Filed Pursuant to Rule 424(b)(1)
Registration No. 333-103598
PROSPECTUS
2,500,000 SHARES
NEWCASTLE INVESTMENT CORP.
9.75% SERIES B CUMULATIVE REDEEMABLE PREFERRED STOCK
[NEWCASTLE LOGO] LIQUIDATION PREFERENCE $25.00 PER SHARE
---------------------
We are offering 2,500,000 shares of our 9.75% Series B Cumulative Redeemable
Preferred Stock (the "Series B Preferred Stock"). We will pay cumulative
dividends on the Series B Preferred Stock from the date of original issuance in
the amount of $2.4375 per share each year, which is equivalent to 9.75% of the
$25.00 liquidation preference per share. Dividends on the Series B Preferred
Stock will be payable quarterly in arrears, beginning on April 30, 2003. The
shares of Series B Preferred Stock have no stated maturity, will not be subject
to any sinking fund or mandatory redemption and will not be convertible into any
other securities. Holders of shares of Series B Preferred Stock will generally
have no voting rights, but will have limited voting rights if we fail to pay
dividends for six or more quarters and in certain other events.
Except in limited circumstances to preserve our status as a real estate
investment trust, we may not redeem the Series B Preferred Stock until March 18,
2008. On or after March 18, 2008, we may, at our option, redeem the Series B
Preferred Stock, in whole or in part, at any time and from time to time, for
cash at $25.00 per share, plus accrued and unpaid distributions, if any, to the
redemption date. Any partial redemption will generally be on a pro rata basis.
Newcastle Investment Holdings Corp. currently owns 68.2% of our common
stock, assuming exercise of all outstanding options. We are externally managed
by Fortress Investment Group LLC. At December 31, 2002, Fortress Investment
Group and its principals had options to purchase 700,000 shares of our common
stock and owned approximately 16.4% of the equity of Newcastle Investment
Holdings (25.8% upon exercise of outstanding options). We have no ownership
interest in Fortress Investment Group. We pay Fortress Investment Group an
annual base management fee and may pay incentive compensation based on certain
performance criteria. Fortress Investment Group also manages and invests in
other entities, including Newcastle Investment Holdings, that invest in real
estate assets.
We are organized and conduct our operations to qualify as a real estate
investment trust (a REIT) for federal income tax purposes. To assist us in
complying with certain federal income tax requirements applicable to REITs, our
charter and bylaws contain certain restrictions relating to the ownership and
transfer of our stock, including an ownership limit of 8.0% of our total capital
stock and 25.0% of the Series B Preferred Stock. See "Description of Series B
Preferred Stock" and "Important Provisions of Maryland Law and of Our Charter
and Bylaws" for a discussion of these restrictions.
No market currently exists for our Series B Preferred Stock. Our Series B
Preferred Stock has been approved for listing on the New York Stock Exchange
(NYSE) under the symbol "NCT PrB", subject to official notice of issuance. We
expect that trading will commence within 30 days after the initial delivery of
the Series B Preferred Stock. Our common stock currently trades on the NYSE
under the symbol "NCT".
SEE "RISK FACTORS" BEGINNING ON PAGE 11 FOR A DISCUSSION OF THE RISKS
RELEVANT TO AN INVESTMENT IN OUR SERIES B PREFERRED STOCK, INCLUDING, AMONG
OTHERS:
- Our Series B Preferred Stock has no established trading market, which may
negatively affect its market value and your ability to transfer or sell
your shares of Series B Preferred Stock.
- The market value of the Series B Preferred Stock could be substantially
affected by interest rates and other factors.
- Our Series B Preferred Stock has not been rated and will be subordinated
to all of our existing and future debt.
- We are dependent upon our manager and may not find a suitable replacement
if our manager terminates the management agreement.
- Our manager manages and invests in other real estate-related vehicles,
including Newcastle Investment Holdings, and our chairman and chief
executive officer and some of our other officers also serve as officers
and/or directors of these other entities, which may result in decisions
made that are not in our best interest.
- We were organized in June 2002, completed the initial public offering of
our common stock in October 2002, and have a limited operating history as
a separate business from Newcastle Investment Holdings and may not operate
successfully as a separate business.
- We may change our investment strategy without stockholder consent, which
could result in investments that are different, and possibly more risky,
than our current investments.
- Many of our investments are illiquid and we may not be able to respond to
changes in market conditions.
- We invest in subordinated securities, which have a greater risk of loss
than more senior securities.
- We may leverage up to 90% of the value of our assets, which may result in
losses.
- Interest rate fluctuations may reduce our net income.
- If we fail to qualify as a REIT, we will be subject to income tax at
regular corporate rates, which would reduce the amount of cash available
for distribution to our stockholders.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
---------------------
PER SHARE TOTAL
--------- -----------
Public offering price....................................... $ 25.00 $62,500,000
Underwriting discounts and commissions...................... $ 0.7875 $ 1,968,750
Proceeds, before expenses, to us............................ $24.2125 $60,531,250
The underwriters are severally underwriting the shares being offered. The
underwriters have an option to purchase up to an additional 375,000 shares of
Series B Preferred Stock from us to cover over-allotments, if any.
The underwriters expect that the shares of Series B Preferred Stock will be
ready for delivery in book-entry form through The Depository Trust Company on or
about March 18, 2003.
---------------------
BEAR, STEARNS & CO. INC.
ADVEST, INC. BB&T CAPITAL MARKETS STIFEL, NICOLAUS & COMPANY
INCORPORATED
The date of this prospectus is March 13, 2003
YOU MAY RELY ON THE INFORMATION CONTAINED IN THIS PROSPECTUS. NEITHER WE
NOR THE UNDERWRITERS HAVE AUTHORIZED ANYONE TO PROVIDE YOU WITH DIFFERENT OR
ADDITIONAL INFORMATION. THIS PROSPECTUS IS NOT AN OFFER TO SELL NOR IS IT
SEEKING AN OFFER TO BUY STOCK IN ANY JURISDICTION WHERE THE OFFER OR SALE IS NOT
PERMITTED. THE INFORMATION CONTAINED IN THIS PROSPECTUS IS ACCURATE ONLY AS OF
THE DATE OF THIS PROSPECTUS, REGARDLESS OF THE TIME OF DELIVERY OF THIS
PROSPECTUS OR OF ANY SALE OF STOCK.
------------------------
TABLE OF CONTENTS
PROSPECTUS SUMMARY.......................................... 1
RISK FACTORS................................................ 11
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS... 22
USE OF PROCEEDS............................................. 23
RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED
SHARE DISTRIBUTIONS....................................... 23
PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS............... 23
CAPITALIZATION.............................................. 25
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION....... 26
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION...... 29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF PRO FORMA FINANCIAL
CONDITION AND RESULTS OF OPERATIONS....................... 33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF HISTORICAL FINANCIAL
CONDITION AND RESULTS OF OPERATIONS....................... 43
NEWCASTLE INVESTMENT CORP................................... 50
FORTRESS INVESTMENT GROUP AND OUR MANAGEMENT AGREEMENT...... 71
MANAGEMENT.................................................. 79
CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS........ 84
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................ 85
DESCRIPTION OF SERIES B PREFERRED STOCK..................... 87
DESCRIPTION OF CAPITAL STOCK................................ 95
IMPORTANT PROVISIONS OF MARYLAND LAW AND OF OUR CHARTER AND
BYLAWS.................................................... 101
FEDERAL INCOME TAX CONSIDERATIONS........................... 104
ERISA CONSIDERATIONS........................................ 120
UNDERWRITING................................................ 123
LEGAL MATTERS............................................... 125
EXPERTS..................................................... 125
WHERE YOU CAN FIND MORE INFORMATION......................... 125
INDEX TO FINANCIAL STATEMENTS............................... F-1
PROSPECTUS SUMMARY
This summary highlights information more fully described elsewhere in this
prospectus. This summary is not complete and does not contain all the
information you should consider before buying shares of our Series B Preferred
Stock. You should read this entire prospectus carefully, including "Risk
Factors" and the consolidated historical and pro forma financial statements and
the related notes included in this prospectus, before deciding to invest in
shares of our Series B Preferred Stock.
NEWCASTLE INVESTMENT CORP.
We invest in real estate securities and other real estate-related assets.
We seek to finance these investments primarily using match-funded financing
structures. Match-funded financing structures match assets and liabilities with
respect to maturities and interest rates. Our objective is to maximize the
difference between the yield on our investments and the cost of financing these
investments while hedging our positions. We are organized and conduct our
operations to qualify as a real estate investment trust (REIT) for federal
income tax purposes.
We were formed in June 2002 for the purpose of separating the real estate
securities and credit leased real estate businesses from Newcastle Investment
Holdings' other investments. We completed the initial public offering of our
common stock in October 2002. Newcastle Investment Holdings Corp. currently owns
68.2% of our outstanding common stock, assuming exercise of all outstanding
options. Newcastle Investment Holdings was formed in May 1998.
We own a diversified portfolio of credit sensitive real estate securities,
including commercial and residential mortgage backed securities and unsecured
REIT debt, rated primarily BBB (BBB- is the lowest investment grade rating) and
BB (BB+ is the highest non-investment grade rating). Mortgage backed securities
are interests in or obligations secured by pools of commercial or residential
mortgage loans. We also own credit leased real estate in Canada and Belgium,
which we refer to in this prospectus as the "Bell Canada portfolio" and the "LIV
portfolio," respectively. We consider credit leased real estate to be real
estate that is leased primarily to tenants with, or whose major tenant has,
investment grade credit ratings. We also own a pool of mortgage loans. At
December 31, 2002:
- our portfolio consisted of approximately $1.6 billion of assets; and
- our portfolio was encumbered by approximately $1.2 billion of debt.
For the year ended December 31, 2002, on a pro forma basis:
- we had revenues of approximately $104.2 million, expenses of
approximately $68.0 million and income from continuing operations of
approximately $36.2 million; and
- our income from continuing operations per common share was $1.95.
We focus on investing in credit sensitive real estate securities, including
mortgage backed securities and REIT securities, and invest in other real estate
related investments, including credit leased real estate and mortgage loans. We
finance our real estate securities investments through the issuance of debt
securities in the form of collateralized bond obligations, known as CBOs, which
are obligations issued in multiple classes secured by an underlying portfolio of
securities. CBO transactions offer us structural flexibility to buy and sell
certain investment positions to manage risk and, subject to certain limitations,
to optimize returns.
The annual gross return on our weighted average equity investment of $93.5
million in our first CBO transaction issued in July 1999, which we refer to as
CBO I, was approximately 22.4% from inception through December 31, 2002. The
annual gross return on our weighted average equity investment of $41.9 million
in our second CBO transaction issued in April 2002, which we refer to as CBO II,
was approximately 29.6% through December 31, 2002. As of December 31, 2002, the
aggregate dollar amount of the collateral in CBO I and CBO II was approximately
$1.1 billion. The weighted average credit rating of the collateral in CBO I and
CBO II is BBB-.
1
RECENT DEVELOPMENTS
On March 12, 2003, we agreed to pricing terms for our third CBO
transaction, which we refer to as CBO III, which we expect will close on or
about March 19, 2003. We expect that upon closing, we will sell $472 million of
senior CBO III securities.
The table below sets forth information with respect to CBO III.
MOODY'S/S&P/ EXPECTED
CLASS FITCH RATINGS FACE AMOUNT COUPON MATURITY(1)
--------- ------------- ------------ ---------- -----------
Senior CBO III
Securities.............. I Aaa/AAA/AAA $412,800,000 LIBOR+0.70% Mar-2013
II-FL A3/A-/A- $15,000,000 LIBOR+1.75% Mar-2013
II-FX A3/A-/A- $35,000,000 5.715% Mar-2013
III Baa2/BBB/BBB $9,200,000 7.436% Mar-2013
------------
TOTAL................ $472,000,000
============
- ---------------
(1) Reflects expected maturities upon refinancing. Contractual maturities are
March 2038.
We will retain the equity interest in CBO III.
The average credit rating of the collateral in CBO III is currently
expected to be BBB. The weighted average credit rating of the collateral in
CBO I, CBO II and CBO III is currently BBB-. Although we expect to close the
transaction on or about March 19, 2003, there is no assurance that the
transaction will close.
OUR INVESTMENT STRATEGY
The keys to our investment strategy are:
- to actively manage our investment portfolio to minimize credit risk;
- to use match-funded financing structures, such as CBOs, to minimize
exposure to interest rate fluctuations and to take advantage of the
structural flexibility offered by CBO transactions to buy and sell
investment positions; and
- to take advantage of our manager's significant existing business
relationships, its expertise in real estate investing and financing,
capital markets, transaction structuring and resolution of distressed
assets, its operational and risk management systems and the economies of
scale associated with its current business operation.
OUR COMPETITIVE STRENGTHS
Our competitive strengths include:
- our diversified portfolio, by asset type, industry, location and issuer;
- our match-funding discipline, whereby we seek to match our assets and
liabilities with respect to interest rates and maturities to finance our
investments with like-kind debt;
- our creative financing strategies, in particular, CBOs and lease
securitizations; and
- our experienced management.
OUR MANAGER
We are externally managed and advised by Fortress Investment Group LLC. At
December 31, 2002, Fortress Investment Group and its principals had options to
purchase 700,000 shares of our common stock and owned approximately 16.4% of the
equity of Newcastle Investment Holdings (25.8% upon exercise of outstanding
options). As a result, our manager and its principals beneficially own
approximately 20.5% of our common equity, taking into account interests in
Newcastle Investment Holdings and assuming exercise of all of their options. We
have no ownership interest in our manager. Fortress Investment Holdings LLC is
the sole member of our manager. The beneficial owners of Fortress Investment
Holdings LLC are
2
Messrs. Wesley R. Edens, Peter L. Briger, Jr., Robert I. Kauffman, Randal A.
Nardone, Michael E. Novogratz and Erik P. Nygaard.
Our chairman and chief executive officer and each of our executive officers
also serve as officers of our manager. Our manager is entitled to receive a base
management fee from us and may receive incentive compensation based on certain
performance criteria.
As required by our management agreement, our manager provides a dedicated
management team to us, including a President, Chief Financial Officer and Chief
Operating Officer, whose primary responsibility is to manage us.
Our manager also serves as manager of Newcastle Investment Holdings. In
addition, our manager also manages other real estate-related assets and intends
to engage in additional management and investment opportunities and investment
vehicles in the future. However, our manager has agreed not to raise or sponsor
any new investment vehicle that targets, as its primary investment category,
investment in credit sensitive real estate securities, although these entities,
and other entities managed by our manager, are not prohibited from investing in
credit sensitive real estate securities.
The following chart shows our corporate structure and equity ownership. The
percentage ownership information in the chart assumes full exercise of all
outstanding options to purchase shares of our common stock and all outstanding
options to purchase shares of Newcastle Investment Holdings.
(NEWCASTLE FLOW CHART)
SUMMARY RISK FACTORS
An investment in our Series B Preferred Stock involves various material
risks. You should consider carefully the risks discussed below and under "Risk
Factors" before purchasing our Series B Preferred Stock.
- Our Series B Preferred Stock has no established trading market, which may
negatively affect its market value and your ability to transfer or sell
your shares of Series B Preferred Stock.
- The market value of the Series B Preferred Stock could be substantially
affected by interest rates and other factors.
- Our Series B Preferred Stock has not been rated and will be subordinated
to all of our existing and future debt.
3
- We are dependent upon our manager and may not find a suitable replacement
if our manager terminates the management agreement.
- We are subject to potential conflicts of interest arising out of our
relationships with our manager, which may result in decisions made that
are not in our best interest.
- We are subject to potential conflicts of interest arising out of our
relationship with Newcastle Investment Holdings, which may result in
decisions made that are not in our best interest.
- Our manager manages and also has an equity interest in both us and in
Newcastle Investment Holdings, which may give rise to conflicts that may
result in decisions made that are not in our best interest.
- Our manager and certain of our officers will devote substantial time to
activities outside of our business, including the management of other
real estate-related vehicles.
- We were organized in June 2002, completed the initial public offering of
our common stock in October 2002, and have a limited operating history as
a separate business from Newcastle Investment Holdings and may not
operate successfully as a separate business.
- We pay our manager substantial base management fees regardless of the
performance of our portfolio and may pay incentive compensation based on
our portfolio's performance, which may lead our manager to place emphasis
on the maximization of revenues which could result in increased risk to
the value of the invested portfolio.
- We may change our investment strategy at any time without the consent of
our stockholders, which could result in our making investments that are
different from, and possibly riskier than, the investments described in
this prospectus.
- Our ability to vary our portfolio in response to changes in economic and
other conditions may be relatively limited because our real estate assets
are generally illiquid and our real estate securities are unregistered
and may have restrictions on transfer.
- We leverage our assets, which can compound losses and reduce the cash
available for distribution to our stockholders.
- The assets we invest in are subject to the credit risk of the underlying
assets and in the event of default of such assets and the exhaustion of
any underlying credit support, we may not recover our full investment.
- The yield on our investments may be sensitive to changes in prevailing
interest rates and changes in prepayment rates, which may result in a
mismatch between our asset yields and borrowing rates and consequently
reduce or eliminate income derived from our investments.
- We are exposed to credit risk from our tenant, Bell Canada. If the credit
quality of this tenant is downgraded, or if it is unable or unwilling to
timely pay rent, the value of and revenue from our Bell Canada portfolio
would decline.
- If we fail to qualify as a REIT, we will be subject to income tax at
regular corporate rates, which will reduce the cash available for
distribution to our stockholders.
- The REIT qualification rules impose limitations on the types of
investments and activities which we may undertake, including limitations
on our use of hedging transactions and derivatives, and these limitations
may, in some cases, preclude us from pursuing the most economically
beneficial investment alternatives.
Newcastle Investment Holdings was incorporated in the State of Maryland in
May 1998. We were incorporated in the State of Maryland in June 2002. Our
principal executive offices are located at 1251 Avenue of the Americas, New
York, New York 10020. Our telephone number is (212) 798-6100.
4
THE OFFERING
The following is a brief summary of certain terms of this offering. For a
more complete description of the terms of the Series B Preferred Stock, see
"Description of Series B Preferred Stock" in this prospectus.
Issuer.............................. Newcastle Investment Corp.
Securities offered.................. 2,500,000 shares of 9.75% Series B
Cumulative Redeemable Preferred Stock.
The underwriters have an option to
purchase up to 375,000 additional
shares of Series B Preferred Stock
from us to cover over-allotments, if
any.
Distributions....................... Investors will be entitled to receive
cumulative cash distributions on the
Series B Preferred Stock at a rate of
9.75% per year of the $25.00
liquidation preference (equivalent to
$2.4375 per year per share). Beginning
on April 30, 2003, distributions on
the Series B Preferred Stock will be
payable quarterly in arrears on the
last calendar day of each January,
April, July and October or, if not a
business day, the next succeeding
business day. Distributions on the
Series B Preferred Stock will be
cumulative from the date of original
issuance, which is expected to be
March 18, 2003. The first distribution
we pay on April 30, 2003 will be for
less than a full quarter.
Liquidation preference.............. If we liquidate, dissolve or wind up,
holders of the Series B Preferred
Stock will have the right to receive
$25.00 per share, plus accrued and
unpaid distributions (whether or not
declared) to and including the date of
payment, before any payments are made
to the holders of our common stock and
any other of our equity securities
ranking junior to the Series B
Preferred Stock as to liquidation
rights. The rights of the holders of
the Series B Preferred Stock to
receive their liquidation preference
will be subject to the proportionate
rights of each other series or class
of our equity securities ranked on
parity with the Series B Preferred
Stock.
Maturity............................ The Series B Preferred Stock has no
maturity date and we are not required
to redeem the Series B Preferred
Stock. Accordingly, the Series B
Preferred Stock will remain
outstanding indefinitely, unless we
decide to redeem it. We are not
required to set aside funds to redeem
the Series B Preferred Stock.
Optional redemption................. We may not redeem the Series B
Preferred Stock prior to March 18,
2008, except in limited circumstances
to preserve our status as a REIT. On
or after March 18, 2008, we may, at
our option, redeem the Series B
Preferred Stock, in whole or in part,
at any time and from time to time, for
cash at $25.00 per share, plus accrued
and unpaid distributions, if any,
5
to the redemption date. Any partial
redemption generally will be on a pro
rata basis.
Ranking............................. The Series B Preferred Stock will rank
senior to our common stock with
respect to the payment of
distributions and amounts upon
liquidation, dissolution or winding
up.
Voting rights....................... Holders of the Series B Preferred
Stock will generally have no voting
rights. However, if distributions on
any outstanding Series B Preferred
Stock have not been paid for six or
more quarterly periods (whether or not
consecutive), holders of the Series B
Preferred Stock, voting as a class
with the holders of all other classes
or series of our equity securities
ranking on a parity with the Series B
Preferred Stock which are entitled to
similar voting rights, will be
entitled to elect two additional
directors to our board of directors to
serve until all unpaid distributions
have been paid or declared and set
apart for payment. In addition,
certain material and adverse changes
to the terms of the Series B Preferred
Stock cannot be made and certain other
actions may not be taken without the
affirmative vote of holders of at
least two-thirds of the outstanding
shares of Series B Preferred Stock.
Restrictions on ownership and
transfer............................ To maintain our qualification as a
REIT for federal income tax purposes,
no person or entity may own, or be
deemed to own, more than 8.0% of the
aggregate value of all outstanding
shares of our capital stock or more
than 25.0% of the shares of Series B
Preferred Stock, in each case unless
they receive an exemption from our
board of directors.
Listing............................. The Series B Preferred Stock has been
approved for listing on the New York
Stock Exchange under the symbol "NCT
PrB," subject to official notice of
issuance. We expect that trading on
the NYSE will commence within 30 days
after the initial delivery of the
Series B Preferred Stock.
Form................................ The Series B Preferred Stock will be
issued and maintained in book-entry
form registered in the name of the
nominee of The Depositary Trust
Company, except under limited
circumstances.
Conversion.......................... The Series B Preferred Stock is not
convertible into, or exchangeable for,
any of our other property or
securities.
6
Use of proceeds..................... We estimate that our net proceeds from
the offering will be approximately
$60.1 million. We intend to use the
net proceeds from this offering to
make investments in real estate
securities and/or other real estate
related assets and for general
corporate purposes.
RESTRICTIONS ON OWNERSHIP OF STOCK
Due to limitations on the concentration of ownership of a REIT imposed by
the Internal Revenue Code of 1986, as amended, our charter generally prohibits
any stockholder from directly or indirectly owning more than 8.0% of the
aggregate value of all outstanding shares of our capital stock, treating all
classes and series of our stock in the aggregate, or more than 25.0% of our
Series B Preferred Stock. Such ownership is referred to in this prospectus as
the stock ownership limit. Our board of directors has discretion to grant
exemptions from the ownership limit, subject to such terms and conditions as it
deems appropriate. Our board of directors has granted limited exemptions to
Newcastle Investment Holdings, our manager, a third party group of funds managed
by Wallace R. Weitz & Company, and certain affiliates of these entities.
RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED SHARE DISTRIBUTIONS
The historical ratio of earnings to combined fixed charges and preferred
share distributions for the periods indicated is as follows:
PERIOD FROM
YEAR ENDED DECEMBER 31, MAY 11,
------------------------- 1998 TO
2002 2001 2000 1999 DECEMBER 31, 1998
---- ---- ---- ---- -----------------
Ratio of Earnings to Combined Fixed Charges and
Preferred Share Distributions.................... 1.62 1.90 1.82 1.39 N/A
The ratios are based solely on historical financial information and no pro
forma adjustments have been made thereto.
7
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
Our predecessor, Newcastle Investment Holdings, contributed to us certain
assets and related liabilities in exchange for shares of our common stock.
However, as presented in the following table, for accounting purposes this
transaction is presented as a reverse spin-off. Under a reverse spin-off,
Newcastle Investment Corp. is treated as the continuing entity and the assets to
be retained by Newcastle Investment Holdings are accounted for as if they were
distributed at historical book basis through a spin-off to Newcastle Investment
Holdings.
As of July 12, 2002, for accounting purposes, we distributed to Newcastle
Investment Holdings assets which represented approximately thirty percent of our
total assets (100% of our real estate loans, our investment in Fortress
Investment Fund LLC, and approximately 75% of our real properties), and related
liabilities. The following assets were retained by us:
- Real estate securities (which serve as collateral for CBO I and CBO II);
- Credit leased real estate (Bell Canada portfolio and LIV portfolio); and
- Other assets.
The following table sets forth certain selected operating information on a
pro forma basis.
The selected unaudited pro forma consolidated statements of income are
presented as if the distribution had been consummated on January 1, 2002 or
2001, as applicable. The historical results of operations of the assets and
liabilities distributed to Newcastle Investment Holdings have been presented as
discontinued operations for those operations that constitute a component of an
entity. A component of an entity must have cash flows that are clearly
distinguished operationally and for financial reporting purposes from the rest
of the entity. Of the assets distributed to Newcastle Investment Holdings, the
U.S. real estate portfolio and the mortgage loans qualify as a component of an
entity. The remaining operations related to the other assets and liabilities
distributed to Newcastle Investment Holdings which are not a component of an
entity have been eliminated.
The selected unaudited pro forma consolidated statements of income are
presented for comparative purposes only, and are not necessarily indicative of
what our actual consolidated results of operations would have been for the
periods presented, nor do they purport to represent the results of any future
periods. In the opinion of management, all adjustments necessary to present
fairly the unaudited pro forma financial information have been made. The summary
selected pro forma financial information set forth below for the years ended
December 31, 2002 and 2001 have been derived from our unaudited pro forma
statements of income included in Note 13 of our consolidated financial
statements included in this prospectus.
The information below should be read in conjunction with "Management's
Discussion and Analysis of Pro Forma Financial Condition and Results of
Operations" and our consolidated financial statements and notes thereto included
in this prospectus.
8
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED
DECEMBER 31,
------------------
2002 2001
-------- -------
OPERATING DATA
Revenues
Interest and dividend income.............................. $72,856 $47,709
Rental and escalation income.............................. 19,874 20,053
Gain on settlement of investments......................... 11,446 7,405
Other income.............................................. 15 43
-------- -------
104,191 75,210
Expenses
Interest expense.......................................... 47,191 32,659
Property operating expense................................ 8,631 8,695
Loan servicing expense.................................... 655 243
General and administrative expense........................ 2,814 1,230
Management fees to affiliate.............................. 3,905 3,642
Preferred incentive return to affiliate................... 2,029 --
Depreciation and amortization............................. 2,769 2,567
-------- -------
67,994 49,036
-------- -------
Income from continuing operations........................... $36,197 $26,174
======== =======
Income from discontinued operations......................... $1,777 $5,016
======== =======
Income from continuing operations per share of common stock,
basic and diluted......................................... $1.95 $1.54
======== =======
Weighted average number of shares of common stock
outstanding, basic........................................ 18,560 16,973
======== =======
Weighted average number of shares of common stock
outstanding, diluted...................................... 18,570 16,973
======== =======
YEAR ENDED
DECEMBER 31,
-------------------
2002 2001
--------- -------
OTHER DATA
Cash flow from continuing operations provided by (used in):
Operating activities...................................... $17,908 $17,483
Investing activities...................................... $(741,971) $(6,973)
Financing activities...................................... $727,141 $16,294
Funds from Operations (FFO) from continuing operations(A)... $38,828 $28,688
- ---------------
(A) We believe funds from operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. We also believe that FFO is an appropriate supplemental
disclosure of operating performance for a REIT due to its widespread
acceptance and use within the REIT and analyst communities. FFO, for our
purposes, represents net income available for common stockholders (computed
in accordance with accounting principles generally accepted in the United
States (GAAP)), excluding extraordinary items, plus real estate depreciation
and amortization, and after adjustments for unconsolidated subsidiaries, if
any. We consider gains and losses on resolution
9
of our investments to be a normal part of our recurring operations and,
therefore, do not exclude such gains and losses when arriving at FFO.
Adjustments for unconsolidated subsidiaries, if any, are calculated to
reflect FFO on the same basis. FFO does not represent cash generated from
operating activities in accordance with GAAP and therefore should not be
considered as an alternative to net income as an indicator of our operating
performance or as an alternative to cash flow as a measure of liquidity and
is not necessarily indicative of cash available to fund cash needs.
YEAR ENDED
DECEMBER 31,
-----------------
2002 2001
------- -------
CALCULATION OF FUNDS FROM OPERATIONS
Income from continuing operations........................... $36,197 $26,174
Real estate depreciation and amortization................... 2,631 2,514
------- -------
Funds from Operations (FFO) from continuing operations...... $38,828 $28,688
======= =======
10
RISK FACTORS
An investment in our Series B Preferred Stock involves a high degree of
risk. You should carefully consider the following information, together with the
other information contained in this prospectus, before buying our Series B
Preferred Stock. In connection with the forward-looking statements that appear
in this prospectus, you should also carefully review the cautionary statement
referred to under "Cautionary Statement Regarding Forward-Looking Statements."
RISKS RELATED TO THIS OFFERING
THE SERIES B PREFERRED STOCK IS A NEW ISSUANCE AND DOES NOT HAVE AN ESTABLISHED
TRADING MARKET, WHICH MAY NEGATIVELY AFFECT ITS MARKET VALUE AND YOUR ABILITY TO
TRANSFER OR SELL YOUR SHARES; THE SERIES B PREFERRED STOCK HAS NO STATED
MATURITY DATE.
The shares of Series B Preferred Stock are a new issue of securities with
no established trading market. Since the securities have no stated maturity
date, investors seeking liquidity will be limited to selling their shares in the
secondary market. The Series B Preferred Stock has been approved for listing on
the NYSE, subject to official notice of issuance. However, an active trading
market on the NYSE for the shares may not develop or, even if it develops, may
not last, in which case the trading price of the shares could be adversely
affected and your ability to transfer your shares of Series B Preferred Stock
will be limited. We have been advised by the underwriters that they intend to
make a market in the shares, but they are not obligated to do so and may
discontinue market-making at any time without notice.
THE MARKET VALUE OF THE SERIES B PREFERRED STOCK COULD BE SUBSTANTIALLY AFFECTED
BY VARIOUS FACTORS.
The trading price of the shares may depend on many factors, including:
- prevailing interest rates;
- the market for similar securities;
- general economic conditions; and
- our financial condition, performance and prospects.
For example, higher market interest rates could cause the market price of
the Series B Preferred Stock to go down.
THE SERIES B PREFERRED STOCK HAS NOT BEEN RATED AND WILL BE SUBORDINATED TO ALL
OF OUR EXISTING AND FUTURE DEBT.
The Series B Preferred Stock has not been rated by any nationally
recognized statistical rating organization, and will be subordinated to all of
our existing and future debt.
RISKS RELATING TO OUR MANAGEMENT
WE ARE DEPENDENT ON OUR MANAGER AND MAY NOT FIND A SUITABLE REPLACEMENT IF OUR
MANAGER TERMINATES THE MANAGEMENT AGREEMENT.
We have no employees. Our officers are employees of our manager. We have no
separate facilities and are completely reliant on our manager, which has
significant discretion as to the implementation of our operating policies and
strategies. We are subject to the risk that our manager will terminate the
management agreement and that no suitable replacement will be found to manage
us. We believe that our success depends to a significant extent upon the
experience of the manager's executive officers, whose continued service is not
guaranteed.
THERE ARE CONFLICTS OF INTEREST IN OUR RELATIONSHIP WITH OUR MANAGER.
Our chairman and chief executive officer and each of our executive officers
also serve as officers of our manager. As a result, the management agreement was
not negotiated at arm's-length and its terms,
11
including fees payable, may not be as favorable to us as if it had been
negotiated with an unaffiliated third party.
Our manager also manages and invests in other real estate-related
investment vehicles, including Newcastle Investment Holdings, and our chairman
and chief executive officer and some of our other officers also serve as
officers and/or directors of these other entities. For example, our manager
manages Fortress Investment Fund, which has a substantial investment in Capstead
Mortgage Corporation, a publicly traded mortgage REIT. Our chairman and chief
executive officer, who is also an officer of our manager, also serves as
chairman and chief executive officer of Capstead. Capstead's portfolio consists
primarily of adjustable-rate residential mortgage backed securities issued by
Fannie Mae, Freddie Mac and Ginnie Mae. However, Capstead has a broader
investment mandate, which could lead to a future conflict with our business.
Certain investments appropriate for us may also be appropriate for one or more
of these other investment vehicles and our manager may decide to make a
particular investment through another investment vehicle rather than through us.
Our manager also intends to engage in additional real estate-related management
and investment opportunities in the future which may also compete with us for
investments.
Our management agreement with our manager generally does not limit or
restrict our manager from engaging in any business or managing any other vehicle
that invests generally in real estate securities. The ability of our manager and
its officers and employees to engage in these other business activities will
reduce the time our manager spends managing us. The manager is required to seek
the approval of the independent members of our board of directors before we
engage in a material transaction with another entity managed by our manager.
The management compensation structure that we have agreed to with our
manager may cause our manager to invest in high risk investments. In addition to
its management fee, our manager is entitled to receive incentive compensation
based in part upon our achievement of targeted levels of funds from operations.
In evaluating investments and other management strategies, the opportunity to
earn incentive compensation based on funds from operations may lead our manager
to place undue emphasis on the maximization of funds from operations at the
expense of other criteria, such as preservation of capital, in order to achieve
higher incentive compensation. Investments with higher yield potential are
generally riskier or more speculative. This could result in increased risk to
the value of our invested portfolio.
Termination of the management agreement with our manager is difficult and
costly. The management agreement may only be terminated annually upon the
affirmative vote of at least two-thirds of our independent directors, or by a
vote of the holders of a majority of the outstanding shares of our common stock,
based upon (1) unsatisfactory performance by our manager that is materially
detrimental to us or (2) a determination that the compensation to our manager is
not fair, subject to our manager's right to prevent such a compensation
termination by accepting a mutually acceptable reduction of fees. Our manager
will be provided 60 days' prior notice of any termination and will be paid a
termination fee equal to the amount of the management fee earned by the manager
during the twelve-month period preceding such termination. In addition,
following any termination of the management agreement, the manager may require
us to purchase its right to receive incentive compensation at a price determined
as if our assets were sold for their fair market value (as determined by an
appraisal, taking into account, among other things, the expected future value of
the underlying investments) or otherwise we may continue to pay the incentive
compensation to our manager. These provisions may increase the effective cost to
us of terminating the management agreement, thereby adversely affecting our
ability to terminate our manager without cause.
THERE ARE CONFLICTS OF INTEREST IN OUR RELATIONSHIP WITH NEWCASTLE INVESTMENT
HOLDINGS.
Our chairman and chief executive officer also serves as chairman and chief
executive officer of Newcastle Investment Holdings and, at the time of our
formation and the contribution of assets and related liabilities to us and when
other organizational matters were approved for us, Newcastle Investment Holdings
was our sole stockholder. As a result, these matters were not approved at arm's
length and the
12
terms of the transfer may not be as favorable to us as if the transfer was with
an unaffiliated third party. Our manager also manages and has an equity interest
in both us and in Newcastle Investment Holdings. In addition, we may enter into
transactions in the future with Newcastle Investment Holdings with the approval
of the independent members of our board.
WE HAVE A LIMITED OPERATING HISTORY AS A SEPARATE BUSINESS FROM NEWCASTLE
INVESTMENT HOLDINGS AND MAY NOT OPERATE SUCCESSFULLY AS A SEPARATE BUSINESS.
Newcastle Investment Holdings was organized in May 1998. We were organized
in June 2002, completed the initial public offering of our common stock in
October 2002, and have a limited operating history as a separate business from
Newcastle Investment Holdings. The results of our operations depend on many
factors, including the availability of opportunities for the acquisition of
assets, the level and volatility of interest rates, readily accessible short and
long term funding, alternative conditions in the financial markets and economic
conditions, and we may not operate successfully as a separate business. We face
substantial competition in acquiring suitable investments, which could increase
our costs.
OUR DIRECTORS HAVE APPROVED VERY BROAD INVESTMENT GUIDELINES FOR OUR MANAGER AND
DO NOT APPROVE EACH INVESTMENT DECISION MADE BY OUR MANAGER.
Our manager is authorized to follow very broad investment guidelines. Our
directors will periodically review our investment guidelines and our investment
portfolio. However, our board does not review each proposed investment. In
addition, in conducting periodic reviews, the directors rely primarily on
information provided to them by our manager. Furthermore, transactions entered
into by our manager may be difficult or impossible to unwind by the time they
are reviewed by the directors. Our manager has great latitude within the broad
investment guidelines in determining the types of assets it may decide are
proper investments for us.
WE MAY CHANGE OUR INVESTMENT STRATEGY WITHOUT STOCKHOLDER CONSENT WHICH MAY
RESULT IN RISKIER INVESTMENTS THAN OUR CURRENT INVESTMENTS.
We may change our investment strategy at any time without the consent of
our stockholders, which could result in our making investments that are
different from, and possibly riskier than, the investments described in this
prospectus. A change in our investment strategy may increase our exposure to
interest rate and real estate market fluctuations.
RISKS RELATING TO OUR BUSINESS
WE ARE SUBJECT TO SIGNIFICANT COMPETITION AND WE MAY NOT COMPETE SUCCESSFULLY.
We are subject to significant competition in seeking investments. We
compete with several other companies, including other REITs, insurance companies
and other investors, including funds and companies affiliated with our manager.
Some of our competitors have greater resources than us and we may not be able to
compete successfully for investments.
WE LEVERAGE OUR PORTFOLIO, WHICH MAY ADVERSELY AFFECT OUR RETURN ON OUR
INVESTMENTS AND MAY REDUCE CASH AVAILABLE FOR DISTRIBUTION.
We leverage our portfolio through borrowings, generally through the use of
bank credit facilities, repurchase agreements, mortgage loans on real estate,
securitizations, including the issuance of CBOs, and other borrowings. The
percentage of leverage varies depending on our ability to obtain credit
facilities and the lender's estimate of the stability of the portfolio's cash
flow. We currently have a policy limiting the use of leverage up to 90% of the
value of our assets on an aggregate basis. Our return on our investments and
cash available for distribution to our stockholders may be reduced to the extent
that changes in market conditions cause the cost of our financing to increase
relative to the income that can be derived from the assets acquired.
13
Our debt service payments reduce the net income available for distributions
to stockholders. For the year ended December 31, 2002, on a pro forma basis, our
debt service payments were $1.8 million and $45.7 million of principal and
interest payments, respectively, excluding debt repayments from the proceeds of
asset sales and refinancings. We may not be able to meet our debt service
obligations and, to the extent that we cannot, we risk the loss of some or all
of our assets to foreclosure or sale to satisfy our debt obligations.
We may leverage certain of our investments through repurchase agreements. A
decrease in the value of the assets may lead to margin calls which we will have
to satisfy. We may not have the funds available to satisfy any such margin
calls.
THE MORTGAGE LOANS WE INVEST IN AND THE MORTGAGE LOANS UNDERLYING THE MORTGAGE
BACKED SECURITIES WE INVEST IN ARE SUBJECT TO DELINQUENCY, FORECLOSURE AND LOSS,
WHICH COULD RESULT IN LOSSES TO US.
Commercial mortgage loans are secured by multifamily or commercial property
and are subject to risks of delinquency and foreclosure, and risks of loss that
are greater than similar risks associated with loans made on the security of
single-family residential property. The ability of a borrower to repay a loan
secured by an income-producing property typically is dependent primarily upon
the successful operation of such property rather than upon the existence of
independent income or assets of the borrower. If the net operating income of the
property is reduced, the borrower's ability to repay the loan may be impaired.
Net operating income of an income-producing property can be affected by, among
other things: tenant mix, success of tenant businesses, property management
decisions, property location and condition, competition from comparable types of
properties, changes in laws that increase operating expense or limit rents that
may be charged, any need to address environmental contamination at the property,
the occurrence of any uninsured casualty at the property, changes in national,
regional or local economic conditions and/or specific industry segments,
declines in regional or local real estate values, declines in regional or local
rental or occupancy rates, increases in interest rates, real estate tax rates
and other operating expenses, changes in governmental rules, regulations and
fiscal policies, including environmental legislation, acts of God, terrorism,
social unrest and civil disturbances.
Residential mortgage loans are secured by single-family residential
property and are subject to risks of delinquency and foreclosure, and risks of
loss. The ability of a borrower to repay a loan secured by a residential
property is dependent upon the income or assets of the borrower. A number of
factors, including a general economic downturn, acts of God, terrorism, social
unrest and civil disturbances, may impair borrowers' abilities to repay their
loans.
