<PAGE>
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 June 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
New York, NY 10036 (Zip Code)
(Address of principal executive offices)
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
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 August 13, 1998, there were 52,389,718 Class A Shares of Starwood
Financial Trust, $1.00 par value, outstanding.
<PAGE>
Starwood Financial Trust
Index to Form 10-Q
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I. Consolidated Financial Information........................................................................3
ITEM 1. Consolidated Balance Sheet at June 30, 1998 and December 31, 1997.........................................3
Consolidated Statements of Operations - For the three and six month periods ended
June 30, 1998 and 1997............................................................................4
Consolidated Statement of Changes in Shareholders' Equity - For the six month periods ended
June 30, 1998.....................................................................................5
Consolidated Statements of Cash Flows - For the three and six month periods ended
June 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........................................................................................19
ITEM 1. Legal Proceedings........................................................................................19
ITEM 2. Changes in Securities and Use of Proceeds................................................................19
ITEM 3. Defaults Upon Senior Securities..........................................................................19
ITEM 4. Submission of Matters to a Vote of Security Holders......................................................20
ITEM 6. Exhibits and Reports on Form 8-K.........................................................................21
Signatures...............................................................................................22
</TABLE>
2
<PAGE>
PART I - FINANCIAL INFORMATION: STARWOOD FINANCIAL TRUST
ITEM 1. FINANCIAL STATEMENTS
Starwood Financial Trust
Consolidated Balance Sheets
(In thousands)
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997*
----------- -----------
(unaudited)
<S> <C> <C>
ASSETS
Real estate loans and related investments, net (Note 3) $ 1,285,133 $ 11,175
Cash and cash equivalents 6,178 296
Accrued interest and rent receivable 13,036 58
Deferred expenses and other assets 7,658 1,912
----------- -----------
Total assets $ 1,312,005 $ 13,441
----------- -----------
----------- -----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable, accrued expenses and other liabilities $ 6,882 $ 1,915
Dividend payable 18,337 --
Debt obligations 536,692 --
----------- -----------
Total liabilities 561,911 1,915
----------- -----------
Minority interest -- 5,175
----------- -----------
Commitments and contingencies -- --
Shareholders' equity:
Class A Shares , $1.00 par value, unlimited shares authorized,
52,389,718 (1) and 7,550,000 shares issued and outstanding
at June 30, 1998 and December 31, 1997, respectively 52,390 7,550
Class B Shares, $.01 par value, unlimited shares authorized,
26,195,145(1) and 3,775,000 shares issued and outstanding
at June 30, 1998 and December 31, 1997, respectively 262 38
Net unrealized gains (losses) on "available-for-sale" investments (67) (162)
Additional paid in capital 700,907 --
Distributions in excess of net earnings (3,398) (1,075)
----------- -----------
Total shareholders' equity 750,094 6,351
----------- -----------
Total liabilities and shareholders' equity $ 1,312,005 $ 13,441
----------- -----------
----------- -----------
</TABLE>
*Reclassified to conform to 1998 presentation.
(1) As adjusted for one-for-six reverse stock split effective
June 19, 1998 (Note 5)
The accompanying notes are an integral part of the financial statements.
3
<PAGE>
Starwood Financial Trust
Consolidated Statements of Operations
(In thousands except per share data)
<TABLE>
<CAPTION>
For the Three Months Ended For the Six Months Ended
June 30, June 30,
-------------------------- ------------------------
1998 1997 1998 1997
-------- -------- -------- --------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Revenue:
Interest income $ 28,663 $ 220 $ 31,956 $ 458
Operating lease income 3,750 -- 4,274 --
Other income 1,291 -- 1,440 2
-------- -------- -------- --------
Total revenue 33,704 220 37,670 460
-------- -------- -------- --------
Costs and expenses:
Interest expense 9,398 -- 10,494 --
Operating lease depreciation 1,374 -- 1,569 --
General and administrative 532 81 813 157
Advisory fees 1,761 -- 1,991 --
Stock option compensation expense (Note 5) -- -- 5,985 --
Provision for possible credit losses 750 -- 750 --
-------- -------- -------- --------
Total costs and expenses 13,815 81 21,602 157
-------- -------- -------- --------
Net income before minority interest 19,889 139 16,068 303
Minority interest -- (134) (54) (280)
-------- -------- -------- --------
Net income $ 19,889 $ 5 $ 16,014 $ 23
-------- -------- -------- --------
-------- -------- -------- --------
Basic earnings per Class A Share(1) $ 0.38 $ 0.00 $ 0.52 $ 0.02
-------- -------- -------- --------
-------- -------- -------- --------
Diluted earnings per Class A Share(1) $ 0.37 $ 0.00 $ 0.51 $ 0.01
-------- -------- -------- --------
-------- -------- -------- --------
</TABLE>
(1) As retroactively adjusted for one-for-six reverse stock split effective
June 19, 1998 (Note 5)
The accompanying notes are an integral part of the financial statements.
