operating expenses. The Company's
capital sources include cash flow from operations, borrowings under lines of
credit, additional term borrowings and reverse repurchase arrangements,
long-term financing secured by the Company's assets, unsecured financing and the
issuance of common, convertible and/or preferred equity securities.
Concurrently with the Recapitalization Transactions, the Company entered
into bank credit agreements under which the Company could borrow up to $625.0
million, with up to an additional $175.0 million available, subject to certain
conditions, to fund loan originations or acquisitions (including the cash
portion of the Recapitalization Transactions previously described) and for other
17
<PAGE>
general corporate purposes. The credit agreements are comprised of: (i) a
$500.0 million revolving credit facility, which bears interest at a fixed margin
over LIBOR and matures on March 13, 2001 and; (ii) a $125.0 million term loan
secured by the Company's operating lease properties, which bears interest at a
fixed margin over LIBOR and matures on March 15, 1999.
During the third quarter, the Company expanded its existing revolving
credit facility from $500.0 million to $675.0 million and entered into an
additional $500.0 million two-year secured credit facility bearing interest at
fixed margins over LIBOR. Availability of amounts to borrow under the revolving
credit facilities are subject to having sufficient assets included as security
under the facilities in accordance with a percentage borrowing base
calculations.
In addition, since the completion of the Recapitalization Transactions, the
Company has entered into approximately $288.0 million in LIBOR based term loans
secured by certain first mortgage loans it acquired during this period of
which approximately $38.0 million had been repaid prior to September 30, 1998.
Further, the Company has borrowed amounts under reverse repurchase agreements
and other obligations, secured by its investments in government securities and
other marketable securities of real estate companies, under which approximately
$33.9 million was outstanding as of September 30, 1998.
An aggregate of $10.3 million in loan fees were incurred in connection with
these credit facilities and term loan agreements. These fees have been deferred
and are being amortized over the related credit facilities and loan terms.
In anticipation of and since the completion of the Recapitalization
Transactions, the Company has entered into LIBOR interest rate caps struck at
9.00% in the notional amounts of $125.0 million and $300.0 million expiring in
March 1999 and 2001, respectively. The Company also entered into LIBOR interest
rate caps struck at 7.50% in the notional amounts of $40.4 million and $38.3
million expiring in January and June 2001, respectively, on amounts borrowed
under additional term loans. Further, the Company has also entered into
approximately $206.8 million of interest rate swaps to effectively fix the
interest rate on a portion of the Company's floating-rate obligations.
The Company is currently pursuing certain anticipated long-term fixed rate
borrowings and has entered into certain derivative instruments based on U.S.
Treasury securities to hedge the potential effects of interest rate movements on
these transactions. As of September 30, 1998, the Company had entered into an
aggregate notional amount of approximately $232.0 million under such agreements.
The distribution requirements under the REIT provisions of the Internal
Revenue Code restrict the Company's ability to retain earnings and thereby
replenish capital committed to its lending operations. However, the Company
believes that its significant capital resources and access to financing will
provide it with financial flexibility and market responsiveness at levels
sufficient to meet current and anticipated capital requirements, including
expected new investment transactions.
The Company's ability to meet its long-term liquidity requirements is
subject to the renewal of its credit lines and repurchase facilities and/or
obtaining other sources of financing, including issuing additional debt or
equity from time to time. Any decision by the Company's lenders and/or
investors' to enter into such transaction with the Company will depend upon a
number of factors such as compliance with the terms of its existing credit
arrangements, the Company's financial performance, industry or market trends,
the general availability of and rates applicable to financing investments,
lenders'/investors' resources and policies concerning the terms under which they
would make such loans and the relative attractiveness of alternative investment
or lending opportunities.
YEAR 2000 ISSUES
The Company utilizes a number of software systems to service mortgage loans
and manage its mortgage assets. The Company is conducting a comprehensive
review of its computer systems to determined if they may be affected by the
"Year 2000 Issue"- caused by computer programs and embedded logic devices which
utilize two digits rather than four to define the applicable year which may fail
to properly recognize date sensitive information or process date sensitive data
when the year changes to 2000. Generally, management believes the Company is
not directly significantly affected by issues resulting from the use of "legacy"
computer systems and software because it and its predecessors' commenced their
active operations within the last five years. Accordingly, the Company does not
anticipate incurring Year 2000 system compliance costs that would be material to
its financial position, results of operations, or cash flows in future periods.