In the event of any default under a mortgage loan held directly by us, we
will bear a risk of loss of principal to the extent of any deficiency between
the value of the collateral and the principal and accrued interest of the
mortgage loan, which could have a material adverse effect on our cash flow from
operations. In the event of the bankruptcy of a mortgage loan borrower, the
mortgage loan to such borrower will be deemed to be secured only to the extent
of the value of the underlying collateral at the time of bankruptcy (as
determined by the bankruptcy court), and the lien securing the mortgage loan
will be subject to the avoidance powers of the bankruptcy trustee or
debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure of a mortgage loan can be an expensive and lengthy process which
could have a substantial negative effect on our anticipated return on the
foreclosed mortgage loan.
Residential mortgage backed securities evidence interests in or are secured
by pools of residential mortgage loans and commercial mortgage backed securities
evidence interests in or are secured by a single commercial mortgage loan or a
pool of commercial mortgage loans. Accordingly, the mortgage backed securities
we invest in are subject to all of the risks of the underlying mortgage loans.
14
ALTHOUGH WE SEEK TO MATCH FUND OUR INVESTMENTS TO LIMIT REFINANCE RISK, IN
PARTICULAR WITH RESPECT TO OUR INVESTMENTS IN REAL ESTATE SECURITIES, WE DO NOT
EMPLOY THIS STRATEGY WITH RESPECT TO OUR INVESTMENTS IN MORTGAGE LOANS, WHICH
INCREASES REFINANCE RISKS FOR OUR MORTGAGE LOANS.
A key to our investment strategy is to finance our investments using
match-funded financing structures, which match assets and liabilities with
respect to maturities and interest rates. This limits our refinance risk,
including the risk of being able to refinance an investment or refinance on
favorable terms. We use match-funded financing structures, such as CBOs, to
finance our investments in real estate securities. However, we do not employ
this strategy with respect to the mortgage loans we invest in, which exposes us
to additional refinance risks that may not apply to our other investments.
WE MAY NOT BE ABLE TO MATCH-FUND OUR FUTURE INVESTMENTS WITH RESPECT TO
MATURITIES AND INTEREST RATES, WHICH EXPOSES US TO THE RISK THAT WE MAY NOT BE
ABLE TO FINANCE OUR INVESTMENTS ON ECONOMICALLY FAVORABLE TERMS.
We focus on investing in credit sensitive real estate securities, including
mortgage backed securities and REIT securities, and invest in other real estate
related investments. We attempt to minimize exposure to interest rate
fluctuation through the use of match-funded financing structures. If we are
unable to match-fund our future investments with respect to maturities and
interest rates, we are subject to the risk that we may not be able to finance
our investments on economically favorable terms. In addition, when financing our
investments through CBO issuances, we accumulate securities through an
arrangement in which a third party provides short-term financing pending the
issuance of the CBO securities and we make a cash deposit with such third party.
Under such arrangement, if such CBO transaction were not consummated we would be
required to either purchase the securities and obtain other financing for such
purchase, or pay the third party the lesser of the difference between the price
it paid for the securities and the price it sold such securities or our deposit.
OUR INVESTMENTS IN SUBORDINATED MORTGAGE BACKED SECURITIES ARE SUBJECT TO
LOSSES.
In general, losses on an asset securing a mortgage loan included in a
securitization will be borne first by the equity holder of the property, then by
a cash reserve fund or letter of credit, if any, and then by the "first loss"
subordinated security holder. In the event of default and the exhaustion of any
equity support, reserve fund, letter of credit and any classes of securities
junior to those in which we invest, we will not be able to recover all of our
investment in the securities we purchase. In addition, if the underlying
mortgage portfolio has been overvalued by the originator, or if the values
subsequently decline and, as a result, less collateral is available to satisfy
interest and principal payments due on the related mortgage backed securities,
the securities in which we invest may effectively become the "first loss"
position behind the more senior securities, which may result in significant
losses to us.
The prices of lower credit quality securities are generally less sensitive
to interest rate changes than more highly rated investments, but more sensitive
to adverse economic downturns or individual issuer developments. A projection of
an economic downturn, for example, could cause a decline in the price of lower
credit quality securities because the ability of obligors of mortgages
underlying mortgage backed securities to make principal and interest payments
may be impaired. In such event, existing credit support in the securitization
structure may be insufficient to protect us against loss of our principal on
these securities.
OUR INVESTMENTS IN REIT SECURITIES ARE SUBJECT TO SPECIFIC RISKS RELATING TO THE
PARTICULAR REIT ISSUER OF THE SECURITIES AND TO THE GENERAL RISKS OF INVESTING
IN SUBORDINATED REAL ESTATE SECURITIES, WHICH MAY RESULT IN LOSSES TO US.
Our investments in REIT securities involve special risks relating to the
particular REIT issuer of the securities, including the financial condition and
business outlook of the issuer. REITs generally are required to substantially
invest in real estate or real estate-related assets and are subject to the
inherent risks associated with real estate-related investments discussed in this
prospectus.
15
Our investments in REIT securities are also subject to the risks described
above with respect to mortgage loans and mortgage backed securities and similar
risks, including (i) risks of delinquency and foreclosure, and risks of loss in
the event thereof, (ii) the dependence upon the successful operation of and net
income from real property, (iii) risks generally incident to interests in real
property, and (iv) risks that may be presented by the type and use of a
particular commercial property.
REIT securities are generally unsecured and may also be subordinated to
other obligations of the issuer. We may also invest in REIT securities that are
rated below investment grade. As a result, investments in REIT securities are
also subject to risks of: (i) limited liquidity in the secondary trading market,
(ii) substantial market price volatility resulting from changes in prevailing
interest rates, (iii) subordination to the prior claims of banks and other
senior lenders to the issuer, (iv) the operation of mandatory sinking fund or
call/redemption provisions during periods of declining interest rates that could
cause the issuer to reinvest premature redemption proceeds in lower yielding
assets, (v) the possibility that earnings of the REIT security issuer may be
insufficient to meet its debt service and dividend obligations and (vi) the
declining creditworthiness and potential for insolvency of the issuer of such
REIT securities during periods of rising interest rates and economic downturn.
These risks may adversely affect the value of outstanding REIT securities and
the ability of the issuers thereof to repay principal and interest or make
dividend payments.
THE B NOTES WE INVEST IN MAY BE SUBJECT TO ADDITIONAL RISKS RELATING TO THE
PRIVATELY NEGOTIATED STRUCTURE AND TERMS OF THE TRANSACTION, WHICH MAY RESULT IN
LOSSES TO US.
We invest in "B Notes." A "B Note" is a mortgage loan typically (a) secured
by a first mortgage on a single large commercial property or group of related
properties and (b) subordinated to an "A Note" secured by the same first
mortgage on the same collateral. As a result, if an issuer defaults, there may
not be sufficient funds remaining for B Note holders. B Notes reflect similar
credit risks to comparably rated commercial mortgage backed securities. However,
since each transaction is privately negotiated, B Notes can vary in their
structural characteristics and risks. For example, the rights of holders of B
Notes to control the process following a borrower default may vary from
transaction to transaction. Further, B Notes typically are secured by a single
property, and so reflect the risks associated with significant concentration. B
Notes also are less liquid than commercial mortgage backed securities.
OUR INSURANCE ON OUR REAL ESTATE AND INSURANCE ON OUR REAL ESTATE COLLATERAL MAY
NOT COVER ALL LOSSES.
There are certain types of losses, generally of a catastrophic nature, such
as earthquakes, floods, hurricanes, terrorism or acts of war, that may be
uninsurable or not economically insurable. Inflation, changes in building codes
and ordinances, environmental considerations, and other factors, including
terrorism or acts of war, also might make the insurance proceeds insufficient to
repair or replace a property if it is damaged or destroyed. Under such
circumstances, the insurance proceeds received might not be adequate to restore
our economic position with respect to the affected real property.
As a result of the events of September 11, 2001, insurance companies are
limiting and/or excluding coverage for acts of terrorism in insurance policies.
As a result, we may suffer losses from acts of terrorism that are not covered by
insurance. In addition, the mortgage loans which are secured by certain of our
properties contain customary covenants, including covenants that require us to
maintain property insurance in an amount equal to the replacement cost of the
properties. There can be no assurance that the lenders under our mortgage loans
will not take the position that exclusions from our coverage for losses due to
terrorist acts is a breach of a covenant which, if uncured, could allow the
lenders to declare an event of default and accelerate repayment of the mortgage
loans.
ENVIRONMENTAL COMPLIANCE COSTS AND LIABILITIES WITH RESPECT TO OUR REAL ESTATE
MAY AFFECT OUR RESULTS OF OPERATIONS.
Our operating costs may be affected by our obligation to pay for the cost
of complying with existing environmental laws, ordinances and regulations, as
well as the cost of complying with future legislation
16
with respect to the assets, or loans secured by assets, with environmental
problems that materially impair the value of the assets. Under various federal,
state and local environmental laws, ordinances and regulations, a current or
previous owner or operator of real property may be liable for the costs of
removal or remediation of hazardous or toxic substances on, under, or in such
property. Such laws often impose liability whether or not the owner or operator
knew of, or was responsible for, the presence of such hazardous or toxic
substances. In addition, the presence of hazardous or toxic substances, or the
failure to remediate properly, may adversely affect the owner's ability to
borrow by using such real property as collateral. Certain environmental laws and
common law principles could be used to impose liability for releases of
hazardous materials, including asbestos-containing materials into the
environment, and third parties may seek recovery from owners or operators of
real properties for personal injury associated with exposure to released
asbestos-containing materials or other hazardous materials. Environmental laws
may also impose restrictions on the manner in which a property may be used or
transferred or in which businesses may be operated, and these restrictions may
require expenditures. In connection with the ownership and operation of
properties, we may be potentially liable for any such costs. The cost of
defending against claims of liability or remediating contaminated property and
the cost of complying with environmental laws could materially adversely affect
our results of operations and financial condition.
MANY OF OUR INVESTMENTS ARE ILLIQUID AND WE MAY NOT BE ABLE TO VARY OUR
PORTFOLIO IN RESPONSE TO CHANGES IN ECONOMIC AND OTHER CONDITIONS.
Real estate and real estate-related assets are generally illiquid. In
addition, the real estate securities that we purchase in connection with
privately negotiated transactions are not registered under the relevant
securities laws, resulting in a prohibition against their transfer, sale, pledge
or other disposition except in a transaction that is exempt from the
registration requirements of, or is otherwise in accordance with, those laws. A
majority of the mortgage backed securities and REIT securities, and all of the B
Notes, that we purchase are purchased in private, unregistered transactions and
are therefore subject to restrictions on resale or otherwise have no established
trading market. As a result, our ability to vary our portfolio in response to
changes in economic and other conditions may be relatively limited.
INTEREST RATE FLUCTUATIONS MAY CAUSE LOSSES.
Our primary interest rate exposures relate to our loans, mortgage backed
securities and variable-rate debt, as well as our interest rate swaps and caps.
Changes in the general level of interest rates can affect our net interest
income, which is the difference between the interest income earned on our
interest-earning investments and the interest expense incurred on our
interest-bearing liabilities. Changes in the level of interest rates also can
affect, among other things, our ability to originate and acquire loans and
securities, the value of our loans and securities and our ability to realize
gains from the settlement of such assets.
Currently, U.S. interest rates are historically low. In the event of a
significant rising interest rate environment and/or economic downturn, mortgage
and loan defaults may increase and result in credit losses that would adversely
affect our liquidity and operating results. 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 our
control.
Our ability to execute our business strategy, particularly the growth of
our investment portfolio, depends to a significant degree on our ability to
obtain additional capital. Our CBO strategy is dependent on our ability to place
the match-funded debt we use to finance our real estate securities investments
at spreads that provide a positive arbitrage. If spreads for CBO liabilities
widen or if demand for such liabilities ceases to exist, then our ability to
execute future CBO transactions will be severely restricted.
Interest rate changes may also impact our net book value as our securities
and related hedge derivatives are marked-to-market each quarter. Generally, as
interest rates increase, the value of our fixed income securities, such as
commercial mortgage backed securities, decreases, which will decrease the book
value of our portfolio.
17
Our operating results will depend in large part on differences between the
income from our assets, net of credit losses, and our financing costs. We
anticipate that, in most cases, for any period during which our assets are not
match-funded, the income from such assets will respond more slowly to interest
rate fluctuations than the cost of our borrowings. Consequently, changes in
interest rates, particularly short-term interest rates, may significantly
influence our net income. Increases in these rates will tend to decrease our net
income and market value of our assets. Interest rate fluctuations resulting in
our interest expense exceeding interest income would result in operating losses
for us.
OUR INVESTMENTS IN REAL ESTATE SECURITIES AND MORTGAGE LOANS ARE SUBJECT TO
CHANGES IN CREDIT SPREADS.
Our investments in real estate securities are subject to changes in credit
spreads. The majority of the real estate securities we invest in are fixed rate
securities, which are valued based on a market credit spread over the rate
payable on fixed rate U.S. Treasuries of like maturity. The value of these
securities is dependent on the yield demanded on these securities by the market
based on their credit relative to U.S. Treasuries. Excessive supply of these
securities combined with reduced demand will generally cause the market to
require a higher yield on these real estate securities, resulting in the use of
a higher, or "wider," spread over the benchmark rate (usually the applicable
U.S. Treasury security yield) to value such securities. Under such conditions,
the value of our securities portfolio would tend to decline. Conversely, if the
spread used to value such securities were to decrease, or "tighten", the value
of our securities portfolio would tend to increase. Such changes in the market
value of our portfolio may effect our net equity, net income or cash flow
directly through their impact on unrealized gains or losses on
available-for-sale securities, and therefore our ability to realize gains on
such securities, or indirectly through their impact on our ability to borrow and
access capital.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also affect the yield
required on our securities and therefore their value. This would have similar
effects on our portfolio and our financial position and operations to a change
in spreads.
Our investments in mortgage loans are also subject to changes in credit
spreads. The majority of mortgage loans we invest in are floating rate loans
valued based on a market credit spread to LIBOR. The value of the loans is
dependent upon the yield demanded by the market based on their credit. The value
of our portfolio would tend to decline should the market require a higher yield
on such loans, resulting in the use of a higher spread over the benchmark rate
(usually the applicable LIBOR yield). If the value of our mortgage loan
portfolio were to decline, it could affect our ability to refinance such
portfolio upon the maturity of the related repurchase agreement. Any credit or
spread losses incurred with respect to our mortgage loan portfolio would affect
us in the same way as similar losses on our real estate securities portfolio as
described above.
As of December 31, 2002, a 25 basis point movement in credit spreads would
impact our net book value by approximately $13.2 million.
OUR HEDGING TRANSACTIONS MAY LIMIT OUR GAINS OR RESULT IN LOSSES.
We use derivatives to hedge our liabilities and this has certain risks,
including the risk that losses on a hedge position will reduce the cash
available for distribution to stockholders and that such losses may exceed the
amount invested in such instruments. Our board of directors has adopted a
general policy with respect to the use of derivatives, which generally allows us
to use derivatives where appropriate, but does not set forth specific policies
and procedures. We use derivative instruments, including forwards, futures,
swaps and options, in our risk management strategy to limit the effects of
changes in interest rates on our operations. A hedge may not be effective in
eliminating all of the risks inherent in any particular position. Our
profitability may be adversely affected during any period as a result of the use
of derivatives.
18
WE MAY NOT BE ABLE TO ACQUIRE ELIGIBLE SECURITIES FOR A CBO ISSUANCE, OR MAY NOT
BE ABLE TO ISSUE CBO SECURITIES ON ATTRACTIVE TERMS, WHICH MAY REQUIRE US TO
SEEK MORE COSTLY FINANCING FOR OUR INVESTMENTS OR TO LIQUIDATE ASSETS.
We acquire real estate securities and finance them on a long-term basis,
such as through the issuance of collateralized bond obligations. During the
period that we are acquiring these assets, we finance our purchases through
relatively short-term credit facilities. We use these warehouse lines of credit
to finance the acquisition of real estate securities until a sufficient quantity
of securities is accumulated at which time we may refinance these lines through
a securitization, such as a CBO issuance, or other long-term financing. As a
result, we are subject to the risk that we will not be able to acquire, during
the period that our warehouse facility is available, a sufficient amount of
eligible securities to maximize the efficiency of a collateralized bond
obligation issuance. In addition, conditions in the capital markets may make the
issuance of a collateralized bond obligation less attractive to us when we do
have a sufficient pool of collateral. If we are unable to issue a collateralized
bond obligation to finance these assets, we may be required to seek such other
forms of potentially less attractive financing or otherwise to liquidate the
assets.
PREPAYMENT RATES CAN INCREASE, ADVERSELY AFFECTING YIELDS ON OUR INVESTMENTS.
The value of our assets may be affected by prepayment rates on mortgage
loans. Prepayment rates on mortgage loans are influenced by changes in current
interest rates and a variety of economic, geographic and other factors beyond
our control, and consequently, such prepayment rates cannot be predicted with
certainty. In periods of declining mortgage interest rates, prepayments on
mortgage loans generally increase. If general interest rates decline as well,
the proceeds of such prepayments received during such periods are likely to be
reinvested by us in assets yielding less than the yields on the assets that were
prepaid. In addition, the market value of the mortgage assets may, because of
the risk of prepayment, benefit less than other fixed-income securities from
declining interest rates. Conversely, in periods of rising interest rates,
prepayments on mortgage loans generally decrease, in which case we would not
have the prepayment proceeds available to invest in assets with higher yields.
Under certain interest rate and prepayment scenarios we may fail to recoup fully
our cost of acquisition of certain investments.
OUR INTERNATIONAL INVESTMENTS ARE SUBJECT TO CURRENCY RATE EXPOSURE AND THE
UNCERTAINTY OF FOREIGN LAWS AND MARKETS.
We own real estate located in Canada and in Belgium, which in addition to
all the risks inherent in the investment in real estate generally discussed in
this prospectus are also subject to fluctuations in foreign currency exchange
rates, unexpected changes in regulatory requirements, political and economic
instability in certain geographic locations, difficulties in managing
international operations, potentially adverse tax consequences, enhanced
accounting and control expenses and the burden of complying with a wide variety
of foreign laws. A change in foreign currency exchange rates may adversely
impact returns on our non-dollar denominated investments. Our principal direct
currency exposures are to the Euro and the Canadian Dollar. Changes in the
currency rates can adversely impact the fair values and earnings streams of our
international holdings. We generally do not directly hedge our foreign currency
risk through the use of derivatives, due to, among other things, REIT income
qualification issues.
WE ARE EXPOSED TO CREDIT RISK FROM BELL CANADA.
As of December 31, 2002, approximately 3.6% of our total assets consisted
of properties leased to Bell Canada and for the year ended December 31, 2002, on
a pro forma basis, approximately 12.9% of our revenue was derived from Bell
Canada. If the credit quality of this tenant is downgraded, or if it is unable
or unwilling to timely pay rent, the value of and revenue from our Bell Canada
portfolio would decline.
19
RISKS RELATED TO OUR COMPANY
OUR FAILURE TO QUALIFY AS A REIT WOULD RESULT IN HIGHER TAXES AND REDUCED CASH
AVAILABLE FOR STOCKHOLDERS.
We operate in a manner so as to qualify as a REIT for federal income tax
purposes. Although we do not intend to request a ruling from the Internal
Revenue Service (the IRS) as to our REIT status, we have received the opinion of
Skadden, Arps, Slate, Meagher & Flom LLP with respect to our qualification as a
REIT. This opinion was issued in connection with this offering of our Series B
Preferred Stock. Investors should be aware, however, that opinions of counsel
are not binding on the IRS or any court. The opinion of Skadden, Arps, Slate,
Meagher & Flom LLP represents only the view of our counsel based on our
counsel's review and analysis of existing law and on certain representations as
to factual matters and covenants made by us and our manager, including
representations relating to the values of our assets and the sources of our
income. The opinion of Skadden, Arps, Slate, Meagher & Flom LLP also relies on
various legal opinions issued by other counsel for Newcastle and its
predecessors with respect to certain issues and transactions. The opinions,
copies of which are filed as an exhibit to the registration statement of which
this prospectus is a part, are expressed as of the date issued, and do not cover
subsequent periods. Counsel has no obligation to advise us or the holders of our
Series B Preferred Shares of any subsequent change in the matters stated,
represented or assumed, or of any subsequent change in applicable law.
Furthermore, both the validity of the opinion of Skadden, Arps, Slate, Meagher &
Flom LLP, and our continued qualification as a REIT will depend on our
satisfaction of certain asset, income, organizational, distribution, stockholder
ownership and other requirements on a continuing basis, the results of which
will not be monitored by Skadden, Arps, Slate, Meagher & Flom LLP. Our ability
to satisfy the asset tests depends upon our analysis of the fair market values
of our assets, some of which are not susceptible to a precise determination, and
for which we will not obtain independent appraisals. Our compliance with the
REIT income and quarterly asset requirements also depends upon our ability to
successfully manage the composition of our income and assets on an ongoing
basis. Moreover, the proper classification of an instrument as debt or equity
for federal income tax purposes may be uncertain in some circumstances, which
could affect the application of the REIT qualification requirements as described
below. Accordingly, there can be no assurance that the IRS will not contend that
our interests in subsidiaries or other issuers will not cause a violation of the
REIT requirements. If we were to fail to qualify as a REIT in any taxable year,
we would be subject to federal income tax, including any applicable alternative
minimum tax, on our taxable income at regular corporate rates, and distributions
to stockholders would not be deductible by us in computing our taxable income.
Any such corporate tax liability could be substantial and would reduce the
amount of cash available for distribution to our stockholders, which in turn
could have an adverse impact on the value of, and trading prices for, our stock.
Unless entitled to relief under certain Internal Revenue Code provisions, we
also would be disqualified from taxation as a REIT for the four taxable years
following the year during which we ceased to qualify as a REIT. The rule against
re-electing REIT status following a loss of such status could also apply to us
if Newcastle Investment Holdings fails to qualify as a REIT, and we are treated
as a successor to Newcastle Investment Holdings for federal income tax purposes.
See "Federal Income Tax Considerations" for a discussion of material federal
income tax consequences relating to us and our stock.
REIT DISTRIBUTION REQUIREMENTS COULD ADVERSELY AFFECT OUR LIQUIDITY.
We generally must distribute annually at least 90% of our net taxable
income, excluding any net capital gain, in order for corporate income tax not to
apply to earnings that we distribute. We intend to make distributions to our
stockholders to comply with the requirements of the Internal Revenue Code.
However, differences in timing between the recognition of taxable income and the
actual receipt of cash could require us to sell assets or borrow funds on a
short-term or long-term basis to meet the 90% distribution requirement of the
Internal Revenue Code. Certain of our assets generate substantial mismatches
between taxable income and available cash. Such assets include (a) rental real
estate that has been financed through financing structures which require some or
all of available cash flows to be used to service borrowings and (b) mortgage
backed securities we hold that have been issued at a discount and
20
require the accrual of taxable economic interest in advance of receipt in cash.
As a result, the requirement to distribute a substantial portion of our net
taxable income could cause us to: (a) sell assets in adverse market conditions,
(b) borrow on unfavorable terms or (c) distribute amounts that would otherwise
be invested in future acquisitions, capital expenditures or repayment of debt in
order to comply with REIT requirements.
Further, amounts distributed will not be available to fund investment
activities. Newcastle Investment Holdings has historically funded its
investments, initially, by raising capital in a private equity offering and,
subsequently, through borrowings from financial institutions, along with
securitization financings. We expect to finance many of our investments this
way. If we fail to obtain debt or equity capital in the future, it could limit
our ability to grow, which could have a material adverse effect on the value of
our Series B Preferred Stock.
MAINTENANCE OF OUR INVESTMENT COMPANY ACT EXEMPTION IMPOSES LIMITS ON OUR
OPERATIONS.
We conduct our operations so as not to become regulated as an investment
company under the Investment Company Act of 1940, as amended. We believe that
there are a number of exemptions under the Investment Company Act that may be
applicable to us. The assets that we may acquire, therefore, are limited by the
provisions of the Investment Company Act and the rules and regulations
promulgated under the Investment Company Act. In addition, we could, among other
things, be required either (a) to change the manner in which we conduct our
operations to avoid being required to register as an investment company or (b)
to register as an investment company, either of which could have an adverse
effect on us and the market price for our stock.
ERISA MAY RESTRICT INVESTMENTS BY PLANS IN OUR SERIES B PREFERRED STOCK.
A plan fiduciary considering an investment in our Series B Preferred Stock
should consider, among other things, whether such an investment is consistent
with the fiduciary obligations under ERISA, including whether such investment
might constitute or give rise to a prohibited transaction under ERISA, the
Internal Revenue Code or any substantially similar federal, state or local law
and, if so, whether an exemption from such prohibited transaction rules is
available. See "ERISA Considerations."
21
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains certain "forward-looking statements" within the
meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements relate to, among other things, the operating
performance of our investments and financing needs. Forward-looking statements
are generally identifiable by use of forward-looking terminology such as "may,"
"will," "should," "potential," "intend," "expect," "endeavor," "seek,"
"anticipate," "estimate," "overestimate," "underestimate," "believe," "could,"
"project," "predict," "continue" or other similar words or expressions.
Forward-looking statements are based on certain assumptions, discuss future
expectations, describe future plans and strategies, contain projections of
results of operations or of financial condition or state other forward-looking
information. Our ability to predict results or the actual effect of future plans
or strategies is inherently uncertain. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, our actual results and performance could differ materially from
those set forth in the forward-looking statements. These forward-looking
statements involve risks, uncertainties and other factors that may cause our
actual results in future periods to differ materially from forecasted results.
Factors which could have a material adverse effect on our operations and future
prospects include, but are not limited to, changes in economic conditions
generally and the real estate and bond markets specifically,
legislative/regulatory changes (including changes to laws governing the taxation
of real estate investment trusts), availability of capital, interest rates and
interest rate spreads, generally accepted accounting principles and policies and
rules applicable to REITs. When considering forward-looking statements, you
should keep in mind the risk factors and other cautionary statements in this
prospectus. Readers are cautioned not to place undue reliance on any of these
forward-looking statements, which reflect our management's views as of the date
of this prospectus. The "Risk Factors" and other factors noted throughout this
prospectus could cause our actual results to differ significantly from those
contained in any forward-looking statement. For a discussion of our critical
accounting policies see "Management's Discussion and Analysis of Pro Forma
Financial Condition and Results of Operations -- Critical Accounting Policies."
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. We are under no duty to update any of the
forward-looking statements after the date of this prospectus to conform these
statements to actual results.
22
USE OF PROCEEDS
We estimate that the net proceeds to us from the sale of the 2,500,000
shares of our Series B Preferred Stock will be approximately $60.1 million, or
approximately $69.1 million if the underwriters exercise their over-allotment
option in full, after deducting underwriting discounts and offering expenses.
We intend to use the net proceeds of this offering to make investments in
real estate securities and/or other real estate related assets and for general
corporate purposes.
RATIO OF EARNINGS TO COMBINED FIXED CHARGES
AND PREFERRED SHARE DISTRIBUTIONS
The historical ratio of earnings to combined fixed charges and preferred
share distributions for the periods indicated is as follows:
PERIOD FROM
YEAR ENDED DECEMBER 31, MAY 11, 1998 TO
------------------------- DECEMBER 31,
2002 2001 2000 1999 1998
---- ---- ---- ---- ---------------
Ratio of Earnings to Combined Fixed Charges and
Preferred Share Distributions..................... 1.62 1.90 1.82 1.39 N/A
For purposes of calculating the above ratios, (i) earnings represent
"Income (loss) before equity in earnings of unconsolidated subsidiaries" from
our consolidated statements of income, as adjusted for fixed charges and
distributions from unconsolidated subsidiaries. Fixed charges represent
"Interest expense" from our consolidated statements of income. The ratios are
based solely on historical financial information and no pro forma adjustments
have been made thereto.
PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS
Our common stock has been listed and has traded on the New York Stock
Exchange (NYSE) under the symbol "NCT" since our initial public offering in
October 2002. The following table sets forth, for the periods indicated, the
high and low sale prices in dollars on the NYSE for our common stock and the
distributions we declared with respect to the periods indicated.
DISTRIBUTION
HIGH LOW DECLARED
------ ------ ------------
2002:
October 10, 2002 through December 31, 2002.................. $15.97 $12.38 $0.39(1)
2003:
First Quarter through March 13, 2003........................ $16.25 $15.46 $ --
- ---------------
(1) When combined with the $0.06 paid for the period October 1 through October 9
(the period of the quarter prior to our initial public offering), represents
a regular quarterly distribution of $0.45 per share.
In addition, prior to our initial public offering we paid a distribution of
$0.40 per share to Newcastle Investment Holdings, which owned substantially all
of our common stock, and to our manager, which owned a de minimis number of
shares of our common stock, for the quarter ending September 30, 2002.
We intend to continue to declare quarterly distributions on our common
stock. The actual amount and timing of distributions, however, will be at the
discretion of our board of directors and will depend upon our financial
condition in addition to the requirements of the Internal Revenue Code and no
assurance can be given as to the amounts or timing of future distributions.
Subject to the distribution requirements applicable to REITs under the
Internal Revenue Code, we intend, to the extent practicable, to invest
substantially all of the proceeds from repayments, sales and refinancings of our
assets in real estate-related assets and other assets. We may, however, under
certain
23
circumstances, make a distribution of capital or of assets. Such distributions,
if any, will be made at the discretion of our board of directors. Distributions
will be made in cash to extent that cash is available for distribution.
On March 13, 2003, the closing sale price for our common stock, as reported
on the NYSE, was $15.88. As of March 10, 2003, there were five record holders of
our common stock. This figure does not reflect the beneficial ownership of
shares held in nominee name.
The record holders described above include Newcastle Investment Holdings,
which held 16,486,339 shares of our common stock as of such date. Newcastle
Investment Holdings' shares of our common stock have not been traded on the NYSE
through such date. Newcastle Investment Holdings has informed us that it may
make a distribution to its stockholders of its holdings of our common stock.
However, Newcastle Investment Holdings has agreed with Bear, Stearns & Co. Inc.,
the managing underwriter of our initial public offering, not to distribute our
common stock to its stockholders prior to April 8, 2003 without the consent of
Bear Stearns.
24
CAPITALIZATION
The following table sets forth our consolidated capitalization as of December
31, 2002:
(i) on an actual basis; and
(ii) as adjusted to give effect to the sale of 2,500,000 shares of our
Series B Preferred Stock offered by us in this offering, after deducting
underwriting discounts and estimated offering expenses payable by us, and
the use of the proceeds as described under "Use of Proceeds."
DECEMBER 31, 2002
------------------------
ACTUAL AS ADJUSTED
---------- -----------
(DOLLARS IN THOUSANDS)
Debt........................................................ $1,217,007 $1,217,007(A)
Stockholders' equity:
Preferred stock, $0.01 par value: 100,000,000 shares
authorized; no shares issued and outstanding actual;
2,500,000 shares, liquidation preference $25.00 per
share, issued and outstanding on an as adjusted
basis.................................................. -- 60,064
Common stock, $0.01 par value: 500,000,000 shares
authorized; 23,488,517 shares issued and outstanding
actual; 23,488,517 shares issued and outstanding on an
as adjusted basis...................................... 235 235
Additional paid-in capital.................................. 290,935 290,935
Dividends in excess of earnings............................. (13,966) (13,966)
Accumulated other comprehensive income...................... 7,037 7,037
---------- ----------
Total stockholders' equity(B)............................... 284,241 344,305
---------- ----------
Total capitalization........................................ $1,501,248 $1,561,312(A)
========== ==========
- ---------------
(A) On March 12, 2003, we agreed to pricing terms for CBO III, which we expect
to close on or about March 19, 2003. In connection with CBO III, we expect
that our Debt and Total capitalization will increase to approximately
$1,689,007 and $2,033,312, respectively. There is no assurance that the
transaction will close.
(B) Total stockholders' equity is subject to change based on the mark-to-market
value of our assets.
25
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
Our predecessor, Newcastle Investment Holdings, contributed to us certain
assets and related liabilities in exchange for shares of our common stock.
However, as presented in the following table, for accounting purposes this
transaction is presented as a reverse spin-off. Under a reverse spin-off,
Newcastle Investment Corp. is treated as the continuing entity and the assets to
be retained by Newcastle Investment Holdings are accounted for as if they were
distributed at historical book basis through a spin-off to Newcastle Investment
Holdings.
As of July 12, 2002, for accounting purposes, we distributed to Newcastle
Investment Holdings assets which represented approximately thirty percent of our
total assets (100% of our real estate loans, our investment in Fortress
Investment Fund LLC, and approximately 75% of our real properties), and related
liabilities. The following assets were retained by us:
- Real estate securities (which serve as collateral for CBO I and CBO II);
- Credit leased real estate (Bell Canada portfolio and LIV portfolio); and
- Other assets.
The following table sets forth certain selected operating information on a
pro forma basis.
The selected unaudited pro forma consolidated statements of income are
presented as if the distribution had been consummated on January 1, 2002 or
2001, as applicable. The historical results of operations of the assets and
liabilities distributed to Newcastle Investment Holdings have been presented as
discontinued operations for those operations that constitute a component of an
entity. A component of an entity must have cash flows that are clearly
distinguished operationally and for financial reporting purposes from the rest
of the entity. Of the assets distributed to Newcastle Investment Holdings, the
U.S. real estate portfolio and the mortgage loans qualify as a component of an
entity. The remaining operations related to the other assets and liabilities
distributed to Newcastle Investment Holdings which are not a component of an
entity have been eliminated.
The selected unaudited pro forma consolidated statements of income are
presented for comparative purposes only, and are not necessarily indicative of
what our actual consolidated results of operations would have been for the
periods presented, nor do they purport to represent the results of any future
periods. In the opinion of management, all adjustments necessary to present
fairly the unaudited pro forma financial information have been made. The
selected pro forma financial information set forth below for the years ended
December 31, 2002 and 2001 have been derived from our unaudited pro forma
statements of income included in Note 13 of our consolidated financial
statements included in this prospectus.
The information below should be read in conjunction with "Management's
Discussion and Analysis of Pro Forma Financial Condition and Results of
Operations" and our consolidated financial statements and notes thereto included
in this prospectus.
26
SELECTED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
-----------------------
2002 2001
----------- ---------
OPERATING DATA
Revenues
Interest and dividend income.............................. $72,856 $47,709
Rental and escalation income.............................. 19,874 20,053
Gain on settlement of investments......................... 11,446 7,405
Other income.............................................. 15 43
--------- -------
104,191 75,210
Expenses
Interest expense.......................................... 47,191 32,659
Property operating expense................................ 8,631 8,695
Loan servicing expense.................................... 655 243
General and administrative expense........................ 2,814 1,230
Management fees to affiliate.............................. 3,905 3,642
Preferred incentive return to affiliate................... 2,029 --
Depreciation and amortization............................. 2,769 2,567
--------- -------
67,994 49,036
--------- -------
Income from continuing operations........................... $36,197 $26,174
========= =======
Income from discontinued operations......................... $1,777 $5,016
========= =======
Income from continuing operations per share of common stock,
basic and diluted......................................... $1.95 $1.54
========= =======
Weighted average number of shares of common stock
outstanding, basic........................................ 18,560 16,973
========= =======
Weighted average number of shares of common stock
outstanding, diluted...................................... 18,570 16,973
========= =======
OTHER DATA
Cash flow from continuing operations provided by (used in):
Operating activities...................................... $17,908 $17,483
Investing activities...................................... $(741,971) $(6,973)
Financing activities...................................... $727,141 $16,294
Funds from Operations (FFO) from continuing operations(A)... $38,828 $28,688
- ---------------
(A) We believe funds from operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. We also believe that FFO is an appropriate supplemental
disclosure of operating performance for a REIT due to its widespread
acceptance and use within the REIT and analyst communities. FFO, for our
purposes, represents net income available for common stockholders (computed
in accordance with accounting principles generally accepted in the United
States (GAAP)), excluding extraordinary items, plus real estate depreciation
and amortization, and after adjustments for unconsolidated subsidiaries, if
any. We consider gains and losses on resolution of our investments to be a
normal part of our recurring operations and, therefore, do not exclude such
gains and losses when arriving at FFO. Adjustments for unconsolidated
subsidiaries, if any, are calculated to reflect FFO on the same basis. FFO
does not represent cash generated from operating activities in accordance
with GAAP and therefore should not be considered as an alternative to net
27
income as an indicator of our operating performance or as an alternative to
cash flow as a measure of liquidity and is not necessarily indicative of
cash available to fund cash needs.
YEAR ENDED
DECEMBER 31,
-----------------
2002 2001
------- -------
CALCULATION OF FUNDS FROM OPERATIONS
Income from continuing operations........................... $36,197 $26,174
Real estate depreciation and amortization................... 2,631 2,514
------- -------
Funds from Operations (FFO) from continuing operations...... $38,828 $28,688
======= =======
28
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following table sets forth certain selected operating information on a
historical basis. As such, it includes the historical results of operations of
the assets and liabilities distributed to Newcastle Investment Holdings which
are not part of our continuing operations, and therefore the information set
forth for periods prior to the commencement of our operations in July 2002 is
not indicative of our ongoing operations.
The selected historical consolidated financial information set forth below
as of December 31, 2002, 2001, 2000, 1999 and 1998 and for the years ended
December 31, 2002, 2001, 2000 and 1999 and for the period from May 11, 1998 to
December 31, 1998 has been derived from our audited historical consolidated
financial statements.
The information below should be read in conjunction with "Management's
Discussion and Analysis of Historical Financial Condition and Results of
Operations" and our consolidated financial statements and notes thereto included
in this prospectus.