4
<PAGE>
Starwood Financial Trust
Consolidated Statements of Changes in Shareholders' Equity
(In thousands)
For the Six Months Ended June 30, 1998
(unaudited)
<TABLE>
<CAPTION>
Net
Par Value Unrealized Distributions
----------------------- Gains Additional In Excess
Class A Class B (Losses) on Paid-In Of Net
Shares Shares Investments Capital Earnings Total
--------- --------- ----------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1997* $ 7,550 $ 38 $ (162) $ -- $ (1,075) $ 6,351
Recapitalization Transactions (Note 5) 306,796 1,534 -- 432,136 -- 740,466
Issuance of options to the Advisor (Note 5) -- -- -- 5,985 -- 5,985
Change in net unrealized gains (losses)
on investments -- -- 95 -- -- 95
Paid or accrued dividends -- -- -- -- (18,337) (18,337)
Effects of reorganization(1) (Note 5) (261,956) (1,310) -- 262,786 -- (480)
Net income for the period -- -- -- -- 16,014 16,014
--------- --------- --------- --------- --------- ---------
Balance as of June 30, 1998 $ 52,390 $ 262 $ (67) $ 700,907 $ (3,398) $ 750,094
--------- --------- --------- --------- --------- ---------
--------- --------- --------- --------- --------- ---------
</TABLE>
* Reclassified to conform to 1998 presentation.
(1) As adjusted for 1-for-six reverse stock split effective
June 19, 1998 (Note 5)
The accompanying notes are an integral part of the financial statements.
5
<PAGE>
Starwood Financial Trust
Consolidated Statements of Cash Flows
(In thousands)
(unaudited)
<TABLE>
<CAPTION>
For the For the
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Net income $ 19,889 $ 5 $ 16,014 $ 23
Adjustments to reconcile net income to cash flows provided
by operating activities:
Minority interest -- 134 54 280
Non-cash expense for options issued to Advisor (Note 5) -- -- 5,985 --
Depreciation and amortization 2,078 -- 2,507 --
Provision for possible credit losses 750 -- 750 --
Changes in assets and liabilities:
Increase in accrued interest and rent receivable (6,083) -- (5,527) --
(Increase) decrease in deferred expenses and other assets 5,116 129 2,941 (9)
Increase in accounts payable, accrued
expenses and other liabilities 5,552 37 4,967 35
--------- --------- --------- ---------
Cash flows provided by operating activities 27,302 305 27,691 329
--------- --------- --------- ---------
Cash flows from investing activities:
Net cash outflow for the Recapitalization Transactions (Notes 2 & 5) -- -- (334,916) --
Investments in real estate loans and related investments (221,588) 13 (224,728) (6,006)
Principal collections from real estate loans and related investments 7,724 4,572 8,772 132
Sale of real estate loans and related investments -- -- -- 4,500
--------- --------- --------- ---------
Cash flows provided by (used in) investing activities (213,864) 4,585 (550,872) (1,374)
--------- --------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of Class B Shares -- -- 1,534 --
Net borrowings under revolving credit facility 70,622 -- 295,622 --
Borrowings under term loans 78,764 -- 203,764 --
Borrowings under asset repurchase agreements 1,676 -- 37,306 --
Payment for deferred financing costs -- -- (8,687) --
Costs incurred in reorganization (480) -- (480) --
Proceeds from exercise of options (Note 5) 4 -- 4 --
Proceeds from exercise of warrants (Note 5) -- -- -- 4,924
--------- --------- --------- ---------
Cash flows provided by financing activities 150,586 -- 529,063 4,924
--------- --------- --------- ---------
Increase (decrease) in cash and cash equivalents (35,976) 4,890 5,882 3,879
Cash and cash equivalents at beginning of period 42,154 877 296 1,888
--------- --------- --------- ---------
Cash and cash equivalents at end of period $ 6,178 $ 5,767 $ 6,178 $ 5,767
--------- --------- --------- ---------
--------- --------- --------- ---------
Supplemental disclosure of cash flow information:
Cash paid during the period for interest $ 6,424 $ -- $ 6,542 $ --
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of the financial statements.
