<PAGE>
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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 JUNE 30, 1999
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)
<TABLE>
<S> <C>
MARYLAND 95-6881527
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
1114 AVENUE OF THE AMERICAS 10036
27(TH) FLOOR (Zip Code)
NEW YORK, NY 10036
(Address of principal executive
offices)
</TABLE>
Registrant's telephone number, including area code: (212) 930-9400
Securities registered pursuant to Section 12(b) of the Act:
<TABLE>
<CAPTION>
Title of each class: Name of Exchange on which registered:
- --------------------------------------------- ---------------------------------------------
<S> <C>
Class A Shares of beneficial interest,
$1.00 par value American Stock Exchange
</TABLE>
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 6, 1999, there were 52,470,951 Class A Shares of beneficial
interest of Starwood Financial Trust, $1.00 par value per share, outstanding.
- --------------------------------------------------------------------------------
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<PAGE>
STARWOOD FINANCIAL TRUST
INDEX TO FORM 10-Q
<TABLE>
<CAPTION>
PAGE
-----------
<S> <C> <C>
PART I. CONSOLIDATED FINANCIAL INFORMATION........................................................... 3
ITEM 1. FINANCIAL STATEMENTS:
CONSOLIDATED BALANCE SHEETS AT JUNE 30, 1999 AND DECEMBER 31, 1998........................... 3
CONSOLIDATED STATEMENTS OF OPERATIONS--FOR THE THREE- AND SIX-MONTH PERIODS ENDED JUNE 30,
1999 AND 1998.............................................................................. 4
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY--FOR THE SIX-MONTH PERIOD ENDED
JUNE 30, 1999.............................................................................. 5
CONSOLIDATED STATEMENTS OF CASH FLOWS--FOR THE THREE- AND SIX-MONTH PERIODS ENDED JUNE 30,
1999 AND 1998.............................................................................. 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS................................................... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS........ 23
PART II. OTHER INFORMATION............................................................................ 32
ITEM 1. LEGAL PROCEEDINGS............................................................................ 32
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.................................................... 32
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.............................................................. 32
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................... 32
ITEM 5. OTHER INFORMATION............................................................................ 32
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................................................. 32
SIGNATURES................................................................................... 33
</TABLE>
2
<PAGE>
PART I--CONSOLIDATED FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
STARWOOD FINANCIAL TRUST
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF AS OF
JUNE 30, DECEMBER 31,
1999 1998
------------ ------------
<S> <C> <C>
(UNAUDITED)
ASSETS
Loans and other investments, net..................................................... $ 2,116,683 $2,013,703
Cash and cash equivalents............................................................ 19,518 10,110
Restricted cash...................................................................... 3,497 5,699
Marketable securities................................................................ 4,862 5,406
Accrued interest and rent receivable................................................. 12,333 13,122
Deferred expenses and other assets................................................... 14,326 11,054
Investment in Starwood Operating..................................................... 409 522
------------ ------------
Total assets..................................................................... $ 2,171,628 $2,059,616
------------ ------------
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable, accrued expenses and other liabilities............................. $ 8,572 $ 10,536
Dividends payable.................................................................... -- 22,633
Debt obligations..................................................................... 1,160,885 1,055,719
------------ ------------
Total liabilities................................................................ 1,169,457 1,088,888
------------ ------------
Minority interest.................................................................... -- --
------------ ------------
Commitments and contingencies........................................................ -- --
Shareholders' equity:
Series A Preferred Shares, $0.01 par value, liquidation value $50.00 per share,
4,400,000 shares authorized 4,400,000 and 4,400,000 shares issued and outstanding
at June 30, 1999 and December 31, 1998, respectively............................... 44 44
Class A Shares, $1.00 par value, 70,000,000 shares authorized, 52,470,951 and
52,407,718 shares issued and outstanding at June 30, 1999 and December 31, 1998,
respectively....................................................................... 52,471 52,408
Class B Shares, $0.01 par value, 35,000,000 shares authorized, 26,235,475 and
26,203,859 shares issued and outstanding at June 30, 1999 and December 31, 1998,
respectively....................................................................... 262 262
Warrants and options................................................................. 18,976 19,131
Net unrealized gains (losses) on "available-for-sale" investments.................... (141) (23)
Additional paid in capital........................................................... 902,487 901,365
Retained earnings (deficit).......................................................... 28,072 (2,459)
------------ ------------
Total shareholders' equity....................................................... 1,002,171 970,728
------------ ------------
Total liabilities and shareholders' equity....................................... $ 2,171,628 $2,059,616
------------ ------------
------------ ------------
</TABLE>
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 FOR THE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ---------------------
1999 1998 1999 1998
--------- --------- ---------- ---------
<S> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
REVENUE:
Interest income...................................... $ 52,007 $ 28,663 $ 101,926 $ 31,956
Operating lease income............................... 3,723 3,750 7,450 4,274
Other income......................................... 3,525 1,291 5,303 1,440
--------- --------- ---------- ---------
Total revenue...................................... 59,255 33,704 114,679 37,670
--------- --------- ---------- ---------
COSTS AND EXPENSES:
Interest expense..................................... 20,556 9,398 40,249 10,494
Operating lease depreciation......................... 1,365 1,374 2,730 1,569
General and administrative........................... 1,185 532 1,669 813
Advisory fees........................................ 5,016 1,761 9,681 1,991
Provision for possible credit losses................. 1,250 750 2,250 750
Stock option compensation expense.................... -- -- -- 5,985
--------- --------- ---------- ---------
Total costs and expenses........................... 29,372 13,815 56,579 21,602
--------- --------- ---------- ---------
Net income before minority interest.................... 29,883 19,889 58,100 16,068
Minority interest...................................... -- -- -- (54)
--------- --------- ---------- ---------
Net income............................................. $ 29,883 $ 19,889 $ 58,100 $ 16,014
Preferred dividends.................................... (5,308) -- (10,615) --
--------- --------- ---------- ---------
Net income allocable to common shareholders............ $ 24,575 $ 19,889 $ 47,485 $ 16,014
--------- --------- ---------- ---------
--------- --------- ---------- ---------
Net income allocable to Class A Shares................. $ 24,329 $ 19,690 $ 47,010 $ 15,854
--------- --------- ---------- ---------
--------- --------- ---------- ---------
Basic earnings per Class A Share(1).................... $ 0.46 $ 0.38 $ 0.90 $ 0.52
--------- --------- ---------- ---------
--------- --------- ---------- ---------
Diluted earnings per Class A Share(1).................. $ 0.43 $ 0.37 $ 0.84 $ 0.51
--------- --------- ---------- ---------
--------- --------- ---------- ---------
</TABLE>
- ------------------------
(1) As adjusted for one-for-six reverse stock split effective June 19, 1998
The accompanying notes are an integral part of the financial statements.