29
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31, PERIOD FROM
---------------------------------------- MAY 11, 1998 TO
2002 2001 2000 1999 DEC. 31, 1998
-------- -------- -------- ------- ---------------
OPERATING DATA
Revenues
Interest and dividend income.................. $73,082 $48,913 $50,985 $30,288 $4,475
Rental and escalation income.................. 19,874 20,053 20,433 14,798 3,885
Gain (loss) on settlement of investments...... 11,417 8,438 20,836 1,765 (15)
Management fee from affiliates................ 4,470 8,941 8,941 944 --
Incentive income (loss) from affiliates....... (1,218) 28,709 -- -- --
Other income.................................. 18 68 728 66 (4)
-------- -------- -------- ------- -------
107,643 115,122 101,923 47,861 8,341
Expenses
Interest expense.............................. 49,527 35,863 36,897 19,741 --
Property operating expense.................... 8,631 8,695 8,957 7,353 1,713
Loan servicing and REO expense................ 655 254 265 112 --
General and administrative expense............ 2,914 1,568 3,272 2,938 1,444
Management fees to affiliate.................. 9,250 14,687 15,587 8,331 6,751
Preferred incentive return to affiliate....... 2,856 17,188 -- -- --
Depreciation and amortization................. 3,199 3,574 2,926 1,693 452
-------- -------- -------- ------- -------
77,032 81,829 67,904 40,168 10,360
Income (loss) before equity in earnings of
unconsolidated subsidiaries................... 30,611 33,293 34,019 7,693 (2,019)
Equity in earnings (losses) of unconsolidated
subsidiaries.................................. 362 2,807 (980) (3,615) 117
-------- -------- -------- ------- -------
Income (loss) from continuing operations........ 30,973 36,100 33,039 4,078 (1,902)
Income from discontinued operations............. 522 7,571 9,821 8,734 12,542
-------- -------- -------- ------- -------
Income before change in accounting principle.... 31,495 43,671 42,860 12,812 10,640
Cumulative effect of change in accounting
principle -- write off of organizational
costs......................................... -- -- -- (513) --
-------- -------- -------- ------- -------
Net Income...................................... 31,495 43,671 42,860 12,299 10,640
Preferred dividends and related accretion....... (1,162) (2,540) (2,084) -- --
-------- -------- -------- ------- -------
Income available for common stockholders........ $30,333 $41,131 $40,776 $12,299 $10,640
======== ======== ======== ======= =======
Net Income per Share of Common Stock, basic and
diluted....................................... $1.68 $2.49 $2.16 $0.59 $0.51
======== ======== ======== ======= =======
Income (loss) from continuing operations per
share of common stock, after preferred
dividends and related accretion, basic and
diluted....................................... $1.65 $2.03 $1.64 $0.19 $(0.09)
======== ======== ======== ======= =======
Income from discontinued operations per share of
common stock, basic and diluted............... $0.03 $0.46 $0.52 $0.42 $0.60
======== ======== ======== ======= =======
Effect of change in accounting principle per
share of common stock, basic and diluted...... -- -- -- $(0.02) --
======== ======== ======== ======= =======
Weighted average number of shares of common
stock outstanding, basic...................... 18,080 16,493 18,892 20,917 20,862
======== ======== ======== ======= =======
Weighted average number of shares of common
stock outstanding, diluted.................... 18,090 16,493 18,892 20,917 20,862
======== ======== ======== ======= =======
Dividends declared per share of common stock.... $2.05 $2.00 $1.50 $2.04 $0.55
======== ======== ======== ======= =======
30
DECEMBER 31,
------------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- ---------- --------
BALANCE SHEET DATA
Real estate securities, available for
sale................................ $1,069,892 $522,258 $509,729 $504,669 --
Operating real estate, net............ $113,652 $524,834 $540,539 $558,849 $383,073
Cash and cash equivalents............. $45,463 $31,360 $10,575 $14,345 $75,596
Total assets.......................... $1,572,567 $1,262,119 $1,331,086 $1,381,600 $765,650
Debt.................................. $1,217,007 $897,390 $975,656 $971,260 $336,845
Stockholders' equity.................. $284,241 $310,545 $300,655 $354,673 $384,924
YEAR ENDED DECEMBER 31, PERIOD FROM
--------------------------------------------- MAY 11, 1998 TO
2002 2001 2000 1999 DEC. 31, 1998
--------- --------- --------- --------- ----------------
OTHER DATA
Cash Flow provided by (used in):
Operating activities............... $21,557 $34,448 $24,823 $32,834 $(7,230)
Investing activities............... $(682,691) $106,053 $151,632 $(683,420) $(638,844)
Financing activities............... $675,237 $(119,716) $(180,225) $589,335 $721,670
Funds from Operations (FFO) (A).... $37,633 $48,264 $53,523 $24,707 $14,337
- ---------------
(A) We believe funds from operations (FFO) is one appropriate measure of the
performance of real es investors with an understanding of estate companies
because it provid our ability to incur and service debt and make capital We
also believe that FFO is an appropriate supplemental expenditures.
disclosure of operating performance for a REIT due to its widespread
acceptance and use within the REIT and FFO, for our purposes, represents
analyst communities. operations net income available for common stockholders
(computed in accordance with GAAP), excluding extraordinary items, plus real
estate depreciation and amortization, and after adjustments for
unconsolidated subsidiaries. We consider gains and losses on resolution of
our investments to be a normal part of our recurring operations and,
therefore, do not exclude such gains and losses when arriving at FFO. In
addition, we exclude accrued incentive income from Fortress Investment Fund
(Fund I) and include incentive income distributed or distributable from Fund
I in accordance with the operating agreement of Fund I since this more
accurately reflects cash distributed or distributable to us from Fund I,
while our accrued incentive income is based upon the fair value of Fund I's
net assets, which is subject to fluctuation in future periods. Adjustments
for unconsolidated subsidiaries, if any, are calculated to reflect FFO on
the same basis. FFO does not represent cash generated from operating
activities in accordance with GAAP and therefore should no to net income as
an indicator of our operating performance or as an alternative to cash flow
as a measure of liquidity and is not necessarily indicative of cash
available to fund cash needs.
31
YEAR ENDED DECEMBER 31, PERIOD FROM
------------------------------------- MAY 11, 1998 TO
2002 2001 2000 1999 DEC. 31, 1998
------- ------- ------- ------- ---------------
CALCULATION OF FUNDS FROM OPERATIONS (FFO):
Income available for common stockholders.... $30,333 $41,131 $40,776 $12,299 $10,640
Extraordinary item -- loss on extinguishment
of debt................................... -- -- -- 2,341 --
Real estate depreciation and amortization... 7,994 12,909 12,621 9,927 3,697
Accumulated depreciation on real estate
sold...................................... (2,847) -- -- -- --
Real estate depreciation and amortization --
unconsolidated subsidiaries............... 1,614 2,564 126 140 --
Incentive (income) loss accrued from Fund I
(A)....................................... 609 (14,354) -- -- --
Equity in incentive return accrued by Fund
I......................................... (70) 1,645 -- -- --
Distributable incentive income from Fund I
(B)....................................... -- 4,369 -- -- --
------- ------- ------- ------- -------
Funds from operations (FFO)................. $37,633 $48,264 $53,523 $24,707 $14,337
======= ======= ======= ======= =======
- ---------------
(A) Represents our predecessor's 50% interest in the incentive income as
follows:
YEAR ENDED DECEMBER
31,
--------------------
2002 2001
-------- --------
Total incentive income (loss)............. $(1,218) $28,708
Manager portion........................... 609 (14,354)
------- -------
Our predecessor's incentive income
(loss).................................. $(609) $14,354
======= =======
(B) Represents our predecessor's 50% interest in the distributable incentive
income:
Total distributable incentive income................. $8,738
Distributable incentive income due to Manager........ (4,369)
------
Our predecessor's distributable incentive income..... $4,369
======
32
MANAGEMENT'S DISCUSSION AND ANALYSIS OF PRO FORMA FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following should be read in conjunction with our consolidated financial
statements and notes thereto, and in particular with the unaudited pro forma
consolidated statements of income included in Note 13 to our consolidated
financial statements, included in this prospectus.
GENERAL
We were formed in June 2002 as a wholly owned subsidiary of Newcastle
Investment Holdings Corp. (referred to as Newcastle Investment Holdings) for the
purpose of separating the real estate securities and credit leased real estate
businesses from Newcastle Investment Holdings' other investments. In July 2002,
prior to our initial public offering, Newcastle Investment Holdings contributed
to us certain assets and liabilities in exchange for 16,488,517 shares of our
common stock (as adjusted for an October stock dividend).
Although we were formed as a wholly owned subsidiary of Newcastle
Investment Holdings, for accounting purposes this transaction is presented as a
reverse spin-off. Under a reverse spin-off, Newcastle Investment Corp. is
treated as the continuing entity and the assets that were retained by Newcastle
Investment Holdings and not contributed to us are accounted for as if they were
distributed at their historical book basis through a spin-off to Newcastle
Investment Holdings. Our operations commenced on July 12, 2002. The following is
a discussion and analysis of our operations on a stand alone basis, without
regard to the operations treated as if they were distributed to Newcastle
Investment Holdings (i.e., without regard to the assets retained by Newcastle
Investment Holdings). Certain activities described herein occurred prior to our
formation and were consummated by Newcastle Investment Holdings.
The unaudited pro forma consolidated statements of income are presented as
if the distribution to Newcastle Investment Holdings and the commencement of our
operations had been consummated on January 1, 2002 and 2001, respectively. The
historical results of operations of the assets and liabilities distributed to
Newcastle Investment Holdings for the period prior to the commencement of our
operations have been presented as discontinued operations for those operations
that constitute a component of an entity. Of the assets treated as being
distributed to Newcastle Investment Holdings, a portfolio of properties located
in the U.S. and primarily leased to the General Services Administration, which
we refer to as the GSA portfolio, and the mortgage loans each qualify as a
component of an entity. The remaining operations related to the other assets and
the liabilities treated as being distributed to Newcastle Investment Holdings
which are not a component of an entity have been eliminated.
The unaudited pro forma consolidated statements of income are presented for
comparative purposes only, and are not necessarily indicative of what our actual
consolidated results of operations would have been for the periods presented,
nor do they purport to represent the results of any future periods. In the
opinion of management, all adjustments necessary to present fairly the unaudited
pro forma financial information have been made.
In October 2002, we sold 7 million shares of our common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million after deducting the underwriters' discount and other
offering expenses. A portion of the proceeds of this offering were used to
purchase a portfolio of mortgage loans and to make additional investments.
Subsequent to this offering, we have 23,488,517 shares of common stock
outstanding.
Newcastle Investment Holdings has informed us that it may make a
distribution to its stockholders of its holdings of our common stock. However,
Newcastle Investment Holdings has agreed with Bear, Stearns & Co. Inc. not to
distribute our common stock to its stockholders earlier than April 8, 2003
without the consent of Bear Stearns.
We conduct our business through three primary segments: (i) real estate
securities, including our first two CBO securitization transactions, which we
refer to as CBO I and CBO II, (ii) revenue-producing real estate, primarily
credit leased real estate, including a portfolio of properties located in
Canada, which we
33
refer to as our Bell Canada portfolio, and a portfolio of properties located in
Belgium, which we refer to as our LIV portfolio, and (iii) real estate loans.
Revenues attributable to each segment are disclosed below on a pro forma basis
(unaudited) (in thousands).
REAL ESTATE REAL ESTATE
SECURITIES REAL ESTATE LOANS UNALLOCATED TOTAL
----------- ----------- ----------- ----------- --------
For the year ended December 31,
2002................................ $83,259 $19,384 $1,281 $267 $104,191
TAXATION
We intend to elect to be taxed as a real estate investment trust, or REIT,
under the Internal Revenue Code of 1986, as amended (the "Code"), commencing
with our first tax year which began on July 12, 2002, and we intend to continue
to operate in such a manner. Our current and continuing qualification as a REIT
depends on our ability to meet various tax law requirements, including, among
others, requirements relating to the sources of our income, the nature of our
assets, the composition of our stockholders, and the timing and amount of
distributions that we make.
If we qualify for taxation as a REIT, we will generally not be subject to
U.S. federal corporate income tax on our net income that is currently
distributed to stockholders. This treatment substantially eliminates the "double
taxation" (at the corporate and stockholder levels) that generally results from
investment in a corporation under current law. We may, however, nevertheless be
subject to certain state, local and foreign income and other taxes, and to U.S.
federal income and excise taxes and penalties in certain situations, including
taxes on our undistributed income. In addition, our stockholders may be subject
to state, local or foreign taxation in various jurisdictions, including those in
which they or we transact business or reside. The state, local and foreign tax
treatment of us and our stockholders may not conform to the U.S. federal income
tax treatment.
If, in any taxable year, we fail to satisfy one or more of the various tax
law requirements, we could fail to qualify as a REIT. In addition, if Newcastle
Investment Holdings fails to qualify as a REIT and we are treated as a successor
to Newcastle Investment Holdings, this could cause us to likewise fail to
qualify as a REIT. If we fail to qualify as a REIT for a particular tax year,
our income in that year would be subject to U.S. federal corporate income tax
(including any applicable alternative minimum tax), and we may need to borrow
funds or liquidate certain investments in order to pay the applicable tax, and
we would not be compelled by the Code to make distributions. Unless entitled to
relief under certain statutory provisions, we would also be disqualified from
treatment as a REIT for the four taxable years following the year during which
qualification is lost.
Although we currently intend to operate in a manner designed to qualify as
a REIT, it is possible that future economic, market, legal, tax or other
developments may cause us to fail to qualify as a REIT, or may cause our Board
of Directors to revoke the REIT election.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP"). The preparation of financial statements in conformity
with GAAP requires the use of estimates and assumptions that could affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities and the reported amounts of revenue and expenses. Actual results
could differ from these estimates. The following is a summary of our accounting
policies that are most effected by judgments, estimates and assumptions.
We have classified our real estate securities as available for sale. As
such, they are carried at market value with net unrealized gains or losses
reported as a component of accumulated other comprehensive income. Market value
is based primarily upon multiple broker quotations, which provide valuation
estimates based upon reasonable market order indications or a good faith
estimate thereof. These quotations are subject to significant variability based
on market conditions, such as interest rates and
34
spreads. Changes in market conditions, as well as changes in the assumptions or
methodology used to determine market value, could result in a significant
increase or decrease in our book equity. We must also assess whether unrealized
losses on securities, if any, reflect a decline in value which is other than
temporary and, accordingly, write the impaired security down to its value
through earnings. Significant judgment is required in this analysis. To date, no
such write-downs have been made.
Income on these securities is recognized using a level yield methodology
based upon a number of assumptions that are subject to uncertainties and
contingencies. Such assumptions include the expected disposal date of such
security (which generally corresponds to the expected maturity of any related
securitization financing) and the rate and timing of principal and interest
receipts (which may be subject to prepayments, delinquencies and defaults).
These uncertainties and contingencies are difficult to predict and are subject
to future events, and economic and market conditions, which may alter the
assumptions.
Similarly, our derivative instruments, held for hedging purposes, are
carried at market value pursuant to Statement of Financial Accounting Standards
("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities,"
as amended. Market value is based on counterparty quotations. To the extent they
qualify as hedges under SFAS No. 133, net unrealized gains or losses are
reported as a component of accumulated other comprehensive income; otherwise,
they are reported as a component of current income. Market values of such
derivatives are subject to significant variability based on many of the same
factors as the securities discussed above. The results of such variability could
be a significant increase or decrease in our book equity and/or earnings.
We purchase mortgage loans to be held as long-term investments. We must
periodically evaluate each of these loans for possible impairment. Impairment is
indicated when it is deemed probable that we will be unable to collect all
amounts due according to the contractual terms of the loan. Upon determination
of impairment, we would establish a specific valuation allowance with a
corresponding charge to earnings. Significant judgment is required both in
determining impairment and in estimating the resulting loss allowance. To date,
we have determined that no loss allowances have been necessary on the loans in
our portfolio.
RESULTS OF OPERATIONS
Our independent operations commenced in July 2002 and our initial public
offering was completed in October 2002. These events resulted in additional
capital being deployed to our investments which, in turn, resulted in changes to
our results of operations.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2002 TO THE YEAR ENDED DECEMBER 31,
2001 ON A PRO FORMA BASIS
Interest and dividend income is derived primarily from our investments in
real estate securities and increased by $25.2 million or 53%, from $47.7 million
to $72.9 million. This increase is primarily the result of interest earned on
the real estate securities purchased in connection with our CBO II transaction.
Rental and escalation income is derived from our Bell Canada and LIV
portfolios and decreased by $0.2 million or 1%, from $20.1 million to $19.9
million. This decrease is primarily the result of foreign currency fluctuations
with respect to our Bell Canada portfolio. Escalation income represents
contractual increases in rental income to offset increases in expenses or
general price increases over a base amount.
Gain on settlement of investments increased by $4.0 million, from $7.4
million to $11.4 million, primarily as a result of an increase in the volume of
sales of real estate securities. Sales of real estate securities are based on a
number of factors including credit, asset type and industry and can be expected
to increase or decrease from time to time. Periodic fluctuations in the volume
of sales of securities is dependent upon, among other things, management's
assessment of credit risk, asset concentration, portfolio balance and other
factors. The increased volume of sales of securities during this period reflects
management's determination that the portfolio required more adjustment than in
prior periods.
35
Interest expense increased by $14.5 million or 44%, from $32.7 million to
$47.2 million. This increase is primarily the result of interest on the CBO II
securitization ($18.6 million), partially offset by lower interest rates being
paid on the variable rate CBO I securities classes ($4.6 million).
Property operating expense on our Bell Canada and LIV portfolios decreased
by $0.1 million or 1%, from $8.7 million to $8.6 million, primarily as the
result of the same factors which effected rental and escalation income.
Loan servicing expense, primarily trustee fees on our securitizations,
increased by $0.5 million or 170%, from $0.2 million to $0.7 million, primarily
as a result of the acquisition of the real estate securities purchased in
connection with our CBO II transaction.
General and administrative expense increased by $1.6 million, from $1.2
million to $2.8 million, primarily as a result of our increased size.
Management fee expense increased by $0.3 million, from $3.6 million to $3.9
million, based on our increased equity.
Preferred incentive return increased by $2.0 million, to $2.0 million, due
to the commencement of our operations and our management agreement.
Depreciation and amortization, primarily of our real estate assets,
increased by $0.2 million or 8%, from $2.6 million to $2.8 million, primarily as
the result of depreciation on the capital expenditures we made with respect to
our real estate assets.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measurement of our ability to meet potential cash
requirements, including ongoing commitments to repay borrowings, fund and
maintain investments, and other general business needs. Additionally, to
maintain our status as a REIT under the Internal Revenue Code, we must
distribute annually at least 90% of our taxable income. Our primary sources of
funds for liquidity, in addition to our initial public offering, consist of net
cash provided by operating activities, borrowings under loans and the issuance
of debt securities. Our loans and debt securities are generally secured directly
by our investment assets. As of December 31, 2002, our real estate securities
purchased in connection with our CBO I and CBO II transactions as well as our
Bell Canada portfolio were securitized, while our LIV portfolio, one of our
marketable real estate securities and our mortgage loan portfolio served as
collateral for loans.
Our ability to execute our business strategy, particularly the growth of
our investment portfolio, depends to a significant degree on our ability to
obtain additional capital. Our CBO strategy is dependent upon our ability to
place the match funded debt we use to finance our real estate securities
investments at spreads that provide a positive arbitrage. If spreads for CBO
liabilities widen or if demand for such liabilities ceases to exist, then our
ability to execute future CBO transactions will be severely restricted.
We expect to meet our short-term liquidity requirements generally through
our cash flow provided by operations, as well as investment specific borrowings.
In addition, at December 31, 2002 we had an unrestricted cash balance of $45.5
million. Our cash flow provided by operations differs from our net income due to
four primary factors: (i) depreciation of our real estate, (ii) accretion of
discounts on our real estate securities, discounts on our debt, and deferred
hedge gains and losses, (iii) straight-lined rental income, and (iv) gains and
losses. Proceeds from the sale of real estate securities which serve as
collateral for our CBO securitizations, including gains thereon, are required to
be retained in the CBO structure until the related bonds are retired and are
therefore not available to fund current cash needs.
Our real estate investments are financed long-term and primarily leased to
credit tenants with long-term leases and are therefore expected to generate
generally stable current cash flows. Our real estate securities are also
financed long-term and their credit status is continuously monitored; therefore,
these investments are also expected to generate a generally stable current
return, subject to interest rate fluctuations. See "Quantitative and Qualitative
Disclosures About Market Risk -- Interest Rate Exposure"
36
below. We consider our ability to generate cash to be adequate and expect it to
continue to be adequate to meet operating requirements both in the short- and
long-terms.
We expect to meet our long-term liquidity requirements, specifically the
repayment of our debt and our investment funding needs, through additional
borrowings, the issuance of debt and/or equity securities and the liquidation or
refinancing of our assets at maturity. We believe that the value of these assets
is, and will continue to be, sufficient to repay our debt at maturity under
either scenario. Our ability to meet our long-term liquidity requirements is
subject to obtaining additional equity and debt financing. Decisions by
investors and lenders to enter into such transactions with us will depend upon a
number of factors, such as our historical and projected financial performance,
compliance with the terms of our current credit arrangements, industry and
market trends, the availability of capital and our investors' and lenders'
policies and rates applicable thereto, and the relative attractiveness of
alternative investment or lending opportunities.
We expect that our cash on hand, our cash flow provided by operations, and
our financing from Bear, Stearns International Limited in connection with our
purchase of securities for our third CBO transaction (as described below) and
our subsequent CBO issuance will satisfy our liquidity needs over the next
twelve months. However, we currently expect to seek additional capital in order
to grow our investment portfolio.
With respect to our real estate assets, we expect to incur approximately
$1.8 million of tenant improvements in connection with the inception of leases
and capital expenditures during the year ending December 31, 2003.
Our long-term debt existing at December 31, 2002 (gross of $13.8 million of
discounts) is expected to mature as follows (in millions):
2003........................................................ $251.8
2004........................................................ 2.0
2005........................................................ 1.7
2006........................................................ 58.4
2007........................................................ 0.0
Thereafter.................................................. 916.9
--------
Total....................................................... $1,230.8
========
In July 1999, we completed our first CBO securitization, CBO I, whereby a
portfolio of real estate securities was contributed to a consolidated subsidiary
which issued $437.5 million face amount of investment grade senior securities
and $62.5 million face amount of non-investment grade subordinated securities in
a private placement. At December 31, 2002, the subordinated securities were
retained by us, and the $429.4 million carrying amount of senior securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of approximately 3.99%, had an expected weighted average life
of approximately 5.26 years. Two classes of the senior securities bear floating
interest rates. We have obtained an interest rate swap and cap in order to hedge
our exposure to the risk of changes in market interest rates with respect to
these securities, at an initial cost of approximately $14.3 million. CBO I's
weighted average effective interest rate, including the effect of such hedges,
was 5.63% at December 31, 2002. In addition, in connection with the sale of two
classes of securities, we entered into two interest rate swaps and three
interest rate cap agreements that do not qualify for hedge accounting.
In April 2002, we refinanced the Bell Canada portfolio through a
securitization transaction. At December 31, 2002, the CAD 58.8 million or
approximately $37.4 million carrying amount of outstanding securities, which
bore interest at a weighted average effective rate, including discount and cost
amortization, of approximately 7.07%, had an expected weighted average life of
approximately 2.75 years. We have retained one class of the issued securities.
In connection with this securitization, we guaranteed
37
certain payments under an interest rate swap to be entered into in 2007 if the
securitization is not fully repaid by such date. We believe the fair value of
this guarantee is negligible at December 31, 2002.
In April 2002, we completed our second CBO securitization, CBO II, whereby
a portfolio of real estate securities was contributed to a consolidated
subsidiary which issued $444.0 million face amount of investment grade senior
securities and $56.0 million face amount of non-investment grade subordinated
securities, in a private placement. At December 31, 2002, the subordinated
securities were retained by us, and the $439.1 million carrying amount of senior
securities, which bore interest at a weighted average effective rate, including
discount and cost amortization, of approximately 3.48%, had an expected weighted
average life of approximately 7.36 years. One class of the senior securities
bears a floating interest rate. We have obtained an interest rate swap and cap
in order to hedge our exposure to the risk of changes in market interest rates
with respect to this security, at an initial cost of $1.2 million. CBO II's
weighted average effective interest rate, including the effect of such hedges,
was 6.16% at December 31, 2002.
In November 2001, we sold the retained subordinated $17.5 million Class E
Note from CBO I to a third party for approximately $18.5 million. The Class E
Note bore interest at a fixed rate of 8.0% and had a stated maturity of June
2038. The sale of the Class E Note represented an issuance of debt and was
recorded as additional CBO bonds payable. In April 2002, a wholly owned
subsidiary of ours repurchased the Class E Note. The repurchase of the Class E
Note represented a repayment of debt and was recorded as a reduction of CBO
bonds payable. The Class E Note is included in the collateral for CBO II. The
Class E Note is eliminated in consolidation.
On March 12, 2003, we agreed to pricing terms for CBO III, which we expect
will close on or about March 19, 2003. We expect that upon closing, we will sell
$472 million of senior CBO III securities.
Pursuant to an agreement entered into in July 2002, Bear, Stearns
International Limited has (BSIL) purchased the commercial mortgage backed
securities, REIT debt, real estate loans and asset backed securities that will
serve as part of the collateral for CBO III, subject to our right to purchase
such securities from BSIL. This agreement is treated as a non-hedge derivative
for accounting purposes and is therefore marked-to-market through current
income; a mark of $0.7 million has been booked to income through December 31,
2002. Pursuant to the agreement, Bear, Stearns & Co. Inc. also has been engaged
to structure and serve as lead manager for the CBO III transaction for which it
will receive customary fees. If the CBO III transaction is not consummated as a
result of our failure to acquire the equity interest or otherwise as a result of
our gross negligence or willful misconduct, we would be required to either
purchase such securities from BSIL or pay BSIL the difference between the price
it paid for such securities and the price at which it sold such securities to a
third party (a collateral loss). If the CBO III transaction fails to close for
any other reason, other than as a result of BSIL's gross negligence or willful
misconduct, we would be required to either purchase such securities from BSIL or
pay BSIL the lesser of the collateral loss and our deposit. There is no
assurance that the CBO III transaction will be consummated. As of December 31,
2002, we estimate that the fair value of the securities purchased by BSIL is in
excess of the purchase price paid by BSIL. In November and December 2002, we
made deposits aggregating $37.1 million under such agreement, known as the CBO
III deposit.
In October 2002, we sold 7 million shares of our common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million after deducting the underwriters' discount and other
offering expenses. A portion of the proceeds of this offering were used to
purchase a portfolio of mortgage loans, as described below, and to make other
investments, including the CBO III deposit. Subsequent to this offering, we have
23,488,517 shares of common stock outstanding.
In November 2002, we utilized $13.5 million of our offering proceeds to
purchase a $260.2 million portfolio of variable rate mortgage loans subject to
$246.7 million of variable rate financing. At December 31, 2002, the $258.2
million carrying amount of mortgage loans bore interest at a net weighted
average effective rate of approximately 3.40%, and the $246.7 million carrying
amount of financing bore interest at a weighted average effective rate of
approximately 1.80%.
38
In November 2002, we refinanced the LIV portfolio. At December 31, 2002,
the EUR 60.0 million or approximately $63.0 million carrying amount of debt bore
interest at a rate of 5.32% and matures in November 2006.
We declared a distribution of $0.40 per share of common stock to
stockholders of record at the close of business on September 27, 2002, Newcastle
Investment Holdings and Fortress Principal Investment Holdings LLC, for the
quarter ending September 30, 2002. In addition, in October 2002 we declared a
distribution of $0.06 per share of common stock to our stockholders of record at
the close of business on October 15, 2002, Newcastle Investment Holdings and
Fortress Principal Investment Holdings LLC, for the period commencing on October
1, 2002 and ending October 9, 2002. Both distributions were paid in October
2002. In December 2002, we declared a distribution of $0.39 per share of common
stock to our stockholders of record at the close of business on December 27,
2002, which included Newcastle Investment Holdings and Fortress Principal
Investment Holdings LLC, which was paid in January 2003.
In February 2003, we sold our entire position in agency eligible
residential mortgage loans (a portion of our mortgage loan portfolio) with an
aggregate unpaid principal balance of approximately $159.0 million for gross
proceeds of approximately $162.6 million at a gain of approximately $0.7
million. As a result of the sale, the existing repurchase agreement allocated to
the agency eligible loans was satisfied for approximately $153.9 million.
Simultaneously, approximately $207.4 million of non-agency/jumbo residential
mortgage loans were purchased for a price of approximately $210.2 million. In
connection with this purchase, the outstanding balance of the existing
repurchase agreement was increased by a net of $45.9 million, after the
repayment described above.
CREDIT, SPREAD AND INTEREST RATE RISK
We are subject to credit and interest rate risk with respect to our
investments in real estate securities.
The commercial mortgage-backed securities (CMBS) we invest in are generally
junior in right of payment of interest and principal to one or more senior
classes, but benefit from the support of one or more subordinate classes of
securities or other form of credit support within a securitization transaction.
The REIT securities we invest in reflect comparable credit risk. We believe,
based on our intensive due diligence process, that these securities offer
attractive risk-adjusted returns with long-term principal protection under a
variety of default and loss scenarios. While the expected yield on these
securities is sensitive to the performance of the underlying assets, the more
subordinated securities or other features of the securitization transaction, in
the case of mortgage backed securities, and the issuer's underlying equity and
subordinated debt, in the case of REIT securities, are designed to bear the
first risk of default and loss. We further minimize credit risk by actively
monitoring our investment portfolio and the underlying credit quality of our
holdings and, where appropriate, repositioning our investments to upgrade the
credit quality and yield on our investments.
Our portfolio is diversified by asset type, industry, location and issuer.
We expect that diversification will also minimize the risk of capital loss.
At December 31, 2002, our real estate securities which serve as collateral
for our CBO transactions have an overall weighted average credit rating of
approximately BBB-, and approximately 68% of these securities have an investment
grade rating (BBB- or higher).
Our real estate securities are also subject to spread risk. The majority of
such securities are fixed rate securities valued based on a market credit spread
to U.S. Treasuries. In other words, their value is dependent on the yield
demanded on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our securities portfolio would tend to
decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our securities would tend to increase.
Such changes in the market value of our portfolio may effect our net equity, net
income or cash
39
flow directly through their impact on unrealized gains or losses on
available-for-sale securities, and therefore our ability to realize gains on
such securities, or indirectly through their impact on our ability to borrow and
access capital. See "-- Quantitative and Qualitative Disclosures About Market
Risk -- Credit Spread Curve Exposure" below.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also affect the yield
required on our securities and therefore their value. This would have similar
effects on our portfolio and our financial position and operations to a change
in spreads.
Returns on these investments are sensitive to interest rate volatility. We
minimize exposure to interest rate fluctuation through the use of match-funded
financing structures and hedges. In particular, we finance our real estate
securities investments through the issuance of debt securities in the form of
CBOs to take advantage of the structural flexibility offered by CBO transactions
to buy and sell certain investment positions to manage risk and, subject to
certain limitations, to optimize returns. We also utilize interest rate swaps
and caps to minimize this risk. As of December 31, 2002, a 100 basis point
change in short term interest rates would affect our earnings by no more than
$1.9 million per annum. See "-- Quantitative and Qualitative Disclosures About
Market Risk -- Interest Rate Exposure" below.
Interest rate changes may also impact our net book value as our securities
and related hedge derivatives are marked-to-market each quarter. Generally, as
interest rates increase, the value of our fixed income securities, such as
commercial mortgage backed securities, decreases and as interest rates decrease,
the value of such securities will increase. We seek to hedge changes in value
attributable to changes in interest rates by entering into interest rate swaps
and other derivative instruments. In general, we would expect that over time,
decreases in value of our securities portfolio attributable to interest rate
changes will be offset to some degree by increases in value of our swaps, and
vice versa. However, the relationship between spreads on securities and spreads
on swaps may vary from time to time, resulting in a net aggregate book value
increase or decline. Our securities portfolio is largely financed to maturity
through long term, collateralized debt obligations that are not callable as a
result of book value changes. Accordingly, unless there is a material impairment
in value that would result in a payment not being received on a security,
changes in the book value of our portfolio will not directly affect our
recurring earnings or our ability to pay a dividend.
Furthermore, our CBO strategy is dependent upon our ability to place the
match funded debt we use to finance our real estate securities investments at
spreads that provide a positive arbitrage. If spreads for CBO liabilities widen
or if demand for such liabilities ceases to exist, then our ability to execute
future CBO transactions will be severely restricted.
Similar to our real estate securities portfolio, we are subject to credit
and spread risk with respect to our mortgage loan portfolio.
Credit risk refers to each individual borrower's ability to make their
required interest and principal payments on the scheduled due dates. Unlike our
real estate securities portfolio, our mortgage loan portfolio does not benefit
from the support of junior classes of securities, but rather bears the first
risk of default and loss. We believe that this credit risk is mitigated through
our extensive due diligence process, periodic reviews of the borrower's payment
history, delinquency status, and the relationship of the loan balance to the
underlying property value.
Our portfolio is diversified by geographic location and by borrower. We
believe that this diversification also helps to minimize the risk of capital
loss.
Our mortgage loan portfolio is also subject to spread risk. The majority of
such loans are floating rate securities valued based on a market credit spread
to LIBOR. The value of the loans is dependent upon the yield demanded by the
market based on their credit. The value of our portfolio would tend to decline
should the market require a higher yield on such loans, resulting in the use of
a higher spread over the benchmark rate (usually the applicable LIBOR yield). If
the value of our mortgage loan portfolio were to decline, it could affect our
ability to refinance such portfolio upon the maturity of the related repurchase
agreement.
40
Any credit or spread losses incurred with respect to our mortgage loan
portfolio would affect us in the same way as similar losses on our real estate
securities portfolio as described above.
OFF-BALANCE SHEET ARRANGEMENTS
As of December 31, 2002, we had the following material off-balance sheet
arrangements:
- The $37.8 million CBO III deposit, as described above under "-- Liquidity
and Capital Resources."
- A $3.3 million equity interest in a securitization, described in Note 7
to our consolidated financial statements included in this prospectus.
- A guarantee of certain payments under an interest rate swap which may be
entered into in 2007 in connection with the securitization of the Bell
Canada portfolio.
In the first two cases, our potential loss is limited to the amounts shown
above which are included in our consolidated balance sheet. At this time, we do
not anticipate a substantial risk of incurring a loss with respect to any of the
arrangements.
INFLATION
Substantially all of our office leases provide for separate escalations of
real estate taxes and operating expenses over a base amount, and/or increases in
the base rent based on changes in the Belgian Sante Index. We believe that
inflationary increases in expenses will generally be offset by the expense
reimbursements and contractual rent increases described above.
We believe that our risk of increases in the market interest rates on our
floating rate debt as a result of inflation is largely offset by our use of
match funding and hedging instruments as described above. See "-- Quantitative
and Qualitative Disclosure About Market Risk -- Interest Rate Exposure" below.
PRO FORMA FUNDS FROM OPERATIONS
We believe Funds from Operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. We also believe that FFO is an appropriate supplemental disclosure
of operating performance for a REIT due to its widespread acceptance and use
within the REIT analyst communities. FFO, for our purposes, represents net
income available for common shareholders (computed in accordance with accounting
principles generally accepted in the United States ("GAAP"), excluding
extraordinary items, plus real estate depreciation and amortization, and after
adjustments for unconsolidated subsidiaries, if any. We consider gains and
losses on resolution of our investments to be a normal part of our recurring
operations and therefore do not exclude such gains and losses when arriving at
FFO. Adjustments for unconsolidated subsidiaries, if any, are calculated to
reflect FFO on the same basis. FFO does not represent cash generated from
operating activities in accordance with GAAP and therefore should not be
considered an alternative to net income as an indicator of our operating
performance or as an alternative to cash flow as a measure of liquidity and is
not necessarily indicative of cash available to fund cash needs.
41
Funds from Operations (FFO), on a pro forma basis after giving effect to
the transactions related to our formation, is calculated as follows (unaudited)
(in thousands):
FOR THE YEAR
ENDED
DECEMBER 31,
2002
------------
Income from continuing operations........................... $36,197
Real estate depreciation and amortization................... 2,631
-------
Funds from Operations (FFO) from continuing operations...... $38,828
=======
Pro forma funds from operations was derived from the Company's segments as
follows (unaudited) (in thousands):
AVERAGE BOOK
EQUITY FOR THE
BOOK EQUITY YEAR ENDED FFO FROM RETURN ON
DECEMBER 31, DECEMBER 31, CONTINUING EQUITY
2002(1) 2002(1) OPERATIONS (ROE)(2)
------------ -------------- ---------- ---------
Real estate securities.......................... $201,498 $152,316 $41,868 27.5%
Revenue-producing real estate................... 39,129 50,585 4,273 8.4%
Real estate loans............................... 12,278 2,168 482 22.2%
Unallocated..................................... 33,759 7,200 (7,795) N/A
-------- -------- ------- ---
Total........................................... 286,664 $212,269 $38,828 18.3%
======== ======= ===
Accumulated depreciation........................ (9,460)
Accumulated other comprehensive income.......... 7,037
--------
Net............................................. $284,241
========
- ---------------
(1) Gross of accumulated depreciation and accumulated other comprehensive
income.
(2) FFO divided by average book equity.
42
MANAGEMENT'S DISCUSSION AND ANALYSIS OF HISTORICAL FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following should be read in conjunction with our consolidated financial
statements and notes thereto included in this prospectus.
GENERAL
We were formed in June 2002 as a wholly owned subsidiary of Newcastle
Investment Holdings Corp. (referred to as Newcastle Investment Holdings) for the
purpose of separating the real estate securities and credit leased real estate
businesses from Newcastle Investment Holdings' other investments. In July 2002,
prior to our initial public offering, Newcastle Investment Holdings contributed
to us certain assets and liabilities in exchange for 16,488,517 shares of our
common stock (as adjusted for our October stock dividend).
Although we were formed as a wholly owned subsidiary of Newcastle
Investment Holdings, for accounting purposes this transaction is presented as a
reverse spin-off. Under a reverse spin-off, Newcastle Investment Corp. is
treated as the continuing entity and the assets that were retained by Newcastle
Investment Holdings and not contributed to us are accounted for as if they were
distributed at their historical book basis through a spin-off to Newcastle
Investment Holdings. Our operations commenced on July 12, 2002.
Management's Discussion and Analysis of Pro Forma Financial Condition and
Results of Operations on the preceding pages pertains to current and historical
information regarding our operations on a stand-alone basis. The analysis in
this section discusses such information by treating us as the successor to
Newcastle Investment Holdings and therefore includes historical information,
through the date of the commencement of our operations, regarding operations of
Newcastle Investment Holdings which were distributed to it and therefore are
unrelated to our ongoing operations. Transactions completed by Newcastle
Investment Holdings related to investments retained by Newcastle Investment
Holdings (not contributed to us) are referred to as being completed by our
predecessor.
Newcastle Investment Holdings was incorporated on May 11, 1998 and was
initially capitalized through the sale of 50 shares of common stock for $1,000.
In June 1998, Newcastle Investment Holdings completed a private offering,
including an over-allotment option, for the sale of 20,912,401 shares of common
stock for proceeds of approximately $384.5 million, net of expenses. In
addition, in July 1998, certain employees of Fortress Investment Group LLC
purchased an aggregate of 4,288 shares of the common stock of Newcastle
Investment Holdings resulting in additional proceeds of approximately $0.1
million. In 2000 and 2001, Newcastle Investment Holdings repurchased an
aggregate of 4,428,222 shares of its common stock for $32.4 million of cash and
$46.3 million of newly issued shares of its Series A Cumulative Convertible
Preferred Stock (the "Series A Preferred"). At the date of the commencement of
our operations, Newcastle Investment Holdings had 16,488,517 shares of its
common stock outstanding. The Series A Preferred was fully redeemed by June 14,
2002.
Our predecessor conducted its business through four primary segments: (1)
real estate securities, (2) revenue-producing real estate, primarily credit
leased real estate, (3) its investment in Fortress Investment Fund LLC ("Fund
I") and (4) real estate loans. Newcastle Investment Holdings' investments in
real estate securities and a portion of its investments in revenue-producing
real estate were contributed to us. The real estate (GSA portfolio) and real
estate loans operations distributed to Newcastle Investment Holdings have been
treated as discontinued operations, because they constituted a component of an
entity, while the other operations distributed to Newcastle Investment Holdings,
including the investment in Fund I, have not been treated as such, because they
did not constitute a component of an entity as defined in SFAS No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets." Revenues
attributable to each segment are disclosed below (in thousands).
43
REAL REAL FORTRESS
ESTATE REAL ESTATE INVESTMENT
SECURITIES ESTATE LOANS FUND UNALLOCATED TOTALS
---------- ------- ------ ---------- ----------- --------
FOR THE YEAR ENDED DECEMBER 31,
2002:
Revenues....................... $83,259 $19,384 $1,281 $3,287 $432 $107,643
FOR THE YEAR ENDED DECEMBER 31,
2001:
Revenues....................... $54,961 $20,249 -- $38,297 $1,615 $115,122
FOR THE YEAR ENDED DECEMBER 31,
2000:
Revenues....................... $46,893 $20,640 -- $8,941 $25,449 $101,923
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP"). The preparation of financial statements in conformity
with GAAP requires the use of estimates and assumptions that could affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities and the reported amounts of revenue and expenses. Actual results
could differ from these estimates. The following is a summary of our
predecessor's accounting policies that were most effected by judgments,
estimates and assumptions.
The investment in Fund I was retained by Newcastle Investment Holdings. The
managing member of Fund I is Fortress Fund MM LLC (the "Fund I Managing
Member"), which is owned jointly, through subsidiaries, by Newcastle Investment
Holdings, approximately 94%, and the Manager, approximately 6%. The Fund I
Managing Member is entitled to an incentive return (the "Fund Incentive Return")
generally equal to 20% of Fund I's returns, as defined, subject to: (1) a 10%
preferred return payable to the Fund I investors and (2) a clawback provision
which requires amounts previously distributed as Fund Incentive Return to be
returned to Fund I if, upon liquidation of Fund I, the amounts ultimately
distributed to each investor do not meet a 10% preferred return to the
investors. Fund I is managed by the Manager pursuant to the Fund I Managing
Member's operating agreement and a management agreement between the Manager and
the Fund I Managing Member. In accordance with those documents, (1) the Manager
is entitled to 100% of the management fee payable by Fund I, (2) the Manager is
entitled to 50% of the Fund Incentive Return payable by Fund I, (3) Newcastle
Investment Holdings is entitled to 50% of the Fund Incentive Return payable by
Fund I and (4) Newcastle Investment Holdings is entitled to receive 100% of the
investment income or loss attributable to the capital invested in Fund I by the
Fund I Managing Member. The Manager of Fund I also manages Newcastle and
Newcastle Investment Holdings. We consolidated the financial results of the Fund
I Managing Member through our predecessor until the date of the commencement of
our operations because our predecessor owned substantially all of the voting
interest in the Fund I Managing Member. As a result, the financial statements
reflect all of the Fund Incentive Return payable to the Fund I Managing Member,
including the 50% portion payable to the Manager which is treated as Incentive
Return to Affiliates, through the date of the commencement of our operations.