6
<PAGE>
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 Notes 4 and 5). As discussed
in Note 5, on March 18, 1998, all the outstanding interests in the Partnership
not held by the Company were exchanged for additional 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 5, pursuant to the concurrent
approval through a shareholder vote on March 18, 1998, the Company entered into
a series of transactions 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) merged with a newly-formed subsidiary incorporated in
Maryland 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.
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 its customers with value-added,
structured financing solutions.
The Company currently plans to originate and make investments in various
types of income-producing commercial real estate loans and its investment
program will emphasize 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 majority 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 - Summary of Significant Accounting Policies
Basis of accounting and 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, its subsidiaries, and the
Partnership.
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 June 30, 1998
and, the results of its operations, changes in shareholders' equity and its cash
flows for the three and six month periods ended June 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.
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 six month period ended June 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 5); (ii) issuance of options to the
Advisor to acquire Class A Shares of the Company (see Note 5); and (iii)
issuance of new Class A Shares in exchange for a portion of the acquisition of
real estate loans and related investments as part of the Recapitalization
Transactions (see Note 5). The cash portion of the Recapitalization Transactions
is as follows (in thousands):
- ---------------- 7
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.
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
Acquisition of real estate loans and related 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)
-------------
-------------
</TABLE>
Revenue recognition - Interest income, including amortization of premiums
or discounts and amortization of loan or commitment fees is recognized using the
effective interest method. Income under 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. In
addition, 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 costs to dispose on an individual loan
basis. In addition, management considers a loan to be impaired when, based upon
current information and events, it believes that it is probable that management
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 disposal
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 and 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 4 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 Corporation
to taxation at the shareholder level only. For income tax purposes, the
Corporation reports revenue and expenses on the accrual method.
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"). 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, 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 share options to purchase Class A Shares issued
to the Advisor and the Trustees of the Company. 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.
The basic and fully diluted earnings per $1.00 par value Class A Share(1)
of the Company (the "Class A Shares") are based upon weighted average shares
outstanding (as indicated in the following table) during each of the three and
six month periods ended June 30, 1998 and 1997, respectively.
8
<PAGE>
<TABLE>
<CAPTION>
(In thousands)
Three months ended Six months ended
June 30, June 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 30,637 1,160
Add effect of assumed shares issued under 560 542 327 20
Treasury stock method for stock options
Add effects of conversion of Class B
Shares (1 for 49 ratio) 1,228 760 701 761
------- ------- ------ -------
Weighted average Class A Shares
outstanding for fully diluted earnings
per share 54,178 2,560 31,665 1,941
------- ------- ------ -------
------- ------- ------ -------
</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.
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 of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
New Accounting Pronouncements - In June 1997, the FASB issued Statement
No. 130, "Reporting Comprehensive Income" ("SFAS No. 130") effective for fiscal
years beginning after December 15, 1997, although earlier application is
permitted. SFAS No. 130 establishes standards for 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 the components therewith under generally accepted
accounting principles. The Company intends to adopt the requirements of this
pronouncement in its financial statements for the year ending December 31, 1998.
The adoption of SFAS 130 is not expected to have a material impact on the
Company's Financial Statement disclosures.
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 financial
statement disclosures.