4
<PAGE>
STARWOOD FINANCIAL TRUST
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(IN THOUSANDS)
FOR THE SIX MONTHS ENDED JUNE 30, 1999
(UNAUDITED)
<TABLE>
<CAPTION>
NET
UNREALIZED
COMMON SHARES, GAINS
SERIES A AT PAR WARRANTS (LOSSES) ADDITIONAL RETAINED
PREFERRED ------------------ AND ON PAID-IN EARNINGS
SHARES CLASS A CLASS B OPTIONS INVESTMENTS CAPITAL (DEFICIT) TOTAL
--------- -------- ------- -------- -------- ---------- --------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1998................... $44 $52,408 $262 $19,131 $(23) $901,365 $ (2,459) $ 970,728
Exercise of options...... -- 63 -- (155) -- 1,039 -- 947
Change in net unrealized
gains (losses) on
investments............ -- -- -- -- (118) -- -- (118)
Dividends
declared--preferred.... -- -- -- -- -- 83 (5,308) (5,225)
Dividends
declared--common....... -- -- -- -- -- -- (22,261) (22,261)
Net income for the
period................. -- -- -- -- -- -- 58,100 58,100
--- -------- ------- -------- -------- ---------- --------- ----------
Balance as of June 30,
1999................... $44 $52,471 $262 $18,976 $(141) $902,487 $ 28,072 $1,002,171
--- -------- ------- -------- -------- ---------- --------- ----------
--- -------- ------- -------- -------- ---------- --------- ----------
</TABLE>
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,
------------------------ ------------------------
<S> <C> <C> <C> <C>
1999 1998 1999 1998
----------- ----------- ----------- -----------
Cash flows from operating activities:
Net income................................................... $ 29,883 $ 19,889 $ 58,100 $ 16,014
Adjustments to reconcile net income to cash flows provided by
operating activities:
Minority interest.......................................... -- -- -- 54
Non-cash expense for options issued to advisor............. -- -- -- 5,985
Equity in earnings of unconsolidated joint ventures and
subsidiaries............................................. 8 -- 113 --
Depreciation and amortization.............................. 2,745 2,078 5,650 2,507
Amortization of discount/premium and deferred interest..... (5,428) -- (12,730) --
Provision for possible credit losses....................... 1,250 750 2,250 750
Changes in assets and liabilities:
Decrease in restricted cash.............................. 649 -- 2,202 --
(Increase) decrease in accrued interest and rent
receivable............................................. 633 (6,083) 789 (5,527)
(Increase) decrease in deferred expenses and other
assets................................................. (623) 5,116 (1,034) 2,941
Increase (decrease) in accounts payable, accrued expenses
and other liabilities.................................. 1,743 5,552 (1,964) 4,967
----------- ----------- ----------- -----------
Cash flows provided by operating activities.............. 30,860 27,302 53,376 27,691
----------- ----------- ----------- -----------
Cash flows from investing activities:
Net cash outflow for the Recapitalization Transactions... -- -- -- (334,916)
New loan or investment originations/acquisitions......... (182,932) (221,588) (337,250) (224,728)
Principal fundings on existing loan commitments.......... (15,597) -- (22,724) --
Repayments of and principal collections from loans and
other investments...................................... 208,502 7,724 265,170 8,772
----------- ----------- ----------- -----------
Cash flows provided by (used in) investing activities.... 9,973 (213,864) (94,804) (550,872)
----------- ----------- ----------- -----------
Cash flows from financing activities:
Proceeds from issuance of Class B Shares................. -- -- -- 1,534
Net borrowings (repayments) under revolving credit
facilities............................................. (41,689) 70,622 45,459 295,622
Net borrowings under term loans.......................... 36,481 78,764 66,198 203,764
Borrowings (repayments) under repurchase agreements...... (6,038) 1,676 (6,491) 37,306
Dividends paid........................................... (27,486) -- (50,119) --
Payments for deferred financing costs.................... (345) -- (5,158) (8,687)
Costs incurred in reorganization......................... -- (480) -- (480)
Proceeds from exercise of options........................ 225 4 947 4
----------- ----------- ----------- -----------
Cash flows provided by (used in) financing activities.... (38,852) 150,586 50,836 529,063
----------- ----------- ----------- -----------
Increase (decrease) in cash and cash equivalents............. 1,981 (35,976) 9,408 5,882
Cash and cash equivalents at beginning of period............. 17,537 42,154 10,110 296
----------- ----------- ----------- -----------
Cash and cash equivalents at end of period................... 19,518 $ 6,178 19,518 $ 6,178
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
Supplemental disclosure of cash flow information:
Cash paid during the period for interest................... $ 19,562 $ 6,424 $ 38,359 $ 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 to
continue and expand its predecessors' business, started in 1993, of delivering
flexible financial solutions to the commercial real estate industry. 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 (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 of beneficial interest
(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 19, 1998, the Company (which had previously been organized
under California law) changed its domicile to Maryland by merging with a
newly-formed subsidiary organized as a real estate investment trust under
Maryland law. As a result of this merger, the Company effectively consummated a
one-for-six(1) reverse split of its capital stock.
Although the Company did not qualify as a real estate investment trust (a
"REIT") for federal income tax purposes for its fiscal years 1993 through 1997,
it did not incur any material tax liabilities as a result of its operations. As
confirmed by a closing agreement with the Internal Revenue Service ("IRS")
obtained in March 1998, the Company is eligible to and intends to make an
election to be taxed as a REIT for its tax year beginning January 1, 1998.
BUSINESS--The Company is a leading structured finance company that delivers
financial solutions to the real estate industry by implementing a creative,
value added and entrepreneurial approach to providing investment capital. The
Company primarily focuses on providing custom-tailored mortgage, mezzanine and
lease financing to the real estate industry through its proprietary origination,
acquisition and servicing platform to create superior risk-adjusted returns for
its shareholders.
The Company currently originates and acquires loans backed by various types
of income-producing commercial real estate, with an emphasis on senior and
junior commercial mortgage loans, mezzanine financing and credit tenant leasing.
The Company has not in the past, and does not currently intend to invest a
significant portion of its capital in commercial mortgage-backed securities. A
significant portion of the Company's loans are structured so that the Company's
investment is subordinate to the third-party first mortgage debt but senior to
the real estate owner/operator's equity position. The Company does not have any
prescribed allocation among investments, and the Company could invest all or any
portion of its assets in any of the investments described above.
- ------------------------
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
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--BASIS OF PRESENTATION
The accompanying unaudited 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. Further, certain other investments in
partnerships or joint ventures which the Company does not unilaterally control
are also accounted for under the equity method.
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, 1999 and the
results of its operations, changes in shareholders' equity and its cash flows
for the three- and six-month periods ended June 30, 1999 and 1998, respectively.
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, discount mortgages, partnership loans, construction loans,
investments in real estate under operating leases, loan participations/loans
secured by mortgage loans 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.
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 months ended June 30, 1998, the Company
had significant non-cash activity including: (i) conversion of units in APMT
Limited Partnership (shown as "minority interest" in the consolidated financial
statements) to Class A Shares (see Note 4); (ii) issuance to Starwood Financial
Advisors, L.L.C. (the "Advisor") of options to acquire Class A Shares of the
Company (see Note 11); 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 (defined below) (see Note 4).
The cash portion of the Recapitalization Transactions is summarized as
follows (in thousands):
<TABLE>
<S> <C>
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)
-----------
-----------
</TABLE>
8
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARKETABLE SECURITIES--The Company has certain investments in marketable
securities such as those issued by the Government National Mortgage Association
(GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan
Mortgage Corporation (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 management of
liquidity. 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 shareholders equity.
DEFERRED FINANCING COSTS--Loan fees, hedging costs and other direct
financing costs are capitalized and amortized as additional interest expense
using the effective interest method over the term of the related obligation.
REPURCHASE AGREEMENTS--The Company may enter into sales of securities or
loans under agreements to repurchase the same security or loan. The amounts
borrowed under repurchase agreements are carried on the balance sheet as part of
debt obligations at the amount advanced plus accrued interest. Interest incurred
on the repurchase agreements is reported as interest expense.
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 10 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, upon filing its tax return, intends to elect to be
taxed as a REIT for its tax 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
9
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
to its shareholders, thereby subjecting the distributed net income of the
Company to taxation at the shareholder level only. 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.
NET INCOME (LOSS) APPLICABLE TO CLASS A SHARES--Net income applicable to
Class A Shares represents net income less current accumulated dividends on the
outstanding preferred shares less 1% of the remaining net income, representing
amounts applicable to the Class B Shares.
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.
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.