The Fund Incentive Return is payable on an asset-by-asset basis, as
realized. Accordingly, a Fund Incentive Return may be paid to the Fund I
Managing Member in connection with a particular Fund I investment if and when
such investment generates proceeds to Fund I in excess of the capital called
with respect to such investment, plus a 10% preferred return thereon. If, upon
liquidation of Fund I, the aggregate amount paid to the Fund I Managing Member
as Fund Incentive Return exceeds the amount actually due to the Fund I Managing
Member (that is, amounts that should instead have been paid to investors) after
taking into account the aggregate return to investors, the excess is required to
be returned by the Fund I Managing Member (that is "clawed back") to Fund I.
44
Our predecessor received a credit against management fees otherwise payable
under the Management Agreement with the Manager for management fees and any Fund
Incentive Return paid to the Manager by Fund I in connection with our
predecessor's investment in Fund I. Our predecessor had adopted Method 2 of
Emerging Issues Task Force Topic D-96 which specifies that companies with
management arrangements that contain a performance based incentive return that
is not finalized until the end of a period of time specified in the contract may
record such return as revenue in the amount that would be due under the formula
at any point in time as if the incentive return arrangement was terminated at
that date.
Our predecessor recorded as incentive income the amount that would be due
based on the fair value of the assets in Fund I exceeding the required return at
a specific point in time as if the management arrangement was terminated on that
date. Based on this methodology, our net income in each reporting period through
the date of the commencement of our operations reflected changes in the fair
value of the assets in Fund I. The fair value of the assets in Fund I is
determined by the Fund I Managing Member pursuant to guidelines established by
Fund I's board of directors. Due to the inherent uncertainty of valuations of
investments without a public market, the estimates of value may differ from the
values that are ultimately realized by Fund I, and the differences could be
material. Such estimates of fair value can fluctuate from quarter to quarter,
which resulted in material fluctuations in the amount of Fund Incentive Return
recorded.
RESULTS OF OPERATIONS
Our independent operations commenced in July 2002 and our initial public
offering was completed in October 2002. These events resulted in additional
capital being deployed to our investments which, in turn, resulted in changes to
our results of operations. Furthermore, the historical results of operations
described below include the operations of our predecessor through the date of
the commencement of our operations. Therefore, many items discussed below will
not have a continuing impact on our operations.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2002 TO THE YEAR ENDED DECEMBER 31,
2001
Interest and dividend income increased by $24.2 million or 49%, from $48.9
million to $73.1 million. This increase is primarily the result of interest
earned on the real estate securities purchased in connection with our CBO II
transaction.
Rental and escalation income decreased by $0.2 million or 1%, from $20.1
million to $19.9 million. This decrease is primarily the result of foreign
currency fluctuations with respect to our Bell Canada portfolio.
Gain on settlement of investments increased by $3.0 million, from $8.4
million to $11.4 million, primarily as a result of an increase in the volume of
sales of certain real estate securities. Sales of real estate securities are
based on a number of factors including credit, asset type and industry and can
be expected to increase or decrease from time to time. Periodic fluctuations in
the volume of sales of securities is dependent upon, among other things,
management's assessment of credit risk, asset concentration, portfolio balance
and other factors. The increased volume of sales of securities during this
period reflects management's determination that the portfolio required more
adjustment than in prior periods.
Equity in earnings of unconsolidated subsidiaries decreased by $2.4 million
or 87%, from $2.8 million to $0.4 million, as a result of the elimination of
income from our predecessor's investments in Fund I and Austin Holdings
Corporation subsequent to their distribution to Newcastle Investment Holdings.
Management fee income from Fund I, all of which is payable to the Manager
and is therefore included in management fee expense, had no net effect on our
reported operations.
Incentive Income from our predecessor's investment in Fund I of $1.2
million of loss was recorded during the period. We recorded as Fund Incentive
Return the amount that would be due based on the fair value of the assets in
Fund I exceeding the required return as if the management arrangement was
45
terminated, through the date of this investment's distribution to Newcastle
Investment Holdings. During the period, the amount previously recognized as Fund
Incentive Return in 2001 was reduced due to losses incurred in Fund I. The
calculation of incentive income is more fully discussed above.
Interest expense increased by $13.6 million or 38%, from $35.9 million to
$49.5 million. This increase is primarily the result of interest on the CBO II
securitization ($18.6 million), partially offset by lower interest rates being
paid on the variable rate CBO securities classes ($4.6 million).
Property operating expense decreased by $0.1 million or 1%, from $8.7
million to $8.6 million, primarily as the result of the same factors which
effected rental and escalation income.
Loan servicing and REO expense increased by $0.4 million or 158%, from $0.3
million to $0.7 million, primarily as a result of the acquisition of the real
estate securities purchased in connection with our CBO II transaction.
General and administrative expense increased by $1.3 million, from $1.6
million to $2.9 million, primarily as a result of increased insurance costs.
Management fee expense decreased by $5.4 million, from $14.7 million to
$9.3 million, based on the reduction in our equity resulting from the
distribution of assets to Newcastle Investment Holdings. Management fee expense
includes management fees related to Fund I through the date of the distribution
of such investment to Newcastle Investment Holdings, that decreased by $4.5
million, which are directly offset by management fee income.
Preferred incentive return decreased by $14.3 million, from $17.2 million
to $2.9 million, primarily as a result of decreased earnings on our
predecessor's investment in Fund I, prior to this investment's distribution to
Newcastle Investment Holdings.
Depreciation and amortization decreased by $0.4 million or 10%, from $3.6
million to $3.2 million, primarily as the result of the elimination of
amortization of certain costs related to our predecessor's investment in Fund I,
prior to this investment's distribution to Newcastle Investment Holdings.
Preferred dividends and related accretion decreased by $1.3 million, from
$2.5 million to $1.2 million, as a result of the redemption of such stock in
June 2002.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 2001 TO THE YEAR ENDED DECEMBER 31,
2000
Interest and dividend income decreased by $2.1 million or 4.1%, from $51.0
million to $48.9 million. This decrease is primarily the result of a decrease in
dividend income from our ICH stock subsequent to our acquisition of ICH ($1.5
million) and a decrease in bank interest due to lower cash balances ($1.3
million), offset by an increase related to the securities acquired from ICH in
November 2000 ($1.1 million).
Rental and escalation income decreased by $0.3 million or 1.9%, from $20.4
million to $20.1 million. This decrease is primarily the result of foreign
currency fluctuations related to our Bell Canada and LIV portfolios.
Gain on settlement of investments decreased by $12.4 million, from $20.8
million to $8.4 million, primarily as a result of gains taken on assets acquired
from ICH in 2000 ($19.8 million) offset by gains on sales of certain real estate
securities in 2001 ($7.4 million). Sales of real estate securities are based on
a number of factors including credit, asset type and industry and can be
expected to increase or decrease from time to time. Periodic fluctuations in the
volume of sales of securities is dependent upon, among other things,
management's assessment of credit risk, asset concentration, portfolio balance
and other factors. The increased volume of sales of securities during this
period reflects management's determination that the portfolio required more
adjustment than in prior periods.
Equity in earnings of unconsolidated subsidiaries increased by $3.8
million, primarily as a result of income from our predecessor's investment in
Fund I. Fund I was more fully invested in 2001 and therefore generated more
income.
46
Incentive Income from our predecessor's investment in Fund I increased by
$28.7 million as a result of the incentive threshold being reached in 2001.
Interest expense decreased by $1.0 million or 2.8%, from $36.9 million to
$35.9 million. This decrease is primarily the result of lower interest rates
being paid on the variable rate CBO I securities classes ($2.9 million), offset
by increased interest on our predecessor's credit facility due to a higher
average outstanding balance ($1.4 million).
Property operating expense decreased by $0.3 million or 2.9%, from $9.0
million to $8.7 million, primarily as the result of foreign currency
fluctuations related to our Bell Canada and LIV portfolios.
Loan servicing expense remained approximately the same at $0.3 million.
General and administrative expense decreased by $1.7 million, from $3.3
million to $1.6 million, primarily as a result of decreased professional fee
expenses.
Management fee expense decreased by $0.9 million, from $15.6 million to
$14.7 million, based on the reduction in our equity resulting from the
repurchase of 4.4 million shares of our predecessor's common stock in late 2000.
Preferred incentive return increased by $17.2 million primarily as a result
of reaching the incentive return thresholds in both our management agreement and
in Fund I's agreement in 2001.
Depreciation and amortization increased by $0.7 million or 22%, from $2.9
million to $3.6 million, primarily as the result of the amortization of certain
costs related to our predecessor's investment in Fund I.
Preferred dividends and related accretion increased by $0.5 million as a
result of the issuance of such stock in 2000.
LIQUIDITY AND CAPITAL RESOURCES
See "Management's Discussion and Analysis of Pro Forma Financial Conditions
and Results of Operations -- Liquidity and Capital Resources" for a discussion
of our current liquidity and capital resources.
The following is a discussion of our predecessor's historical liquidity and
capital resources, primarily related to operations distributed to them.
Our primary sources of funds for liquidity, subsequent to our predecessor's
private equity offering in 1998, have consisted of net cash provided by
operating activities, borrowings under loans, the issuance of debt securities
and the settlement of investments.
Our predecessor had certain investments in, and commitments to, two
unconsolidated subsidiaries as described below. Both of these investments, and
the related commitments, were distributed to Newcastle Investment Holdings.
Newcastle Investment Holdings committed to contribute approximately $100
million to Fund I, along with other major institutional investors who, together
with Newcastle Investment Holdings and its affiliates, committed approximately
$872.8 million over the three years ending April 28, 2003.
In 1998, Newcastle Investment Holdings and Fortress Principal Investment
Group LLC ("FPIG"), an affiliate of our manager, formed Austin Holdings
Corporation ("Austin"). FPIG contributed cash and Newcastle Investment Holdings
contributed its interest in entities that owned certain assets, primarily
nonperforming loans and foreclosed real estate intended for sale, which it
originally acquired as part of a loan pool acquisition. The assets Newcastle
Investment Holdings contributed, and any income generated from them, are not
well suited to be held by a REIT for the reasons described below. If the assets
were treated as inventory held for sale in the ordinary course of business, any
gain from the sale of these assets would be subject to a 100% excise tax in the
hands of a REIT. By holding these assets indirectly through Austin, a corporate
entity, Newcastle Investment Holdings instead received dividend income from the
47
corporation, which is not subject to the 100% excise tax, and is treated as
qualifying income for purposes of the 95% income test that applies to REITs.
Newcastle Investment Holdings held non-voting preferred stock of Austin.
Newcastle Investment Holdings' preferred stock in Austin represented a 95%
economic ownership interest in Austin and had a liquidation preference over the
common stockholders. Newcastle Investment Holdings' interest in Austin was
accounted for under the equity method. Newcastle Investment Holdings acquired
stock that is non-voting in order to comply with the rule that REITs generally
may not hold more than 10% of the voting stock of any corporation. FPIG was the
holder of all of the common stock, which represented 100% of the vote and 5% of
the economic ownership interest in Austin. Austin also owned 100% of the common
stock of Ascend Residential Holdings, Inc. ("Ascend"). Ascend's primary business
was the acquisition, rehabilitation and sale of single-family residential
properties.
In May 1999, Newcastle Investment Holdings closed on the $399.1 million GSA
securitization. The GSA securitization, and related assets, were retained by
Newcastle Investment Holdings.
In November 1999, Newcastle Investment Holdings securitized a U.S.
commercial mortgage loan by issuing $55.6 million of bonds. The bonds were also
secured by a $15.0 million letter of credit. These obligations were repaid in
December 2001.
In November 1999, Newcastle Investment Holdings obtained the $24.8 million
GSA Kansas City mortgage, which was repaid in May 2002 upon sale of the related
asset.
In July 2000, Newcastle Investment Holdings entered into a $40 million
revolving credit agreement, which bore interest at LIBOR + 4.25% and was due in
July 2003. Newcastle Investment Holdings hedged its exposure to the risk of
changes in market interest rates with respect to the credit agreement by
obtaining an interest rate swap. This credit agreement was retained by Newcastle
Investment Holdings.
Net cash flow provided by operating activities decreased from $34.4 million
for the year ended December 31, 2001 to $21.6 million for the year ended
December 31, 2002. It increased from $24.8 million for the year ended December
31, 2000 to $34.4 million for the year ended December 31, 2001. These changes
resulted from the acquisition and settlement of Newcastle's investments as
described above, including the distribution of investments to Newcastle
Investment Holdings.
Investing activities provided (used) ($682.7 million), $106.1 million and
$151.6 million during the years ended December 31, 2002, 2001 and 2000,
respectively. Investing activities consisted primarily of the acquisition and
improvement of properties and the investments made in certain real estate
securities, net of proceeds from the settlement of debt and equity investments
as well as the sale of properties.
Financing activities provided (used) $675.2 million, ($119.7 million) and
($180.2 million) during the years ended December 31, 2002, 2001 and 2000,
respectively. The borrowings and debt issuances described above served as the
primary sources of cash flow from financing activities. Offsetting uses included
the payment of related deferred financing costs (including the purchase of
hedging instruments), the payment of dividends, the redemption of common and
preferred stock and the repayment of debt as described above.
See the consolidated statements of cash flows in our consolidated financial
statements included in this prospectus for a reconciliation of our cash position
(including our predecessor's cash position prior to the commencement of our
operations) for the periods described herein.
FUNDS FROM OPERATIONS
We believe Funds from Operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. We also believe that FFO is an appropriate supplemental disclosure
of operating performance for a REIT due to its widespread acceptance and use
within the REIT analyst communities. FFO, for our purposes, represents net
income available for common shareholders (computed in accordance with accounting
principles generally accepted in the United States (GAAP)), excluding
extraordinary items, plus real estate depreciation and amortization, and after
adjustments for unconsoli-
48
dated subsidiaries. We consider gains and losses on resolution of our
investments to be a normal part of our recurring operations and therefore do not
exclude such gains and losses when arriving at FFO. In addition, we excluded
accrued incentive income from our predecessor's investment in Fortress
Investment Fund LLC (Fund I) and included incentive income distributed or
distributable from Fund I in accordance with the operating agreement of Fund I
since this reflects cash distributed or distributable from Fund I, while accrued
incentive income is based upon the fair value of Fund I's net assets, which is
subject to fluctuation. Adjustments for unconsolidated subsidiaries are
calculated to reflect FFO on the same basis. FFO does not represent cash
generated from operating activities in accordance with GAAP and therefore should
not be considered an alternative to net income as an indicator of operating
performance or as an alternative to cash flow as a measure of liquidity and is
not necessarily indicative of cash available to fund cash needs.
Funds from Operations is calculated as follows (unaudited) (in thousands):
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------
2002 2001 2000
-------- --------- --------
Income available for common stockholders.................... $30,333 $41,131 $40,776
Real estate depreciation and amortization................... 7,994 12,909 12,621
Accumulated depreciation on real estate sold................ (2,847) -- --
Real estate depreciation and amortization-unconsolidated
subsidiaries.............................................. 1,614 2,564 126
Incentive income accrued from Fund I(A)..................... 609 (14,354) --
Equity in incentive return accrued by Fund I................ (70) 1,645 --
Distributable incentive income from Fund I(B)............... -- 4,369 --
------- -------- -------
Funds from Operations (FFO)................................. $37,633 $48,264 $53,523
======= ======== =======
- ---------------
(A) Represents our predecessor's 50% interest in the incentive income as
follows:
Total incentive income................................ $(1,218) $28,708
Manager portion....................................... 609 (14,354)
------- --------
Our predecessor's incentive income.................... $(609) $14,354
======= ========
(B) Represent our predecessor's 50% interest in the distributable incentive
income:
Total distributable incentive income................................ $8,738
Distributable incentive income due to Manager.................. (4,369)
--------
Our predecessor's distributable incentive income............... $4,369
========
49
NEWCASTLE INVESTMENT CORP.
We invest in real estate securities and other real estate-related assets.
We seek to finance these investments primarily using match-funded financing
structures. Match-funded financing structures match assets and liabilities with
respect to maturities and interest rates. Our objective is to maximize the
difference between the yield on our investments and the cost of financing these
investments while hedging our positions. We are organized and conduct our
operations to qualify as a real estate investment trust (REIT) for federal
income tax purposes.
We were formed in June 2002 for the purpose of separating the real estate
securities and credit leased real estate businesses from Newcastle Investment
Holdings's other investments. We completed the initial public offering of our
common stock in October 2002. Newcastle Investment Holdings currently owns 68.2%
of our outstanding common stock, assuming exercise of all outstanding options.
Newcastle Investment Holdings was formed in May 1998. Prior to the completion of
our initial public offering, Newcastle Investment Holdings contributed to us
certain assets and related liabilities in exchange for shares of our common
stock. However, for accounting purposes this transaction is presented as a
reverse spin-off. Under a reverse spin-off, Newcastle Investment Corp. is
treated as the continuing entity and the assets retained by Newcastle Investment
Holdings are accounted for as if they were distributed at historical book basis
through a spin-off to Newcastle Investment Holdings.
We own a diversified portfolio of credit sensitive real estate securities,
including commercial and residential mortgage backed securities (CMBS) and
unsecured REIT debt, rated primarily BBB (BBB- is the lowest investment grade
rating) and BB (BB+ is the highest non-investment grade rating). Mortgage backed
securities are interests in or obligations secured by pools of commercial or
residential mortgage loans. We also own credit leased real estate in Canada and
Belgium. We consider credit leased real estate to be real estate that is leased
primarily to tenants with, or whose major tenant has, investment grade credit
ratings. We also own a pool of mortgage loans. We describe each of these assets
and liabilities below under "-- Our Investments."
We are externally managed and advised by Fortress Investment Group LLC. Our
chairman and chief executive officer and each of our executive officers also
serve as officers of our manager. We have no ownership interest in our manager.
We have chosen to be externally managed by Fortress Investment Group to take
advantage of the existing business relationships, operational and risk
management systems, expertise and economies of scale associated with our
manager's current business operation. At December 31, 2002, our manager and its
principals owned approximately 16.4% of the equity of Newcastle Investment
Holdings (25.8% upon exercise of outstanding options to purchase shares of
Newcastle Investment Holdings). In addition, we granted to our manager options
to purchase 700,000 shares of our common stock, at the offering price of our
shares in our initial public offering. As a result, Fortress Investment Group
and its principals beneficially own approximately 20.5% of our common equity,
taking into account interests in Newcastle Investment Holdings and assuming
exercise of all of their options. We pay Fortress Investment Group an annual
base management fee and may pay incentive compensation based on certain
performance criteria. Fortress Investment Group also manages and invests in
other entities, including Newcastle Investment Holdings, that invest in real
estate assets.
OUR STRATEGY
We focus on investing in credit sensitive real estate securities, including
mortgage backed securities and REIT securities, and invest in other real estate
related investments, including credit leased real estate and mortgage loans. The
mortgage backed securities we invest in will generally be junior in right of
payment of interest and principal to one or more senior classes, but will
benefit from the support of one or more subordinate classes of securities or
other form of credit support within a securitization transaction. The REIT
securities we invest in will reflect a comparable credit position and rating. We
believe that these securities offer attractive risk-adjusted returns with
long-term principal protection under a variety of default and loss scenarios.
While the expected yield on these securities is sensitive to the performance of
the underlying assets, the more subordinated securities or other features of the
securitization transaction, in
50
the case of mortgage backed securities, and the issuer's underlying equity, in
the case of REIT securities, are designed to bear the first risk of default and
loss. We further minimize credit risk through active surveillance and management
of our portfolio.
Returns on these investments can be sensitive to interest rate volatility.
We attempt to minimize exposure to interest rate fluctuation through the use of
match-funded financing structures. In particular, we finance our real estate
securities investments through the issuance of debt securities in the form of
collateralized bond obligations (CBOs) to take advantage of the structural
flexibility offered by CBO transactions to buy and sell certain investment
positions to manage risk and, subject to certain limitations, to optimize
returns.
We actively monitor our investment portfolio and the underlying credit
quality of our holdings and, where appropriate, may reposition our investments
to upgrade the credit quality and yield on our investments. We selectively
pursue special investment situations where we believe cash flows have been
mispriced, including discounted securities purchases in sectors or jurisdictions
which have fallen out of favor due to economic pressures, regulatory issues or
illiquidity. We draw on our manager's expertise and significant business
relationships with participants in the real estate securities industry to
enhance our access to these investments, which may not be broadly marketed.
Our investments may be made directly or indirectly, such as in the form of
an investment in a vehicle created to hold such assets. We conduct our business
such that our investments in the securities of other issuers do not require us
to register as an "investment company" under the Investment Company Act of 1940,
as amended, and we would divest securities before any such registration would be
required.
OUR COMPETITIVE STRENGTHS
Asset Quality and Diversification
Our portfolio is diversified by asset type, industry, location and issuer.
We expect that diversification will minimize the risk of capital loss, and will
also enhance the terms of our financing structures.
Our portfolio of real estate securities has an overall weighted average
credit rating of BBB-, and approximately 68% of these securities have an
investment grade rating (BBB- or higher). As of December 31, 2002, 81% of the
square footage of our credit leased real estate was occupied by tenants having
investment grade credit ratings. For a detailed description of the ratings
assigned by Standard and Poor's and Moody's, see "-- Ratings."
Match-Funding Discipline
Generally, we seek to "match fund" our assets and liabilities with respect
to maturities and interest rates. We attempt to match the maturities of our
investments with the maturities of our financial obligations. In addition, our
objective is to finance our investments with like-kind debt (i.e., floating-rate
assets are financed with floating-rate debt and fixed-rate assets are financed
with fixed-rate debt), directly or through the use of hedges such as interest
rate swaps, caps and other financial instruments, subject to limitations on the
ability to utilize these instruments pursuant to the tax rules applicable to
REITs. This allows us to reduce interim refinancing risk and the impact of
changing interest rates on our earnings and net asset value. As of December 31,
2002, a 100 basis point change in short-term interest rates would affect our
earnings by no more than $1.9 million per annum.
Creative Financing Strategies
We seek to enhance returns to stockholders through the use of leverage. We
finance our investments in real estate securities by issuing debt securities, in
particular CBOs, to take advantage of the structural flexibility offered by CBO
transactions. Unlike typical securitization structures, the assets underlying
the CBOs may be sold, subject to certain limitations, without a corresponding
pay-down of the CBO debt, provided the proceeds are reinvested in qualifying
assets. As a result, CBOs enable us to actively manage, subject to certain
limitations, the pool of assets. We have also employed lease securitizations to
finance
51
certain of our credit leased real estate. We use short term financing, in the
form of repurchase agreements, bridge financings and bank warehousing
facilities, prior to implementing optimal match-funded financing.
Experienced Management
The principal executives of our manager have an average of more than 17
years of experience in the fields of real estate investing and finance, private
equity investment, capital markets, transaction structuring and risk management
with respect to both dollar and non-dollar denominated investments, providing us
with significant expertise in key areas of our business. Over the last six years
alone, the founders of our manager have managed the acquisition of over $20
billion of real estate-related assets and the issuance of over $11 billion of
real estate securities.
OUR INVESTMENT GUIDELINES
Our board of directors has adopted general guidelines for our investments
and borrowings to the effect that:
- no investment shall be made which would cause us to fail to qualify as a
REIT;
- no investment shall be made which would cause us to be regulated as an
investment company;
- no more than 20% of our equity, determined as of the date of such
investment, shall be invested in any single asset;
- our leverage shall not exceed 90% of the value of our assets; and
- we shall not co-invest with the manager or any of its affiliates unless
(i) our co-investment is otherwise in accordance with these guidelines
and (ii) the terms of such co-investment are at least as favorable to us
as to the manager or such affiliate (as applicable) making such
co-investment.
Our manager is required to seek the approval of the independent members of
our board of directors before we engage in a material transaction with another
entity managed by our manager. These investment guidelines may be changed by our
board of directors without the approval of our stockholders.
OUR TARGETED INVESTMENTS
COMMERCIAL MORTGAGE BACKED SECURITIES. We invest in commercial mortgage
backed securities (CMBS), which are secured by or evidence ownership interests
in a single commercial mortgage loan or a pool of mortgage loans secured by
commercial properties. These securities may be senior, subordinate, investment
grade or non-investment grade securities. We expect the majority of our CMBS
investments to be rated by at least one nationally recognized rating agency. The
majority of our investments in CMBS consist of securities that are part of a
capital structure or securitization where the rights of such class to receive
principal and interest are subordinate to senior classes but senior to the
rights of lower rated classes of securities. We seek to invest in CMBS that will
yield high current interest income and where we consider the return of principal
to be likely. We acquire CMBS from private originators of, or investors in,
mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, finance companies, investment banks and other entities.
The yield on CMBS depends, in part, on the timely payment of interest and
principal due on the underlying mortgage loans and defaults by the borrowers on
such loans may ultimately result in deficiencies and defaults on the CMBS. In
the event of a default, the trustee for the benefit of the holders of CMBS has
recourse only to the underlying pool of mortgage loans and, if a loan is in
default, to the mortgaged property securing such mortgage loan. After the
trustee has exercised all of the rights of a lender under a defaulted mortgage
loan and the related mortgaged property has been liquidated, no further remedy
will be available. However, holders of relatively senior classes of CMBS will be
protected to a certain degree by the structural features of the securitization
transaction within which such CMBS were issued, such as the subordination of the
relatively more junior classes of the CMBS.
52
The credit quality of CMBS depends primarily on the credit quality of the
underlying mortgage loans. Among the factors determining credit quality of a
mortgage loan are (i) the purpose of the mortgage loan (e.g., refinancing or new
purchase), (ii) the principal amount of the mortgage loan relative to the value
of the related mortgaged property at origination and at maturity, (iii) the
mortgage loan terms (e.g., amortization, balloon amounts, reserves, prepayment
terms), (iv) the geographic location of the mortgaged property securing the
mortgage loan, and (v) the creditworthiness of tenants occupying the underlying
properties.
In considering whether to acquire a CMBS, we perform due diligence to
assess the credit quality of the mortgage loans as discussed above, as well as
(i) the capabilities of the master and special servicer servicing the mortgage
loans, (ii) the CMBS structure including subordination levels, (iii) the
prepayment and default history of the other mortgage loans previously originated
by lenders, (iv) cash flow analyses under various prepayment and interest rate
scenarios (including sensitivity analyses), and (v) an analysis of various
default scenarios.
B NOTES. We invest in "B Notes" rated by at least one nationally
recognized rating agency. A "B Note" is typically a privately negotiated loan
(a) secured by a first mortgage on a single large commercial property or group
of related properties and (b) subordinated to an "A Note" secured by the same
first mortgage on the same property. The subordination of a B Note is typically
evidenced by an inter-creditor agreement with the holder of the related A Note.
B Notes share certain credit characteristics with subordinated CMBS, in
that both reflect an interest in a first mortgage and are subject to more credit
risk with respect to the underlying mortgage collateral than the corresponding
senior securities or the A Notes, as the case may be. As opposed to a typical
CMBS secured by a large pool of mortgage loans, B Notes typically are secured by
a single property, and the associated credit risk is concentrated in that single
property. B Notes also share certain credit characteristics with second
mortgages, in that both are subject to more credit risk with respect to the
underlying mortgage collateral than the corresponding first mortgage or the A
Note, as the case may be. We acquire B Notes in negotiated transactions with the
originators, as well as in the secondary market.
The yield on a B Note depends on the timely payment by the borrower of
interest and principal. Default by the borrower may, depending on the
transaction structure, result in the immediate interruption of current cash flow
and may ultimately result in the loss of principal of the B Note. In the event
of such a default, the rights of the B Note holders to foreclose on the mortgage
collateral are typically subject to the prior right of the holder of the
corresponding A Note. As a result, the rights of the holder of a B Note to
mitigate losses in the event of a borrower default may be impaired.
The credit quality of a B Note depends on (i) the borrower under the
underlying mortgage, (ii) the value of the underlying collateral and the extent
to which it secures the obligation owed to the B Note holder, (iii) the rights
under the mortgage loan documents (e.g. personal guarantees, additional
collateral, default covenants, remedies), (iv) the B Note holder's rights under
an inter-creditor agreement with the A Note holders, (v) the level and stability
of cash flow from the property available to service the mortgage debt, and (vi)
the availability of capital for refinancing by the borrower if the mortgage loan
does not fully amortize.
We perform extensive due diligence and credit analysis including (i)
borrower credit underwriting, (ii) property review (e.g. appraisal,
environmental, structural), (iii) mortgage loan and B Note documentation review,
(iv) property cash flow analysis, and (v) analysis of the eligibility of each
mortgage loan for inclusion as collateral in a future securitization or
appropriateness for other forms of financing or sale.
REIT SECURITIES. We invest in securities issued by other REITs, including
investment grade and non-investment grade debt and preferred equity securities
issued by other REITs. REIT debt securities are generally unsecured corporate
obligations of REITs. We expect the majority of these REIT securities to be
rated by at least one nationally recognized rating agency. We seek to invest in
REIT securities that will yield high current interest and dividend income and
where we consider the return of principal to be likely. We acquire REIT
securities from companies representing a variety of property types.
53
The credit quality of REIT securities is directly dependent on the
financial condition and business outlook of the issuer. Factors determining the
financial condition and outlook include (i) portfolio credit quality (e.g.
diversity, type of asset and stability of cash flow), (ii) availability of
capital, (iii) leverage and leverage trends, (iv) size of portfolio, (v)
competition, and (vi) quality of the REIT's management team.
In analyzing these REIT securities, we consider, among other factors, the
credit quality factors described above as well as unencumbered and encumbered
cash flow coverage, capital structure, refinancing risks, and covenants of the
issuer's outstanding debt.
RESIDENTIAL MORTGAGE SECURITIES. We may invest in residential mortgage
backed securities (RMBS), which are secured by or evidence ownership interests
in pools of mortgage loans secured by single family residential properties. We
would invest in securities with credit quality and subordination levels similar
to those described above for our CMBS investments.
We seek to invest in RMBS that will yield high current interest income and
where we consider the return of principal to be likely. We will acquire RMBS
from private originators of, or investors in, mortgage loans, including savings
and loan associations, mortgage bankers, commercial banks, finance companies,
investment banks and other entities.
Like CMBS, the yield on RMBS depends, in part, on the timely payment of
interest and principal due on the underlying mortgage loans by the borrowers
under such mortgage loans and defaults by such borrowers may ultimately result
in deficiencies and defaults on the RMBS. In the event of a default, the trustee
for the benefit of the holders of RMBS has rights similar to corresponding
rights of a CMBS trustee.
Like CMBS, the credit quality of RMBS depends on the credit quality of the
underlying mortgage loans, which is a function of factors such as (i) the
purpose of the mortgage loans (e.g. refinancing or new purchase), (ii) the
principal amount of the mortgage loans relative to the value of the related
mortgaged properties, (iii) the mortgage loan terms (e.g. amortization), (iv)
the geographic location of the properties securing the mortgage loans, and (v)
the creditworthiness of the borrowers.
In considering whether to acquire an RMBS, we perform due diligence to
assess the credit quality of the mortgage loans as discussed above for CMBS, as
well as the likelihood of prepayment, which residential borrowers are generally
permitted to do without penalty. For RMBS, credit quality may also depend on the
extent of any government or agency guarantee of the mortgage loans securing the
RMBS.
MORTGAGE LOANS. We invest in portfolios of mortgage loans from various
sellers, including life insurance companies, banks and other owners, generally
secured by commercial or residential properties in the U.S. Among the factors
determining credit quality of a mortgage loan are (i) the purpose of the
mortgage loan (e.g. refinancing or new purchase), (ii) the principal amount of
the mortgage loan relative to the value of the related mortgaged property at
origination and at maturity, (iii) the mortgage loan terms (e.g. amortization,
balloon amounts, reserves, prepayment terms), (iv) the geographic location of
the mortgaged property securing the mortgage loan, and (v) the creditworthiness
of tenants or borrowers occupying the underlying property.
OTHER REAL ESTATE-RELATED INVESTMENTS. We may also make investments in
other types of commercial real estate assets as well as in non-mortgage backed
securities. In particular, we may invest in credit leased real property similar
to our current credit leased real estate portfolio.
Although we invest in the investments described above, our business
decisions will depend on changing market conditions. As a result, we cannot
predict with any certainty the percentage of our assets that will be invested in
each category. We may change our investment strategy and policies without a vote
of stockholders. We may acquire assets from our manager or its affiliates,
including securities issued by our manager or its affiliates. There are no
limitations on such transactions, except that they must comply with our general
investment guidelines and our management agreement with our manager.
54
OUR FINANCING STRATEGY
We seek to enhance returns to stockholders through the use of leverage. Our
financing strategy focuses on the use of match-funded financing structures. This
means that we seek to match the maturities of our financial obligations with the
maturities of our investments to minimize the risk that we have to refinance our
liabilities prior to the maturities of our assets, and to reduce the impact of
changing interest rates on earnings. In addition, we generally match fund
interest rates with like-kind debt (i.e., fixed-rate assets are financed with
fixed-rate debt, and floating-rate assets are financed with floating-rate debt),
through the use of hedges such as interest rate swaps, caps, or through a
combination of these strategies. This allows us to reduce the impact of changing
interest rates on our earnings. In this regard, we intend to utilize
securitization structures, particularly CBOs, as well as other match-funded
financing structures. CBOs are multiple class debt securities, or bonds, secured
by pools of assets, such as mortgage backed securities, B Notes and REIT debt.
Like typical securitization structures, in a CBO (a) the assets are pledged to a
trustee for the benefit of the holders of the bonds, (b) one or more classes of
the bonds are rated by one or more rating agencies, and (c) one or more classes
of the bonds are marketed to a wide variety of fixed income investors, which
enables the CBO sponsor to achieve a relatively low cost of long-term financing.
Unlike typical securitization structures, we prefer to structure our CBOs such
that the underlying assets may be sold, subject to certain limitations, without
a corresponding pay-down of the CBO debt, provided the proceeds are reinvested
in qualifying assets. As a result, CBOs enable the sponsor to actively manage,
subject to certain limitations, the pool of assets. We believe that our CBO
financing structures are an appropriate financing vehicle for our targeted asset
classes, because they will enable us to lock in a long-term cost of funds and
minimize the risk that we have to refinance our liabilities prior to the
maturities of our investments while giving us the flexibility to manage credit
risk and, subject to certain limitations, to take advantage of profit
opportunities.
We may also use short term financing, in the form of repurchase agreements,
bridge financings and bank warehousing facilities, as an intermediary step prior
to the implementation of optimal match-funded financing. We utilize leverage for
the sole purpose of financing our portfolio and not for the purpose of
speculating on changes in interest rates.
OUR HEDGING ACTIVITIES
We enter into hedging transactions to protect our positions from interest
rate fluctuations and other changes in market conditions. These transactions may
include interest rate swaps, the purchase or sale of interest rate collars, caps
or floors, options, mortgage derivatives and other hedging instruments. These
instruments may be used to hedge as much of the interest rate risk as our
manager determines is in the best interest of our stockholders, given the cost
of such hedges and the need to maintain our status as a REIT. Our manager may
elect to have us bear a level of interest rate risk that could otherwise be
hedged when our manager believes, based on all relevant facts, that bearing such
risks is advisable. Our manager has extensive experience in hedging real estate
positions with these types of instruments. Our manager engages in hedging for
the sole purpose of protecting against interest rate risk and not for the
purpose of speculating on changes in interest rates.
OUR INVESTMENTS
We own a diversified portfolio of credit sensitive real estate securities,
including commercial mortgage backed securities and unsecured REIT debt rated
primarily BBB (the lowest investment grade rating) and BB (one level below
investment grade). We also own certain credit leased real estate in Canada and
Belgium and a pool of mortgage loans.
Information regarding our business segments is provided in "Management's
Discussion and Analysis of Pro Forma Financial Condition and Results of
Operations," in "Management's Discussion and Analysis of Historical Financial
Condition and Results of Operations," and in Note 3 to our consolidated
financial statements which are included in the prospectus.
55
Our equity at December 31, 2002 is invested 75% in our real estate
securities segment, 9% in our credit leased real estate segment, 4% in our real
estate loan segment, and 12% in other investments, primarily cash equivalents.
The following is a description of our investment assets as of December 31,
2002. For an explanation of the ratings assigned by Standard & Poor's and
Moody's Investor Services, see "-- Ratings."
REAL ESTATE SECURITIES
CBO I: In July 1999, Fortress CBO Investments I, Limited and Fortress CBO
Investments I Corp. issued approximately $500 million face amount of CBOs and
other securities in transactions exempt from the registration requirements of
the Securities Act of 1933, as amended (the "Securities Act") pursuant to Rule
144A and Regulation S thereunder. As of December 31, 2002, the underlying
securities securing CBO I consist of:
- $323.0 million face amount in CMBS with a weighted average coupon of
6.72%, a weighted average rating of approximately BB and a weighted
average term to maturity of 7.11 years. Retail, multifamily and office
properties comprise 48%, 19% and 15%, respectively, of the underlying
collateral.
- $234.6 million face amount in unsecured REIT debt securities with a
weighted average coupon of 7.41%, a weighted average rating of
approximately BBB and a weighted average remaining term to maturity of
5.48 years. Office, retail, industrial and residential REIT industries
comprise 17%, 29%, 19% and 14%, respectively, of the debt.
$437.5 million of Senior CBO I securities were sold to third parties and we
own $62.5 million of the Subordinate CBO I securities. The table below sets
forth further information with respect to the CBO I structure.
MOODY'S/S&P EXPECTED
CLASS RATINGS FACE AMOUNT COUPON MATURITY(1)
--------- ----------- ------------ ----------- -----------
Senior CBO I
Securities............. A Aaa/AAA $322,500,000 LIBOR +0.65% July-04
B Aa2/AA $20,000,000 LIBOR +0.80% July-04
C A2/NR $62,500,000 7.85% July-09
D Baa2/NR $32,500,000 8.60% July-09
------------
TOTAL............... $437,500,000
============
Subordinate CBO I
Securities............. E Ba2 $17,500,000 8.00% July-09
Preferred B2 $17,500,000 9.00% July-09
Common I $26,400,000 N/A N/A
Common II $1,100,000 N/A N/A
------------
TOTAL............... $62,500,000
============
- ---------------
(1) Reflects expected maturities upon refinancing. Contractual maturities are
July 2038.
We act as collateral manager for CBO I and are paid a monthly fee of 0.5%
per annum of the principal balance of the CBO I collateral. We have the
discretion to buy and sell up to 15% of the outstanding face of the collateral
annually, and to sell defaulted and credit risk securities on an unlimited
basis. Until 2004, we are obligated to reinvest principal received from the
collateral. In 2004, we intend to refinance the Class A and B Senior CBO I
securities, provided it would not result in a downgrade of any rated classes of
securities. Failure to so refinance on the scheduled date in 2004 will result in
an additional allocation of cash flows from certain of the Subordinate CBO I
securities to the Class A and B Senior CBO I securities. To better match the
collateral cash flow to the debt service on the CBO I Securities, we entered
into interest rate swap and cap agreements.
56
CBO II: On April 25, 2002, Newcastle CDO I Limited and Newcastle CDO I
Corp. issued $500 million face amount of collateralized bond obligations and
other securities in our second CBO transaction. As of December 31, 2002 the
second CBO, which we refer to as CBO II, consisted of:
- $299.0 million face amount in CMBS with a weighted average coupon of
6.35%, a weighted average rating of approximately BBB- and a weighted
average term to maturity of 7.17 years. Retail, multifamily and office
properties comprise 35%, 29% and 19%, respectively, of the underlying
collateral.
- $113.4 million face amount in unsecured REIT debt securities with a
weighted average coupon of 7.81%, a weighted average rating of
approximately BBB- and a weighted average remaining term to maturity of
7.85 years. Office, retail and residential REIT industries comprise 13%,
41% and 16% respectively, of the debt.
- $58.2 million face amount in asset backed securities with a weighted
average coupon of 7.29% and a weighted average term to maturity of 7.89
years.
$444 million face amount of Senior CBO II securities were sold to third
parties and we own $56 million of the Subordinate CBO II securities. The table
below sets for the further information with respect to the structure of CBO II.