9
<PAGE>
Note 3 - Real Estate Loans and Related Investments
The following is a summary description of the Company's current investments:
<TABLE>
<CAPTION>
Company's
Current Carrying value as of
Number of Original Principal --------------------
Underlying Borrowers Commitment Balances June 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/ 10 $602,694 $550,780 $549,243 --
Mixed Use/
Apartment
Subordinated Office/Hotel/ 9 257,873 238,904 250,926 --
Mortgages Resort/Planned
Communities
Opportunistic Office/Hotel/ 2 166,644 125,402 81,300 --
Mortgages Apartment
Partnership loans/ Office/Hotel 3 52,300 52,279 50,230 --
Unsecured Notes
Construction Loans Assisted 2 92,390 91,929 97,104 --
Living/Resorts
Real Estate Under Hotels 1 N/A(3) N/A(3) 192,660 --
Operating Leases
Loan Participations Various 2 15,422 15,783 10,821 --
Other Real Marketable real N/A 43,150 N/A 53,599 $ 11,175
Estate-Related estate related ---------- ----------
Investments securities
Subtotal Investments 1,285,883 11,175
Provision for
Possible Credit
Losses (750) --
---------- ----------
Total Real
Estate Loans
and Related
Investments, net $ 1,285,133 $ 11,175
----------- ----------
----------- ----------
</TABLE>
<TABLE>
<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 2007 Fixed: 7.28 to 16.00% Fixed 7.28-10.82% Yes (1) Yes (2)
Variable: LIBOR + Variable: LIBOR +
1.25 to 3.25% 1.25 to 3.25%
Subordinated 2001 to 2007 Fixed 10.00 to 17.00% Fixed 10.00 to 15.25% Yes (1) Yes (2)
Mortgages
Opportunistic 1999 and 2007 6.00 to 7.00% 6.00 to 7.00% Yes (1) Yes (2)
Mortgages
Partnership loans/ 2002 and 2004 11.25% to 15.0% 11.25% to 15.00% No Yes (2)
Unsecured Notes
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%
Other Real 2002 and 2007 12.50 to 12.75% 12.50 to 12.75% No No
Estate-Related
Investments
</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, 2010,
and can be extended for up to five 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.
10
<PAGE>
Note 4 - 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 June 30, 1998 and December 31, 1997.
Note 5 - Historical Capital Activities and Current Transactions
The shares of the Company are of two classes: Class A Shares (par value
$1.00 per share) and Class B Shares (par value $.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. 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. All distributions of cash will be
distributed 99% to the Class A Shareholders and 1% to the Class B Shareholders.
In November 1993, the Company was notified that SAHI, Inc. had acquired
all of the Company's 212,500 outstanding Class B Shares. Subsequent to the
acquisition of the Class B Shares, SAHI Partners, purchased the Class B Shares
from SAHI, Inc. and accumulated 40,683 Class A Shares or 9.57% of the total
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 $.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 first Class A and
Class B Shares purchased pursuant to the warrants. On March 28, 1996, the Class
A Warrants were 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 a 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
Warrants, 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 Warrants, 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 utilized 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."
Effective on June 18, 1998, the Company consummated a merger with a
newly-formed subsidiary for the purpose of changing its state of organization
from California to Maryland. As part of the merger, the existing shareholders
received shares of the former subsidiary in exchange for existing shares of the
Company. Expenses incurred in connection with this reorganization of
approximately $480,000 have been reflected as a reduction in shareholder equity.
11
<PAGE>
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 real estate loans
and related investments to the Company in exchange for 9,191,333 Class A Shares
and $25.5 million in cash, as adjusted. SOF IV contributed real estate loans and
related 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 pursuant to 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. 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.
New Credit Facilities
On March 18, 1998, the Company entered into bank credit agreements under
which the Company had the capacity to 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 described above) and for other general corporate purposes. The
current credit agreement is comprised of: (i) a $500.0 million revolving credit
facility which bears interest at a fixed margin over LIBOR and with outstanding
principal due at maturity 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 which matures on March 15, 1999. Availability
of amounts to borrow under the revolving credit facility is subject to having
sufficient assets included as security under the facility based upon a
percentage borrowing base calculation. An aggregate of $6.25 million in loan
fees relating to these arrangements were paid at closing of the Recapitalization
Transactions. These fees will be amortized over the related loan terms. In
addition, upon closing of the Recapitalization Transactions, approximately $1.75
million in loan fees were paid with respect to the additional $175.0 million of
available credit. Such fees are refundable if the related facility is not
utilized.
In anticipation of consummating these financing transactions, effective
on March 16, 1998, the Company entered into LIBOR interest rate caps struck at
9.00% in the notional amounts of $125.0 million and $300.0 million expiring on
March 16, 1999 and 2001, respectively.