NOTE 4--TRANSACTIONS WITH AFFILIATES AND RECAPITALIZATION
TRANSACTIONS WITH AFFILIATES--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 Class A Shares then outstanding.
On March 15, 1994, the Company announced that it had entered into an
agreement with SAHI Partners 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 APMT
Limited Partnership by contributing $400,000 in cash in exchange for an 8.05%
interest in such partnership. 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 units, which were
convertible into cash, Class A Shares or a combination of both pursuant to an
exchange rights agreement. 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
10
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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
Warrants, SAHI Partners, SAHI, Inc. and Starwood Mezzanine jointly owned 69.46%
of the outstanding Class A Shares and, with the voting interest of the Class B
Shares, controlled 79.64% of the voting interest of the Company. The Company
increased its capital by approximately $5.0 million, 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--Pursuant to a series of transactions
beginning in March 1994 and including the exercise of certain warrants in
January 1997, Starwood Mezzanine and certain entities affiliated with the
general partners of Starwood Mezzanine acquired joint ownership of 69.46% and
100% of the outstanding Class A Shares and Class B Shares of the Company,
respectively, through which they controlled approximately 79.64% of the voting
interest in the Company as of December 31, 1997. Prior to the consummation of
these transactions (collectively, the "Recapitalization Transactions"), Starwood
Mezzanine also owned 761,491 units which represented the remaining 91.95% of
APMT Limited Partnership not held by the Company, which 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 partnership 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 contributed various real estate loan
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
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 were 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
approximately 99.27% of the outstanding Class A Shares of the Company and 100%
of the Class B Shares. Assets acquired from Starwood Mezzanine were recorded
using step acquisition accounting at predecessor basis adjusted to fair value to
the extent of post-transaction third-party ownership. Assets acquired from SOF
IV were recorded 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 in APMT Limited
Partnership 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 months ended June 30, 1998 is presented as if the transactions
had been completed on January 1, 1998.
11
<PAGE>
PRO FORMA
CONDENSED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
FOR THE SIX
MONTHS ENDED
JUNE 30, 1998
--------------
<S> <C>
(UNAUDITED)
REVENUE:
Interest income................................................................................. $ 51,326
Operating lease income.......................................................................... 7,500
Other income.................................................................................... 1,716
-------
Total revenue................................................................................. 60,542
-------
COSTS AND EXPENSES:
Interest expense................................................................................ 16,355
Operating lease depreciation.................................................................... 2,958
General and administrative...................................................................... 1,259
Advisory fees................................................................................... 4,840
Provision for possible credit losses............................................................ 750
-------
Total costs and expenses...................................................................... 26,162
-------
Pro forma net income............................................................................ $ 34,380
-------
-------
Pro forma basic net income per Class A Share.................................................... $ 0.65
-------
-------
Weighted average number of Class A Shares outstanding........................................... 52,390
-------
-------
</TABLE>
The pro forma operating data for the six months 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 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 originations or
acquisitions are not reflected in these pro forma numbers until the actual
origination or acquisition date by Starwood Mezzanine or SOF IV. 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 period
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 the Advisor entered into an Advisory Agreement (the "Advisory
Agreement") pursuant to which the Advisor manages the 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: (i) identifying investment opportunities
for the Company; (ii) advising the Company with respect to and effecting
acquisitions and dispositions of the Company's investments; (iii) monitoring,
managing and servicing the Company's loan portfolio; and (iv) 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.
12
<PAGE>
PRO FORMA
CONDENSED STATEMENT OF OPERATIONS (CONTINUED)
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
The Company pays the Advisor a quarterly base management fee of 0.3125%
(1.25% per annum) of the "Book Equity Value" of the Company determined as of the
last day of each quarter but estimated and paid in advance subject to
recomputation. "Book Equity Value" is generally defined as the excess of the
book value of the assets of the Company over all liabilities of the Company.
In addition, the Company pays the Advisor a quarterly incentive fee of 5.00%
of the Company's "Adjusted Net Income" 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." "Adjusted Net Income" is generally defined as the Company's gross
income less the Company's expenses for the applicable quarter (including the
base fee for such quarter but not the incentive fee for such quarter). In
calculating both Book Equity Value and Adjusted Net Income, real estate-related
depreciation and amortization (other than amortization of financing costs and
other prepaid expenses to the extent such costs and prepaid expenses have
previously been booked as an asset of the Company) are not deducted. In
addition, debt that is exchangeable or convertible into equity securities is not
treated as a liability of the Company if the value of the equity securities into
which such debt obligation is convertible equals or exceeds the outstanding
balance of such debt obligation and the interest expense of such debt is not
included as an expense and, thus, does operate to reduce the Company's gross
income. The Advisor is also reimbursed for certain expenses it incurs on behalf
of the Company.
Because payment of both the base fee and the incentive fee commenced 90 days
after the consummation of the Recapitalization Transactions, fees were
recognized ratably over the period from March 18, 1998 through December 31,
1998. The operating results of the Company for such period were greater than
they would have been had the advisory fee not been deferred.
The Company may be subject to conflicts of interest with the Advisor because
the incentive fee, which is based on the Company's income, may create an
incentive for the Advisor to recommend investments with greater income
potential, which may be riskier and more speculative, than would be the case if
the fee did not include a performance-related component.
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' written 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 affirmative vote of the holders of two thirds or more of
the voting shares of the Company at the time outstanding.
The Company is dependent on the services of the Advisor and its officers and
employees for the successful execution of its business strategy. The Company is
subject to the risk that the Advisor might terminate the Advisory Agreement to
the extent that no suitable replacement were found to manage the affairs of the
Company.
13
<PAGE>
NOTE 5--LOANS AND OTHER INVESTMENTS
The following is a summary description of the Company's loans and other
investments as of June 30, 1999 (in thousands):
<TABLE>
<CAPTION>
# OF ORIGINAL PRINCIPAL CARRYING VALUE AS OF
UNDERLYING BORROWERS COMMITMENT BALANCES JUNE 30, DECEMBER 31,
TYPE OF INVESTMENT PROPERTY TYPE IN CLASS AMOUNT OUTSTANDING 1999 1998
- ------------------------------------------- ------------- ------------- ------------ ----------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
(UNAUDITED)
Senior Mortgages........................... 13 $ 785,983 $ 731,916 $ 727,418 $ 656,631
Office/Hotel/
Mixed Use/
Apartment/
Retail
Subordinated Mortgages..................... 16 587,035 567,314 581,285 458,280
Office/Hotel/
Mixed Use/
Retail
Discount Mortgages......................... 1 72,900 72,900 50,542 86,259
Office/Hotel/
Apartment
Partnership Loans/Unsecured Notes.......... 12 343,585 330,751 335,059 346,421
Office/Hotel/
Residential/
Land
Construction Loans......................... Resorts/ 2 91,390 52,908 57,461 97,819
Conference
Center
Real Estate Under Operating Leases......... Hotels 1 N/A(3) N/A(3) 187,211 189,942
Loan Participations/Loans Secured By 4 44,328 44,206 43,607 40,877
Mortgage Loans............................. Hotel/Office/
Residential
Specialty Finance Joint Venture Loans Various 4 50,400 51,084 47,427 47,722
(4)........................................