MOODY'S/S&P
CLASS RATINGS FACE AMOUNT COUPON MATURITY
--------- ----------- ------------ ---------- --------
Senior CBO II Securities...... Class I Aaa/AAA $372,000,000 LIBOR+0.55% April-32
Class II A3/A- $38,000,000 7.59% April-37
Class III Baa2/BBB $34,000,000 8.37% April-37
------------
TOTAL.................... $444,000,000
============
Subordinate CBO II
Securities.................. Class IV Ba2/BB $19,000,000 7.50% April-37
Preferred NR $37,000,000 N/A April-37
------------
TOTAL.................... $56,000,000
============
We act as collateral manager for CBO II and are paid a quarterly fee of
1/4 of 0.35% of the principal balance of the CBO II collateral. We have the
discretion to buy and sell up to 15% of the outstanding face of the collateral
annually, and to sell defaulted and credit risk securities on an unlimited
basis. Until 2007, we are obligated to reinvest principal received from the
collateral. To better match the collateral cash flow to the debt service on the
CBO II securities, we entered into interest rate swap and cap agreements.
CBO III: On March 12, 2003, we agreed to pricing terms for CBO III, which
we expect will close on or about March 19, 2003. We expect that upon closing, we
will sell $472 million of senior CBO III securities. Pursuant to an agreement
entered into in July 2002, Bear, Stearns International Limited (BSIL) has
purchased the commercial mortgage backed securities, REIT debt, real estate
loans and asset backed securities that will serve as part of the collateral for
CBO III, subject to our right to purchase such securities from BSIL. This
agreement is treated as a non-hedge derivative for accounting purposes and is
therefore marked-to-market through current income; a mark of $0.7 million has
been booked to income through December 31, 2002. Pursuant to the agreement,
Bear, Stearns & Co. Inc. also has been engaged to structure and serve as lead
manager for the CBO III transaction for which it will receive customary fees. If
the CBO III transaction is not consummated as a result of our failure to acquire
the equity interest or otherwise as a result of our gross negligence or willful
misconduct, we would be required to either purchase such securities from BSIL or
pay BSIL the difference between the price it paid for such securities and the
price at which it sold such securities to a third party (a collateral loss). If
the CBO III transaction fails to close for any other reason, other than as a
result of BSIL's gross negligence or willful misconduct, we would be required to
either purchase such securities from BSIL or pay BSIL the lesser of the
collateral loss and our deposit. There is no assurance that the CBO III
transaction will be consummated. As of December 31, 2002, we estimate that the
fair value of the
57
securities purchased by BSIL is in excess of the purchase price paid by BSIL. In
November and December 2002, we made deposits aggregating $37.1 million under
such agreement, known as the CBO III deposit. The table below sets forth
information with respect to CBO III.
MOODY'S/S&P/ EXPECTED
CLASS FITCH RATINGS FACE AMOUNT COUPON MATURITY(1)
--------- ------------- ------------ ---------- -----------
Senior CBO III
Securities.............. I Aaa/AAA/AAA $412,800,000 LIBOR+0.70% Mar-2013
II-FL A3/A-/A- $15,000,000 LIBOR+1.75% Mar-2013
II-FX A3/A-/A- $35,000,000 5.715% Mar-2013
III Baa2/BBB/BBB $9,200,000 7.436% Mar-2013
------------
TOTAL................ $472,000,000
============
- ---------------
(1) Reflects expected maturities upon refinancing. Contractual maturities are
March 2038.
We will retain the equity interest in CBO III.
CREDIT LEASED REAL ESTATE
We own real estate located in Canada and in Belgium which, in addition to
all the risks inherent in the investment in real estate generally, is also
subject to fluctuations in foreign currency exchange rates, unexpected changes
in regulatory requirements, political and economic instability in certain
geographic locations, difficulties in managing international operations,
potentially adverse tax consequences, enhanced accounting and control expenses
and the burden of complying with a wide variety of foreign laws. A change in
foreign currency exchange rates may adversely impact returns on our non-dollar
denominated investments. Our principal currency exposures are to the Euro and
the Canadian Dollar. Changes in the currency rates can adversely impact the fair
values and earnings streams of our international holdings. We generally do not
directly hedge our foreign currency risk through the use of derivatives, due to,
among other things, REIT qualification issues.
Bell Canada Portfolio. We own four office properties and an industrial
property in Canada leased primarily to Bell Canada. We refer to these properties
as the Bell Canada Portfolio. The total net rentable area is approximately 1.3
million square feet and the current annual rent as of December 31, 2002 is
approximately $5.7 million. We believe that these properties are adequately
covered by insurance against potential loss.
To more effectively monetize lease cash flows and the anticipated value of
the properties in the Bell Canada Portfolio, in April 2002 we issued
approximately $70 million (Canadian dollars) face amount of securities secured
by the lease payments and by the five Bell Canada properties in a transaction
exempt from the registration requirements of both Canadian and U.S. securities
laws. The Series A and B Notes were sold to third parties and the Series C Notes
were retained by us.
The table below sets forth further information on the securities issued:
FACE
DBRS* (CANADIAN
SERIES RATINGS DOLLARS) COUPON MATURITY
- ------ ------- ------------ ------ ----------
Series A Class I Notes................ AAA C$18,000,000 6.150% April-2012
Series A Class II Notes............... AA C$6,000,000 6.150% April-2012
Series A Class III Notes.............. A+ C$30,000,000 6.150% April-2012
Series B Notes........................ A C$6,000,000 7.675% April-2012
Series C Notes........................ BBB C$10,000,000 11.000% April-2012
------------
TOTAL................................. C$70,000,000
============
- ---------------
* Dominion Bond Rating Service Limited
58
The following table sets forth certain information with respect to the Bell
Canada Portfolio as of December 31, 2002:
BELL CANADA PORTFOLIO
NET
RENTABLE YEAR
STATE/ SQUARE BUILT/ OWNERSHIP
PROPERTY ADDRESS CITY/SUBMARKET(1) PROVINCE FEET RENOVATED % USE
- ---------------- -------------------- -------- --------- --------- --------- ------------
20-40 Norelco Drive, Toronto/North York ON 624,786 1963/ 100% Industrial/
83 Signet Drive 1971/ Distribution
1979
2 Fieldway Road Etobicoke (Toronto)/ ON 177,214 1972/ 100% Office
Metro West expanded
1978
100 Dundas Street London/CBD ON 325,764 1980 100% Office
449 Princess Kingston/CBD ON 45,691 1981 100% Office
Street(3)
66 Bay Street Hamilton/CBD ON 118,787 1974 100% Office
South(3)
---------
Total/Average 1,292,242
% OF TENANT
TOTAL NET
SQUARE RENTABLE LEASE LEASE TENANT
FOOTAGE SQUARE START EXP CREDIT
PROPERTY ADDRESS TENANT LEASED FEET DATE DATE RATING
- ---------------- --------------------- ------- --------- ------- -------- ------
20-40 Norelco Drive, Bell Canada-Office 98.48% 615,274 3/26/98 3/31/07 A
83 Signet Drive Bell Canada-Cafeteria 0.73% 4,559 3/26/98 3/31/07 A
Bell Canada-Storage 0.47% 2,960 3/26/98 3/31/07 A
Bell Canada-O&Y 0.32% 1,993 3/26/98 3/31/07
2 Fieldway Road Bell Canada-Office 94.1% 166,753 3/26/98 3/31/04 A
Bell Canada-Cafeteria 4.25% 7,533 3/26/98 3/31/04 A
Bell Canada-Storage 0.91% 1,619 3/26/98 3/31/04 A
Bell Canada-Mgmt 0.65% 1,153 3/26/98 3/31/04 A
Hosnya Elshaarawy 0.09% 156 4/1/01 3/31/06
100 Dundas Street Bell Canada-Office 89.24% 290,706 3/26/98 3/31/06 A
Bell Canada-Storage 3.96% 12,890 3/26/98 3/31/06 A
Bell Canada- 0.52% 1,686 3/26/98 3/31/47 A
Communications
Bell Canada-Mgmt 0.45% 1,478 3/26/98 3/31/06 A
ComTech 0.03% 96 1/01/00 12/31/05
MacTel 0.47% 1,536 6/1/00 5/31/03
MacTel 0.21% 673 4/1/01 5/31/03
Tony & Fay Gardner 0.15% 475 9/1/99 8/31/07
Palmieri's Fine 0.58% 1,884 10/1/00 9/30/10
Food Inc
449 Princess Bell Canada-Office 99.41% 45,422 3/26/98 3/31/03 A
Street(3) Bell Canada-Storage 0.59% 269 3/26/98 3/31/03 A
66 Bay Street Bell Canada-Office 92.94% 110,400 3/26/98 3/31/03 A
South(3) Bell Canada-Cafeteria 6.42% 7,621 3/26/98 3/31/03 A
Bell Canada-Storage 0.41% 492 3/26/98 3/31/03 A
Bell Canada-Mgmt 0.23% 274 3/26/98 3/31/03 A
---------
Total/Average 98.89% 1,277,902
CURRENT
RENT ANNUAL
PER REAL LEASE
ANNUAL SQUARE ESTATE RENEWAL
PROPERTY ADDRESS RENT(2) FOOT TAXES OPTION
- ---------------- ---------- ------- ---------- ----------
20-40 Norelco Drive, $2,726,588 $ 4.43 $ 924,789 One 5 Yr
83 Signet Drive $ 28,862 $ 6.33
$ 9,369 $ 3.17
$ 8,832 $ 4.43
2 Fieldway Road $ 738,966 $ 4.43 $ 564,715 One 5 Yr
$ 47,689 $ 6.33
$ 5,125 $ 3.17
$ 7,299 $ 6.33
$ 691 $ 4.43
100 Dundas Street $1,288,264 $ 4.43 $ 951,266 One 5 Yr
$ 40,801 $ 3.17 One 5 Yr
$ 21,347 $12.66 None
$ 9,825 $ 6.65
$ 486 $ 5.06
$ 7,779 $ 5.06 One 2 Yr
$ 3,408 $ 5.06 One 2 Yr
$ 2,706 $ 5.70 None
$ 31,010 $16.46 One 5 Yr
449 Princess $ 201,288 $ 4.43 $ 55,170 One 5 Yr
Street(3) $ 851 $ 3.17 One 5 Yr
66 Bay Street $ 489,238 $ 4.43 $ 209,414 One 5 Yr
South(3) $ 48,246 $ 6.33 One 5 Yr
$ 1,557 $ 3.17 One 5 Yr
$ 1,215 $ 4.43
---------- ----------
Total/Average $5,721,442 $2,705,354
- ---------------
(1) CBD means central business district.
(2) Certain operating expenses are reimbursed by tenants at rates ranging up to
15% above actual cost.
(3) Under contract for sale upon lease expiration in April 2003.
All monetary amounts are in U.S. dollars based on the December 31, 2002 Canadian
dollar to U.S. dollar exchange rate of 1.5796.
59
The following schedule represents the leases expiring over the next 10
years for the Bell Canada portfolio as of December 31, 2002.
SCHEDULE OF LEASE EXPIRATIONS
BELL CANADA PORTFOLIO
% OF GROSS ANNUAL
NUMBER OF TENANTS SQUARE FEET OF ANNUAL RENT OF RENT REPRESENTED
YEAR LEASE EXPIRING EXPIRING LEASES* EXPIRING LEASES** BY EXPIRING LEASES
- ---- ----------------- ---------------- ----------------- ------------------
2003 8 166,687 $753,584 13.17%
2004 4 177,058 $799,080 13.97%
2005 1 96 $486 0.01%
2006 4 305,230 $1,339,582 23.41%
2007 5 625,261 $2,776,357 48.53%
2008 0 0 $0 0.00%
2009 0 0 $0 0.00%
2010 1 1,884 $31,010 0.54%
2047 1 1,686 $21,343 0.37%
- ---------------
* 2003 includes 164,478 square feet expiring in properties which are under
contract to be sold upon lease expiration in April 2003.
** Monetary amount is in U.S. dollars based on a Canadian dollar to U.S. dollar
exchange rate of 1.5796 as of December 31, 2002.
LIV Portfolio. As of December 31, 2002, we own eight office and industrial
properties in Belgium leased primarily to government or quasi-governmental
entities, referred to as the LIV portfolio. The total net rentable area of the
portfolio is approximately 456,000 square feet and the current annual rent is
approximately $6.0 million.
The LIV portfolio is financed with a loan from a commercial bank in
Belgium, $63.0 million of which was outstanding as of December 31, 2002. The
loan bears interest at a rate equal to 5.32% and matures in November 2006.
60
The following table sets forth certain information with respect to the LIV
portfolio as of December 31, 2002:
LIV PORTFOLIO
NET
STATE/ RENTABLE YEAR BUILT/ OWNERSHIP
PROPERTY ADDRESS CITY/SUBMARKET PROVINCE SQUARE FEET RENOVATED % USE
- ---------------- ---------------- -------- ----------- -------------- --------- ---------
54 Gossetlaan Groot-Bijgaarden Belgium 81,763 1994 100% Office
325 Leuvensesteenweg Zaventum Belgium 65,175 1975/1990 100% Office
15-17 Rue Belliard Brussels Belgium 28,180 1974/1996 100% Office
159 Dreve Richelle Waterloo Belgium 46,231 1930/1990 100% Office
4 Rue de la Science Brussels Belgium 26,651 1952/1993/1998 100% Office
4-6 Rue Belliard Brussels Belgium 32,206 1987/2001 100% Office
5 Hoge Wei Zaventum Belgium 55,606 1986 100% Warehouse
10 Rue Guimard Brussels Belgium 119,781 1973/1995 100% Office
-------
Total/Average 455,593
% OF
TOTAL
SQUARE TENANT NET LEASE LEASE
FOOTAGE RENTABLE START EXP
PROPERTY ADDRESS TENANT LEASED SQUARE FEET DATE DATE
- ---------------- ---------------------------- ------- ----------- -------- --------
54 Gossetlaan Lucent 27.95% 22,852 12/1/98 4/30/11
Wella 14.96% 12,228 1/1/99 12/31/07
United Biscuits 13.95% 11,410 3/1/99 2/28/08
Job @ 10.02% 8,191 7/1/00 6/30/09
325 Leuvensesteenweg Space Applic. Services 7.27% 4,736 8/15/93 8/14/11
K & L 4.38% 2,852 10/1/97 9/30/06
Integri 14.93% 9,730 4/1/98 3/31/07
Euro Business 2.89% 1,884 6/1/99 5/31/08
Elsevier 23.32% 15,199 6/1/99 5/31/08
Aprico 7.27% 4,736 3/1/00 2/28/09
Secproof 1.90% 1,238 1/1/01 12/31/09
Quality Infor 4.57% 2,982 3/1/01 2/28/10
15-17 Rue Belliard Foratom 18.87% 5,318 6/1/97 5/31/06
Foratom 10.73% 3,025 6/1/99 5/31/08
Alliance for Beverages 10.73% 3,025 2/1/00 1/31/09
Czech Trade Promotion Agency 4.39% 1,238 12/1/00 11/30/09
C.V.N 10.73% 3,025 9/1/01 8/31/10
159 Dreve Richelle CBC Banque 4.66% 2,153 11/1/93 10/31/11
Battersby Chung 1.70% 786 7/1/96 6/30/05
Europay 91.01% 42,075 1/1/00 12/31/07
Lunch Time 2.63% 1,217 5/1/00 4/30/09
4 Rue de la Science Swedish & Finnish Ass. 13.81% 3,681 8/15/95 8/14/04
Vedior Interim 11.03% 2,939 6/1/96 5/31/05
Local Government 19.91% 5,307 1/1/00 12/31/08
Denmark
Government of Belgium 55.25% 14,724 4/1/01 03/31/10
4-6 Rue Belliard Nouvelle Entreprise Stragier 28.7% 9,235 04/01/02 03/31/11
5 Hoge Wei Noortman/UPS Logistics 100% 55,606 7/1/00 6/30/09
10 Rue Guimard European Commission 100% 119,781 10/1/95 9/30/07
----- -------
Total/Average 81.47% 371,173
ANNUAL
CURRENT REAL
ANNUAL RENT PER ESTATE
PROPERTY ADDRESS RENT SQUARE FOOT TAXES
- ---------------- ---------- ----------- --------
54 Gossetlaan $ 312,782 $13.69 $ 51,724
$ 173,627 $14.20
$ 167,802 $14.71
$ 104,160 $12.72
325 Leuvensesteenweg $ 50,419 $10.65 $ 30,034
$ 29,858 $10.47
$ 106,791 $10.98
$ 23,024 $12.22
$ 173,868 $11.44
$ 55,007 $11.61
$ 13,833 $11.18
$ 31,589 $10.59
15-17 Rue Belliard $ 69,413 $13.05
$ 38,087 $12.59 $ 74,619
$ 36,936 $12.21
$ 17,071 $13.79
$ 35,202 $11.64
159 Dreve Richelle $ 42,383 $19.69
$ 10,513 $13.38 $ 53,161
$ 552,051 $13.12
$ 28,997 $23.83
4 Rue de la Science $ 61,352 $16.67
$ 32,772 $11.15 $ 54,295
$ 73,443 $13.84
$ 233,442 $15.85
4-6 Rue Belliard $ 105,741 $11.45 $ 85,760
5 Hoge Wei $ 282,772 $ 5.09 $ 16,308
10 Rue Guimard $3,171,793 $26.48 $405,456
---------- --------
Total/Average $6,034,728 $771,357
- ---------------
All monetary amounts are in U.S. dollars based on the December 31, 2002 Euro to
U.S. dollars exchange rate of 0.95202
61
The following schedule represents the leases expiring over the next 10
years for the LIV portfolio as of December 31, 2002.
SCHEDULE OF LEASE EXPIRATIONS
LIV PORTFOLIO
% OF GROSS ANNUAL
NUMBER OF TENANTS SQUARE FEET OF ANNUAL RENT OF RENT REPRESENTED
YEAR LEASE EXPIRING EXPIRING LEASES EXPIRING LEASES* BY EXPIRING LEASES
- ---- ----------------- --------------- ---------------- ------------------
2003........................... 0 0 $0 0.00%
2004........................... 1 3,681 $61,352 1.02%
2005........................... 2 3,725 $43,286 0.72%
2006........................... 2 8,170 $99,270 1.64%
2007........................... 4 183,816 $4,004,261 66.35%
2008........................... 5 36,824 $476,224 7.89%
2009........................... 7 75,251 $538,777 8.93%
2010........................... 3 20,730 $300,233 4.98%
2011........................... 4 38,976 $511,325 8.47%
- ---------------
* Monetary amount is in U.S. dollars based on Euro to U.S. dollars exchange rate
of 0.95202 as of December 31, 2002.
MORTGAGE LOANS
In November 2002, we purchased a portfolio of approximately 1,200
residential mortgage loans, secured by first priority liens on properties
located primarily in the central and southeastern regions of the U.S. The
purchase price of the portfolio aggregated approximately $259.7 million plus
accrued interest and was initially 95% financed pursuant to a repurchase
agreement. The following table sets forth certain information with respect to
our mortgage loan portfolio and repurchase agreement at December 31, 2002
(dollars in thousands):
LOAN PORTFOLIO
WEIGHTED
UNPAID AVG.
LOAN PRINCIPAL CARRYING EFFECTIVE RANGE OF STATED
COUNT BALANCE AMOUNT RATE MATURITY DATES
----- --------- -------- -------------- ---------------
Agency eligible loans..... 914 $160,489 $163,416 3.31% 9/2027-11/2032
Jumbo/Non-agency loans.... 292 93,712 94,782 3.56% 10/2027-11/2032
----- -------- -------- ----
1,206 $254,201 $258,198 3.40%
REPURCHASE AGREEMENT
WEIGHTED
UNPAID AVG.
PRINCIPAL CARRYING EFFECTIVE MATURITY
BALANCE AMOUNT RATE DATES
--------- -------- -------------- --------------
Agency eligible loans.................. $156,615 $156,615 1.78% 5/2003
Jumbo/Non-agency loans................. 90,097 90,097 1.83% 5/2003
-------- -------- ----
$246,712 $246,712 1.80%
In February 2003, we sold our entire position in agency eligible
residential mortgage loans (a portion of our mortgage loan portfolio) with an
aggregate unpaid principal balance of approximately $159.0 million
62
for gross proceeds of approximately $162.6 million at a gain of approximately
$0.7 million. As a result of the sale, the existing repurchase agreement
allocated to the agency eligible loans was satisfied for approximately $153.9
million. Simultaneously, approximately $207.4 million of non-agency/jumbo
residential mortgage loans were purchased for a price of approximately $210.2
million. In connection with this purchase, the outstanding balance of the
existing repurchase agreement was increased by a net of $45.9 million, after the
repayment described above.
RATINGS
The following are the explanations of the ratings provided by Standard and
Poor's and Moody's. Ratings of BBB- and Baa3 and above are considered investment
grade.
STANDARD AND POOR'S RATINGS:
AAA: The highest rating assigned by Standard & Poor's. The obligor's
capacity to meet its financial commitment on the obligation is extremely strong.
AA: Differs from the highest rated obligations only in small degree. The
obligor's capacity to meet its financial commitment on the obligation is very
strong.
A: Somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than obligations in higher rated
categories. However, the obligor's capacity to meet its financial commitment on
the obligation is still strong.
BBB: Exhibits adequate protection parameters. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation.
BB: Less vulnerable to nonpayment than other speculative issues. However,
it faces major ongoing uncertainties or exposure to adverse business, financial,
or economic conditions which could lead to the obligor's inadequate capacity to
meet its financial commitment on the obligation.
PLUS (+) OR MINUS (-): Shows relative standing within the major rating
categories.
MOODY'S RATINGS:
AAA: Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
AA: Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high-grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risk appear somewhat larger than the Aaa securities.
A: Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper-medium-grade obligations. Factors giving
security to principal and interest are considered adequate, but elements may be
present which suggest a susceptibility to impairment some time in the future.
BAA: Bonds which are rated Baa are considered as medium-grade obligations
(i.e., they are neither highly protected nor poorly secured). Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
63
BA: Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well-assured. Often the protection of
interest and principal payments may be very moderate, and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
B: Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranging; and the modifier 3 indicates a ranking in the lower end of
that generic rating category.
POLICIES WITH RESPECT TO CERTAIN OTHER ACTIVITIES
If our board of directors determines that additional funding is required,
we may raise such funds through additional equity offerings, debt financing,
retention of cash flow (subject to provisions in the Internal Revenue Code
concerning taxability of undistributed REIT taxable income) or a combination of
these methods.
In the event that our board of directors determines to raise additional
equity capital, it has the authority, without stockholder approval, to issue
additional common stock or preferred stock in any manner and on such terms and
for such consideration it deems appropriate, including in exchange for property.
Borrowings may be in the form of bank borrowings, secured or unsecured, and
publicly or privately placed debt instruments, purchase money obligations to the
sellers of assets, long-term, tax-exempt bonds or other publicly or privately
placed debt instruments, financing from banks, institutional investors or other
lenders, securitizations, including CBOs, any of which indebtedness may be
unsecured or may be secured by mortgages or other interests in the asset. Such
indebtedness may be recourse to all or any part of our assets or may be limited
to the particular asset to which the indebtedness relates.
We have authority to offer our common stock or other equity or debt
securities in exchange for property and to repurchase or otherwise reacquire our
shares or any other securities and may engage in such activities in the future.
We also may make loans to our subsidiaries. Although we have no current
intention of doing so, we may repurchase or otherwise reacquire our shares or
other securities.
Subject to the percentage ownership limitations and gross income and asset
tests necessary for REIT qualification, we may invest in securities of other
REITs, other entities engaged in real estate activities or securities of other
issuers, including for the purpose of exercising control over such entities.
We may engage in the purchase and sale of investments. We do not underwrite
the securities of other issuers.
Our officers and directors may change any of these policies without a vote
of our stockholders.
COMPETITION
We are subject to significant competition in seeking investments. We
compete with several other companies for investments, including other REITs,
insurance companies and other investors. Some of our competitors have greater
resources than we do and we may not be able to compete successfully for
investments.
COMPLIANCE WITH THE AMERICANS WITH DISABILITIES ACT OF 1990
Our properties are required to meet federal requirements related to access
and use by disabled persons as a result of the Americans with Disabilities Act
of 1990. In addition, a number of additional federal, state and local laws may
require modifications to any properties we purchase, or may restrict further
64
renovations thereof, with respect to access by disabled persons. Noncompliance
with these laws or regulations could result in the imposition of fines or an
award of damages to private litigants. Additional legislation could impose
additional financial obligations or restrictions with respect to access by
disabled persons. If required changes involve greater expenditures than we
currently anticipate, or if the changes must be made on a more accelerated
basis, our ability to make expected distributions could be adversely affected.
COMPLIANCE WITH FEDERAL, STATE AND LOCAL ENVIRONMENTAL LAWS
Our properties are subject to various federal, state and local
environmental laws, ordinances and regulations. Under these laws, ordinances and
regulations, a current or previous owner of real estate (including, in certain
circumstances, a secured lender that succeeds to ownership or control of a
property) may become liable for the costs of removal or remediation of certain
hazardous or toxic substances or petroleum product releases at, on, under or in
its property. These laws typically impose cleanup responsibility and liability
without regard to whether the owner or control party knew of or was responsible
for the release or presence of the hazardous or toxic substances. The costs of
investigation, remediation or removal of these substances may be substantial and
could exceed the value of the property. An owner or control party of a site may
be subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from a site. Certain
environmental laws also impose liability in connection with the handling of or
exposure to asbestos-containing materials, pursuant to which third parties may
seek recovery from owners of real properties for personal injuries associated
with asbestos-containing materials. Our operating costs and values of these
assets may be adversely affected by the obligation to pay for the cost of
complying with existing environmental laws, ordinances and regulations, as well
as the cost of complying with future legislation, and our income and ability to
make distributions to our stockholders could be affected adversely by the
existence of an environmental liability with respect to our properties. We
endeavor to ensure our properties are in compliance in all material respects
with all Federal, state and local laws, ordinances and regulations regarding
hazardous or toxic substances or petroleum products.
EMPLOYEES
We have entered into a management agreement with Fortress Investment Group
LLC pursuant to which they advise us regarding investments, portfolio
management, and other aspects of our business, and manage our day-to-day
operations. As a result, we have no employees. The employees of Fortress
Investment Group LLC are not a party to any collective bargaining agreement.
LEGAL PROCEEDINGS
We are not a party to any material legal proceedings.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in interest
rates, credit spreads, foreign currency exchange rates, commodity prices and
equity prices. The primary market risks that we are exposed to are interest rate
risk and foreign currency exchange rate risk. Interest rate risk and foreign
currency exchange rate risk are highly sensitive to many factors, including
governmental monetary and tax policies, domestic and international economic and
political considerations and other factors beyond our control. All of our market
risk sensitive assets, liabilities and related derivative positions are for
non-trading purposes only.
Interest Rate Exposure
Our primary interest rate exposures relate to our loans, mortgage backed
securities and variable-rate debt, as well as our interest rate swaps and caps.
Changes in the general level of interest rates can effect our net interest
income, which is the difference between the interest income earned on
interest-earning
65
assets and the interest expense incurred in connection with our interest-bearing
liabilities. Changes in the level of interest rates also can effect, among other
things, our ability to originate and acquire loans and securities, the value of
our loans and securities, and our ability to realize gains from the settlement
of such assets.
While we have not experienced any significant credit losses, in the event
of a significant rising interest rate environment and/or economic downturn,
mortgage and loan defaults may increase and result in credit losses that would
adversely affect our liquidity and operating results.
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 our control. Our general financing strategy
focuses on the use of match-funded financing structures. This means that we seek
to match the maturities of our financial obligations with the maturities of our
investments to minimize the risk that we have to refinance our liabilities prior
to the maturities of our assets, and to reduce the impact of changing interest
rates on earnings. In addition, we generally match-fund interest rates with
like-kind debt (i.e., fixed-rate assets are financed with fixed-rate debt and
floating-rate assets are financed with floating-rate debt), directly or through
the use of interest rate swaps, caps, or other financial instruments, or through
a combination of these strategies.
Interest rate swaps are agreements in which a series of interest rate flows
are exchanged with a third party (counterparty) over a prescribed period. The
notional amount on which swaps are based is not exchanged. In general, our swaps
are "pay fixed" swaps involving the exchange of variable-rate interest payments
from the counterparty for fixed interest payments from us. This can effectively
convert a variable-rate obligation into a fixed-rate obligation.
Similarly, an interest rate cap or floor agreement is a contract in which
we purchase a cap or floor contract on a notional face amount. We will make an
up-front payment to the counterparty for which the counterparty agrees to make
future payments to us 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. Should the reference rate rise above the
contractual strike rate in a cap, we will earn cap income; should the reference
rate fall below the contractual strike rate in a floor, we will earn floor
income. Payments on an annualized basis will equal the contractual notional face
amount multiplied by the difference between the actual reference rate and the
contracted strike rate.
While a REIT may utilize these types of derivative instruments to hedge
interest rate risk on its liabilities or for other purposes, such derivative
instruments could generate income that is not qualified income for purposes of
maintaining REIT status. As a consequence, we may only engage in such
instruments to hedge such risks within the constraints of maintaining our
standing as a REIT. We do not enter into derivative contracts for speculative
purposes nor as a hedge against changes in credit risk.
The above strategies are specifically designed to reduce our exposure, on
specific transactions or on a portfolio basis, to changes in cash flows as a
result of interest rate movements in the market. In this regard, we utilize
securitization structures, particularly CBOs, as well as other match-funded
financing structures. Our financing strategy is dependent on our ability to
place the match-funded debt we create in the market at spreads that provide a
positive arbitrage. If spreads for CBO liabilities widen or if demand for such
liabilities ceases to exist, then our ability to execute future CBO transactions
will be severely restricted.
While our strategy is to utilize interest rate swaps, caps and match-funded
financings in order to limit the effects of changes in interest rates on our
operations, there can be no assurance that our profitability will not be
adversely affected during any period as a result of changing interest rates. As
of December 31, 2002, a 100 basis point change in short term interest rates
would effect our earnings by no more than $1.9 million per annum.
Our hedging transactions using derivative instruments also involve certain
additional risks such as counterparty credit risk, the 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. The counterparties
66
to our derivative arrangements are major financial institutions with high credit
ratings with which we and our affiliates may also have other financial
relationships. As a result, we do not anticipate that any of these
counterparties will fail to meet their obligations. There can be no assurance
that we will be able to adequately protect against the foregoing risks and will
ultimately realize an economic benefit that exceeds the related amounts incurred
in connection with engaging in such hedging strategies.
Interest rate changes may also impact our net book value as our securities
and related hedge derivatives are marked-to-market each quarter. Generally, as
interest rates increase, the value of our fixed income securities, such as
commercial mortgage backed securities, decreases and as interest rates decrease,
the value of such securities will increase. We seek to hedge changes in value
attributable to changes in interest rates by entering into interest rate swaps
and other derivative instruments. In general, we would expect that over time,
decreases in value of our securities portfolio attributable to interest rate
changes will be offset to some degree by increases in value of our swaps, and
vice versa. However, the relationship between spreads on securities and spreads
on swaps may vary from time to time, resulting in a net aggregate book value
increase or decline. Our securities portfolio is largely financed to maturity
through long term, collateralized debt obligations that are not callable as a
result of book value changes. Accordingly, unless there is a material impairment
in value that would result in a payment not being received on a security,
changes in the book value of our portfolio will not directly affect our
recurring earnings or our ability to pay a dividend.
Credit Spread Curve Exposure
Our real estate securities are also subject to spread risk. The majority of
such securities are fixed rate securities valued based on a market credit spread
to U.S. Treasuries. In other words, their value is dependent on the yield
demanded on such securities by the market based on their credit relative to U.S.
Treasuries. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher (or "wider") spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our securities portfolio would tend to
decline. Conversely, if the spread used to value such securities were to
decrease (or "tighten"), the value of our securities portfolio would tend to
increase. Such changes in the market value of our portfolio may effect our net
equity, net income or cash flow directly through their impact on unrealized
gains or losses on available-for-sale securities, and therefore our ability to
realize gains on such securities, or indirectly through their impact on our
ability to borrow and access capital.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the
market's expectations of future interest rates, would also effect the yield
required on our securities and therefore their value. This would have similar
effects on our portfolio and our financial position and operations as a change
in spreads would.
As of December 31, 2002, a 25 basis point movement in credit spreads would
impact our net book value by approximately $13.2 million.
Currency Rate Exposure
Our primary foreign currency exchange rate exposures relate to our real
estate leases and assets. Our principal direct currency exposures are to the
Euro and the Canadian Dollar. Changes in the currency rates can adversely impact
the fair values and earnings streams of our international holdings. We have
attempted to mitigate this impact in part by utilizing local
currency-denominated financing on our foreign investments to partially hedge, in
effect, these assets.
We have material investments in a portfolio of Belgian properties, the LIV
portfolio, and a portfolio of Canadian properties, the Bell Canada portfolio.
These properties are financed utilizing debt instruments denominated in their
respective local currencies (the Euro and the Canadian Dollar). The net equity
invested in these portfolios, approximately $8.1 million and $18.3 million,
respectively, at December 31, 2002, is exposed to foreign currency exchange
risk.
67
Fair Values
For certain of our financial instruments, fair values are not readily
available since there are no active trading markets as characterized by current
exchanges between willing parties. Accordingly, fair values can only be derived
or estimated for these investments using various valuation techniques, such as
computing the present value of estimated future cash flows using discount rates
commensurate with the risks involved. However, the determination of estimated
future cash flows is inherently subjective and imprecise. We note that minor
changes in assumptions or estimation methodologies can have a material effect on
these derived or estimated fair values, and that the fair values reflected below
are indicative of the interest rate and currency rate environments as of
December 31, 2002 and do not take into consideration the effects of subsequent
interest rate or currency rate fluctuations.
We note that the values of our investments in real estate securities, and
in derivative instruments, primarily interest rate hedges on our debt, are
sensitive to changes in market interest rates, interest rate spreads, credit
spreads and other market factors. The value of these investments can vary, and
has varied, materially from period to period. Historically, the values of our
real estate securities have tended to vary inversely with those of our
derivative instruments. We held the following interest rate risk sensitive
instruments at December 31, 2002 (unaudited) (dollars in thousands):
PRINCIPAL WEIGHTED
BALANCE OR AVERAGE
CARRYING NOTIONAL EFFECTIVE MATURITY
AMOUNT AMOUNT INTEREST RATE DATE OTHER TERMS FAIR VALUE
-------- ---------- ------------- -------- ----------- ----------
Assets:
Real estate
securities,
available for
sale(A)............ $1,069,892 $1,028,150 8.14% Various Various (mixed floating $1,069,892
and fixed rates,
amortizing and interest
only)
CBO III deposit(B)... 37,777 (B) (B) (B) (B) 37,777
Marketable
securities,
available for
sale(C)............ 11,209 23,953 16.34% (C) (C) 11,209
Mortgage loans(D).... 258,198 254,201 3.40% Various Various (all floating 258,198
rate)
Interest rate caps,
treated as hedges,
net(E)............. 4,638 213,035 N/A (E) (E) 4,638
Liabilities:
CBO bonds
payable(F)......... 868,497 881,500 3.73% (F) Amortizes principal 892,117
based on collateral
payments, subject to
reinvestment
Other bonds
payable(G)......... 37,389 38,173 7.07% Apr-12 Amortizes principal 36,784
with a balloon payment
at maturity
Notes payable(G)..... 62,952 62,952 5.32% Nov-06 Amortizes principal 58,970
with a balloon payment
at maturity
Repurchase
agreements(H)...... 248,169 248,169 1.81% Short-term Interest only 248,169
Interest rate swaps,
treated as hedges,
net(I)............. 51,110 437,465 N/A (I) (I) 51,110
Non-hedge derivative
obligations(J)..... 745 (J) N/A (J) (J) 745
- ---------------
(A) These securities serve as collateral for our CBO transactions. The fair
value of these securities is estimated by obtaining third party independent
broker quotations, if available and practicable, or counterparty quotations.
68
(B) The CBO III deposit was valued based on a counterparty quotation. See
"Management's Discussion and Analysis of Pro Forma Financial Condition and
Results of Operations-Liquidity and Capital Resources" for a further
discussion of the CBO III deposit.
(C) These three securities with carrying amounts of $3.9 million, $3.3 million
and $4.0 million, respectively, mature in November 2007, August 2030 and
November 2017, respectively. The former two represent subordinate and
residual interests in securitizations; the latter represents a CMBS
security. The fair values of the former two securities, for which quoted
market prices are not readily available, are estimated by means of a
price/yield analysis based on our expected disposition strategies for such
assets. The fair value of the latter security was obtained from independent
third party broker quotations.
(D) This portfolio of mortgage loans bears a floating rate of interest. We
believe that for similar financial investments with comparable credit risks,
the effective rate on this portfolio approximates the market rate.
Accordingly, the carrying amount of this portfolio is believed to
approximate fair value.
(E) These two agreements have notional balances of $195.0 million and $18.0
million, respectively, mature in March 2009 and October 2015, respectively,
and cap 1-month LIBOR at 6.50% and 3-month LIBOR at 8.00%, respectively. The
fair value of these agreements is estimated by obtaining counterparty
quotations.
(F) For those bonds bearing floating rates at spreads over market indices,
representing approximately $710.7 million of the carrying amount of the CBO
bonds payable, we believe that for similar financial instruments with
comparable credit risks, the effective rates approximate market rates.
Accordingly, the carrying amount outstanding on these bonds is believed to
approximate fair value. For those bonds bearing fixed interest rates, values
were obtained by discounting expected future payments by a rate calculated
by imputing a spread over a market index on the date of borrowing. The
weighted average stated maturity of the CBO bonds payable is September 2035.
(G) The Bell Canada Securitization and Belgian Mortgage were valued by
discounting expected future payments by a rate calculated by imputing a
spread over a market index on the date of borrowing.
(H) These agreements bear floating rates of interest and we believe that for
similar financial instruments with comparable credit risks, the effective
rates approximate market rates. Accordingly, the carrying amounts
outstanding are believed to approximate fair value.
(I) These two agreements have notional balances of $147.5 million and $290.0
million, respectively, mature in July 2005 and April 2011, respectively,
and swap 1-month LIBOR for 6.1755% and 3-month LIBOR for 5.93%,
respectively. The fair value of these agreements is estimated by obtaining
counterparty quotations.
(J) These are two essentially offsetting interest rate caps and two essentially
offsetting interest rate swaps, each with notional amounts of $32.5
million, an interest rate cap with a notional balance of $17.5 million, and
an interest rate cap with a notional balance of approximately $61.6
million. The maturity date of the purchased swap is July 2009; the maturity
date of the sold swap is July 2014, the maturity date of the $32.5 million
caps is July 2038, the maturity date of the $17.5 million cap is July 2009,
and the maturity date of the $61.6 million cap is August 2004. They have
been valued by reference to counterparty quotations.
69
We held the following currency rate risk sensitive balances at December 31,
2002 (unaudited):
CURRENT EFFECT OF A EFFECT OF A
CARRYING EXCHANGE 5% NEGATIVE 5% NEGATIVE
AMOUNT LOCAL RATE TO CHANGE IN CHANGE IN
(USD) CURRENCY USD EURO RATE CAD RATE
-------- -------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT EXCHANGE RATES)
Assets:
LIV portfolio......................... $67,852 Euro 0.95311 $(3,392) N/A
Bell Canada portfolio................. 49,271 CAD 1.57180 N/A $(2,464)
LIV other, net........................ 3,157 Euro 0.95311 (158) N/A
Bell Canada other, net................ 6,456 CAD 1.57180 N/A (323)
Liabilities:
LIV mortgage.......................... 62,952 Euro 0.95311 3,148 N/A
Bell Canada bonds..................... 37,389 CAD 1.57180 N/A 1,869
------- -------
Total................................. $(402) $(918)
======= =======
- ---------------
USD refers to U.S. dollars; CAD refers to Canadian dollars
70
FORTRESS INVESTMENT GROUP AND OUR MANAGEMENT AGREEMENT
FORTRESS INVESTMENT GROUP LLC
Fortress Investment Group LLC is a global alternative investment and asset
management firm with over $3 billion in equity capital currently under
management. Fortress was founded in 1998 by a group of senior professionals led
by Wesley R. Edens. Today, the principals of Fortress include Mr. Edens, Peter
L. Briger, Jr., Robert I. Kauffman, Randal A. Nardone, Michael E. Novogratz and
Erik P. Nygaard. Fortress is headquartered in New York, with offices in London
and Rome. Fortress employs approximately 100 people worldwide in three
alternative investment businesses: private equity, real estate securities and
hedge funds.
Our manager's principals have an average of more than 15 years of
experience in the fields of real estate investing and finance, private equity
investment, capital markets, transaction structuring and risk management with
respect to both dollar and non-dollar denominated investments. The founding
professionals of our manager, Wesley R. Edens, Robert I. Kauffman, Randal A.