Modification to Company's Investment Policy
As approved by the shareholders of the Company in March 1998, the primary
purpose and investment policy of the Company is to originate and acquire a
diverse portfolio of structured, higher-yielding debt and debt-like interests in
real estate and real estate-related assets. In addition, although not currently
part of the Company's primary investment policy, the Company may: (i) acquire
securities collateralized, in whole or in part, by mortgage loans, as well as
make equity investments in real estate and real estate-related assets; (ii)
acquire direct or indirect interests in short-, medium- and long-term real
estate-related debt securities and mortgage interests, which may include
warrants, equity participations or similar rights incidental to a debt
investment by the Company; (iii) make, hold and dispose of purchase money loans
with respect to assets sold by the Company; and (iv) acquire positions in
non-performing and sub-performing debt for the purpose of either restructuring
it as performing debt or, if such efforts are unsuccessful, of obtaining shortly
thereafter primary management rights over or equity interests in the underlying
assets securing such debt (the "Diversified Portfolio").
As discussed above, the Company currently plans to originate and make
investments in various types of income-producing commercial real estate loans
and its investment program will emphasize 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 majority
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.
The investment and financing policies of the Company and its policies
with respect to all other activities, including its growth, debt,
capitalization, dividends and operating policies, will be determined by the
Board of Trustees. Although the Board of Trustees has no present intention to do
so, these policies may be amended or revised at any time and from time to time
at the discretion of the Board of Trustees, without a vote of the shareholders.
12
<PAGE>
The Company is restricted from making certain types of investments as a
result of the restrictions and conflicts described below (the "Investment
Restrictions"). These restrictions may limit the flexibility of the Company in
implementing its investment policy. Specifically, without the amendment,
termination or waiver of provisions of certain non-competition agreements
between Starwood Capital Group, L.P. and Starwood Hotels & Resorts, the Company
is prohibited from: (i) making investments in loans collateralized by hotel
assets where it is anticipated that the underlying equity will be acquired by
the debt holder within one year from the acquisition of such debt; (ii)
acquiring equity interests in hotels (other than acquisitions of warrants,
equity participations or similar rights incidental to a debt investment by the
Company or that are acquired as a result of the exercise of remedies in respect
of a loan in which the Company has an interest); or (iii) selling or
contributing to or acquiring any interests in Starwood Hotels & Resorts,
including debt positions or equity interests obtained by the Company under,
pursuant to or by reason of the holding of debt positions.
The Company's authority with respect to the Diversified Portfolio
includes the power to acquire, hold, own, develop, redevelop, construct,
improve, maintain, operate, manage, sell, lease, rent, transfer, encumber,
mortgage, convey, exchange and otherwise dispose of or deal with the Diversified
Portfolio and the Diversified Portfolio may be held by the Company directly or
indirectly. The Diversified Portfolio may include controlling or non-controlling
investments in or relating to any general category of real estate assets,
including without limitation, hotel, office, mixed-use, retail, industrial,
mini-storage and residential improvements to land, excluding any investments
prohibited by the Investment Restrictions.
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/or the officers of the Company with
respect to its activities.
Commencing on the 90th day after the consummation of the Recapitalization
Transactions, the Company commenced paying to the Advisor a quarterly base
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, commencing 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 the "Benchmark
BB Rate" (as defined in the Advisory Agreement). The Advisor is also reimbursed
for certain expenses it incurs on behalf of the Company.
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.
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 directors 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 directors, 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
13
<PAGE>
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%.
Options issued to the Advisor, accordingly, resulted in a charge to earnings
upon consummation of the Recapitalization Transactions equal to 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.