Investments in Unconsolidated Ventures..... Various 7 N/A N/A 29,359 30,104
Other Real Estate-Related Investments...... Real Estate- N/A N/A N/A 62,314 62,398
Related
Securities
----------- ------------
Gross Carrying Value....................... $2,121,683 $2,016,453
Provision for Possible Credit Losses....... (5,000) (2,750)
----------- ------------
Total, Net................................. $2,116,683 $2,013,703
----------- ------------
----------- ------------
<CAPTION>
CONTRACTUAL CONTRACTUAL
EFFECTIVE INTEREST INTEREST
MATURITY ACCRUAL PAYMENT PRINCIPAL
TYPE OF INVESTMENT DATES RATES (5) RATES (5) AMORTIZATION
- ------------------------------------------- ------------- ---------------------- ---------------------- ---------------
<S> <C>
Senior Mortgages........................... 2001 to 2009 Fixed: 7.28% to 16.00% Fixed: 7.28% to 12.00% Yes(1)
Variable: LIBOR + Variable: LIBOR +
4.50% to 6.00% 1.50% to 6.00%
Subordinated Mortgages..................... 2000 to 2007 Fixed: 9.53% to 20.00% Fixed: 9.53% to 18.00% Yes(1)
Variable: LIBOR + Variable: LIBOR +
4.50% to 5.80% 4.50% to 5.80%
Discount Mortgages......................... 2007 Fixed: 7.00% Fixed: 7.00% Yes
Partnership Loans/Unsecured Notes.......... 2000 to 2008 Fixed: 8.50% to 17.50% Fixed: 8.00% to 15.00% Yes
Variable: LIBOR + Variable: LIBOR +
5.37% 5.37%
Construction Loans......................... 2004 to 2007 Fixed: 10.30% to Fixed: 11.25% to Yes
12.50% 12.50%
Real Estate Under Operating Leases......... N/A(3) N/A(3) N/A(3) N/A(3)
Loan Participations/Loans Secured By 1999 to 2005 Fixed: 7.13% to 14.00% Fixed: 5.65% to 13.60% Yes
Mortgage Loans............................. Variable: LIBOR + Variable: LIBOR +
5.00% 5.00%
Specialty Finance Joint Venture Loans 2000 to 2018 Fixed: 9.45% Fixed: 9.45% Yes
(4)........................................ Variable: LIBOR + Variable: LIBOR +
3.75% to 4.50% 3.75% to 4.50%
Investments in Unconsolidated Ventures..... N/A Various Various No
Other Real Estate-Related Investments...... 2002 and 2007 Fixed: 12.50% to Fixed: 12.50% to No
12.75% 12.75%
Gross Carrying Value.......................
Provision for Possible Credit Losses.......
Total, Net.................................
<CAPTION>
PARTICIPATION
TYPE OF INVESTMENT FEATURES
- ------------------------------------------- ---------------
Senior Mortgages........................... Yes(2)
Subordinated Mortgages..................... Yes(2)
Discount Mortgages......................... Yes(2)
Partnership Loans/Unsecured Notes.......... Yes(2)
Construction Loans......................... No
Real Estate Under Operating Leases......... N/A(3)
Loan Participations/Loans Secured By No
Mortgage Loans.............................
Specialty Finance Joint Venture Loans No
(4)........................................
Investments in Unconsolidated Ventures..... No
Other Real Estate-Related Investments...... No
Gross Carrying Value.......................
Provision for Possible Credit Losses.......
Total, 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 from 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
of approximately $7.01 million as of June 30, 1999.
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 the joint venture in this note.
5. Substantially all variable-rate loans are based on 30-day LIBOR and reprice
monthly.
14
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5--LOANS AND OTHER INVESTMENTS
During the six months ended June 30, 1999 and 1998, respectively, the
Company and its affiliated ventures originated or acquired an aggregate of
$183.8 million and $206.1 million in loans and related investments, funded $15.6
million and $10.0 million under existing loan commitments and received principal
repayments of $208.5 million and $7.7 million.
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 70.00% with third-party debt and 30.00% with capital
contributions from the Company and its venture partner. The Company will
contribute preferred equity in exchange for a 12.00% preferred return and 50.00%
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 $47.4 million, representing its
interim funding of the venture's senior debt and its share of the venture's
preferred equity. On June 30, 1999, three of the loans repaid, and the venture
received approximately $2.8 million in principal and accrued interest which was
distributed out of the venture subsequent to quarter end.
The Company has reflected additional provisions for possible credit losses
of approximately $2.3 million and $0.8 million in its results of operations
during the six-month periods ended June 30, 1999 and 1998, respectively, and
approximately $1.3 million and $0.8 million for the three-month periods ended
June 30, 1999 and 1998, respectively. There was no other activity in the
Company's reserve balances during this period. 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.
15
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 6--DEBT OBLIGATIONS
The Company had obligations under various arrangements with financial
institutions as follows (in thousands):
<TABLE>
<CAPTION>
MAXIMUM PRINCIPAL PRINCIPAL
AMOUNT BALANCE AS OF BALANCE AS OF INTEREST MATURITY
AVAILABLE JUNE 30, 1999 DECEMBER 31, 1998 RATE DATE
----------- -------------- ----------------- ---------------------- ----------------------
<S> <C> <C> <C> <C> <C>
(UNAUDITED)
REVOLVING CREDIT
FACILITIES:
Line of credit......... $ 675,000 $ 541,065 $ 554,907 LIBOR + 1.50% March 2001
Line of credit......... 500,000 169,952 86,038 LIBOR + 1.00-1.25% August 2000
-------------- -----------------
Total revolving
credit
facilities......... 711,017 640,945
-------------- -----------------
TERM LOANS:
Secured by real estate under 154,955 7.44% March 2009
operating leases.................. 125,000 LIBOR + 1.50% March 1999
Secured by senior mortgage
investment........................ 89,985 89,991 LIBOR + 1.00% August 2000
Secured by senior and subordinate
mortgage investments.............. 111,328 112,927 LIBOR + 1.00% August 2000
Secured by senior mortgage
investment........................ -- 40,765 LIBOR + 1.00% May 1999
Secured by senior mortgage
investment........................ 54,000 -- LIBOR + 1.75(1) November 2000
-------------- -----------------
Total term loans.................. 410,268 368,683
-------------- -----------------
OTHER DEBT OBLIGATIONS:............... 39,600 46,091 Various Various
-------------- -----------------
TOTAL DEBT OBLIGATIONS................ $ 1,160,885 $ 1,055,719
-------------- -----------------
-------------- -----------------
</TABLE>
- ------------------------------
(1) Based on a 12-month LIBOR contract currently at 5.317%, repricing in May
2000.
Availability of amounts under the revolving credit facilities is based on a
percentage borrowing base calculation. Except as indicated above, all debt
obligations are based on 30-day LIBOR and reprice monthly.
NOTE 7--PREFERRED SHARES
On December 15, 1998, the Company issued 4.4 million preferred shares and
warrants to acquire 6.0 million Class A Shares at $35.00 per share, for
aggregate proceeds of $220.0 million. The proceeds were allocated between the
two securities issued based on estimated relative fair values.
The preferred shares have a liquidation value of $50.00 per share, carry an
initial dividend yield of 9.50% per annum and are callable without premium at
the Company's option on or after December 15, 2003. The dividend rate on the
preferred shares will increase to 9.75% on December 15, 2005, to 10.00% on
December 15, 2006 and to 10.25% on December 15, 2007 and thereafter. No other
classes of preferred shares of beneficial interest were outstanding as of June
30, 1999 or December 31, 1998.
Dividends on the preferred shares are payable quarterly in arrears and are
cumulative. The preferred shares have preference over the Company's Class A and
Class B Shares with respect to the payment of dividends and the distribution of
assets in the event of a liquidation or dissolution of the Company.
16
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 8--CLASS A SHARES AND CLASS B SHARES
The Company is authorized to issue 105.0 million shares, representing 70.0
million Class A Shares and 35.0 million Class B Shares, with a par value of
$1.00 and $0.01 per share, respectively. 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 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 holders of Class A Shares
and 1% to the holders of Class B Shares.
On December 15, 1998, for an aggregate purchase price of $220.0 million, the
Company issued 4.4 million preferred shares and warrants to acquire 6.0 million
Class A Shares at $35.00 per share. The proceeds were allocated between the two
securities issued based on estimated relative fair values.