Nardone, and Erik P. Nygaard, have worked together for more than 15 years. Over
the last six years, the principals of our manager have managed the acquisition
of over $20 billion of real estate-related assets and the issuance of over $11
billion of real estate securities. At December 31, 2002, our manager and its
principals had options to purchase 700,000 shares of our common stock and owned
approximately 16.4% of the equity of Newcastle Investment Holdings (25.8% upon
exercise of outstanding options to purchase shares of Newcastle Investment
Holdings). As a result, Fortress Investment Group and its principals has a total
beneficial ownership in our common stock of approximately 20.5%, taking into
account interests in Newcastle Investment Holdings and exercise of all of their
options. Our manager is entitled to receive an annual base management fee from
us and may receive incentive compensation based on certain performance criteria.
Our manager continues to manage Newcastle Investment Holdings and also
manages and invests in other entities that invest in real estate and other
assets.
The executive offices of Fortress Investment Group are located at 1251
Avenue of the Americas, New York, New York 10020 and the telephone number of its
executive offices is (212) 798-6100.
PRINCIPALS OF FORTRESS INVESTMENT GROUP
The principals of Fortress include Messrs. Edens, Briger, Kauffman,
Nardone, Novogratz and Nygaard. The following table sets forth certain
information with respect to the principals of our manager. Certain principals
and officers of our manager also serve as our executive officers.
WESLEY R. EDENS has been our Chief Executive Officer and the Chairman of
our board of directors since inception. Mr. Edens co-founded our manager and is
its Chief Executive Officer. Mr. Edens was previously a Managing Director of
Union Bank of Switzerland from May 1997 to May 1998. Prior to joining Union Bank
of Switzerland, Mr. Edens was a partner and Managing Director of BlackRock
Financial Management, Inc. In addition, Mr. Edens was formerly a partner and
Managing Director of Lehman Brothers, where he was head of the Non-Agency
Mortgage Trading Desk. Mr. Edens received a B.S. degree in Business
Administration from Oregon State University. Mr. Edens has been Chief Executive
Officer, President and Chairman of the board of directors of Capstead Mortgage
Corporation since April 2000.
PETER L. BRIGER, JR. has been Senior Managing Director of our manager since
March 2002. Mr. Briger was previously with Goldman, Sachs & Co. from 1986 to
2002, and a partner from 1996 to 2002 and worked for fifteen years, where he
held the positions of co-head of the Global Whole Loan Sales and Trading
Business, co-head of the Fixed-Income Principal Investments Group, co-head of
the Asian Distressed Debt Business, co-head of the Goldman Sachs Special
Opportunities (Asia) Fund and co-head of the Asian Real Estate Private Equity
business. In addition, Mr. Briger was a member of the Goldman Sachs Global
Control and Compliance Committee, a member of the Goldman Sachs Asian Management
71
Committee and a member of the Goldman Sachs Japan Executive Committee. Mr.
Briger received a B.A. from Princeton University and an M.B.A. from The Wharton
School of Business.
ROBERT I. KAUFFMAN has been President of our manager since inception. Mr.
Kauffman co-founded our manager and has been the President of our manager since
inception. Mr. Kauffman was previously a Managing Director of Union Bank of
Switzerland from May 1997 to May 1998. Prior to joining Union Bank of
Switzerland in 1997, Mr. Kauffman was a principal of BlackRock Financial
Management, Inc. Prior to joining BlackRock, Mr. Kauffman was an Executive
Director of Lehman Brothers International in London from December 1992. Mr.
Kauffman received a B.S. degree in Business Administration from Northeastern
University.
RANDAL A. NARDONE has been our Secretary since inception. Mr. Nardone
co-founded our manager and has been Chief Operating Officer of our manager since
inception. Mr. Nardone was previously a Managing Director of Union Bank of
Switzerland from May 1997 to May 1998. Prior to joining Union Bank of
Switzerland in 1997, Mr. Nardone was a principal of BlackRock Financial
Management, Inc. Prior to joining BlackRock, Mr. Nardone was a partner and a
member of the executive committee at the law firm of Thacher Proffitt & Wood.
Mr. Nardone joined Thacher Proffitt & Wood in 1980 and became head of its
structured finance group in 1993. Mr. Nardone received a B.A. degree in English
and Biology from the University of Connecticut and a J.D. degree from the Boston
University School of Law.
MICHAEL E. NOVOGRATZ has been Senior Managing Director of our manager since
March 2002. Prior to joining Fortress, Mr. Novogratz spent 11 years at Goldman,
Sachs & Co., where he became a partner in 1998. Mr. Novogratz held the positions
of president of Goldman Sachs Latin America and head of Fixed Income, Currencies
and Commodities Risk in Asia. Mr. Novogratz received a B.A. from Princeton
University.
ERIK P. NYGAARD has been our Chief Information Officer since our inception
and Chief Information Officer of our manager since inception. Mr. Nygaard
co-founded our manager with Messrs. Edens, Kauffman and Nardone. Mr. Nygaard was
previously a Managing Director of Union Bank of Switzerland from May 1997 to May
1998. Prior to joining Union Bank of Switzerland, Mr. Nygaard was a principal of
BlackRock Financial Management, Inc. From April 1990 to July 1994, Mr. Nygaard
was a Director at Nomura Securities International. Mr. Nygaard received a B.S.
degree in Electrical Engineering and Computer Science from the Massachusetts
Institute of Technology.
THE MANAGEMENT AGREEMENT
We are party to a management agreement with Fortress Investment Group,
dated as of June 6, 2002, as amended on March 4, 2003, pursuant to which
Fortress Investment Group, our manager, provides for the day-to-day management
of our operations.
The management agreement requires our manager to manage our business
affairs in conformity with the policies and the investment guidelines that are
approved and monitored by our board of directors. Our manager's management is
under the direction of our board of directors. The manager is responsible for
(i) the purchase and sale of real estate securities and other real
estate-related assets, (ii) management of our real estate, including arranging
for purchases, sales, leases, maintenance and insurance, (iii) the purchase,
sale and servicing of mortgages for us, and (iv) investment advisory services.
Our manager is responsible for our day-to-day operations and performs (or causes
to be performed) such services and activities relating to our assets and
operations as may be appropriate, including, without limitation, the following:
(i) serving as our consultant with respect to the periodic review of
the investment criteria and parameters for our investments, borrowings and
operations for the approval of our board of directors;
(ii) investigating, analyzing and selecting possible investment
opportunities;
(iii) conducting negotiations with real estate brokers, sellers and
purchasers and their agents and representatives, investment bankers and
owners of privately and publicly held real estate companies;
72
(iv) engaging and supervising, on our behalf and at our expense,
independent contractors which provide real estate brokerage, investment
banking and leasing services, mortgage brokerage, securities brokerage and
other financial services and such other services as may be required
relating to our investments;
(v) negotiating on our behalf for the sale, exchange or other
disposition of any of our investments;
(vi) coordinating and managing operations of any joint venture or
co-investment interests held by us and conducting all matters with any
joint venture or co-investment partners;
(vii) coordinating and supervising, on our behalf and at our expense,
all property managers, leasing agents and developers for the
administration, leasing, management and/or development of any of our
investments;
(viii) providing executive and administrative personnel, office space
and office services required in rendering services to us;
(ix) administering our day-to-day operations and performing and
supervising the performance of such other administrative functions
necessary to our management as may be agreed upon by our manager and the
board of directors, including the collection of revenues and the payment of
our debts and obligations and maintenance of appropriate computer services
to perform such administrative functions;
(x) communicating on our behalf with the holders of any of our equity
or debt securities as required to satisfy the reporting and other
requirements of any governmental bodies or agencies or trading markets and
to maintain effective relations with such holders;
(xi) counseling us in connection with policy decisions to be made by
our board of directors;
(xii) evaluating and recommending to our board of directors
modifications to the hedging strategies in effect and engaging in overall
hedging strategies, engaging in hedging activities on our behalf,
consistent with our status as a REIT and with the investment guidelines;
(xiii) counseling us regarding the maintenance of our status as a REIT
and monitoring compliance with the various REIT qualification tests and
other rules set out in the Internal Revenue Code and Treasury Regulations
thereunder;
(xiv) counseling us regarding the maintenance of our exemption from
the Investment Company Act and monitoring compliance with the requirements
for maintaining an exemption from that Act;
(xv) assisting us in developing criteria for asset purchase
commitments that are specifically tailored to our investment objectives and
making available to us its knowledge and experience with respect to
mortgage loans, real estate, real estate securities and other real
estate-related assets;
(xvi) representing and making recommendations to us in connection with
the purchase and finance and commitment to purchase and finance of mortgage
loans (including on a portfolio basis), real estate, real estate securities
and other real estate-related assets, and the sale and commitment to sell
such assets;
(xvii) monitoring the operating performance of our investments and
providing periodic reports with respect thereto to our board of directors,
including comparative information with respect to such operating
performance and budgeted or projected operating results;
(xviii) investing or reinvesting any money of ours (including
investing in short-term investments pending investment in long-term asset
investments, payment of fees, costs and expenses, or payments of dividends
or distributions to our stockholders and partners), and advising us as to
our capital structure and capital raising;
73
(xix) causing us to retain qualified accountants and legal counsel, as
applicable, to assist in developing appropriate accounting procedures,
compliance procedures and testing systems with respect to financial
reporting obligations and compliance with the REIT provisions of the
Internal Revenue Code and to conduct quarterly compliance reviews with
respect thereto;
(xx) causing us to qualify to do business in all applicable
jurisdictions and to obtain and maintain all appropriate licenses;
(xxi) assisting us in complying with all regulatory requirements
applicable to us in respect of our business activities, including preparing
or causing to be prepared all financial statements required under
applicable regulations and contractual undertakings and all reports and
documents, if any, required under the Securities Exchange Act of 1934, as
amended (the "Exchange Act");
(xxii) taking all necessary actions to enable us to make required tax
filings and reports, including soliciting stockholders for required
information to the extent provided by the REIT provisions of the Internal
Revenue Code;
(xxiii) handling and resolving all claims, disputes or controversies
(including all litigation, arbitration, settlement or other proceedings or
negotiations) in which we may be involved or to which we may be subject
arising out of our day-to-day operations, subject to such limitations or
parameters as may be imposed from time to time by our board of directors;
(xxiv) using commercially reasonable efforts to cause expenses
incurred by or on behalf of us to be reasonable or customary and within any
budgeted parameters or expense guidelines set by our board of directors
from time to time;
(xxv) performing such other services as may be required from time to
time for management and other activities relating to our assets as our
board of directors shall reasonably request or our manager shall deem
appropriate under the particular circumstances; and
(xxvi) using commercially reasonable efforts to cause us to comply
with all applicable laws.
Pursuant to the management agreement, our manager will not assume any
responsibility other than to render the services called for thereunder and will
not be responsible for any action of our board of directors in following or
declining to follow its advice or recommendations. Our manager, its directors
and its officers will not be liable to us, any subsidiary of ours, our
directors, our stockholders or any subsidiary's stockholders for acts performed
in accordance with and pursuant to the management agreement, except by reason of
acts constituting bad faith, willful misconduct, gross negligence, or reckless
disregard of their duties under the management agreement. We have agreed to
indemnify our manager, its directors and its officers with respect to all
expenses, losses, damages, liabilities, demands, charges and claims arising from
acts of our manager not constituting bad faith, willful misconduct, gross
negligence, or reckless disregard of duties, performed in good faith in
accordance with and pursuant to the management agreement. Our manager has agreed
to indemnify us, our directors and officers with respect to all expenses,
losses, damages, liabilities, demands, charges and claims arising from acts of
our manager constituting bad faith, willful misconduct, gross negligence or
reckless disregard of its duties under the management agreement. Our manager
carries errors and omissions and other customary insurance.
Pursuant to the terms of the management agreement, the manager is required
to provide a dedicated management team, including a President, Chief Financial
Officer and Chief Operating Officer, to provide the management services to be
provided by the manager to us, the members of which team shall have as their
primary responsibility the management of us and shall devote such of their time
to the management of us as our board of directors reasonably deems necessary and
appropriate, commensurate with our level of activity from time to time.
The management agreement provides for automatic one-year extensions from
and after June 6, 2003. Our independent directors review our manager's
performance annually and the management agreement may be terminated annually
upon the affirmative vote of at least two-thirds of our independent directors,
or by a vote of the holders of a majority of the outstanding shares of our
common stock, based upon unsatisfactory performance that is materially
detrimental to us or a determination by our independent
74
directors that the compensation to our manager is not fair, subject to our
manager's right to prevent such a compensation termination by accepting a
mutually acceptable reduction of fees. Our manager will be provided with 60
days' prior notice of any such termination and will be paid a termination fee
equal to the amount of the management fee earned by our manager during the
twelve-month period preceding such termination which may make it more difficult
for us to terminate the management agreement. Following any termination of the
management agreement, we shall be entitled to purchase the portion of our
manager's incentive return, as described below, at a price determined as if our
assets were sold for cash at their then current fair market value (as determined
by an appraisal, taking into account, among other things, the expected future
value of the underlying investments) or otherwise we may continue to pay the
incentive return to our manager. In addition, if we do not elect to so purchase
our manager's incentive return, our manager will have the right to require us to
purchase the same at the price discussed above. In addition, the management
agreement may be terminated by us at any time for cause, which is defined as
fraud, misappropriation of funds, willful violation of the management agreement,
or gross negligence, without payment of the termination fee. Our manager may at
any time assign certain duties under the management agreement to any affiliate
of our manager provided that certain officers of the manager also jointly manage
and supervise the day-to-day business and operations of such affiliate and
provided, further, that our manager shall be fully responsible to us for all
errors or omissions of such assignee.
MANAGEMENT FEES AND INCENTIVE COMPENSATION
We do not maintain an office or employ personnel. Instead we rely on the
facilities and resources of our manager to conduct our operations. Expense
reimbursements to our manager are made monthly. The management fee and any other
expenses are payable on the first business day of each calendar month. Below is
a summary of the fees and other amounts earned by the manager.
2002 2001 2000
-------------- ------------ ------------
Management Fee to Manager.......................... $4.3 million $4.8 million $5.1 million
Expense Reimbursements to Manager.................. $0.5 million $0.9 million $1.6 million
Preferred Incentive Return to Manager.............. $3.5 million $2.8 million --
Stock options...................................... 700,000 shares -- --
Management Fee. We pay our manager an annual management fee equal to 1.5%
of our gross equity. Our manager uses the proceeds from its management fee in
part to pay compensation to its officers and employees who, notwithstanding that
certain of them also are our officers, receive no cash compensation directly
from us.
Reimbursement of Expenses. Because our manager's employees perform certain
legal, accounting, due diligence tasks and other services that outside
professionals or outside consultants otherwise would perform, our manager is
paid or reimbursed for the cost of performing such tasks, provided that such
costs and reimbursements are no greater than those which would be paid to
outside professionals or consultants on an arm's-length basis; and provided,
further that such costs shall not be reimbursed in excess of $500,000 per annum.
In addition, our manager will be reimbursed for any expenses incurred in
contracting with third parties, including affiliates of our manager, for the
special servicing of our assets.
We also pay all operating expenses, except those specifically required to
be borne by our manager under the management agreement. Our manager is
responsible for all costs incident to the performance of its duties under the
management agreement, including compensation of our manager's employees, rent
for facilities and other "overhead" expenses. The expenses required to be paid
by us include, but are not limited to, issuance and transaction costs incident
to the acquisition, disposition and financing of our investments, legal and
auditing fees and expenses, the compensation and expenses of our independent
directors, the costs associated with the establishment and maintenance of any
credit facilities and other indebtedness of ours (including commitment fees,
legal fees, closing costs, etc.), expenses associated with other securities
offerings of ours, the costs of printing and mailing proxies and reports to our
stockholders, costs incurred by employees of our manager for travel on our
behalf, costs associated with any computer
75
software or hardware that is used solely for us, costs to obtain liability
insurance to indemnify our directors and officers and the compensation and
expenses of our transfer agent.
Incentive Compensation. Our manager is entitled to receive annual
incentive compensation pursuant to the terms of the management agreement with
us. The purpose of the incentive compensation is to provide an additional
incentive for our manager to achieve targeted levels of funds from operations
(including gains and losses) and to increase our stockholder value. This
incentive compensation, which is calculated on a cumulative, but not
compounding, basis is an amount equal to the product of:
(A) 25% of the dollar amount by which
(1)(a) the funds from operations before the incentive return per
share of common stock, plus (b) gains (or losses) from debt
restructuring and gains (or losses) from sales of property and other
assets per share of common stock,
exceed
(2) an amount equal to (a) the weighted average of the book value
per share of the net assets transferred to us from Newcastle Investment
Holdings on or prior to July 12, 2002 and the prices per share of our
common stock in any offerings by us (adjusted for prior capital
dividends or capital distributions) multiplied by (b) a simple interest
rate of 10% per annum
multiplied by
(B) the weighted average number of shares of common stock
outstanding.
"Funds from operations" means net income (computed in accordance with GAAP),
excluding gains (losses) from debt restructuring and gains (or losses) from
sales of property, plus depreciation and amortization on real estate assets, and
after adjustments for unconsolidated partnerships and joint ventures. Funds from
operations does not represent cash generated from operating activities in
accordance with GAAP and should not be considered as an alternative to net
income as an indication of our performance or to cash flows as a measure of
liquidity or ability to make distributions.
Upon any termination of the management agreement by either party, we shall
be entitled to purchase the manager's right to receive incentive compensation
from our manager for a cash purchase price equal to the amount that would be
distributed to our manager if all of our assets were sold for cash at their then
current fair market value (taking into account, among other things, expected
future performance of the underlying investments) or otherwise continue to pay
the incentive compensation to our manager. In addition, if we do not elect to so
purchase our manager's right to receive incentive compensation, our manager will
have the right to require us to purchase the same at the price described above.
In either case, such fair market value shall be determined by independent
appraisal to be conducted by a nationally recognized appraisal firm mutually
agreed upon by us and our manager.
Our board of directors may request that our manager accept all or a portion
of its incentive compensation in shares of our common stock, and our manager may
elect, in its discretion, to accept such payment in the form of shares, subject
to limitations that may be imposed by the rules of the NYSE or otherwise.
Manager Options. We granted to our manager options representing the right
to acquire 10% of the number of shares offered and sold in our initial public
offering at an exercise price per share equal to the initial public offering
price per share of the shares in our initial public offering. The options are
exercisable as to 1/30 of the shares subject to the option on the first day of
each of the 30 calendar months following the date of grant. The manager options
provide a means of performance-based compensation in order to provide an
additional incentive for our manager to enhance the value of our common stock.
CONFLICTS OF INTEREST IN OUR RELATIONSHIP WITH OUR MANAGER
Our chairman and chief executive officer and certain of our executive
officers also serve as officers of our manager. As a result, the management
agreement was not negotiated at arm's-length and its terms,
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including fees payable, may not be as favorable to us as if it had been
negotiated with an unaffiliated third party.
Our manager also manages and invests in other real estate-related
investment vehicles, including Newcastle Investment Holdings, and our chairman
and chief executive officer and some of our other officers also serve as
officers and/or directors of these other entities. For example, our manager
manages Fortress Investment Fund, which has a substantial investment in Capstead
Mortgage Corporation, a publicly traded mortgage REIT. Our chairman and chief
executive officer, who is an officer of our manager, also serves as chairman and
chief executive officer of Capstead. Capstead's portfolio consists primarily of
adjustable-rate and short-maturity assets, including residential mortgage backed
securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. However, Capstead
has a broader investment mandate, which could lead to a future conflict. Certain
investments appropriate for us may also be appropriate for one or more of these
other investment vehicles and our manager may decide to make a particular
investment through another investment vehicle rather than through us. Our
manager also intends to engage in additional real estate-related management and
investment opportunities in the future which may also compete with us for
investments.
Our management agreement with our manager generally does not limit or
restrict our manager from engaging in any business or managing any other vehicle
that invests generally in real estate securities. However, the terms of the
management agreement prohibit our manager and any entity controlled by or under
common control with our manager from raising or sponsoring any new investment
fund, company or vehicle whose investment policies, guidelines or plan targets
as its primary investment category investment in credit sensitive real estate
securities, but no such fund, company or vehicle shall be prohibited from
investing in credit sensitive real estate securities. Our manager is also
required to seek the approval of our independent directors before we engage in a
material transaction with another unrelated entity managed by our manager. The
ability of our manager and its officers and employees to engage in these other
business activities will reduce the time our manager spends managing us.
The management compensation structure that we have agreed to with our
manager may cause our manager to invest in high risk investments. In addition to
its management fee, our manager may receive an incentive return based in part
upon our achievement of targeted levels of funds from operations. In evaluating
investments and other management strategies, the opportunity to earn incentive
return based on funds from operations may lead our manager to place undue
emphasis on the maximization of funds from operations at the expense of other
criteria, such as preservation of capital, in order to achieve a higher
incentive return. Investments with higher yield potential are generally riskier
or more speculative. This could result in increased risk to the value of our
invested portfolio.
Termination of the management agreement with our manager is difficult and
costly. The management agreement may only be terminated annually upon the
affirmative vote of at least two-thirds of our independent directors, or by a
vote of the holders of a majority of the outstanding shares of our common stock,
based upon (1) unsatisfactory performance by our manager that is materially
detrimental to us or (2) a determination that the compensation to our manager is
not fair, subject to our manager's right to prevent such a compensation
termination by accepting a mutually acceptable reduction of fees. Our manager
will be provided 60 days' prior notice of any such termination and will be paid
a termination fee equal to the amount of the management fee earned by the
manager during the twelve-month period preceding such termination. In addition,
following any termination of the management agreement, the manager may require
us to purchase its incentive return at a price determined as if our assets were
sold for their fair market value (as determined by an appraisal, taking into
account, among other things, the expected future value of the underlying
investments) or we may otherwise continue to pay the incentive return to our
manager. These provisions may increase the effective cost to us of terminating
the management agreement, thereby adversely affecting our ability to terminate
our manager without cause.
Our manager is authorized to follow very broad investment guidelines. Our
directors periodically review our investment guidelines and our investment
portfolio. However, our board does not review each proposed investment. In
addition, in conducting periodic reviews, the directors rely primarily on
77
information provided to them by our manager. Furthermore, transactions entered
into by our manager may be difficult or impossible to unwind by the time they
are reviewed by the directors. Our manager has great latitude within the broad
guidelines of the investment guidelines in determining the types of assets it
may decide are proper investments for us.
Our manager manages and also has an equity interest in both us and in
Newcastle Investment Holdings, which may result in decisions that are not in our
best interest.
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MANAGEMENT
OUR DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth certain information about our directors and
executive officers:
NAME AGE POSITION WITH US
- ---- --- ----------------
Wesley R. Edens............................ 41 Chief Executive Officer and Chairman of the
Board of Directors (Class III)
David J. Grain............................. 40 Director (Class II)
Stuart A. McFarland........................ 55 Independent Director (Class I)
David K. McKown............................ 65 Independent Director (Class III)
Peter M. Miller............................ 47 Independent Director (Class I)
Kenneth M. Riis............................ 43 President
Jonathan Ashley............................ 37 Chief Operating Officer
Michael I. Wirth........................... 44 Chief Financial Officer and Treasurer
Erik P. Nygaard............................ 43 Chief Information Officer
Randal A. Nardone.......................... 47 Secretary
Pursuant to our charter, the board of directors is divided into three
classes of directors. The current terms of the Class I, Class II and Class III
directors will expire in 2003, 2004 and 2005, respectively. Directors of each
class will be chosen for three-year terms upon the expiration of their current
terms and each year one class of directors will be elected by the stockholders.
All officers serve at the discretion of our board of directors. We currently
have a 5-person board of directors. We have three qualified audit committee
members. Our Bylaws provide that a majority of the entire board of directors may
establish, increase or decrease the number of directors, provided that the
number of directors shall never be less than the minimum number required by the
Maryland General Corporation Law, which is one, nor more than 15.
Information regarding our directors and officers, other than Messrs. Edens,
Nardone and Nygaard, is set forth below. For biographical information on Messrs.
Edens, Nardone and Nygaard see "Fortress Investment Group and our Management
Agreement -- Principals of Fortress Investment Group."
DAVID J. GRAIN has been a member of our board of directors since October
2002. Mr. Grain was a director of Newcastle Investment Holdings from January
2002 to October 2002. Mr. Grain currently serves as the President of Pinnacle
Holdings Inc., whose equity is partially owned by Fortress Investment Fund, an
affiliate of ours managed by our manager. Prior to joining Pinnacle in February
2003, Mr. Grain was a Senior Vice President for AT&T Broadband's Northeast
Region. Prior to joining AT&T in June 2000, Mr. Grain was a Principal at the New
York investment banking firm of Morgan Stanley from 1992 to June 2000. Mr. Grain
is a Director and member of the Investment Committee of the Pension Reserves
Investment Management (PRIM) Board of Massachusetts and is a Trustee of Emerson
College. Mr. Grain earned a B.A. degree in English from the College of the Holy
Cross and an M.B.A. degree from the Amos Tuck School at Dartmouth College.
STUART A. MCFARLAND has been a member of our board of directors since
October 2002 and a member of the audit committee of our board of directors since
November 2002. Mr. McFarland was a director of Newcastle Investment Holdings
from May 1998 until October 2002. Mr. McFarland is Managing Partner of Federal
City Capital Advisors, a strategic advisory and corporate financial services
firm located in Washington, D.C. Previously, Mr. McFarland was President and
Chief Executive Officer of Pedestal Inc., an internet secondary mortgage market
trading exchange for the trading of spot and pooled mortgage loans. Mr.
McFarland was Executive Vice President and General Manager of GE Capital
Mortgage Services and President and CEO of GE Capital Asset Management
Corporation from 1990 to 1995 where
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he ran GE Capital's mortgage business. Prior to GE Capital, Mr. McFarland was
President and CEO of Skyline Financial Services Corp., where he was the U.S.
Bankruptcy Court appointed asset manager for the EPIC Bankruptcy. Before joining
Skyline, Mr. McFarland was President and CEO of National Permanent Federal
Savings Bank in Washington, D.C. Prior to this, Mr. McFarland was Executive Vice
President and Chief Financial Officer with Fannie Mae (Federal National Mortgage
Association). From 1972 to 1981, he was also President and Director of Ticor
Mortgage Insurance Company in Los Angeles, California. Mr. McFarland currently
serves as a Director of the Brandywine Funds, as a Director and Member of the
Executive Committee of the Center for Housing Policy, is a Trustee of the
National Building Museum and a Member of the Board of Trustees of the Brookings
Greater Washington Research Program. Mr. McFarland attended Lafayette College in
Easton, Pennsylvania, where he earned an A.B. degree in Government and Law in
1970.
DAVID K. MCKOWN has been a member of our board of directors since November
2002 and a member of the audit committee of our board of directors since
November 2002. Mr. McKown has been a senior advisor to Eaton Vance Management,
an investment fund manager located in Boston, Massachusetts, since May 2000.
Prior to this, Mr. McKown was a group executive of Diversified Finance of
BankBoston, N.A., a commercial bank, from 1993 until April 2000. Mr. McKown was
chairman of the Domestic Senior Credit Committee of BankBoston, N.A. from 1985
until 1990 and was managing director for problem loan management of BankBoston,
N.A. from 1990 until 1993. Mr. McKown has been a trustee of Equity Office
Properties Trust since July 1997 where he serves on the executive, compensation
and option and conflicts committees. Mr. McKown also serves as a director of
American Investment Bank, Friends of Post Office Square and POWDR Corp. He holds
advisory directorships with the Eiger Fund and Alliance Energy, Inc.
PETER M. MILLER has been a member of our board of directors since February
2003 and a member of the audit committee of our board of directors since
February 2003. Mr. Miller is a Managing Director at ING Financial Markets LLC
and Head of their Latin Debt Advisory Group. Previously, he was responsible for
ING's Latin American Debt Products Group. Mr. Miller joined ING in 1989
following seven years at Bankers Trust where he held various positions in the
Latin American Merchant Banking Group. Mr. Miller has a B.A. degree in
Management Science from Duke University and a M.B.A. degree from the Johnson
School of Management at Cornell University. Mr. Miller previously served on the
Board of Directors of Nicolini Hermanos S.A. (Peru), Supermercados La Favorita
S.A. (Ecuador) and Venepal C.A. (Venezuela).
KENNETH M. RIIS has been our President since inception and a Managing
Director of our manager since December 2001. From November 1996 to December
2001, Mr. Riis was an independent consultant for our manager as well as other
financial companies. From 1989 to 1996, Mr. Riis was a Principal and Managing
Director of the real estate finance group at Donaldson, Lufkin & Jenrette. Mr.
Riis received a B.S. degree in Finance and Business Management from San Jose
State University.
JONATHAN ASHLEY has been our Chief Operating Officer since our formation
and a Managing Director of our manager since its formation in May 1998. Mr.
Ashley previously worked for Union Bank of Switzerland from May 1997 to May
1998. Prior to joining Union Bank of Switzerland, Mr. Ashley worked for an
affiliate of BlackRock Financial Management, Inc. from April 1996 to May 1997.
Prior to joining BlackRock, Mr. Ashley worked at Morgan Stanley, Inc. in its
Real Estate Investment Banking Group. Prior to joining Morgan Stanley, Mr.
Ashley was in the Structured Finance Group at the law firm of Skadden, Arps,
Slate, Meagher & Flom LLP. Mr. Ashley received a B.A. degree in History from
Tufts University and a J.D. degree from the University of Pennsylvania Law
School.
MICHAEL I. WIRTH has been our Chief Financial Officer since our formation
and joined our manager in May 2002. From August 2000 to May 2002, Mr. Wirth was
the Senior Vice President and Chief Financial Officer of three public companies:
Charter Municipal Mortgage Acceptance Company, American Mortgage Acceptance
Company and Aegis Realty Inc. He was also a Senior Vice President of Related
Capital Company which externally managed these companies. Prior to joining
Related Capital in August 2000, Mr. Wirth was a Vice President at CGA Investment
Management. From 1988 to 1997, Mr. Wirth was a Senior Manager with the Estate
Consulting Practice of Deloitte & Touche, where he specialized in
80
real estate capital markets and the financial services industry. From 1986 to
1988, Mr. Wirth was the Chief Financial Officer for Cochran Properties, Inc., an
Atlanta, Georgia commercial real estate development company and from 1983 to
1986 was a Senior Accountant with Deloitte Haskins & Sells. Mr. Wirth holds a
Bachelor of Business Administration from Georgia State University and is a
member of the American Institute of Certified Public Accountants.
We pay an annual director's fee to each independent director equal to
$20,000, with no additional fee to be paid for the first four meetings of our
board of directors each year. After the first four meetings, each independent
director will be paid a fee of $1,000 for each additional meeting of our board
of directors attended in person by such independent director. All members of our
board of directors are reimbursed for their costs and expenses in attending all
meetings of our board of directors. In addition, an annual fee of $1,000 will be
paid to the chair of any committee of our board of directors. Affiliated
directors, however, will not be separately compensated by us. Fees to the
independent directors may be made by issuance of common stock, based on the
value of such common stock at the date of issuance, rather than in cash.
In addition, the option plan provides for the automatic grant of 2,000
options to each of our independent directors on the first business day after
each annual meeting of our board of directors each year during which the option
plan is effective. These options will have an exercise price equal to 100% of
the fair market value of our common stock on the date of grant, subject to
adjustment as necessary to preserve the value of such options in connection with
the occurrence of certain events. At the time of our initial public offering, we
granted to each of our independent directors an option to purchase 2,000 shares
of our common stock at an exercise price equal to the initial public offering
price.
EXECUTIVE COMPENSATION
Because our management agreement provides that our manager will assume
principal responsibility for managing our affairs, our officers, in their
capacities as such, will not receive compensation from us. However, in their
capacities as officers or employees of our manager, or its affiliates, they will
devote such portion of their time to our affairs as is required for the
performance of the duties of our manager under the management agreement. Our
manager has informed us that, because the services performed by its officers or
employees in their capacities as such are not performed exclusively for us, it
cannot segregate and identify that portion of the compensation awarded to,
earned by or paid to our named executive officers by the manager that relates
solely to their services to us. For the year ended December 31, 2002, pursuant
our management agreement with our manager, we paid our manager a management fee
of $4.3 million and an incentive return of $3.5 million and reimbursed the
manager for $0.5 million in expenses. See "Fortress Investment Group and Our
Management Agreement -- Management Fees" and "Management -- Stock Options."
STOCK OPTIONS
We have adopted the Newcastle Investment Corp. Nonqualified Stock Option
and Incentive Award Plan, referred to in this prospectus as the option plan, to
provide incentives to attract and retain the highest qualified directors,
officers, employees, advisors, consultants and other personnel. The option plan
is currently administered by our full board of directors. We expect to create a
committee, a majority of whose members will be independent directors, which will
administer our option plan. The maximum number of shares of our common stock
reserved and available for issuance each year under the option plan is that
number of shares equal to 15% of the number of our outstanding equity interests
but in no event more than 10,000,000 shares in the aggregate over the term of
the plan.
Stock Options
The option plan permits the granting of options to purchase common stock
that do not qualify as incentive stock options under section 422 of the Internal
Revenue Code ("Non-Qualified Options"). The option exercise price of each option
will be determined by the committee and may be less than 100% of the fair market
value of our common stock subject to such option on the date of grant.
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The terms of each option will be fixed by the committee. The committee will
determine at what time or times each option may be exercised and, subject to the
provisions of the option plan, the period of time, if any, after retirement,
death, disability or termination of employment during which options may be
exercised. Options become vested and exercisable in installments, and the
exercisability of options may be accelerated by the committee. Upon exercise of
options, the option exercise price must be paid in full either in cash or by
certified or bank check or other instrument acceptable to the committee or, if
the committee so permits, by delivery of shares of common stock already owned by
the optionee or delivery of a promissory note. The exercise price may also be
delivered to us by a broker pursuant to irrevocable instructions to the broker
from the optionee.
At the discretion of the committee, stock options granted under the option
plan may include a "re-load" feature pursuant to which an optionee exercising an
option by the delivery of shares of common stock would automatically be granted
an additional stock option (with an exercise price equal to the fair market
value of the common stock on the date the additional stock option is granted) to
purchase that number of shares of common stock equal to the number delivered to
exercise the original stock option. The purpose of this feature is to enable
participants to exercise options using previously owned shares of common stock
while continuing to maintain their previous level of equity ownership in us.
The committee may also grant stock appreciation rights, restricted stock,
performance awards, tandem awards and other stock and non-stock-based awards
under the option plan. These awards will be subject to such conditions and
restrictions as the committee may determine, which may include the achievement
of certain performance goals or continued employment with us through a specific
period.
Stock Option Grants
In connection with our initial public offering, we granted to our manager
an option to purchase 700,000 shares of our common stock. In addition, we have
granted to each of Messrs. Grain and McFarland, our independent directors at the
time of our initial public offering, options to purchase 2,000 shares of our
common stock. These options expire in 2012. These options have an exercise price
equal to the initial public offering price of $13.00 per share, subject to
adjustment as necessary to preserve the value of such options in connection with
the occurrence of certain events.
Equity Compensation Plan Information
NUMBER OF SECURITIES TO BE WEIGHTED-AVERAGE NUMBER OF SECURITIES REMAINING
ISSUED UPON EXERCISE OF EXERCISE PRICE OF AVAILABLE FOR FUTURE ISSUANCE
PLAN CATEGORY: OUTSTANDING OPTIONS OUTSTANDING OPTIONS UNDER EQUITY COMPENSATION PLANS
- -------------- -------------------------- ------------------- -------------------------------
EQUITY COMPENSATION PLANS
APPROVED BY SECURITY HOLDERS:
Newcastle Investment Corp.
Nonqualified Stock
Option and Incentive
Award Plan.............. 704,000 $13.00 9,296,000 (A)
EQUITY COMPENSATION PLANS NOT
APPROVED BY SECURITY HOLDERS:
None....................... N/A N/A N/A
- ---------------
(A) The maximum available for issuance each year is equal to 15% of the number
of outstanding equity interests, subject to a maximum of 10,000,000 shares
in the aggregate over the term of the plan.
LIABILITY AND INDEMNIFICATION OF OFFICERS AND DIRECTORS
Maryland law permits a Maryland corporation to include in its charter a
provision limiting the liability of its directors and officers to the
corporation and its stockholders for money damages except for liability
resulting from (a) actual receipt of an improper benefit or profit in money,
property or services or (b) active and deliberate dishonesty established by a
final judgment and which is material to the cause of
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action. Our charter contains such a provision which eliminates directors' and
officers' liability to the maximum extent permitted by Maryland law.
Our charter authorizes us, to the maximum extent permitted by Maryland law,
to indemnify any present or former director or officer or any individual who,
while our director and at our request, serves or has served another corporation,
real estate investment trust, partnership, joint venture, trust, employee
benefit plan or other enterprise as a director, officer, partner or trustee,
from and against any claim or liability to which that person may become subject
or which that person may incur by reason of his or her status as a present or
former director or officer of ours and to pay or reimburse their reasonable
expenses in advance of final disposition of a proceeding. Our bylaws obligate
us, to the maximum extent permitted by Maryland law, to indemnify any present or
former director or officer or any individual who, while our director and at our
request, serves or has served another corporation, real estate investment trust,
partnership, joint venture, trust, employee benefit plan or other enterprise as
a director, officer, partner or trustee and who is made a party to the
proceeding by reason of his service in that capacity from and against any claim
or liability to which that person may become subject or which that person may
incur by reason of his or her status as a present or former director or officer
of ours and to pay or reimburse their reasonable expenses in advance of final
disposition of a proceeding. The charter and bylaws also permit us to indemnify
and advance expenses to any person who served a predecessor of ours in any of
the capacities described above and any employee or agent of ours or a
predecessor of ours.
Maryland law requires a corporation (unless its charter provides otherwise,
which our charter does not) to indemnify a director or officer who has been
successful in the defense of any proceeding to which he is made a party by
reason of his service in that capacity. Maryland law permits a corporation to
indemnify its present and former directors and officers, among others, against
judgments, penalties, fines, settlements and reasonable expenses actually
incurred by them in connection with any proceeding to which they may be made a
party by reason of their service in those or other capacities unless it is
established that (a) the act or omission of the director or officer was material
to the matter giving rise to the proceeding and (i) was committed in bad faith
or (ii) was the result of active and deliberate dishonesty, (b) the director or
officer actually received an improper personal benefit in money, property or
services or (c) in the case of any criminal proceeding, the director or officer
had reasonable cause to believe that the act or omission was unlawful. However,
under Maryland law, a Maryland corporation may not indemnify for an adverse
judgment in a suit by or in the right of the corporation or for a judgment of
liability on the basis that personal benefit was improperly received, unless in
either case a court orders indemnification and then only for expenses. In
addition, Maryland law permits a corporation to advance reasonable expenses to a
director or officer upon the corporation's receipt of (a) a written affirmation
by the director or officer of his good faith belief that he has met the standard
of conduct necessary for indemnification by the corporation and (b) a written
undertaking by him or on his behalf to repay the amount paid or reimbursed by
the corporation if it is ultimately determined that the standard of conduct was
not met.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers or persons controlling the registrant
pursuant to the foregoing provisions, the registrant has been informed that in
the opinion of the Securities and Exchange Commission such indemnification is
against public policy as expressed in the Securities Act and is therefore
unenforceable.
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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
In July 2002, Newcastle Investment Holdings contributed certain assets and
liabilities to us in exchange for all of the shares of our common stock. Our
chairman and chief executive officer also serves as chairman and chief executive
officer of Newcastle Investment Holdings and, at the time the transfer of assets
and liabilities from Newcastle Investment Holdings to us was approved and other
organizational matters were approved for us, Newcastle Investment Holdings was
our sole stockholder. As a result, these matters were not approved at arm's
length and the terms of the transfer may not be as favorable to us as if the
transfer was with an unaffiliated third party. We may enter into future
transactions with Newcastle Investment Holdings with the approval of our
independent directors.
Our chairman and chief executive officer and all of our executive officers
also serve as officers of our manager. As a result, the management agreement
between us and our manager and an amendment to the agreement in March 2003 were
not negotiated at arm's-length and the terms, including fees payable, may not be
as favorable to us as if it had been negotiated with an unaffiliated third
party. See "Fortress Investment Group and Our Management Agreement -- Conflicts
of Interest in Our Relationship with Our Manager."
Our manager also manages Newcastle Investment Holdings and may become
subject to conflicts of interest with respect to managing our interests and the
interests of Newcastle Investment Holdings.