Pro Forma Operating Results
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 six-month
periods ended June 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)
<TABLE>
<CAPTION>
For the Six
Month Period Ended
June 30,
------------------
1998 1997
----- -----
(unaudited)
<S> <C> <C>
Revenue:
Interest income $51,326 $24,391
Prepayment income -- 13,990
Operating lease income 7,500 7,500
Other income 1,716 1,035
------- -------
60,542 46,916
------- -------
Costs and Expenses:
Interest expense 16,355 --
Operating lease depreciation 2,958 3,167
General and administrative 1,259 1,554
Advisory fees 4,840 4,840
Stock option compensation expense -- --
Provision for possible credit losses 750 750
------- -------
26,162 10,311
------- -------
Pro forma net income $34,380 $36,605
------- -------
------- -------
Pro forma basic net income per Class A Share $ 0.65 $ 0.69
------- -------
------- -------
Weighted average number of Class A Shares outstanding 52,390 52,289
------- -------
------- -------
</TABLE>
The pro forma operating data for the six-month period ended June 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 described in the preceding section), 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 June 30,
1997, the revenue from these assets is not included in the 1997 pro forma
results. Pro forma prepayment income in the six months ended June 30, 1997,
represented the early repayment of an improvement note held by the Starwood
Mezzanine. No interest expense has
14
<PAGE>
been reflected in the pro forma operating data for the six-month period ended
June 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.
New loan originations and acquisitions
From March 18, 1998 through June 30, 1998, the Company originated or acquired
seven new secured loans with an aggregate principal balance of approximately
$206.1 million and funded an additional approximately $10.0 million under
existing loan commitments. These originations and acquisitions were funded in
part by approximately $70.6 million borrowed under the Company's revolving
credit facility (net of repayments), $78.8 million borrowed under new
non-recourse term loans bearing interest at a fixed margins over LIBOR and $35.6
million borrowed under reverse repurchase arrangements bearing interest at fixed
margins over LIBOR, secured by certain real estate securities held by the
Company.
Interest rate hedging activity
The Company entered into LIBOR interest rate caps struck at 9.00% in the
notional amount of $300.0 million (expiring March 16, 2001) and $125.0
million (expiring March 16, 1999) on amounts borrowed under its credit
facility and one of its term loans, 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 on January 1, 2001 and June 1, 2001,
respectively, on amounts borrowed under additional term loans. The
Company also entered into a Treasury rate lock to hedge interest rate risks
on approximately $125.0 million in anticipated fixed rate borrowings to
refinance one of its term loans.
Note 6: Subsequent Events
Subsequent to June 30, 1998, the Company consummated the following significant
transactions or financial arrangements:
New loan originations, acquisitions and repayments
Subsequent to June 30, 1998, the Company originated or acquired four secured
loans for an aggregate funding amount of approximately $345.8 million. In
addition, the Company entered into a $110.0 million hotel acquisition facility
with a single borrower, which the Company expects will be refinanced with a
seven-year term loan in 1999. As of August 13, 1998, approximately $40.8 million
of this facility had been drawn.
In addition, on July 24, 1998, the Company entered into a strategic origination
venture with another public finance company to originate up to $300.0 million of
loans secured by specialty real estate. Under its terms, the venture will
ultimately be 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 debt to the venture at a fixed margin over LIBOR. On
July 24, 1998, the venture funded approximately $22.5 million of loans. Of the
total loan amounts, the Company funded an aggregate of $21.2 million,
representing its interim funding of the venture's senior debt and its share of
the venture's preferred equity.
These new loan originations and acquisitions were funded by approximately
$198.6 million borrowed under the Company's revolving credit facility (net of
repayments) and $209.2 million borrowed under new term loans, as described
below.
On July 9, 1998, a borrower repaid one of the Company's first mortgage notes,
which was secured by a regional mall and carried an outstanding principal
balance of approximately $47.4 million plus accrued interest and a $1.6 million
prepayment penalty. The Company utilized the proceeds to repay a related term
loan obligation.
New financing and hedging arrangements
Subsequent to quarter end, the Company expanded its existing revolving credit
facility from $500.0 million to $675.0 million and entered into several new
financing arrangements, which were in part used to fund the transactions
described in the preceding section. The new financing arrangements include: (i)
an additional $500.0 million, two-year secured credit facility bearing interest
at fixed margins over LIBOR; and (ii) an additional $209.2 million borrowed
under two new term loans bearing interest at a fixed margin over LIBOR and
maturing between June and August, 2000.
In addition, since June 30, 1998, the Company entered into a Treasury rate lock
to hedge interest rate risks on approximately $100.0 million in anticipated
fixed rate borrowings and approximately $206.8 million of interest rate swaps to
effectively fix the interest rate on a portion of the Company's floating-rate
obligations.
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. The Company is a leading provider of flexible,
structured mortgage, mezzanine and lease financing.