NOTE 9--RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS
RISK MANAGEMENT--In the normal course of its on-going 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
agreements or other instruments to manage interest rate risk 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 may 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 had entered into a LIBOR interest rate cap struck at
9.00% in the notional amount of $300.0 million expiring in March 2001. 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. In
addition, the Company acquired a LIBOR interest rate cap struck at 8.50% in the
notional amount of $32.5 million expiring December 1999. Further, the Company
has entered into approximately $236.8 million of interest rate swaps to
effectively fix the interest rate on a portion of the Company's floating-rate
obligations.
17
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9--RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS (CONTINUED)
The Company is currently pursuing or recently consummated certain
anticipated long-term fixed rate borrowings and had 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 June 30, 1999,
the Company had an aggregate notional amount of approximately $63.0 million
still outstanding under such agreements, representing fixed rates of
approximately 5.5%. Under these agreements, the Company would generally receive
additional cash flow at settlement if interest rates rise and pay cash if
interest rates fall. The effects of such receipts or payments will be deferred
and amortized over the term of the specific related fixed-rate borrowings.
During the six-month period ended June 30, 1999, the Company refinanced its
$125.0 million term loan maturing March 15, 1999 with a $155.4 million term loan
maturing March 5, 2009. The new term loan bears interest at 7.44% per annum,
payable monthly, and amortizes over an approximately 22-year schedule. The new
term loan represented one of the forecasted transactions for which the Company
had previously entered into U.S. Treasury-based hedging transactions. The net
cost of the settlement of the related interest rate hedges has been deferred and
will be amortized as an increase to the effective financing cost of the new term
loan over its effective 10-year term.
In the event that, in the opinion of management, it is no longer probable
that the remaining forecasted transactions will occur under terms substantially
equivalent to those projected, the Company will cease recognizing such
transactions as hedges and immediately recognize related gains or losses based
on actual settlement or estimated settlement value. No such gains or losses have
been recognized by the Company.
NOTE 10--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 ("NOLs") of approximately $4.0
million, 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 NOLs 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, 1999 or December 31, 1998.
NOTE 11 -- 1996 SHARE INCENTIVE PLAN
The Company maintains a stock option plan to provide a means of incentive
compensation for officers, key employees, trustees, consultants and advisors.
Stock options, restricted stock awards and other performance awards may be
granted under the Starwood Financial Trust 1996 Share Incentive
18
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11 -- 1996 SHARE INCENTIVE PLAN (CONTINUED)
Plan (as amended, the "Plan"). Under the Plan, up to of 9.00% 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 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 subcommittee 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 on
March 13, 1998 under the Plan in connection with the consummation of the
Recapitalization Transactions, and additional grants may be made to the Advisor
or employees of the Company in the future.
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 27.50% volatility rate and an estimated annual dividend rate of 8.50%.
Options issued to employees will be accounted for using the intrinsic method
and, accordingly, no earnings charge will be reflected for options issued to
direct employees since the exercise price approximates the concurrent exchange
transaction price at date of grant. Options issued to the Advisor will be
accounted for under the option value method and, 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. The charge of approximately $6.0 million was 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.
NOTE 12--EARNINGS PER SHARE
Basic EPS is computed based on the income applicable to Class A Shares
(which is net income reduced by accrued dividends on the preferred shares and 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 and warrants to acquire Class A Shares.
Basic and diluted
19
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--EARNINGS PER SHARE (CONTINUED)
earnings per Class A Share are based upon the following weighted average shares
outstanding during each of the three- and six-month periods ended June 30, 1999
and 1998, respectively.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- --------------------
<S> <C> <C> <C> <C>
1999 1998 1999 1998
--------- --------- --------- ---------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Weighted average Class A Shares outstanding for basic earnings per
Class A Share........................................................ 52,471 52,390 52,459 30,637
Add effect of assumed shares issued under treasury stock method for
stock options........................................................ 1,706 1,228 1,712 701
Add effects of conversion of Class B Shares (49-for-one ratio)......... 560 560 560 327
Add effect of assumed warrants exercised under treasury stock method
for stock options.................................................... 1,865 -- 1,857 --
--------- --------- --------- ---------
Weighted average Class A Shares outstanding for diluted earnings per
Class A Share........................................................ 56,602 54,178 56,588 31,665
--------- --------- --------- ---------
--------- --------- --------- ---------
</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 and the information presented above have been retroactively
restated to reflect the reverse split for comparative purposes.
NOTE 13--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 shareholders 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
$58.4 million and $16.1 million for the six-month periods ended June 30, 1999
and 1998, respectively, and $30.3 and $20.0 for the three-month periods ended
June 30, 1999 and 1998, 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 14--DIVIDENDS
In order to maintain its election to qualify as a REIT, the Company must
distribute, at minimum, an amount equal to 95% of its taxable income and must
distribute 100% of its taxable income to avoid paying 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.
20
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14--DIVIDENDS (CONTINUED)
Total dividends declared by the Company aggregated $22.3 million or $0.42
per Class A Share for the three and six months ended June 30, 1999. On July 1,
1999, the Company declared a dividend of approximately $22.8 million or $0.43
per Class A Share, applicable to the second quarter and payable to shareholders
of record on July 15, 1999. In addition, on July 1, 1999, the Company also
declared dividends aggregating approximately $0.2 million to the Class B
Shareholders, applicable to the second quarter and payable to shareholders of
record on July 15, 1999. The Company also declared a preferred dividend of
approximately $5.2 million to all preferred shareholders of record on June 30,
1999. The exact amount of future quarterly dividends to 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.
NOTE 15--PROPOSED TRANSACTIONS
On June 16, 1999, the Company announced that it entered into an Agreement
and Plan of Merger (the "Merger Agreement"), dated as of June 15, 1999, with
TriNet Corporate Realty Trust, Inc. ("TriNet"), pursuant to which TriNet will
merge with and into a subsidiary of the Company, with TriNet surviving as a
subsidiary of the Company (the "Merger"). Following the Merger, the Company will
continue to qualify as a REIT for federal income tax purposes.
The Merger is expected to close in the fourth quarter of 1999, subject to
receipt of approval by the TriNet shareholders and satisfaction of customary
closing conditions. In the Merger, each share of common stock of TriNet will be
converted into 1.15 common shares of the Company. Each share of Series A, Series
B or Series C Cumulative Redeemable Preferred Stock of Trinet will be converted
into a share of Series B, Series C or Series D (respectively) Cumulative
Redeemable Preferred Stock of the Company. The Company's preferred stock issued
to the former TriNet preferred stockholders will have substantially the same
terms as the TriNet preferred stock, except that the new Series B, C, and D
preferred stock will have additional voting rights not associated with the
TriNet preferred stock. The holders of the Company's Series A preferred stock
will retain their preferred shares with the same rights and preferences as
existed prior to the merger.
Contemporaneously with the consummation of the Merger, the Company will
acquire 100% of the interests in the Advisor in exchange for total consideration
of four million common shares of the Company (the "Advisor Transaction"). The
closings of the Merger and the Advisor Transaction are conditions to the
completion of each other.
Prior to the consummation of the Merger and the Advisor Transaction, the
Company intends to change its form from a Maryland trust to a Maryland
corporation through a merger with a wholly-owned subsidiary of the Company
formed solely to effect such merger (the "Incorporation Merger"). In the
Incorporation Merger, the Class B Shares will be converted into shares of common
stock on a 49-for-one basis (the same ratio at which Class B Shares are
currently convertible into Class A Shares) and the Class A Shares will be
converted into shares of common stock on a one-for-one basis.
Following completion of the Incorporation Merger, but prior to the effective
time of the Merger with TriNet and the Advisor Transaction, the Company intends
to pay a special dividend of an aggregate of one million Class A Shares pro rata
to all holders of its Class A Shares.