In addition, the Company is in the process of contacting its significant
depository institutions, lenders, custodians, vendors, tenants under operating
leases and borrowers with which it interfaces to evaluate if they are taking
similar appropriate steps to alleviate Year 2000 Issue risks. This process is
expected to be essentially complete by early 1999. Management believes it is
devoting the necessary resources to timely address all Year 2000 issues over
which it has control.
NEW ACCOUNTING STANDARDS
In June 1997, the FASB issued Statement No. 131, "Disclosure about Segments
of an Enterprise and Related Information" ("SFAS No. 131") effective for
financial statements issued for periods beginning after December 15, 1997. SFAS
No. 131 requires disclosures about segments of an enterprise and related
information regarding the different types of business activities in which an
enterprise engages and the different economic environments in which it operates.
The Company intends to adopt the requirements of this pronouncement in its
financial statements for the year ended December 31, 1998. The adoption of
SFAS No. 131 is not expected to have a material impact on the Company's
18
<PAGE>
financial statement disclosures.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes accounting
and reporting standards for derivative financial instruments and hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value. If certain conditions are met, a derivative may be
specifically designated as: (i) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment;
(ii) a hedge of the exposure to variable cash flows of a forecasted transaction;
or (iii) in certain circumstances, a hedge of a foreign currency exposure. This
statement becomes effective in fiscal year ending December 31, 2001. The
adoption of SFAS 133 is not expected to have a material impact on the financial
position or results of operations of the Company.
OTHER MATTERS
1940 ACT EXEMPTION
The Company at all times intends to conduct its business so as to not
become regulated as an investment company under the Investment Company Act of
1940. If the Company were to become regulated as an investment company, then
the Company's ability to use leverage would be substantially reduced. 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" (i.e., "Qualifying Interests"). Under the current
interpretation of the staff of the SEC, in order to qualify for this exemption,
the Company must maintain at least 55% of its assets directly in Qualifying
Interests. As of September 30, 1998, the Company calculates that it is in
and has maintained compliance with this requirement.
FORWARD LOOKING STATEMENTS
When used in this Form 10-Q, in future SEC filings or in press releases or
other written or oral communications, the words or phrases "will likely result",
"are expected to", "will continue", "is anticipated", "estimate", "project" or
similar expressions are intended to identify "forward looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. The
Company cautions that such forward looking statements speak only as of the date
made and that various factors including regional and national economic
conditions, changes in levels of market interest rates, credit and other risks
of lending and investment activities, and competitive and regulatory factors
could affect the Company's financial performance and could cause actual results
for future periods to differ materially from those anticipated or projected.
The Company does not undertake and specifically disclaims any obligation to
update any forward-looking statements to reflect events or circumstances after
the date of such statements.
19
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On September 29, 1998, the Company issued 18,000 Class A Shares upon
exercise of certain options previously issued to the Advisor with an
exercise price of $15.00 per share. These options were exercised by a
consultant to the Advisor who had received such options from the
Advisor in connection with services provided to the Advisor which do
not affect the Company. The shares issued are exempt from
registration under the Securities Act of 1933, as amended pursuant to
Section (4)(2) thereof. As required by the Company's Declaration of
Trust, on the same day, 9,000 Class B Shares were issued to the
current holders of the Class B Shares for a price of $0.01 per share.
ITEM 3. DEFAULT UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM-8-K
A. EXHIBITS
None
B. REPORTS ON FORM 8-K
None
20
<PAGE>
SIGNATURES
Pursuant to the requirements of Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
STARWOOD FINANCIAL TRUST
---------------------------------------------
Registrant
Date November 13, 1998 /s/ Jay Sugarman
---------------------------------------------
Jay Sugarman
Chief Executive Officer and President
Date November 13, 1998 /s/ Spencer B. Haber
---------------------------------------------
Spencer B. Haber
Chief Financial Officer
(Principal Financial and Accounting Officer)
21
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<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
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