Prior to the Recapitalization Transactions (described in Note 5 to the
Company's consolidated financial statements), the Company's primary source of
cash during 1998 and 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 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 terminated.
On January 22, 1997, Starwood Mezzanine exercised its rights under a
warrant to acquire 833,333 Class A Shares. In addition, SAHI, Inc. exercised its
rights under the warrant 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 5 to the Company's consolidated financial
statements, pursuant to the concurrent approval through a shareholder vote on
March 18, 1998, the Company entered into a series of transactions 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) merged 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 4 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.
Liquidity and Capital Resources
The Company requires capital to fund its financing activities and
operating expenses. The Company's capital sources include cash flow from
operations, borrowings under lines of credit, additional bank borrowings or
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
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 which had an outstanding principal
balance of approximately $295.6 million on June 30, 1998; 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.
Availability of amounts to borrow under the revolving credit facility is subject
to having sufficient assets included as security under the facility in
accordance with a percentage borrowing base calculation. An aggregate of $8.0
million in loan fees relating to these arrangements were paid at closing of the
Recapitalization Transactions. These fees will be amortized over the related
loan terms.
During the second quarter, the Company entered into LIBOR interest rate
caps struck at 9.00% in the notional amounts of $125.0 million and $300.0
million and expiring on March 16, 1999 and 2001, respectively. The Company
entered into LIBOR interest rate caps struck at 7.50% in the notional amounts
of $40.4 million and $38.3 million expiring on January 1, 2001 and June 1,
2001 respectively, on amounts borrowed under additional term loans. The
Company also entered into a Treasury rate lock to hedge interest rate risks
on approximately $125.0 million in anticipated fixed rate borrowings. In
addition,
- -------------- 16
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.
<PAGE>
subsequent to June 30, 1998, the Company also arranged a Treasury rate lock to
hedge the interest rate risks on approximately $100.0 million in anticipated
fixed rate borrowings and approximately $206.8 million of interest rate swaps to
effectively fix the interest rate on a portion of the Company's floating-rate
obligations.
Subsequent to June 30, 1998, the Company expanded its existing revolving
credit facility from $500.0 million to $675.0 million and entered into several
new financing arrangements, which were in part used to fund the new origination
and acquisitions described above including: (i) an additional $500.0 million
two-year secured credit facility bearing interest at fixed margins over LIBOR;
and (ii) an additional $209.2 million borrowed under two new term loans bearing
interest at a fixed margin over LIBOR and maturing between June and August,
2000. In addition, a borrower repaid one of the Company's first mortgage notes,
which was secured by a regional mall and carried an outstanding principal
balance of approximately $47.4 million plus accrued interest and a $1.6 million
prepayment penalty. The Company utilized the proceeds to repay a related term
loan obligation.
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.
Three Month Period Ended June 30, 1998 Compared to 1997
During the three months ended June 30, 1998, total revenue increased
$33,484,000 as compared to total revenue for the three months ended March 31,
1997. This increase is a result of the interest generated by the real estate
loan investments contributed in the Recapitalization Transactions, as well as
approximately $206.1 million of other loan investments newly originated or
acquired by the Company during 1998 and an additional $10.0 million funded
under existing loan commitments. Included in other income for the three
month period ended June 30, 1998 is a gain of $860,000 from the early repayment
of a $2.8 million loan participation that had been acquired at a discount.
The increase in the Company's total costs and expenses during the three
months ended June 30, 1998 compared to the three months ended June 30, 1997 is
primarily due to the expense associated with the interest expense on the
borrowings under the revolving credit facility 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 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.
Six Month Period Ended June 30, 1998 compared to 1997
During the six months ended June 30, 1998, total revenue increased
$37,210,000 as compared to total revenue for the six months ended June 30, 1997.
This increase is a result of the interest generated by the real estate loan
investments contributed in the Recapitalization Transactions, as well as
approximately $206.1 million of other loan investments newly originated or
acquired by the Company during 1998 and an additional $10.0 million funded
under existing loan commitments. Included in other income for the six month
period ended June 30, 1998 is a gain of $860,000 from the early repayment of a
$2.8 million loan participation that had been acquired at a discount.