The Company's principal shareholders, who together represent approximately
99% of the outstanding voting power of the Company, have entered into agreements
with TriNet, pursuant to
21
<PAGE>
STARWOOD FINANCIAL TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--PROPOSED TRANSACTIONS (CONTINUED)
which, among other things, those holders have granted to TriNet irrevocable
proxies to vote their shares in favor of the Merger, and against any proposal
which would compete with the Merger. Those shareholders have also agreed to vote
all of their shares in favor of the Advisor Transaction and the Incorporation
Merger. TriNet has agreed with the Company that if the Merger Agreement is
terminated under certain circumstances, TriNet will pay the Company certain fees
and expenses described in the Merger Agreement. The Company has agreed with
TriNet that if the Merger Agreement is terminated under certain other
circumstances, the Company will pay TriNet certain fees and expenses described
in the Merger Agreement.
The Company and TriNet have developed a preliminary plan to integrate the
two organizations and are now implementing the integration process. In this
regard, both companies have: (i) established integration task forces comprised
of senior executives from the Company and TriNet in each of six key disciplines;
(ii) created a unified organizational chart and preliminary roles and
responsibilities for key management personnel for the combined company; and
(iii) begun aligning their investment, financing and asset management
activities. In the integration process, the Company and TriNet have adopted a
"best practices" policy to leverage the complementary strengths of both
companies. The companies have also retained an experienced third-party
management consultant to assist in the integration process.
22
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
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 a mortgage note secured by an interest in the Warwick Hotel 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
and other short-term real estate investments.
On September 26, 1996, the Company became sole general partner of APMT
Limited 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. 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 the Company's consolidated financial statements) 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 warrants to purchase Class A and Class B Shares in January 1997, the
Company's capital increased by approximately $5.0 million, and the resulting
funds were used to purchase short-term government securities (see Note 4).
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 19,
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.
Immediately prior to the consummation of the Recapitalization Transactions,
the Company's assets primarily consisted of approximately $11.0 million in
short-term, liquid real estate investments, cash and cash equivalents.
On December 15, 1998, the Company sold $220.0 million of preferred shares
and warrants to purchase Class A Shares to Lazard Freres Real Estate Fund II,
L.P. ("Fund II"), Lazard Freres Real Estate Offshore Fund II, L.P. (the
"Offshore Fund"), and LF Mortgage REIT (the "Private REIT" and, collectively
with Fund II and the Offshore Fund, the "Investors"). Concurrent with the sale
of the preferred shares and warrants, the Company purchased $280.3 million in
real estate loans and participation interests (the "Acquired Assets") from
Lazard Freres Real Estate Fund L.P. ("Fund I"), Fund II, Prometheus Mid-Atlantic
Holding, L.P. ("PMAH"), Pacific Preferred LLC ("Pacific"), Atlantic Preferred II
LLC ("Atlantic"), Indian Preferred LLC ("Indian") and Prometheus Investment
Holding L.P. ("PIHLP" and, collectively with Fund I, Fund II, PMAH, Pacific,
Atlantic, Indian and PIHLP, the "Sellers"). Such transactions are referred to
collectively as the "Lazard Transaction."
The Recapitalization Transactions, the Lazard Transaction and other related
transactions have materially impacted the operations of the Company and will
continue to impact the Company's future operations. Accordingly, the reported
historical financial information for periods prior to the Recapitalization
Transactions is not believed to be indicative of the Company's future operating
results or financial condition.
23
<PAGE>
RESULTS OF OPERATIONS
<TABLE>
<CAPTION>
ORIGINATIONS
AND ADDITIONAL PRINCIPAL
ACQUISITIONS FUNDINGS REPAYMENTS
----------- ----------- -----------
(IN MILLIONS)
<S> <C> <C> <C>
Quarter Ended March 31, 1998
(Including Recapitalization Transactions)................................ $ 1,061.0 $ -- $ --
Quarter Ended June 30, 1998................................................ 206.1 10.0 (2.8)
Quarter Ended September 30, 1998........................................... 564.8 0.5 (87.4)
Quarter Ended December 31, 1998
(Including Lazard Transaction)........................................... 250.1 6.0 (13.7)
Quarter Ended March 31, 1999............................................... 152.1 7.1 (56.7)
Quarter Ended June 30, 1999................................................ 183.8 15.6 (208.5)
----------- ----- -----------
Totals..................................................................... $ 2,417.9 $ 39.2 $ (369.1)
----------- ----- -----------
----------- ----- -----------
</TABLE>
THREE-MONTH PERIOD ENDED JUNE 30, 1999 COMPARED TO 1998
During the three months ended June 30, 1999, total revenue increased by
$25.7 million as compared to total revenue for the three months ended June 30,
1998. This increase is a result of the interest generated by the real estate
loan investments contributed in the Recapitalization Transactions, as well as
other loan investments newly originated or acquired by the Company and
additional fundings under loan commitments.
Included in other income for the three-month period ended June 30, 1999 is a
gain of $3.1 million from the early repayment of a $90.6 million senior mortgage
and a $50.1 million non-recourse subordinate mortgage, which had been acquired
at a discount, from a single borrower.
The increase in the Company's total costs during the three months ended June
30, 1998 compared to the three months ended June 30, 1999 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 and acquisition activities, as well general 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 conditions.
SIX-MONTH PERIOD ENDED JUNE 30, 1999 COMPARED TO 1998
During the six months ended June 30, 1999, total revenue increased by $77.2
million as compared to total revenue for the six months ended June 30, 1998.
This increase is a result of the interest generated by the real estate loan
investments contributed in the Recapitalization Transactions, as well as other
loan investments newly originated or acquired by the Company and additional
fundings under loan commitments.
Included in other income for the six-month period ended June 30, 1999 is a
gain of $3.1 million from the early repayment of a $90.6 million senior mortgage
and a $50.1 million non-recourse subordinate mortgage, which had been acquired
at a discount, from a single borrower. Additionally, included in other income is
a $1.9 million prepayment penalty from the early repayment of a $40.0 million
senior mortgage.
The increase in the Company's total costs during the six months ended June
30, 1998 compared to the six months ended June 30, 1999 is primarily due to the
expense associated with the interest expense
24
<PAGE>
on the borrowings under the revolving credit facility and other borrowings used
to fund the Company's loan origination and acquisition activities. Further, as
discussed in Note 5 to the consolidated financial statements, the Company
recognized a $2.3 million provision in the six-month period ended June 30, 1999
for possible credit losses as compared to $0.8 million taken in the six-month
period ended June 30, 1998. Additionally, general and administrative costs
associated with the implementation of the Company's new business plan and
advisory fee expenses under the Advisory Agreement increased the Company's total
costs and expenses during the six months ended June 30, 1999. These increases
were partially offset by a $6.0 million charge in the six-month period ended
June 30, 1998 for the stock option compensation for options issued to the
Advisor concurrently with the Recapitalization Transactions (see Note 11 to the
Company's consolidated financial statements.)
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 conditions.
INTEREST RATE RISK MANAGEMENT
Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices and equity prices. In
pursuing its business plan, the primary market risk to which the Company is
exposed is interest rate risk. Consistent with its expected election to qualify
as a REIT, the Company has implemented an interest rate risk management policy
based on match funding, with the objective that floating-rate assets be
primarily financed by floating-rate liabilities and fixed-rate assets be
primarily 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 real estate financing 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 interest rates could reduce the average life of the
Company's interest-earning assets.