We have not entered into any other transactions in which any other director
or officer or stockholder of ours or of our manager had any material interest.
We were formed in June 2002 and completed the initial public offering of
our common stock in October 2002. Newcastle Investment Holdings was formed in
May 1998. We were formed for the purpose of separating the real estate
securities and credit leased real estate businesses from Newcastle Investment
Holdings' other investments. Newcastle Investment Holdings owns 68.2% of our
common stock, assuming exercise of all outstanding options. At December 31,
2002, our manager, Fortress Investment Group and its principals had options to
purchase 700,000 shares of our common stock and owned approximately 16.4% of the
equity of Newcastle Investment Holdings (25.8% upon exercise of outstanding
options).
Fortress Investment Holdings LLC is the sole member of Fortress Investment
Group LLC, our manager. The beneficial owners of Fortress Investment Holdings
are Messrs. Edens, Briger, Kauffman, Nardone, Novogratz and Nygaard. The
beneficial owners of Fortress Principal Investment Holdings are the same as the
holders of Fortress Investment Holdings (Messrs. Edens, Briger, Kauffman,
Nardone, Novogratz and Nygaard).
David J. Grain, a member of our board of directors, serves as President of
Pinnacle Holdings Inc., whose equity is partially owned by Fortress Investment
Fund, an affiliate of ours managed by our manager.
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SECURITY OWNERSHIP OF
CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Substantially all shares of our outstanding common stock are owned by
Newcastle Investment Holdings Corp. The following table sets forth, as of March
13, 2003, the total number of shares of our common stock beneficially owned, and
the percent so owned, by (i) each person known by us to own more than 5% of our
common stock, (ii) each of our directors and executive officers and (iii) all
directors and executive officers as a group.
AMOUNT AND NATURE OF
BENEFICIAL OWNERSHIP(1)
---------------------------
NUMBER OF
NAME AND ADDRESS OF BENEFICIAL OWNER SHARES PERCENT(5)
- ------------------------------------ ---------- ----------
Newcastle Investment Holdings Corp.(2)(3)................... 16,486,339 70.2%
Fortress Principal Investment Holdings LLC(2)(4)............ 4,394,032(6) 18.6%(8)
Wesley R. Edens(2).......................................... 4,405,032(6)(7) 18.6%(8)
David J. Grain(2)........................................... -- *
Stuart A. McFarland(2)...................................... -- *
David K. McKown(2).......................................... -- --
Peter M. Miller(2).......................................... -- --
Jonathan Ashley(2).......................................... -- *
Randal A. Nardone(2)........................................ 4,395,032(6)(7) 18.6%(8)
Erik P. Nygaard(2).......................................... 4,404,032(6)(7) 18.6%(8)
Kenneth M. Riis(2).......................................... -- *
Michael I. Wirth(2)......................................... -- *
All directors and executive officers as a group (10
persons).................................................. 4,441,782 18.8%(8)
- ---------------
* Less than 1%
(1) Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of common stock subject
to options or warrants currently exercisable, or exercisable within 60 days
of the date hereof, are deemed outstanding for computing the percentage of
the person holding such options or warrants but are not deemed outstanding
for computing the percentage of any other person.
(2) The address of Newcastle Investment Holdings Corp., Fortress Principal
Investment Holdings LLC and all officers and directors listed above are in
care of Fortress Investment Group, 1251 Avenue of the Americas, New York, NY
10020.
(3) All of the shares held by Newcastle Investment Holdings have been pledged by
Newcastle Investment Holdings as collateral to Fleet National Bank in
connection with a credit facility between a subsidiary of Newcastle
Investment Holdings and Fleet National Bank.
(4) The beneficial owners of Fortress Principal Investment Holdings LLC are
Messrs. Edens, Briger, Kauffman, Nardone, Novogratz and Nygaard. Fortress
Investment Holdings LLC is the sole member of the manager. The beneficial
owners of Fortress Investment Holdings LLC are also Messrs. Edens, Briger,
Kauffman, Nardone, Novogratz and Nygaard.
(5) Percentage amount assumes the exercise by such persons of all options to
acquire shares of common stock and no exercise by any other person.
(6) Includes 2,178 shares and 140,000 options to purchase shares of our common
stock, exercisable within 60 days from the date hereof, beneficially owned
by Fortress Principal Investment Holdings LLC directly in us and 4,251,854
shares beneficially owned by Fortress Principal Investment Holdings as a
result of the ownership of shares in Newcastle Investment Holdings. Messrs.
Edens, Briger, Kauffman, Nardone, Novogratz and Nygaard own all of the
beneficial interests in Fortress Principal Investment Holdings.
(7) An aggregate of 4,394,032 of these shares are held by Fortress Principal
Investment Holdings LLC.
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(8) Includes options to acquire 140,000 shares of common stock, which represents
the portion of 700,000 options that are currently exercisable and
exercisable within 60 days of the date hereof. As of December 31, 2002 our
manager, through Fortress Principal Investment Holdings LLC, beneficially
owns approximately 20.5% of our common equity, taking into account its
interest in Newcastle Investment Holdings and assuming exercise of all its
outstanding options to purchase 700,000 shares of our common stock and
2,091,673 shares of common stock of Newcastle Investment Holdings.
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DESCRIPTION OF SERIES B PREFERRED STOCK
The following is a summary of the material terms and provisions of the
Series B Preferred Stock. The Series B Preferred Stock is more completely
described in the articles supplementary to our charter establishing the Series B
Preferred Stock, which is available from us.
GENERAL
Under our charter, our board of directors is authorized to issue 600
million shares of stock, consisting of 500 million shares of common stock, $.01
par value per share, and 100 million shares of preferred stock, $.01 par value
per share, to classify any unissued shares of preferred stock and to reclassify
any previously classified but unissued shares of preferred stock of any series
from time to time, in one or more series, subject to the rights of holders of
any class or series of our preferred stock, without shareholder approval.
Our Board of Directors has adopted articles supplementary to our charter
establishing the number and fixing the terms, designations, powers, preferences,
rights, limitations and restrictions of a series of preferred stock designated
the 9.75% Series B Cumulative Redeemable Preferred Stock. Up to 2,875,000 shares
of Series B Preferred Stock are authorized. As of the date of this prospectus,
there are currently no other classes or series of preferred stock authorized,
except the Series A Junior Participating Preferred Stock. See "Description of
Capital Stock -- Stockholder Rights Plan."
Under Maryland law applicable to us, a shareholder is not personally liable
for our obligations solely as a result of his or her status as a shareholder.
The Series B Preferred Stock has been approved for listing on the NYSE,
subject to official notice of issuance and we expect that trading will commence
within 30 days after initial issuance of the Series B Preferred Stock. See
"Underwriting."
RANKING
The Series B Preferred Stock, with respect to distribution rights and the
distribution of assets upon our liquidation, dissolution or winding up, will
rank (i) senior to all classes or series of our common stock and to all equity
securities the terms of which specifically provide that such equity securities
rank junior to the Series B Preferred Stock; (ii) on a parity with all equity
securities issued by us other than those referred to in clauses (i) and (iii);
and (iii) junior to all equity securities issued by us the terms of which
specifically provide that such equity securities rank senior to such Series B
Preferred Stock. The term "equity securities" shall not include convertible debt
securities.
DISTRIBUTIONS
As holders of Series B Preferred Stock, you will be entitled to receive,
when and as authorized by our board of directors, out of legally available
funds, cumulative preferential cash distributions at the rate of 9.75% of the
liquidation preference per annum, which is equivalent to $2.4375 per share of
Series B Preferred Stock per year.
Distributions on the Series B Preferred Stock will cumulate from the date
of original issuance (March 18, 2003) and will be payable quarterly in arrears
on the last calendar day of each January, April, July and October of each year,
or, if not a business day, the next succeeding business day. The initial
distribution on the Series B Preferred Stock, which will be paid on April 30,
2003 if authorized by our board of directors, will be for less than a full
quarter. We will prorate and compute this initial distribution and any other
distribution payable for a partial distribution period on the basis of a 360-day
year consisting of twelve 30-day months.
We will pay distributions to holders of record as they appear in our share
records at the close of business on the applicable distribution record date. The
distribution record date will be the first day of the calendar month in which
the related distribution payment date falls, or such other date that our board
of
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directors designates for the payment of distributions that is not more than 30
nor less than 10 days prior to the distribution payment date.
No distribution on the Series B Preferred Stock will be authorized or
declared or paid or set apart for payment by us if such authorization,
declaration, payment or setting apart for payment would violate any of our
agreements or is restricted or prohibited by law.
Notwithstanding the foregoing, distributions on the Series B Preferred
Stock will cumulate whether or not we have earnings, whether or not there are
funds legally available for the payment of distributions and whether or not such
distributions are authorized by our board of directors. Accumulated but unpaid
distributions will cumulate as of the distribution payment date on which they
first become payable or on the date of redemption, as the case may be.
When distributions are not paid in full (or a sum sufficient for such full
payment is not so set apart) on the Series B Preferred Stock and all other
equity securities ranking on a parity as to distributions with the Series B
Preferred Stock, all distributions declared upon the Series B Preferred Stock
and any other equity securities ranking on a parity as to distributions with the
Series B Preferred Stock shall be declared pro rata so that the amount of
distributions declared per share of Series B Preferred Stock and such other
series of preferred stock shall in all cases bear to each other the same ratio
that accumulated distributions per share on the Series B Preferred Stock and
such other equity security (which shall not include any accumulation in respect
of unpaid distributions for prior distribution periods if such other equity
securities do not have a cumulative distribution) bear to each other. No
interest, or sum of money in lieu of interest, shall be payable in respect of
any distribution payment or payments on the Series B Preferred Stock which may
be in arrears.
Except as provided in the immediately preceding paragraph, unless full
cumulative distributions on the Series B Preferred Stock have been or
contemporaneously are authorized and paid or authorized and a sum sufficient set
apart for payment for all past distribution periods and the then current
distribution period:
- no distributions, other than distributions in kind of our common stock or
other shares of our equity securities ranking junior to Series B
Preferred Stock as to distributions and upon liquidation, may be
authorized or paid or set aside for payment, and no other distribution
may be authorized or made upon, our shares of common stock or any other
shares of our equity securities ranking junior to or on a parity with the
Series B Preferred Stock as to distributions or upon liquidation (other
than pro rata distributions on preferred stock ranking on a parity as to
distributions with the Series B Preferred Stock); and
- no shares of common stock or any other shares of our equity securities
ranking junior to or on a parity with the Series B Preferred Stock as to
distributions or upon liquidation may be redeemed, purchased or otherwise
acquired for any consideration (or any moneys be paid to or made
available for a sinking fund for the redemption of any such shares) by
us, except by conversion into or exchange for other shares ranking junior
to the Series B Preferred Stock as to distributions and amounts upon
liquidation.
Holders of Series B Preferred Stock shall not be entitled to any
distribution, whether payable in cash, property or shares, in excess of full
cumulative distributions on the Series B Preferred Stock as described above. We
will credit any distribution payment we make on the Series B Preferred Stock
against the earliest accumulated but unpaid distribution due with respect to the
Series B Preferred Stock which remains payable.
LIQUIDATION PREFERENCE
Upon any voluntary or involuntary liquidation, dissolution or winding up of
us, as a holder of Series B Preferred Stock you will be entitled to receive out
of our assets available for distribution to shareholders (after payment or
provision for all of our debts and other liabilities) a liquidating distribution
in the amount of a liquidation preference of $25.00 per share, plus any
accumulated and unpaid distributions to
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the date of payment, whether or not authorized, before any distribution of
assets is made to holders of our common stock and any other shares of our equity
securities ranking junior to the Series B Preferred Stock as to liquidation
rights.
If, upon any voluntary or involuntary liquidation, dissolution or winding
up of us, our assets are insufficient to make full payment of the liquidating
distributions to holders of the Series B Preferred Stock and any other shares of
our equity securities ranking on a parity with the Series B Preferred Stock as
to liquidation rights, then the holders of the Series B Preferred Stock and
parity shares will share ratably in any distribution of assets in proportion to
the full liquidating distributions to which they would otherwise be respectively
entitled.
After payment of the full amount of the liquidating distributions to which
they are entitled, the holders of Series B Preferred Stock will have no right or
claim to any of our remaining assets.
Our consolidation or merger with or into another entity, the merger of
another entity with or into us, a statutory share exchange by us, or the sale,
lease, transfer or conveyance of all or substantially all of our property or
business, will in each case not be deemed to constitute a liquidation,
dissolution or winding up of us.
As permitted by Maryland law, the articles supplementary creating the
shares of Series B Preferred Stock provide that the liquidating preference of
outstanding shares of Series B Preferred Stock will not be added to our total
liabilities in determining whether we may make a dividend or other distribution
(other than upon voluntary or involuntary dissolution) on our shares of common
stock (or any other class or series of stock that junior to the Series B
Preferred Stock with respect to liquidating distributions). Maryland does not
allow a corporation to make a distribution if, after giving effect to the
distribution, (a) the corporation would not be able to pay its obligations as
they become due in the usual course of business or (b) the corporation's total
assets would be less than its total liabilities. Unless the corporation's
charter provides otherwise, liquidation preferences of stockholders whose
preferential rights on dissolution are superior to those receiving the
distribution are considered liabilities for the purpose of this test.
REDEMPTION
Except in certain circumstances relating to the preservation of our status
as a REIT for federal income tax purposes, the Series B Preferred Stock will not
be redeemable prior to March 18, 2008. On or after March 18, 2008, we, at our
option, upon giving the notice described below, may redeem the Series B
Preferred Stock, in whole or from time to time in part, for cash, at a
redemption price of $25.00 per share, plus all accumulated and unpaid
distributions to the date of redemption, whether or not authorized.
If we redeem fewer than all of the shares of Series B Preferred Stock, our
board of directors will determine the number of shares to be redeemed. In such
circumstances, the Series B Preferred Stock to be redeemed generally will be
selected pro rata, by lot or in another equitable manner determined by our board
of directors. If such redemption is to be by lot and as a result of such
redemption any holder of Series B Preferred Stock would become a holder of a
number of shares of Series B Preferred Stock in excess of the Ownership Limit
described herein because such holder's shares of Series B Preferred Stock were
not redeemed, or were only redeemed in part, then, except in certain instances,
we will redeem the requisite number of shares of Series B Preferred Stock from
such holder such that such stockholder will not hold in excess of the Ownership
Limit subsequent to such redemption.
Notwithstanding the foregoing, unless full cumulative distributions on all
shares of Series B Preferred Stock have been or contemporaneously are authorized
and paid or authorized and a sum sufficient set apart for payment for all past
distribution periods and the current distribution period, we will not:
- redeem any shares of Series B Preferred Stock unless we simultaneously
redeem all shares of Series B Preferred Stock; or
- purchase or otherwise acquire directly or indirectly any shares of Series
B Preferred Stock or any other shares of our equity securities ranking
junior to or on a parity with the Series B Preferred
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Stock as to distributions or upon liquidation, except by conversion into
or exchange for shares ranking junior to the Series B Preferred Stock as
to distributions and upon liquidation.
The foregoing restrictions on redemptions, purchases and other acquisitions
will not prevent the redemption, purchase or acquisition by us of preferred
stock of any series to preserve our REIT status (see "Restrictions on Ownership
and Transfer" and "Federal Income Tax Considerations -- Taxation of
Newcastle -- Requirements for Qualification -- General") or pursuant to a
purchase or exchange offer made on the same terms to all holders of the Series B
Preferred Stock.
Immediately prior to any redemption of shares of Series B Preferred Stock,
we will pay, in cash, any accumulated and unpaid distributions to the redemption
date, whether or not authorized, unless a redemption date falls after a
distribution record date and prior to the corresponding distribution payment
date, in which case each holder of Series B Preferred Stock at the close of
business on such distribution record date will be entitled to the distribution
payable on such shares on the corresponding distribution payment date
notwithstanding the redemption of such shares before the distribution payment
date. Except as provided in the previous sentence, we will make no payment or
allowance for unpaid distributions, whether or not in arrears, on Series B
Preferred Stock to be redeemed.
We will mail to you, if you are a record holder of Series B Preferred
Stock, a notice of redemption no less than 30 days nor more than 60 days before
the redemption date. We will send the notice to your address, as shown on our
share transfer books. Each notice will state, in addition to any information
required by law or by the applicable rules of any exchange upon which the Series
B Preferred Stock may be listed or admitted to trading, the following:
- the redemption date;
- the redemption price;
- the number of Series B Preferred Stock to be redeemed;
- the place where you may surrender certificates for payment of the
redemption price; and
- that distributions on the Series B Preferred Stock to be redeemed will
cease to accumulate on the redemption date.
If we redeem fewer than all of the Series B Preferred Stock, we will
specify in the notice to you the number of Series B Preferred Stock to be
redeemed from you.
On or after the date fixed for redemption, each holder of shares of Series
B Preferred Stock to be redeemed must present and surrender each certificate
representing his shares of such Series B Preferred Stock to us at the place
designated in the applicable notice and thereupon the redemption price of such
shares will be paid to or on the order of the person whose name appears on such
certificate representing shares of Series B Preferred Stock as the owner thereof
and each surrendered certificate will be canceled. If fewer than all the shares
represented by any such certificate representing shares of Series B Preferred
Stock are to be redeemed, a new certificate will be issued representing the
unredeemed shares.
At our election, on or prior to a redemption date, we may irrevocably
deposit the redemption price (including accumulated and unpaid distributions) of
the Series B Preferred Stock so called for redemption in trust for the holders
thereof with a bank or trust company, in which case the notice to holders of the
Series B Preferred Stock to be redeemed will (i) state the date of such deposit,
(ii) specify the office of such bank or trust company as the place of payment of
the redemption price and (iii) require such holders to surrender the
certificates representing such shares at such place on or about the date fixed
in such redemption notice (which may not be later than such redemption date)
against payment of the redemption price (including all accumulated and unpaid
distributions to the redemption date). Any interest or other earnings earned on
the redemption price (including all accumulated and unpaid distributions)
deposited with a bank or trust company will be paid to us. Any monies so
deposited which remain unclaimed by the holders of the shares of Series B
Preferred Stock at the end of two years after the redemption date will be
returned to us by such bank or trust company.
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From and after the redemption date (unless we default in payment of the
redemption price), all distributions will cease to cumulate on the Series B
Preferred Stock designated for redemption and all of your rights as a holder of
the Series B Preferred Stock will terminate with respect to such shares, except
the right to receive the redemption price and all accumulated and unpaid
distributions up to the redemption date.
Notwithstanding any other provision relating to the redemption of the
Series B Preferred Stock to the contrary, we may redeem shares of Series B
Preferred Stock at any time, in whole or in part, whether or not prior to March
18, 2008, if the board of directors determines that such redemption is necessary
to preserve our status as a REIT.
MATURITY
The Series B Preferred Stock does not have a stated maturity and is not
subject to any sinking fund or mandatory redemption provisions.
VOTING RIGHTS
As a holder of Series B Preferred Stock, you will not have any voting
rights, except as set forth below.
Whenever distributions on the Series B Preferred Stock are in arrears for
six or more quarterly periods (whether or not consecutive), the holders of
Series B Preferred Stock will be entitled, voting together as a single class
with all other series of preferred stock of ours upon which like voting rights
have been conferred and are exercisable, to elect a total of two additional
directors to our board of directors at a special meeting called by the holders
of record of at least twenty (20%) of any series of preferred stock as to which
distributions are so in arrears, unless the request is received less than 90
days before the date fixed for the next annual meeting or special meeting of
stockholders, or at the next annual meeting of stockholders, and at each
subsequent annual meeting until all distributions accumulated on the Series B
Preferred Stock for the past distribution periods and the then current
distribution period shall have been fully paid or declared and a sum sufficient
for the payment thereof set aside for payment. In such case, our entire board of
directors will be increased by two directors.
So long as any shares of Series B Preferred Stock remain outstanding, we
may not, without the affirmative vote of holders of at least two-thirds of the
outstanding Series B Preferred Stock voting separately as a class:
- authorize, or create, or increase the authorized or issued amount of, any
class or series of equity securities ranking senior to the outstanding
Series B Preferred Stock with respect to the payment of distributions or
the distribution of assets upon our voluntary or involuntary liquidation,
dissolution or winding up;
- reclassify any authorized equity securities into any such senior equity
securities;
- create, authorize or issue any obligation or security convertible into or
evidencing the right to purchase any such senior equity securities; or
- amend, alter or repeal the provisions of our charter (including the
articles supplementary for the Series B Preferred Stock), whether by
merger, consolidation or otherwise, so as to materially and adversely
affect any right, preference, privilege or voting power of the Series B
Preferred Stock or the holders thereof.
However, with respect to any such amendment, alteration or repeal of the
provisions of our charter (including the articles supplementary for the Series B
Preferred Stock), whether by merger or consolidation, so long as the Series B
Preferred Stock remain outstanding with the terms thereof materially unchanged
in any adverse respect, taking into account that, upon the occurrence of such
event, we may not be the surviving entity and such surviving entity may
thereafter be the issuer of the Series B Preferred Stock, the occurrence of any
such event will not be deemed to materially and adversely affect the rights,
91
preferences, privileges or voting powers of Series B Preferred Stock or the
holders thereof. In addition, (i) any increase in the amount of the authorized
preferred stock or the creation or issuance of any other series of preferred
stock or (ii) any increase in the amount of authorized shares of Series B
Preferred Stock or any other class or series of our preferred stock, in each
case ranking on a parity with or junior to the Series B Preferred Stock with
respect to the payment of distributions and the distribution of assets upon
voluntary or involuntary liquidation, dissolution or our winding up, will not be
deemed to materially and adversely affect the rights, preferences, privileges or
voting powers of Series B Preferred Stock or the holders thereof.
The foregoing voting provisions will not apply if, at or prior to the time
when the act with respect to which such vote would otherwise be required will be
effected, all outstanding shares of Series B Preferred Stock have been redeemed
or called for redemption and sufficient funds shall have been deposited in trust
to effect such redemption.
CONVERSION
The Series B Preferred Stock is not convertible into or exchangeable for
our property or securities.
RESTRICTIONS ON OWNERSHIP AND TRANSFER
Our charter contains restrictions on the number of shares of our stock that
a person may own. No person may acquire or hold, directly or indirectly, in
excess of 8.0% of the aggregate value of all the outstanding shares of our
capital stock, treating all classes and series of our stock in the aggregate, or
in excess of 25.0% of the Series B Preferred Stock, unless they receive an
exemption from our board of directors.
Our charter further prohibits (a) any person from owning shares of our
stock that would result in our being "closely held" under Section 856(h) of the
Internal Revenue Code or otherwise cause us to fail to qualify as a REIT and (b)
any person from transferring shares of our stock if the transfer would result in
our stock being owned by fewer than 100 persons. Any person who acquires or
intends to acquire shares of our stock that may violate any of these
restrictions, or who is the intended transferee of shares of our stock which are
transferred to the Trust, as defined below, is required to give us immediate
written notice and provide us with such information as we may request in order
to determine the effect of the transfer on our status as a REIT. The above
restrictions will not apply if our board of directors determines that it is no
longer in our best interests to continue to qualify as a REIT.
Our board of directors, in its sole discretion, may exempt a person from
these limits, subject to such terms, conditions, representations and
undertakings as it may determine. Our board of directors has granted limited
exemptions to certain persons who directly or indirectly own our stock,
including Newcastle Investment Holdings, our manager, a third party group of
funds managed by Wallace R. Weitz & Company, and certain affiliates of these
entities.
Any attempted transfer or ownership of our stock which, if effective, would
result in violation of the above limitations, will cause the number of shares
causing the violation (rounded to the nearest whole share) to be automatically
transferred to a trust ("Trust") for the exclusive benefit of one or more
charitable beneficiaries ("Charitable Beneficiary"), and the proposed holder
will not acquire any rights in the shares. The automatic transfer will be deemed
to be effective as of the close of business on the business day (as defined in
our charter) prior to the date of such violation. The shares transferred to the
Trust will generally be selected so as to minimize the aggregate value of shares
transferred to the Trust. Shares of our stock held in the Trust will be issued
and outstanding shares. The proposed holder will not benefit economically from
ownership of any shares of stock held in the Trust, will have no rights to
dividends and no rights to vote or other rights attributable to the shares of
stock held in the Trust. The trustee of the Trust will have all voting rights
and rights to dividends or other distributions with respect to shares held in
the Trust. These rights will be exercised for the exclusive benefit of the
Charitable Beneficiary. Any dividend or other distribution paid prior to our
discovery that shares of stock have been transferred to the Trust will be paid
by the recipient to the Trustee upon demand. Any dividend or other
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distribution authorized but unpaid will be paid when due to the Trustee. Any
dividend or distribution paid to the Trustee will be held in trust for the
Charitable Beneficiary. Subject to Maryland law, the Trustee will have the
authority (i) to rescind as void any vote cast by the proposed holder prior to
our discovery that the shares have been transferred to the Trust and (ii) to
recast the vote in accordance with the desires of the Trustee acting for the
benefit of the Charitable Beneficiary. However, if we have already taken
irreversible corporate action, then the Trustee will not have the authority to
rescind and recast the vote. If necessary to protect our status as a REIT, we
may establish additional Trusts with distinct Trustees and Charitable
Beneficiaries to which shares may be transferred.
Within 20 days of receiving notice from us that shares of our stock have
been transferred to the Trust, the Trustee will sell the shares to a person
designated by the Trustee, whose ownership of the shares will not violate the
above ownership limitations. Upon the sale, the interest of the Charitable
Beneficiary in the shares sold will terminate and the Trustee will distribute
the net proceeds of the sale to the proposed holder and to the Charitable
Beneficiary as follows. The proposed holder will receive the lesser of (i) the
price paid by the proposed holder for the shares or, if the proposed holder did
not give value for the shares in connection with the event causing the shares to
be held in the Trust (e.g., a gift, devise or other similar transaction), the
Market Price (as defined in our charter) of the shares on the day of the event
causing the shares to be held in the Trust and (ii) the price received by the
Trustee from the sale or other disposition of the shares. Any net sale proceeds
in excess of the amount payable to the proposed holder will be paid immediately
to the Charitable Beneficiary. If, prior to our discovery that shares of our
stock have been transferred to the Trust, the shares are sold by the proposed
holder, then (i) the shares shall be deemed to have been sold on behalf of the
Trust and (ii) to the extent that the proposed holder received an amount for the
shares that exceeds the amount he was entitled to receive, the excess shall be
paid to the Trustee upon demand.
In addition, shares of our stock held in the Trust will be deemed to have
been offered for sale to us, or our designee, at a price per share equal to the
lesser of (i) the price per share in the transaction that resulted in the
transfer to the Trust (or, in the case of a devise or gift, the Market Price at
the time of the devise or gift) and (ii) the Market Price on the date we, or our
designee, accept the offer. We will have the right to accept the offer until the
Trustee has sold the shares. Upon a sale to us, the interest of the Charitable
Beneficiary in the shares sold will terminate and the Trustee will distribute
the net proceeds of the sale to the proposed holder.
If an investor acquires an amount of stock that exceeds 8.0 percent of the
shares of a particular class, but is less than 8.0 percent of the value of the
Company's stock of all classes in the aggregate, subsequent fluctuations in the
relative values of the Company's different classes of stock could cause the
investor's ownership to exceed the 8.0 percent ownership limitation, with the
consequences described above.
Our charter further provides that, prior to the date the preferred stock
qualifies as a class of "publicly offered securities" (within the meaning of
Department of Labor Regulation Section 2510.3-101(a)(2)), (a) no plan investor
may acquire shares of our stock without our prior written consent; and (b) any
transfers to plan investors that would increase the aggregate plan investors'
ownership of shares of our stock to a level that meets or exceeds 25% or more of
the value of any class of our stock will be void ab initio. If any transfer of
shares of our stock to plan investors occurs which, if effective, would result
in plan investors beneficially or constructively owning, in the aggregate,
shares of our stock in excess or in violation of the above transfer or ownership
limitations, then that number of shares of our stock, the beneficial or
constructive ownership of which otherwise would cause such plan investors to
violate such limitations shall be automatically transferred to the Trust (as
defined above) to be held, subject to certain adjustments, in accordance with
the provisions detailed above.
Every record owner of more than a specified percentage of our stock as
required by the Internal Revenue Code or the regulations promulgated thereunder
(which may be as low as 0.5% depending upon the number of stockholders of record
of our stock), within 30 days after the end of each taxable year, is required to
give us written notice, stating his name and address, the number of shares of
each class and series of our stock which he beneficially owns and a description
of the manner in which the shares are
93
held. Each such owner shall provide us with such additional information as we
may request in order to determine the effect, if any, of his beneficial
ownership on our status as a REIT and to ensure compliance with the ownership
limits. In addition, each stockholder shall upon demand be required to provide
us with such information as we may request in good faith in order to determine
our status as a REIT and to comply with the requirements of any taxing authority
or governmental authority or to determine such compliance.
These ownership limits could delay, defer or prevent a transaction or a
change in control that might involve a premium price for the common stock or
otherwise be in the best interest of the stockholders.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for the Series B Preferred Stock is
American Stock Transfer & Trust Company, New York, New York.
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DESCRIPTION OF CAPITAL STOCK
The following description of the terms of our stock is only a summary. For
a complete description, we refer you to the Maryland General Corporation Law,
our charter and our bylaws. We have filed our charter and bylaws as exhibits to
this registration statement.
GENERAL
Our charter provides that we may issue up to 500,000,000 shares of common
stock, $.01 par value per share, and up to 100,000,000 shares of preferred
stock, $.01 par value per share. As of December 31, 2002, 23,488,517 shares of
common stock, and no shares of preferred stock were issued and outstanding.
Under Maryland law, our stockholders generally are not liable for our debts or
obligations.
COMMON STOCK
All outstanding shares of our common stock are duly authorized, fully paid
and nonassessable. Holders of our common stock are entitled to receive dividends
when authorized by our board of directors out of assets legally available for
the payment of dividends. They are also entitled to share ratably in our assets
legally available for distribution to our stockholders in the event of our
liquidation, dissolution or winding up, after payment of or adequate provision
for all of our known debts and liabilities. These rights are subject to the
preferential rights of any other class or series of our stock and to the
provisions of our charter regarding restrictions on transfer of our stock.
Subject to our charter restrictions on transfer of our stock, each
outstanding share of common stock entitles the holder to one vote on all matters
submitted to a vote of stockholders, including the election of directors. Except
as provided with respect to any other class or series of stock, the holders of
our common stock will possess the exclusive voting power. There is no cumulative
voting in the election of directors, which means that the holders of a majority
of the outstanding shares of common stock can elect all of the directors then
standing for election, and the holders of the remaining shares will not be able
to elect any directors.
Holders of our common stock have no preference, conversion, exchange,
sinking fund, redemption or appraisal rights and have no preemptive rights to
subscribe for any of our securities. Subject to our charter restrictions on
transfer of stock, all shares of common stock will have equal dividend,
liquidation and other rights.
Under Maryland law, a Maryland corporation generally cannot dissolve, amend
its charter, merge, sell all or substantially all of its assets, engage in a
share exchange or engage in similar transactions outside the ordinary course of
business, unless approved by the affirmative vote of stockholders holding at
least two thirds of the shares entitled to vote on the matter. However, a
Maryland corporation may provide in its charter for approval of these matters by
a lesser percentage, but not less than a majority of all of the votes entitled
to be cast on the matter. Our charter provides that these matters may be
approved by a majority of all of the votes entitled to be cast on the matter.
POWER TO RECLASSIFY UNISSUED SHARES OF OUR STOCK
Our charter authorizes our board of directors to classify and reclassify
any unissued shares of our common stock or preferred stock into other classes or
series of stock. Prior to issuance of shares of each class or series, our board
is required by Maryland law and by our charter to set, subject to our charter
restrictions on transfer of stock, the terms, preferences, conversion or other
rights, voting powers, restrictions, limitations as to dividends or other
distributions, qualifications and terms or conditions of redemption for each
class or series. Therefore, our board could authorize the issuance of shares of
preferred stock with terms and conditions which could have the effect of
delaying, deferring or preventing a transaction or a change in control that
might involve a premium price for holders of our common stock or otherwise be in
their best interest. Prior to this offering, no shares of our preferred stock
are presently outstanding.
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POWER TO ISSUE ADDITIONAL SHARES OF COMMON STOCK AND PREFERRED STOCK
We believe that the power to issue additional shares of common stock or
preferred stock and to classify or reclassify unissued shares of common stock or
preferred stock and thereafter to issue the classified or reclassified shares
provides us with increased flexibility in structuring possible future financings
and acquisitions and in meeting other needs which might arise. These actions can
be taken without stockholder approval, unless stockholder approval is required
by applicable law or the rules of any stock exchange or automated quotation
system on which our securities may be listed or traded. Although we have no
present intention of doing so, we could issue a class or series of stock that
could delay, defer or prevent a transaction or a change in control of us that
might involve a premium price for holders of common stock or otherwise be in
their best interest.
STOCKHOLDER RIGHTS PLAN
Our board of directors has adopted a stockholder rights agreement. The
adoption of the stockholder rights agreement could make it more difficult for a
third party to acquire, or could discourage a third party from acquiring, us or
a large block of our common stock.
Pursuant to the terms of the stockholder rights agreement, our board of
directors declared a dividend distribution of one preferred stock purchase right
for each outstanding share of common stock to stockholders of record at the
close of business on October 16, 2002. In addition, one preferred stock purchase
right will automatically attach to each share of common stock issued between the
record date and the distribution date. Each preferred stock purchase right
entitles the registered holder to purchase from us a unit consisting of one
one-hundredth of a share, each a rights unit, of Series A Junior Participating
Preferred Stock, par value $0.01 per share, the Series A Preferred Stock, at a
purchase price of $70 per rights unit, the purchase price, subject to
adjustment. Each share offered hereby will be entitled to a preferred stock
purchase right when distributed.
Initially, the preferred stock purchase rights are not exercisable and are
attached to and transfer and trade with, the outstanding shares of common stock.
The preferred stock purchase rights will separate from the common stock and will
become exercisable upon the earliest of (i) the close of business on the tenth
business day following the first public announcement that an acquiring person
has acquired beneficial ownership of 15% or more of the sum of the outstanding
shares of common stock, subject to certain exceptions, the date of said
announcement being referred to as the stock acquisition date, or (ii) the close
of business on the tenth business day (or such later date as our board of
directors may determine) following the commencement of a tender offer or
exchange offer that would result upon its consummation in a person or group
becoming an acquiring person, the earlier of such dates being the distribution
date. For these purposes, a person will not be deemed to beneficially own shares
of common stock which may be issued in exchange for rights units. The
stockholder rights agreement contains provisions that are designed to ensure
that the manager and its affiliates will never, alone, be considered a group
that is an acquiring person.
Until the distribution date (or earlier redemption, exchange or expiration
of rights), (a) the rights will be evidenced by the common stock certificates
and will be transferred with and only with such common stock certificates, (b)
new common stock certificates issued after the record date will contain a
notation incorporating the stockholder rights agreement by reference, and (c)
the surrender for transfer of any certificates for common stock outstanding will
also constitute the transfer of the rights associated with common stock
represented by such certificate.
The rights are not exercisable until the distribution date and will expire
ten years after the issuance thereof, on October 16, 2012 unless such date is
extended or the rights are earlier redeemed or exchanged by us as described
below.
As soon as practicable after the distribution date, rights certificates
will be mailed to holders of record of common stock as of the close of business
on the distribution date and, thereafter, the separate rights
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certificates alone will represent the rights. Except as otherwise determined by
our board of directors, only shares of common stock issued prior to the
distribution date will be issued with rights.
In the event that a person becomes an acquiring person, except pursuant to
an offer for all outstanding shares of common stock which the independent
directors determine to be fair to, not inadequate and to otherwise be in our
best interests and the best interest of our stockholders, after receiving advice
from one or more investment banking firms, a qualified offer, each holder of a
right will thereafter have the right to receive, upon exercise, common stock
(or, in certain circumstances, cash, property or other securities of ours)
having a value equal to two times the exercise price of the right. The exercise
price is the purchase price times the number of rights units associated with
each right. Notwithstanding any of the foregoing, following the occurrence of
the event set forth in this paragraph, all rights that are, or (under certain
circumstances specified in the rights agreement) were, beneficially owned by any
acquiring person will be null and void. However, rights are not exercisable
following the occurrence of the event set forth above until such time as the
rights are no longer redeemable by us as set forth below.
In the event that, at any time following the stock acquisition date, (i) we
engage in a merger or other business combination transaction in which we are not
the surviving corporation (other than with an entity which acquired the shares
pursuant to a qualified offer), (ii) we engage in a merger or other business
combination transaction in which we are the surviving corporation and our common
stock changed or exchanged, or (iii) 50% or more of our assets, cash flow or
earning power is sold or transferred, each holder of a right (except rights
which have previously been voided as set forth above) shall thereafter have the
right to receive, upon exercise, common stock of the acquiring company having a
value equal to two times the exercise price of the right. The events set forth
in this paragraph and in the preceding paragraph are referred to as the
"triggering events."
At any time after a person becomes an acquiring person and prior to the
acquisition by such person or group of fifty percent (50%) or more of the
outstanding common stock, our board may exchange the rights (other than rights
owned by such person or group which have become void), in whole or in part, at
an exchange ratio of one share of common stock, or one one-hundredth of a share
of preferred stock (or of a share of a class or series of our preferred stock
having equivalent rights, preferences and privileges), per right (subject to
adjustment).
We may redeem the rights in whole, but not in part, at a price of $0.01 per
right (payable in cash, common stock or other consideration deemed appropriate
by our board of directors) at any time until the earlier of (i) the close of
business on the tenth business day after the stock acquisition date, or (ii) the
expiration date of the rights agreement. Immediately upon the action of our
board of directors ordering redemption of the rights, the rights will terminate
and thereafter the only right of the holders of rights will be to receive the
redemption price.
The rights agreement may be amended by our board of directors in its sole
discretion at any time prior to the distribution date. After the distribution
date, subject to certain limitations set forth in the rights agreement, our
board of directors may amend the rights agreement only to cure any ambiguity,
defect or inconsistency, to shorten or lengthen any time period, or to make
changes that do not adversely affect the interests of rights holders (excluding
the interests of an acquiring person or its associates or affiliates). The
foregoing notwithstanding, no amendment may be made at such time as the rights
are not redeemable.
Until a right is exercised, the holder thereof, as such, will have no
rights as our stockholder, including, without limitation, the right to vote or
to receive dividends. While the distribution of the rights will not be taxable
to stockholders or to us, stockholders may, depending upon the circumstances,
recognize taxable income in the event that the rights become exercisable for
common stock, other securities of ours, other consideration or for common stock
of an acquiring company or in the event of the redemption of the rights as set
forth above.
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A copy of the rights agreement is available from us upon written request.
The foregoing description of the rights does not purport to be complete and is
qualified in its entirety by reference to the rights agreement, which is filed
as an exhibit to the registration statement of which this prospectus is a part.
DIVIDEND REINVESTMENT PLAN
We may implement a dividend reinvestment plan whereby stockholders may
automatically reinvest their dividends in our common stock. Details about any
such plan would be sent to our stockholders following adoption thereof by our
board of directors.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for our common stock and our Series B
Preferred Stock is American Stock Transfer & Trust Company, New York, New York.
TRANSFER RESTRICTIONS
Our charter contains restrictions on the number of shares of our stock that
a person may own. No person may acquire or hold, directly or indirectly, in
excess of 8.0% of the aggregate value of the outstanding shares of our stock,
treating all classes and series of our stock as one for this purpose, or in
excess of 25.0% of our Series B Preferred Stock, in each case unless they
receive an exemption from our board of directors.
Our charter further prohibits (a) any person from owning shares of our
stock that would result in our being "closely held" under Section 856(h) of the
Internal Revenue Code or otherwise cause us to fail to qualify as a REIT and (b)
any person from transferring shares of our stock if the transfer would result in
our stock being owned by fewer than 100 persons. Any person who acquires or
intends to acquire shares of our stock that may violate any of these
restrictions, or who is the intended transferee of shares of our stock which are
transferred to the Trust, as defined below, is required to give us immediate
written notice and provide us with such information as we may request in order
to determine the effect of the transfer on our status as a REIT. The above
restrictions will not apply if our board of directors determines that it is no
longer in our best interests to continue to qualify as a REIT.