The increase in the Company's total costs and expenses during the six
months ended June 30, 1998 compared to the six months ended June 30, 1997 is
primarily due to the expense associated with the issuance of approximately
2,493,843 options to the Advisor (see Note 5 to the Company's consolidated
financial statements) as well as the interest expense on the borrowings under
the revolving credit facility 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 six month period ended June
30, 1998 and the comparable prior periods are not necessarily indicative of the
Company's future operating results or financial condition.
Interest Rate Risks
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
17
<PAGE>
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 various 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 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 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.
Other Matters
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 June
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.
18
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company changed its state of organization from California to
Maryland on June 19, 1998. In connection therewith, the constituent instruments
defining the rights of the capital stock of the Company were modified as
previously reported and described in the Company's Proxy Statement / Prospectus
dated May 14, 1998.
ITEM 3. DEFAULT UPON SENIOR SECURITIES
None.
19
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On June 18, 1998, the Company held a special meeting to vote on various
proposals described in following summary, along with the vote(1) on such
proposals:
Election of Trustees:
The four trustees elected as a result of the meeting to hold office until the
next annual meeting of Shareholders are Jeffrey G. Dishner, Jonathan D. Ellian,
Merrick R. Kleeman and Robin Josephs.
<TABLE>
<CAPTION>
Eligible
Trustee Votes For Against Abstain
------- ---------- ---------- ------- -------
<S> <C> <C> <C> <C>
Jeffery G. Dishner 78,472,774 78,468,875 3,899 -
Jonathan D. Ellian 78,472,774 78,468,916 3,858 -
Merrick R. Kleeman 78,472,774 78,468,916 3,858 -
Robin Josephs. 78,472,774 78,468,833 3,941 -
</TABLE>
Other Proposals:
<TABLE>
<CAPTION>
Eligible
Proposals Votes For Against Abstain
--------- ---------- ---------- ------- -------
<S> <C> <C> <C> <C>
1. To approve the reorganization
of the Company under the laws
of the State of Maryland
through the merger and transfer
of all of the assets and
liabilities to
Starwood Financial Trust. 78,472,774 78,339,450 4,476 5,004
2. To ratify the appointment of
PricewaterhouseCoopers LLP as
Independent Auditors for the
fiscal year ended
December 31, 1998. 78,472,774 78,467,824 2,110 2,840
</TABLE>
ITEM 5. OTHER INFORMATION
None.
- ----------------- 20
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.
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM-8-K
a. Exhibits
<TABLE>
<CAPTION>
Exhibit
Number Description of Exhibit
------- ----------------------
<S> <C>
2.1 Merger and Reorganization Agreement between the Company and SFT-Maryland*
3.1 Amended and Restated Declaration of Trust of Starwood Financial Trust*
3.2 Bylaws of Starwood Financial Trust*
* Incorporated by reference from the Company's Registration Statement on Form S-4
(file number 333-52405)
</TABLE>
b. Reports on Form 8-K
On April 2, 1998, a report on Form 8-K was filed in
connection with the Recapitalization Transactions.
21
<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 August 14, 1998 /s/ Jay Sugarman
---------------------------------------
Jay Sugarman
Chief Executive Officer and President
Date August 14, 1998 /s/ Spencer B. Haber
---------------------------------------
Spencer B. Haber
Chief Financial Officer and Secretary
(Principal Financial and Accounting Officer)
22
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 6,178
<SECURITIES> 53,599
<RECEIVABLES> 13,036
<ALLOWANCES> 750
<INVENTORY> 0
<CURRENT-ASSETS> 72,063
<PP&E> 194,229
<DEPRECIATION> 1,569
<TOTAL-ASSETS> 1,312,005
<CURRENT-LIABILITIES> 25,219
<BONDS> 0
0
0
<COMMON> 52,652
<OTHER-SE> 697,442
<TOTAL-LIABILITY-AND-EQUITY> 1,312,005
<SALES> 0
<TOTAL-REVENUES> 37,670
<CGS> 0
<TOTAL-COSTS> 21,602
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 750
<INTEREST-EXPENSE> 10,494
<INCOME-PRETAX> 16,014
<INCOME-TAX> 0
<INCOME-CONTINUING> 16,014
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 16,014
<EPS-PRIMARY> 0.52
<EPS-DILUTED> 0.51
</TABLE>