A substantial portion of the Company's loan investments are subject to
significant prepayment protection in the form of lock-outs, yield maintenance
provisions or other prepayment premiums which provide substantial yield
protection to the Company. Those assets generally not subject to prepayment
penalties include: (i) variable-rate loans based on LIBOR, originated or
acquired at par, which would not result in any gain or loss upon repayment; and
(ii) discount loans and loan participations acquired at discounts to face
values, which would result in gains upon repayment. Further, while the Company
generally seeks to enter into loan investments which provide for substantial
prepayment protection, in the event of declining interest rates, the Company
could receive such prepayments and may not be able to reinvest such proceeds at
favorable returns. Such prepayments could have an adverse effect on the spreads
between interest-earning assets and interest-bearing liabilities.
While the Company has not experienced any significant credit losses,
delinquencies or defaults, in the event of a significant rising interest rate
environment and/or economic downturn, defaults could increase and result in
credit losses to the Company which adversely affect its liquidity and operating
results. Further, such delinquencies or defaults could have an adverse effect on
the spreads between interest-earning assets and interest-bearing liabilities.
25
<PAGE>
Interest rates are highly sensitive to many factors, including governmental
monetary and tax policies, domestic and international economic and political
conditions, and other factors beyond the control of the Company. As more fully
discussed in Note 9 to the Company's consolidated financial statements, 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
caps, floors, swaps, futures and other interest rate-related derivative
contracts. These strategies are specifically designed to reduce the Company's
exposure, on specific transactions or on a portfolio basis, to changes in cash
flows as a result of interest rate movements in the market. The Company does not
enter into derivative contracts for speculative purposes nor as a hedge against
changes in credit risk of its borrowers or of the Company itself.
Each interest rate cap or floor agreement is a legal contract between the
Company and a third party (the "counterparty"). When the Company purchases a cap
or floor contract, the Company makes an up-front payment to the counterparty and
the counterparty agrees to make payments to the Company in the future should the
reference rate (typically one- or three-month LIBOR) rise above (cap agreements)
or fall below (floor agreements) the "strike" rate specified in the contract.
Each contract has a notional face amount. Should the reference rate rise above
the contractual strike rate in a cap, the Company will earn cap income. Should
the reference rate fall below the contractual strike rate in a floor, the
Company will earn floor income. Payments on an annualized basis will equal the
contractual notional face amount multiplied by the difference between actual
reference rate and the contracted strike rate. The cost of the up-front payment
is amortized over the term of the contract.
Interest rate swaps are agreements in which a series of interest rate flows
are exchanged over a prescribed period. The notional amount on which swaps are
based is not exchanged. In general, the Company's swaps are "pay fixed" swaps
involving the exchange of floating-rate interest payments from the counterparty
for fixed interest payments from the Company.
Interest rate futures are contracts, generally settled in cash, in which the
seller agrees to deliver on a specified future date the cash equivalent of the
difference between the specified price or yield indicated in the contract and
the value of that of the specified instrument (e.g., U.S. Treasury securities)
upon settlement. The Company generally uses such instruments to hedge forecasted
fixed-rate borrowings. Under these agreements, the Company will generally
receive additional cash flow at settlement if interest rates rise and pay cash
if interest rates fall. The effects of such receipts or payments will be
deferred and amortized over the term of the specific related fixed-rate
borrowings. In the event that, in the opinion of management, it is no longer
probable that a forecasted transaction will occur under terms substantially
equivalent to those projected, the Company will cease recognizing such
transactions as hedges and immediately recognize related gains or losses based
on actual settlement or estimated settlement value. No such gains or losses have
been recognized by the Company.
While a REIT may freely utilize the types of derivative instruments
discussed above to hedge interest rate risk on its liabilities, the use of
derivatives for other purposes, including hedging asset-related risks such as
credit, prepayment or interest rate exposure on the Company's loan assets, could
generate income which is not qualified income for purposes of maintaining REIT
status. As a consequence, the Company may only engage in such instruments to
hedge such risks on a limited basis.
There can be no assurance that the Company's profitability 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 counterparty 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
based may be more or less variable than the indices upon which the hedged assets
or liabilities are based, thereby making the hedge less effective. The
counterparties to these contractual arrangements are major financial
institutions with which the Company and its affiliates may also have
26
<PAGE>
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. 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 which exceeds the related costs incurred in
connection with engaging in such hedges.
LIQUIDITY AND CAPITAL RESOURCES
The Company requires capital to fund its loan and other investment
origination and 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.
During 1998, the Company completed two significant transactions including
the issuance of shares and the purchase of new assets and entered into several
credit facilities.
Concurrently with the Recapitalization Transactions, the Company entered
into bank credit agreements under which the Company has the ability 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) and for other general
corporate purposes. The credit agreements were comprised of: (i) a $500.0
million revolving credit facility, which bore 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 bore interest at a fixed
margin over LIBOR and matured on March 15, 1999.
During the third quarter of 1998, 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 percentage borrowing base
calculations.
In addition, since the completion of the Recapitalization Transactions, the
Company has entered into approximately $496.4 million in LIBOR-based term loans
secured by certain first mortgage loans it acquired since March 18, 1998.
Approximately $85.7 million of these loans were repaid prior to June 30, 1999.
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. Approximately $39.6
million of such borrowings were outstanding as of June 30, 1999.
In anticipation of and since the completion of the Recapitalization
Transactions, the Company had entered into a LIBOR interest rate cap struck at
9.00% in the notional amount of $300.0 million, which expires in March 2001. 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 which expire in January and
June 2001, respectively, on amounts borrowed under additional term loans. In
addition, the Company acquired a LIBOR interest rate cap struck at 8.50% in the
notional amount of $32.5 million expiring December 1999. Further, the Company
has originated or acquired assets subject to approximately $236.8 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 or has recently consummated certain
anticipated long-term fixed-rate borrowings and had 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
27
<PAGE>
June 30, 1999, the Company had derivative instruments with an aggregate
remaining notional amount of approximately $63.0 million, which represent fixed
rates of approximately 5.50%. Under these agreements, the Company would
generally receive additional cash flow at settlement if interest rates rise and
pay cash if interest rates fall. The effects of such receipts or payments will
be deferred and amortized over the term of the specific related fixed-rates
borrowings.
During the six-month period ended June 30, 1999, the Company refinanced its
$125.0 million term loan maturing March 15, 1999 with a $155.4 million term loan
maturing March 5, 2009. The new term loan bears interest at 7.44% per annum,
payable monthly, and amortizes over an approximately 22-year schedule. The new
term loan represented one of the forecasted transactions for which the Company
had previously entered into U.S. Treasury-based hedging transactions. The net
cost of the settlement of such hedges has been deferred and will be amortized as
an increase to the effective financing cost of the new term loan over its
effective 10-year term.
In the event that, in the opinion of management, it is no longer probable
that the remaining forecasted transactions will occur under terms substantially
equivalent to those projected, the Company will cease recognizing such
transactions as hedges and immediately recognize related gains or losses based
on actual settlement or estimated settlement value. No such gains or losses have
been recognized by the Company.
The distribution requirements under the REIT provisions of the 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 lending transactions.
The Company's ability to meet its long-term (i.e., beyond one year)
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 investors to enter into such transactions 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, such lenders' and investors' resources and policies concerning the
terms under which they make such loan investments and the relative
attractiveness of alternative investment or lending opportunities.
Based on its monthly interest and other expenses, monthly cash receipts,
existing lending commitments and funding plans, the Company believes that its
existing sources of funds will be adequate for purposes of meeting its short-and
long-term liquidity needs. However, in light of recent volatility in financial
markets, which may affect the Company's ability to obtain additional capital
resources, there can be no assurance that this will in fact be the case.
Material increases in monthly interest expense or material decreases in monthly
cash receipts, generally would negatively impact the Company's liquidity. On the
other hand, material decreases in monthly interest expense would positively
affect the Company's liquidity.
YEAR 2000 ISSUES
Many computer systems were originally designed to recognize calendar years
by the last two digits in the date code field. Beginning in the Year 2000, these
date code fields will need to accept four-digit entries to distinguish 21(st)
century dates. As a result, in less than one year, computerized systems, which
include information and non-information technology systems and applications used
by the Company, will need to be reviewed, evaluated and modified or replaced, if
necessary, to ensure all such financial information and operating systems are
Year 2000 compliant.
28
<PAGE>
STATE OF READINESS
The Company has adopted a plan and formed a team of internal and external
personnel to address Year 2000 issues. The Company has conducted the discovery
and assessment stages on all its in-house systems that could be significantly
affected by the Year 2000. The completed assessment indicated that all of the
Company's in-house systems are Year 2000 capable. The Company has a 95% economic
interest in Starwood Operating, which is in the third-party mortgage servicing
business. Starwood Operating has completed the assessment of its systems and
implemented all required upgrades and modifications. Starwood Operating has
tested all systems, which was completed during the first half of 1999. Year 2000
issues at Starwood Operating were addressed by the previous owner of the
business, which agreed to indemnify Starwood Operating for any of Starwood
Operating's losses relating to Starwood Operating's systems and has ensured
Starwood Operating that all such systems are Year 2000 compliant.
The Company is in the process of communicating with its significant
depository institutions, lenders, custodians, vendors, tenants under operating
leases and borrowers with which it interfaces to evaluate their Year 2000
compliance. Approximately 75% of these counterparties have provided written
responses to the Company's written questionnaires. The Company is currently
contacting all counterparties that have not yet been responsive to the written
questionnaires. These counterparties are being interviewed telephonically to
assess their Year 2000 compliance. To date, the Company is not aware of any such
counterparty with a Year 2000 issue that would materially impact the Company's
results of operations, liquidity, or capital resources. Other than communicating
with its counterparties, the Company has no means of ascertaining whether a
given counterparty will be Year 2000 ready. The inability of counterparties to
complete their Year 2000 resolution process in a timely manner could materially
impact the Company.
YEAR 2000 PROJECT COSTS
The Company estimates that total costs for the Year 2000 compliance review,
evaluation, assessment and remediation efforts should not exceed $20,000,
although there can be no assurance that actual costs will not exceed this
amount. This amount will be funded through cash flows from operations.
RISKS OF YEAR 2000
The Company believes that it has an effective program in place to resolve
the Year 2000 issue in a timely manner. However, disruptions in the economy
generally resulting from Year 2000 issues could materially affect the Company.
The amount of potential liability and lost revenue cannot be reasonably
estimated at this time.
The Company has asked substantially all of its significant vendors and
service providers to provide reasonable assurances as to those parties' Year
2000 state of readiness. To the extent that vendors and service providers do not
provide satisfactory evidence that their products and services are Year 2000
compliant, the Company will seek to obtain the necessary products and services
from alternate sources. There can be no assurance, however, that Year 2000
remediation by vendors and service providers will be available, and any failure
of such third parties' systems could have a material adverse impact on the
Company's operations. In addition, the failure of borrowers to address Year 2000
issues fully could have a material and adverse effect on their operations and
financial condition, which could impact their ability to service the outstanding
obligations to the Company. This, in turn, could have a material and adverse
effect on the Company's operations and financial position.
29
<PAGE>
CONTINGENCY PLAN
Based on the assessment to date, the Company believes it is prepared for the
most reasonably likely worst-case scenarios regarding Year 2000 compliance.
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 adopted the requirements of this pronouncement in its financial
statements beginning with the three-month periods ended March 31, 1999 and 1998.
The adoption of SFAS No. 131 has not had a material impact on the Company's
financial statement disclosures because it is currently considered to operate in
a single segment.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
No. 133"). On June 23, 1999 the FASB voted to defer the effectiveness of SFAS
133 for one year. SFAS 133 is now effective for fiscal years beginning after
June 15, 2000, but earlier application is permitted as of the beginning of any
fiscal quarter subsequent to June 15, 1998. 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. The
Company currently plans to adopt this pronouncement as required effective
January 1, 2001. The adoption of SFAS 133 is not expected to have a material
impact on the financial 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 June
30, 1999, 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
30
<PAGE>
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 except as required by law.
31
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On June 1, 1999, 31,616 Class B Shares were issued to current holders of the
Class B Shares for a price of $0.01 per share and options to purchase an
aggregate of 4,998 Class A Shares with an exercise price of $57.50 were granted
to the independent trustees, in each case pursuant to an exemption from
registration under Section 4(2) of the Securities Act of 1933, as amended.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On June 1, 1999, the Company held its 1999 annual meeting of shareholders to
vote on various proposals described in the following summary:
ELECTION OF TRUSTEES:
The four trustees elected as a result of the meeting to hold office until
their respective successors are elected are William M. Matthes, Barry S.
Sternlicht, Jay Sugarman, and Kneeland C. Youngblood. Jeffrey Dishner, Jonathan
Eilian, Merrick Kleeman and Robin Josephs are the members of the Board of
Trustees whose office did not expire in 1999 and who continue as trustees.
<TABLE>
<CAPTION>
ELIGIBLE
TRUSTEE VOTES FOR AGAINST ABSTAIN
- --------------------------------------------- ------------ ------------ --------- ---------
<S> <C> <C> <C> <C>
William M. Matthes........................... 78,674,810 78,539,503 25,651 109,656
Barry S. Sternlicht.......................... 78,674,810 78,539,803 25,351 109,656
Jay Sugarman................................. 78,674,810 78,539,803 25,351 109,656
Kneeland C. Youngblood....................... 78,674,810 78,539,803 25,351 109,656
</TABLE>
OTHER PROPOSALS:
<TABLE>
<CAPTION>
ELIGIBLE
PROPOSAL VOTES FOR AGAINST ABSTAIN
- ---------------------------------------------- ------------ ------------ --------- -----------
<S> <C> <C> <C> <C>
1.To ratify the appointment of
PricewaterhouseCoopers LLP as the
Independent Auditors for the fiscal year
ended December 31, 1999..................... 78,674,810 78,562,487 357 2,310
</TABLE>
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM-8-K
A. EXHIBITS
None.
B. REPORTS ON FORM 8-K
On June 21, 1999, a report on Form 8-K was filed in connection with the
TriNet Merger Agreement.
32
<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.
<TABLE>
<CAPTION>
STARWOOD FINANCIAL TRUST
---------------------------------------------
Registrant
<S> <C>
Date August 11, 1999 /s/ Jay Sugarman
---------------------------------------------
Jay Sugarman
Chief Executive Officer and President
Date August 11, 1999 /s/ Spencer B. Haber
---------------------------------------------
Spencer B. Haber
Chief Financial Officer and Secretary
(Principal Financial and Accounting Officer)
</TABLE>
33
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> JUN-30-1999
<CASH> 19,518
<SECURITIES> 4,862
<RECEIVABLES> 12,333
<ALLOWANCES> 5,000
<INVENTORY> 0
<CURRENT-ASSETS> 31,713
<PP&E> 194,229
<DEPRECIATION> 7,017
<TOTAL-ASSETS> 2,171,628
<CURRENT-LIABILITIES> 8,572
<BONDS> 0
0
44
<COMMON> 52,733
<OTHER-SE> 949,394
<TOTAL-LIABILITY-AND-EQUITY> 2,171,628
<SALES> 0
<TOTAL-REVENUES> 114,679
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 14,080
<LOSS-PROVISION> 2,250
<INTEREST-EXPENSE> 40,249
<INCOME-PRETAX> 58,100
<INCOME-TAX> 0
<INCOME-CONTINUING> 58,100
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 58,100
<EPS-BASIC> .90
<EPS-DILUTED> .84
</TABLE>