Our board of directors, in its sole discretion, may exempt a person from
these limits, subject to such terms, conditions, representations and
undertakings as it may determine. Our board of directors has granted limited
exemptions to certain persons who directly or indirectly own our stock,
including Newcastle Investment Holdings, our manager, a third party group of
funds managed by Wallace R. Weitz & Company, and certain affiliates of these
entities.
Any attempted transfer or ownership of our stock which, if effective, would
result in violation of the above limitations, will cause the number of shares
causing the violation (rounded to the nearest whole share) to be automatically
transferred to a trust ("Trust") for the exclusive benefit of one or more
charitable beneficiaries ("Charitable Beneficiary"), and the proposed holder
will not acquire any rights in the shares. The automatic transfer will be deemed
to be effective as of the close of business on the business day (as defined in
our charter) prior to the date of such violation. The shares transferred to the
Trust will generally be selected so as to minimize the aggregate value of shares
transferred to the Trust. Shares of our stock held in the Trust will be issued
and outstanding shares. The proposed holder will not benefit economically from
ownership of any shares of stock held in the Trust, will have no rights to
dividends and no rights to vote or other rights attributable to the shares of
stock held in the Trust. The trustee of the Trust will have all voting rights
and rights to dividends or other distributions with respect to shares held in
the Trust. These rights will be exercised for the exclusive benefit of the
Charitable Beneficiary. Any dividend or other distribution paid prior to our
discovery that shares of stock have been transferred to the Trust will be paid
by the recipient to the Trustee upon demand. Any dividend or other distribution
authorized but unpaid will be paid when due to the Trustee. Any dividend or
distribution paid to the Trustee will be held in trust for the Charitable
Beneficiary. Subject to Maryland law, the Trustee will have the authority (i) to
rescind as void any vote cast by the proposed holder prior to our discovery
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that the shares have been transferred to the Trust and (ii) to recast the vote
in accordance with the desires of the Trustee acting for the benefit of the
Charitable Beneficiary. However, if we have already taken irreversible corporate
action, then the Trustee will not have the authority to rescind and recast the
vote. If necessary to protect our status as a REIT, we may establish additional
Trusts with distinct Trustees and Charitable Beneficiaries to which shares may
be transferred.
Within 20 days of receiving notice from us that shares of our stock have
been transferred to the Trust, the Trustee will sell the shares to a person
designated by the Trustee, whose ownership of the shares will not violate the
above ownership limitations. Upon the sale, the interest of the Charitable
Beneficiary in the shares sold will terminate and the Trustee will distribute
the net proceeds of the sale to the proposed holder and to the Charitable
Beneficiary as follows. The proposed holder will receive the lesser of (i) the
price paid by the proposed holder for the shares or, if the proposed holder did
not give value for the shares in connection with the event causing the shares to
be held in the Trust (e.g., a gift, devise or other similar transaction), the
Market Price (as defined in our charter) of the shares on the day of the event
causing the shares to be held in the Trust and (ii) the price received by the
Trustee from the sale or other disposition of the shares. Any net sale proceeds
in excess of the amount payable to the proposed holder will be paid immediately
to the Charitable Beneficiary. If, prior to our discovery that shares of our
stock have been transferred to the Trust, the shares are sold by the proposed
holder, then (i) the shares shall be deemed to have been sold on behalf of the
Trust and (ii) to the extent that the proposed holder received an amount for the
shares that exceeds the amount he was entitled to receive, the excess shall be
paid to the Trustee upon demand.
In addition, shares of our stock held in the Trust will be deemed to have
been offered for sale to us, or our designee, at a price per share equal to the
lesser of (i) the price per share in the transaction that resulted in the
transfer to the Trust (or, in the case of a devise or gift, the Market Price at
the time of the devise or gift) and (ii) the Market Price on the date we, or our
designee, accept the offer. We will have the right to accept the offer until the
Trustee has sold the shares. Upon a sale to us, the interest of the Charitable
Beneficiary in the shares sold will terminate and the Trustee will distribute
the net proceeds of the sale to the proposed holder.
If an investor acquires an amount of stock that exceeds 8.0 percent of the
shares of a particular class, but is less than 8.0 percent of the value of the
Company's stock of all classes in the aggregate, subsequent fluctuations in the
relative values of the Company's different classes of stock could cause the
investor's ownership to exceed the 8.0 percent ownership limitation, with the
consequences described above.
Our charter further provides that, prior to the date the common stock
qualifies as a class of "publicly offered securities" (within the meaning of
Department of Labor Regulation Section 2510.3-101(a)(2)), (a) no plan investor
may acquire shares of our stock without our prior written consent; and (b) any
transfers to plan investors that would increase the aggregate plan investors,
ownership of shares of our stock to a level that meets or exceeds 25% or more of
the value of any class of our stock will be void ab initio. If any transfer of
shares of our stock to plan investors occurs which, if effective, would result
in plan investors beneficially or constructively owning, in the aggregate,
shares of our stock in excess or in violation of the above transfer or ownership
limitations, then that number of shares of our stock, the beneficial or
constructive ownership of which otherwise would cause such plan investors to
violate such limitations shall be automatically transferred to the Trust (as
defined above) to be held, subject to certain adjustments, in accordance with
the provisions detailed above.
All certificates representing shares of our stock will bear a legend
referring to the restrictions described above.
Every record owner of more than a specified percentage of our stock as
required by the Internal Revenue Code or the regulations promulgated thereunder
(which may be as low as 0.5% depending upon the number of stockholders of record
of our stock), within 30 days after the end of each taxable year, is required to
give us written notice, stating his name and address, the number of shares of
each class and series of our stock which he beneficially owns and a description
of the manner in which the shares are held. Each such owner shall provide us
with such additional information as we may request in order to
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determine the effect, if any, of his beneficial ownership on our status as a
REIT and to ensure compliance with the ownership limits. In addition, each
stockholder shall upon demand be required to provide us with such information as
we may request in good faith in order to determine our status as a REIT and to
comply with the requirements of any taxing authority or governmental authority
or to determine such compliance.
These ownership limits could delay, defer or prevent a transaction or a
change in control that might involve a premium price for the common stock or
otherwise be in the best interest of the stockholders.
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IMPORTANT PROVISIONS OF MARYLAND LAW AND
OF OUR CHARTER AND BYLAWS
The following description of the terms of our stock and of certain
provisions of Maryland law is only a summary. For a complete description, we
refer you to the Maryland General Corporation Law, our charter and our bylaws.
We have filed our charter and bylaws as exhibits to this registration statement.
CLASSIFICATION OF OUR BOARD OF DIRECTORS
Our bylaws provide that the number of our directors may be established by
our board of directors but may not be fewer than the minimum required by the
MGCL (which is currently one) nor more than fifteen. Any vacancy will be filled,
at any regular meeting or at any special meeting called for that purpose, by a
majority of the remaining directors, except that a vacancy resulting from an
increase in the number of directors must be filled by a majority of the entire
board of directors.
Pursuant to our charter, the board of directors is divided into three
classes of directors. The current terms of the Class I, Class II and Class III
directors will expire in 2003, 2004 and 2005, respectively. Directors of each
class will be chosen for three-year terms upon the expiration of their current
terms and each year one class of directors will be elected by the stockholders.
We believe that classification of the board of directors will help to assure the
continuity and stability of our business strategies and policies as determined
by the board of directors. Holders of shares of our common stock will have no
right to cumulative voting in the election of directors. Consequently, at each
annual meeting of stockholders, the holders of a majority of the shares of our
common stock will be able to elect all of the successors of the class of
directors whose terms expire at that meeting.
The classified board provision could have the effect of making the
replacement of incumbent directors more time-consuming and difficult. At least
two annual meetings of stockholders, instead of one, will generally be required
to effect a change in a majority of our board of directors. Thus, the classified
board provision could increase the likelihood that incumbent directors will
retain their positions. The staggered terms of directors may delay, defer or
prevent a tender offer or an attempt to change the control of us, even though
the tender offer or change in control might be in the best interest of our
stockholders.
REMOVAL OF DIRECTORS
Our charter provides that a director may be removed only for cause (as
defined in the charter) and only by the affirmative vote of at least two-thirds
of the votes entitled to be cast in the election of directors. This provision,
when coupled with the provision in our bylaws authorizing our board of directors
to fill vacant directorships, precludes stockholders from removing incumbent
directors except for cause and by a substantial affirmative vote and filling the
vacancies created by the removal with their own nominees.
BUSINESS COMBINATIONS
Under Maryland law, "business combinations" between a Maryland corporation
and an interested stockholder or an affiliate of an interested stockholder are
prohibited for five years after the most recent date on which the interested
stockholder becomes an interested stockholder. These business combinations
include a merger, consolidation, share exchange, or, in circumstances specified
in the statute, an asset transfer or issuance or reclassification of equity
securities. An interested stockholder is defined as:
- any person who beneficially owns 10% or more of the voting power of the
corporation's shares; or
- an affiliate or associate of the corporation who, at any time within the
two-year period prior to the date in question, was the beneficial owner
of 10% or more of the voting power of the then outstanding voting stock
of the corporation.
A person is not an interested stockholder under the statute if the board of
directors approved in advance the transaction by which he otherwise would have
become an interested stockholder. However, in
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approving a transaction, the board of directors may provide that its approval is
subject to compliance, at or after the time of approval, with any terms and
conditions determined by the board.
After the five-year prohibition, any business combination between the
Maryland corporation and an interested stockholder generally must be recommended
by the board of directors of the corporation and approved by the affirmative
vote of at least:
- 80% of the votes entitled to be cast by holders of outstanding shares of
voting stock of the corporation; and
- two-thirds of the votes entitled to be cast by holders of voting stock of
the corporation other than shares held by the interested stockholder with
whom or with whose affiliate the business combination is to be effected
or held by an affiliate or associate of the interested stockholder.
These super-majority vote requirements do not apply if the corporation's
common stockholders receive a minimum price, as defined under Maryland law, for
their shares in the form of cash or other consideration in the same form as
previously paid by the interested stockholder for its shares.
The statute permits various exemptions from its provisions, including
business combinations that are exempted by the board of directors before the
time that the interested stockholder becomes an interested stockholder. Pursuant
to the statute, our board of directors has exempted any business combinations
(a) between us and Fortress Investment Group LLC or any of its affiliates, (b)
between us and Newcastle Investment Holdings, or any of its affiliates and (c)
between us and any interested stockholder, provided that any such business
combination is first approved by our board of directors (including a majority of
our directors who are not affiliates or associates of such interested
stockholder). Consequently, the five-year prohibition and the super-majority
vote requirements will not apply to business combinations between us and any of
them. As a result, such parties may be able to enter into business combinations
with us that may not be in the best interest of our stockholders, without
compliance with the super-majority vote requirements and the other provisions of
the statute.
The business combination statute may discourage others from trying to
acquire control of us and increase the difficulty of consummating any offer.
CONTROL SHARE ACQUISITIONS
Maryland law provides that control shares of a Maryland corporation
acquired in a control share acquisition have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on the
matter. Shares owned by the acquiror, by officers or by directors who are
employees of the corporation are excluded from shares entitled to vote on the
matter. Control shares are voting shares of stock which, if aggregated with all
other shares of stock owned by the acquiror or in respect of which the acquiror
is able to exercise or direct the exercise of voting power (except solely by
virtue of a revocable proxy), would entitle the acquiror to exercise voting
power in electing directors within one of the following ranges of voting power:
- one-tenth or more but less than one-third,
- one-third or more but less than a majority, or
- a majority or more of all voting power.
Control shares do not include shares the acquiring person is then entitled
to vote as a result of having previously obtained stockholder approval. A
control share acquisition means the acquisition of control shares, subject to
certain exceptions.
A person who has made or proposes to make a control share acquisition may
compel the board of directors of the corporation to call a special meeting of
stockholders to be held within 50 days of demand to consider the voting rights
of the shares. The right to compel the calling of a special meeting is subject
to the satisfaction of certain conditions, including an undertaking to pay the
expenses of the meeting. If no request for a meeting is made, the corporation
may itself present the question at any stockholders meeting.
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If voting rights are not approved at the meeting or if the acquiring person
does not deliver an acquiring person statement as required by the statute, then
the corporation may redeem for fair value any or all of the control shares,
except those for which voting rights have previously been approved. The right of
the corporation to redeem control shares is subject to certain conditions and
limitations. Fair value is determined, without regard to the absence of voting
rights for the control shares, as of the date of the last control share
acquisition by the acquiror or of any meeting of stockholders at which the
voting rights of the shares are considered and not approved. If voting rights
for control shares are approved at a stockholders meeting and the acquiror
becomes entitled to vote a majority of the shares entitled to vote, all other
stockholders may exercise appraisal rights. The fair value of the shares as
determined for purposes of appraisal rights may not be less than the highest
price per share paid by the acquiror in the control share acquisition.
The control share acquisition statute does not apply (a) to shares acquired
in a merger, consolidation or share exchange if the corporation is a party to
the transaction, or (b) to acquisitions approved or exempted by the charter or
bylaws of the corporation.
Our bylaws contain a provision exempting from the control share acquisition
statute any and all acquisitions by any person of shares of our stock. This
provision may be amended or eliminated at any time in the future.
AMENDMENT TO OUR CHARTER
Our charter, including its provisions on classification of our board of
directors and removal of directors, may be amended only by the affirmative vote
of the holders of not less than a majority of all of the votes entitled to be
cast on the matter.
ADVANCE NOTICE OF DIRECTOR NOMINATIONS AND NEW BUSINESS
Our bylaws provide that with respect to an annual meeting of stockholders,
nominations of persons for election to our board of directors and the proposal
of business to be considered by stockholders may be made only (i) pursuant to
our notice of the meeting, (ii) by our board of directors or (iii) by a
stockholder of record who is entitled to vote at the meeting and who has
complied with the advance notice procedures of our bylaws. With respect to
special meetings of stockholders, only the business specified in our notice of
the meeting may be brought before the meeting. Nominations of persons for
election to our board of directors at a special meeting may be made only (i)
pursuant to our notice of the meeting, (ii) by the board of directors, or (iii)
provided that the board of directors has determined that directors will be
elected at the meeting, by a stockholder who is entitled to vote at the meeting
and who has complied with the advance notice provisions of our bylaws.
ANTI-TAKEOVER EFFECT OF CERTAIN PROVISIONS OF MARYLAND LAW AND OF OUR CHARTER
AND BYLAWS
The business combination provisions and, if the applicable provision in our
bylaws is rescinded, the control share acquisition provisions of Maryland law,
the provisions of our charter on classification of our board of directors and
removal of directors and the advance notice provisions of our bylaws could
delay, defer or prevent a transaction or a change in the control of us that
might involve a premium price for holders of our common stock or otherwise be in
their best interest.
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FEDERAL INCOME TAX CONSIDERATIONS
The following is a summary of the material federal income tax consequences
relating to the acquisition, holding, and disposition of our stock, including
our Series B Preferred Stock. For purposes of this section under the heading
"Federal Income Tax Considerations", references to Newcastle mean only Newcastle
Investment Corp. and not its subsidiaries, except as otherwise indicated. This
summary is based upon the Internal Revenue Code of 1986, as amended (the
Internal Revenue Code), the regulations promulgated by the U.S. Treasury
Department, rulings and other administrative pronouncements issued by the IRS,
and judicial decisions, all as currently in effect, and all of which are subject
to differing interpretations or to change, possibly with retroactive effect. No
assurance can be given that the IRS would not assert, or that a court would not
sustain, a position contrary to any of the tax consequences described below. No
advance ruling has been or will be sought from the IRS regarding any matter
discussed in this prospectus. The summary is also based upon the assumption that
the operation of Newcastle and its subsidiaries and affiliated entities will be
in accordance with its applicable organizational documents or partnership
agreement. This summary is for general information only, and does not purport to
discuss all aspects of federal income taxation that may be important to a
particular investor in light of its investment or tax circumstances, or to
investors subject to special tax rules, such as:
- financial institutions;
- insurance companies;
- broker-dealers;
- regulated investment companies;
- holders who receive Newcastle stock through the exercise of employee
stock options or otherwise as compensation;
- persons holding Newcastle stock as part of a "straddle," "hedge,"
"conversion transaction," "synthetic security" or other integrated
investment;
and, except to the extent discussed below:
- tax-exempt organizations; and
- foreign investors.
This summary assumes that investors will hold our stock as capital assets,
which generally means as property held for investment.
THE FEDERAL INCOME TAX TREATMENT OF HOLDERS OF NEWCASTLE STOCK DEPENDS IN
SOME INSTANCES ON DETERMINATIONS OF FACT AND INTERPRETATIONS OF COMPLEX
PROVISIONS OF FEDERAL INCOME TAX LAW FOR WHICH NO CLEAR PRECEDENT OR AUTHORITY
MAY BE AVAILABLE. IN ADDITION, THE TAX CONSEQUENCES OF HOLDING NEWCASTLE STOCK
TO ANY PARTICULAR STOCKHOLDER WILL DEPEND ON THE STOCKHOLDER'S PARTICULAR TAX
CIRCUMSTANCES. YOU ARE URGED TO CONSULT YOUR TAX ADVISOR REGARDING THE FEDERAL,
STATE, LOCAL, AND FOREIGN INCOME AND OTHER TAX CONSEQUENCES TO YOU IN LIGHT OF
YOUR PARTICULAR INVESTMENT OR TAX CIRCUMSTANCES OF ACQUIRING, HOLDING,
EXCHANGING, OR OTHERWISE DISPOSING OF NEWCASTLE STOCK.
TAXATION OF NEWCASTLE
Newcastle will elect to be taxed as a REIT, commencing with its initial
taxable year ending December 31, 2002, upon the filing of its federal income tax
return for that year. Newcastle believes that it was organized and has operated
in such a manner as to qualify for taxation as a REIT, and intends to continue
to operate in such a manner.
The law firm of Skadden, Arps, Slate, Meagher & Flom LLP has acted as our
tax counsel in connection with our election to be taxed as a REIT. Newcastle has
received an opinion of Skadden, Arps, Slate, Meagher & Flom LLP to the effect
that Newcastle was organized in conformity with the requirements for
qualification as a REIT under the Internal Revenue Code, and that its actual
method of
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operation has enabled, and its proposed method of operation will enable, it to
meet the requirements for qualification and taxation as a REIT. It must be
emphasized that the opinion of Skadden, Arps, Slate, Meagher & Flom LLP is based
on various assumptions relating to the organization and operation of Newcastle,
and is conditioned upon representations and covenants made by the management of
Newcastle regarding its organization, assets and the past, present and future
conduct of its business operations. While Newcastle intends to operate so that
it will qualify as a REIT, given the highly complex nature of the rules
governing REITs, the ongoing importance of factual determinations, and the
possibility of future changes in the circumstances of Newcastle, no assurance
can be given by Skadden, Arps, Slate, Meagher & Flom LLP or Newcastle that
Newcastle will so qualify for any particular year. The opinion of Skadden, Arps,
Slate, Meagher & Flom LLP also relies on various legal opinions issued by other
counsel for Newcastle and its predecessors, including Sidley Austin Brown & Wood
LLP and Thacher Proffitt & Wood, with respect to certain issues and
transactions. The opinions, copies of which are filed as an exhibit to the
registration statement of which this prospectus is a part, are expressed as of
the date issued, and do not cover subsequent periods. Counsel will have no
obligation to advise Newcastle or the holders of Newcastle stock of any
subsequent change in the matters stated, represented or assumed, or of any
subsequent change in the applicable law. You should be aware that opinions of
counsel are not binding on the IRS, and no assurance can be given that the IRS
will not challenge the conclusions set forth in such opinions.
Qualification and taxation as a REIT depends on the ability of Newcastle to
meet on a continuing basis, through actual operating results, distribution
levels, and diversity of stock ownership, various qualification requirements
imposed upon REITs by the Internal Revenue Code, the compliance with which will
not be reviewed by Skadden, Arps, Slate, Meagher & Flom LLP. In addition,
Newcastle's ability to qualify as a REIT depends in part upon the operating
results, organizational structure and entity classification for federal income
tax purposes of certain affiliated entities, including affiliates that have made
elections to be taxed as REITs, the status of which may not have been reviewed
by Skadden, Arps, Slate, Meagher & Flom LLP. Newcastle's ability to qualify as a
REIT also requires that it satisfies certain asset tests, some of which depend
upon the fair market values of assets directly or indirectly owned by Newcastle.
Such values may not be susceptible to a precise determination. Accordingly, no
assurance can be given that the actual results of Newcastle's operations for any
taxable year satisfy such requirements for qualification and taxation as a REIT.
TAXATION OF REITS IN GENERAL
As indicated above, qualification and taxation as a REIT depends upon the
ability of Newcastle to meet, on a continuing basis, various qualification
requirements imposed upon REITs by the Internal Revenue Code. The material
qualification requirements are summarized below under "-- Requirements for
Qualification -- General." While Newcastle intends to operate so that it
qualifies as a REIT, no assurance can be given that the IRS will not challenge
its qualification, or that it will be able to operate in accordance with the
REIT requirements in the future. See "-- Failure to Qualify."
Provided that Newcastle qualifies as a REIT, it will generally be entitled
to a deduction for dividends that it pays and therefore will not be subject to
federal corporate income tax on its net income that is currently distributed to
its stockholders. This treatment substantially eliminates the "double taxation"
at the corporate and stockholder levels that generally results from investment
in a corporation. Rather, income generated by a REIT generally is taxed only at
the stockholder level upon a distribution of dividends by the REIT. Net
operating losses, foreign tax credits and other tax attributes of a REIT
generally do not pass through to the stockholders of the REIT, subject to
special rules for certain items such as capital gains recognized by REITs. See
"Taxation of Stockholders."
If Newcastle qualifies as a REIT, it will nonetheless be subject to federal
tax in the following circumstances:
- Newcastle will be taxed at regular corporate rates on any undistributed
income, including undistributed net capital gains.
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- Newcastle may be subject to the "alternative minimum tax" on its items of
tax preference, including any deductions of net operating losses.
- If Newcastle has net income from prohibited transactions, which are, in
general, sales or other dispositions of property held primarily for sale
to customers in the ordinary course of business, other than foreclosure
property, such income will be subject to a 100% excise tax. See
"-- Prohibited Transactions", and "-- Foreclosure Property", below.
- If Newcastle elects to treat property that it acquires in connection with
a foreclosure of a mortgage loan or certain leasehold terminations as
"foreclosure property", it may thereby avoid the 100% excise tax on gain
from a resale of that property (if the sale would otherwise constitute a
prohibited transaction), but the income from the sale or operation of the
property may be subject to corporate income tax at the highest applicable
rate (currently 35%).
- If Newcastle should fail to satisfy the 75% gross income test or the 95%
gross income test, as discussed below, but nonetheless maintains its
qualification as a REIT because other requirements are met, it will be
subject to a 100% tax on an amount equal to (a) the greater of the amount
by which Newcastle fails the 75% or the 95% gross income test, as the
case may be, multiplied by (b) a fraction intended to reflect the
profitability of Newcastle.
- If Newcastle should fail to distribute during each calendar year at least
the sum of (a) 85% of its REIT ordinary income for such year, (b) 95% of
its REIT capital gain net income for such year, and (c) any undistributed
taxable income from prior periods, Newcastle would be subject to a 4%
excise tax on the excess of the required distribution over the sum of (i)
the amounts actually distributed, plus (ii) retained amounts on which
income tax is paid at the corporate level.
- Newcastle may be required to pay monetary penalties to the IRS in certain
circumstances, including if it fails to meet record keeping requirements
intended to monitor its compliance with rules relating to the composition
of a REIT's stockholders, as described below in "-- Requirements for
Qualification -- General."
- A 100% excise tax may be imposed on some items of income and expense that
are directly or constructively paid between a REIT and a taxable REIT
subsidiary (as described below) if and to the extent that the IRS
successfully adjusts the reported amounts of these items.
- If Newcastle acquires assets from a corporation that is not a REIT (i.e.,
a corporation taxable under subchapter C of the Internal Revenue Code),
in a transaction in which the adjusted tax basis of the assets in the
hands of Newcastle is determined by reference to the adjusted tax basis
of the assets in the hands of the subchapter C corporation, under
Temporary Treasury Regulations the subchapter C corporation would
generally be required to recognize any net built-in gain that would have
been realized if it had liquidated on the day before the date of the
transfer (i.e., as if it had sold its assets in a taxable transaction).
The regulations provide, however, that in lieu of taxation of the
transferor subchapter C corporation as described immediately above, a
REIT that acquires the assets may elect to be subject to tax at the
highest corporate income tax rate then applicable if it subsequently
recognizes the built-in gain on a disposition of any such assets during
the ten-year period following their acquisition from the subchapter C
corporation.
- Certain of Newcastle's subsidiaries may be subchapter C corporations, the
earnings of which would subject to federal corporate income tax.
In addition, Newcastle and its subsidiaries may be subject to a variety of
taxes, including payroll taxes and state, local, and foreign income, property
and other taxes on their assets and operations. Newcastle could also be subject
to tax in situations and on transactions not presently contemplated.
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REQUIREMENTS FOR QUALIFICATION -- GENERAL
The Internal Revenue Code defines a REIT as a corporation, trust or
association:
(1) that is managed by one or more trustees or directors;
(2) the beneficial ownership of which is evidenced by transferable
shares, or by transferable certificates of beneficial interest;
(3) which would be taxable as a domestic corporation but for the
special Internal Revenue Code provisions applicable to REITs;
(4) that is neither a financial institution nor an insurance company
subject to specific provisions of the Internal Revenue Code;
(5) the beneficial ownership of which is held by 100 or more persons;
(6) in which, during the last half of each taxable year, not more than
50% in value of the outstanding stock is owned, directly or indirectly, by
five or fewer "individuals" (as defined in the Internal Revenue Code to
include specified entities); and
(7) which meets other tests described below, including with respect to
the nature of its income and assets.
The Internal Revenue Code provides that conditions (1) through (4) must be
met during the entire taxable year, and that condition (5) must be met during at
least 335 days of a taxable year of 12 months, or during a proportionate part of
a shorter taxable year. Newcastle's charter provides restrictions regarding
transfers of its shares, which are intended to assist Newcastle in satisfying
the share ownership requirements described in conditions (5) and (6) above.
To monitor compliance with the share ownership requirements, Newcastle is
generally required to maintain records regarding the actual ownership of its
shares. To do so, Newcastle must demand written statements each year from the
record holders of significant percentages of its stock in which the record
holders are to disclose the actual owners of the shares, i.e., the persons
required to include in gross income the dividends paid by Newcastle. A list of
those persons failing or refusing to comply with this demand must be maintained
as part of the records of Newcastle. Failure by Newcastle to comply with these
record keeping requirements could subject it to monetary penalties. A
stockholder that fails or refuses to comply with the demand is required by
Treasury regulations to submit a statement with its tax return disclosing the
actual ownership of the shares and other information.
In addition, a corporation generally may not elect to become a REIT unless
its taxable year is the calendar year. Newcastle satisfies this requirement.
EFFECT OF SUBSIDIARY ENTITIES
Ownership of Partnership Interests. In the case of a REIT that is a
partner in a partnership, Treasury regulations provide that the REIT is deemed
to own its proportionate share of the partnership's assets, and to earn its
proportionate share of the partnership's income, for purposes of the asset and
gross income tests applicable to REITs as described below. In addition, the
assets and gross income of the partnership are deemed to retain the same
character in the hands of the REIT. Thus, Newcastle's proportionate share of the
assets and items of income of its subsidiary partnerships are treated as assets
and items of income of Newcastle for purposes of applying the REIT requirements
described below. A summary of certain rules governing the federal income
taxation of partnerships and their partners is provided below in "Tax Aspects of
Investments in Affiliated Entities -- Partnerships."
Disregarded Subsidiaries. If a REIT owns a corporate subsidiary that is a
"qualified REIT subsidiary", that subsidiary is disregarded for federal income
tax purposes, and all assets, liabilities and items of income, deduction and
credit of the subsidiary are treated as assets, liabilities and items of income,
deduction and credit of the REIT itself, including for purposes of the gross
income and asset tests
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applicable to REITs as summarized below. A qualified REIT subsidiary is any
corporation, other than a "taxable REIT subsidiary" as described below, that is
wholly-owned by a REIT, or by other disregarded subsidiaries, or by a
combination of the two. Newcastle has several qualified REIT subsidiaries. Other
entities wholly-owned by Newcastle, including single member limited liability
companies, are also generally disregarded as a separate entities for federal
income tax purposes, including for purposes of the REIT income and asset tests.
Disregarded subsidiaries, along with subsidiary partnerships of Newcastle, are
sometimes referred to in this prospectus as "pass-through subsidiaries."
In the event that a disregarded subsidiary of Newcastle ceases to be
wholly-owned -- for example, if any equity interest in the subsidiary is
acquired by a person other than Newcastle or another disregarded subsidiary of
Newcastle -- the subsidiary's separate existence would no longer be disregarded
for federal income tax purposes. Instead, it would have multiple owners and
would be treated as either a partnership or a taxable corporation. Such an event
could, depending on the circumstances, adversely affect Newcastle's ability to
satisfy the various asset and gross income requirements applicable to REITs,
including the requirement that REITs generally may not own, directly or
indirectly, more than 10% of the securities of another corporation. See
"-- Asset Tests" and "-- Income Tests."
Taxable Subsidiaries. A REIT, in general, may jointly elect with
subsidiary corporations, whether or not wholly-owned, to treat the subsidiary
corporation as a taxable REIT subsidiary ("TRS"). The separate existence of a
TRS or other taxable corporation, unlike a disregarded subsidiary as discussed
above, is not ignored for federal income tax purposes. Accordingly, such an
entity would generally be subject to corporate income tax on its earnings, which
may reduce the cash flow generated by Newcastle and its subsidiaries in the
aggregate, and Newcastle's ability to make distributions to its stockholders.
A parent REIT is not treated as holding the assets of a taxable subsidiary
corporation or as receiving any income that the subsidiary earns. Rather, the
stock issued by the subsidiary is an asset in the hands of the parent REIT, and
the REIT recognizes as income, the dividends, if any, that it receives from the
subsidiary. This treatment can affect the income and asset test calculations
that apply to the REIT, as described below. Because a parent REIT does not
include the assets and income of such subsidiary corporations in determining the
parent's compliance with the REIT requirements, such entities may be used by the
parent REIT to indirectly undertake activities that the REIT rules might
otherwise preclude it from doing directly or through pass-through subsidiaries
(for example, activities that give rise to certain categories of income such as
management fees or foreign currency gains).
INCOME TESTS
In order to maintain qualification as a REIT, Newcastle annually must
satisfy two gross income requirements. First, at least 75% of Newcastle's gross
income for each taxable year, excluding gross income from sales of inventory or
dealer property in "prohibited transactions", must be derived from investments
relating to real property or mortgages on real property, including "rents from
real property," dividends received from other REITs, interest income derived
from mortgage loans secured by real property (including certain types of
mortgage backed securities), and gains from the sale of real estate assets, as
well as income from some kinds of temporary investments. Second, at least 95% of
Newcastle's gross income in each taxable year, excluding gross income from
prohibited transactions, must be derived from some combination of such income
from investments in real property (i.e., income that qualifies under the 75%
income test described above), as well as other dividends, interest, and gain
from the sale or disposition of stock or securities, which need not have any
relation to real property.
Rents received by Newcastle will qualify as "rents from real property" in
satisfying the gross income requirements described above, only if several
conditions are met, including the following. If rent is partly attributable to
personal property leased in connection with a lease of real property, the
portion of the total rent that is attributable to the personal property will not
qualify as "rents from real property" unless it constitutes 15% or less of the
total rent received under the lease. Moreover, for rents received to qualify as
"rents from real property," the REIT generally must not operate or manage the
property or furnish or render services to the tenants of such property, other
than through an "independent contractor" from
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which the REIT derives no revenue. Newcastle and its affiliates are permitted,
however, to perform services that are "usually or customarily rendered" in
connection with the rental of space for occupancy only and are not otherwise
considered rendered to the occupant of the property. In addition, Newcastle and
its affiliates may directly or indirectly provide non-customary services to
tenants of its properties without disqualifying all of the rent from the
property if the payment for such services does not exceed 1% of the total gross
income from the property. For purposes of this test, the income received from
such non-customary services is deemed to be at least 150% of the direct cost of
providing the services. Moreover, Newcastle is permitted to provide services to
tenants or others through a TRS without disqualifying the rental income received
from tenants for purposes of the REIT income requirements. Also, rental income
will qualify as rents from real property only to the extent that Newcastle does
not directly or constructively hold a 10% or greater interest, as measured by
vote or value, in the lessee's equity.
To the extent that a REIT derives interest income from a mortgage loan or
income from the rental of real property where all or a portion of the amount of
interest or rental income payable is contingent, such income generally will
qualify for purposes of the gross income tests only if it is based upon the
gross receipts or sales, and not the net income or profits, of the borrower or
lessee. This limitation does not apply, however, where the borrower or lessee
leases substantially all of its interest in the property to tenants or
subtenants, to the extent that the rental income derived by the borrower or
lessee, as the case may be, would qualify as rents from real property had it
been earned directly by a REIT.
To the extent that the terms of a loan provide for contingent interest that
is based on the cash proceeds realized upon the sale of the property securing
the loan (a "shared appreciation provision"), income attributable to the
participation feature will be treated as gain from sale of the underlying
property, which generally will be qualifying income for purposes of both the 75%
and 95% gross income tests.
Interest income constitutes qualifying mortgage interest for purposes of
the 75% income test (as described above) to the extent that the obligation is
secured by a mortgage on real property. If Newcastle receives interest income
with respect to a mortgage loan that is secured by both real property and other
property, and the highest principal amount of the loan outstanding during a
taxable year exceeds the fair market value of the real property on the date that
Newcastle acquired or originated the mortgage loan, the interest income will be
apportioned between the real property and the other collateral, and Newcastle's
income from the arrangement will qualify for purposes of the 75% income test
only to the extent that the interest is allocable to the real property. Even if
a loan is not secured by real property, or is undersecured, the income that it
generates may nonetheless qualify for purposes of the 95% income test.
Newcastle may indirectly receive distributions from TRSs or other
corporations that are not REITs or qualified REIT subsidiaries. These
distributions will be classified as dividend income to the extent of the
earnings and profits of the distributing corporation. Such distributions will
generally constitute qualifying income for purposes of the 95% gross income
test, but not under the 75% gross income test. Any dividends received by
Newcastle from a REIT will be qualifying income in Newcastle's hands for
purposes of both the 95% and 75% income tests.
If Newcastle fails to satisfy one or both of the 75% or 95% gross income
tests for any taxable year, it may still qualify as a REIT for the year if it is
entitled to relief under applicable provisions of the Internal Revenue Code.
These relief provisions will be generally available if the failure of Newcastle
to meet these tests was due to reasonable cause and not due to willful neglect,
Newcastle attaches to its tax return a schedule of the sources of its income,
and any incorrect information on the schedule was not due to fraud with intent
to evade tax. It is not possible to state whether Newcastle would be entitled to
the benefit of these relief provisions in all circumstances. If these relief
provisions are inapplicable to a particular set of circumstances involving
Newcastle, Newcastle will not qualify as a REIT. As discussed above under
"-- Taxation of REITs in General," even where these relief provisions apply, a
tax would be imposed upon the amount by which Newcastle fails to satisfy the
particular gross income test.
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ASSET TESTS
Newcastle, at the close of each calendar quarter, must also satisfy four
tests relating to the nature of its assets. First, at least 75% of the value of
the total assets of Newcastle must be represented by some combination of "real
estate assets", cash, cash items, U.S. government securities, and, under some
circumstances, stock or debt instruments purchased with new capital. For this
purpose, real estate assets include interests in real property, such as land,
buildings, leasehold interests in real property, stock of other corporations
that qualify as REITs, and some kinds of mortgage backed securities and mortgage
loans. Newcastle Investment Holdings has held and currently holds stock of
subsidiary entities that have made elections to be taxed as REITs. If any of
these entities were to fail to qualify as a REIT, it could adversely affect
Newcastle's compliance with the REIT qualification requirements described in
this prospectus. Assets that do not qualify for purposes of the 75% test are
subject to the additional asset tests described below.
The second asset test is that the value of any one issuer's securities
owned by Newcastle may not exceed 5% of the value of Newcastle's total assets.
Third, Newcastle may not own more than 10% of any one issuer's outstanding
securities, as measured by either voting power or value. The 5% and 10% asset
tests do not apply to securities of TRSs, and the 10% value test does not apply
to "straight debt" having specified characteristics. Fourth, the aggregate value
of all securities of TRSs held by a REIT may not exceed 20% of the value of the
REIT's total assets.
Notwithstanding the general rule, as noted above, that for purposes of the
REIT income and asset tests, a REIT is treated as owning its share of the
underlying assets of a subsidiary partnership, if a REIT holds indebtedness
issued by a partnership, the indebtedness will be subject to, and may cause a
violation of the asset tests, unless it is a qualifying mortgage asset or
otherwise satisfies the rules for "straight debt". Similarly, although stock of
another REIT is a qualifying asset for purposes of the REIT asset tests, non-
mortgage debt held by Newcastle that is issued by another REIT may not so
qualify.
Interests held by Newcastle in a real estate mortgage investment conduit,
or "REMIC," are generally treated as qualifying real estate assets, and income
derived by Newcastle from interests in REMICs is generally treated as qualifying
income for purposes of the REIT income tests described above. If less than 95%
of the assets of a REMIC are real estate assets, however, then only a
proportionate part of Newcastle's interest in the REMIC, and its income derived
from the interest, qualifies for purposes of the REIT asset and income tests.
Newcastle believes that its holdings of securities and other assets comply,
and will continue to comply, with the foregoing REIT asset requirements, and it
intends to monitor compliance on an ongoing basis. No independent appraisals
have been obtained, however, to support Newcastle's conclusions as to the value
of its total assets, or the value of any particular security or securities.
Moreover, values of some assets, including instruments issued in securitization
transactions, may not be susceptible to a precise determination, and values are
subject to change in the future. Furthermore, the proper classification of an
instrument as debt or equity for federal income tax purposes may be uncertain in
some circumstances, which could affect the application of the REIT asset
requirements. Accordingly, there can be no assurance that the IRS will not
contend that Newcastle's interests in its subsidiaries or in the securities of
other issuers will not cause a violation of the REIT asset requirements.
ANNUAL DISTRIBUTION REQUIREMENTS
In order to qualify as a REIT, Newcastle is required to distribute
dividends, other than capital gain dividends, to its stockholders in an amount
at least equal to:
(a) the sum of
(1) 90% of the "REIT taxable income" of Newcastle (computed without
regard to the deduction for dividends paid and net capital gains of
Newcastle), and
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(2) 90% of the net income, if any, (after tax) from foreclosure
property (as described below), minus
(b) the sum of specified items of noncash income.
These distributions must be paid in the taxable year to which they relate,
or in the following taxable year if declared before Newcastle timely files its
tax return for the year and if paid with or before the first regular dividend
payment after such declaration. In order for distributions to be counted for
this purpose, and to give rise to a tax deduction by Newcastle, they must not be
"preferential dividends". A dividend is not a preferential dividend if it is pro
rata among all outstanding shares of stock within a particular class, and is in
accordance with the preferences among different classes of stock as set forth in
Newcastle organizational documents.
To the extent that Newcastle distributes at least 90%, but less than 100%,
of its "REIT taxable income," as adjusted, it will be subject to tax at ordinary
corporate tax rates on the retained portion. Newcastle may elect to retain,
rather than distribute, its net long-term capital gains and pay tax on such
gains. In this case, Newcastle could elect to have its stockholders include
their proportionate share of such undistributed long-term capital gains in
income, and to receive a corresponding credit for their share of the tax paid by
Newcastle. Stockholders of Newcastle would then increase the adjusted basis of
their Newcastle stock by the difference between the designated amounts included
in their long-term capital gains and the tax deemed paid with respect to their
shares.
To the extent that a REIT has available net operating losses carried
forward from prior tax years, such losses may reduce the amount of distributions
that it must make in order to comply with the REIT distribution requirements.
Such losses, however, will generally not affect the character, in the hands of
stockholders, of any distributions that are actually made by the REIT, which are
generally taxable to stockholders to the extent that the REIT has current or
accumulated earnings and profits. See "-- Taxation of Stockholders -- Taxation
of Taxable Domestic Stockholders -- Distributions."
If Newcastle should fail to distribute during each calendar year at least
the sum of (a) 85% of its REIT ordinary income for such year, (b) 95% of its
REIT capital gain net income for such year, and (c) any undistributed taxable
income from prior periods, Newcastle would be subject to a 4% excise tax on the
excess of such required distribution over the sum of (x) the amounts actually
distributed and (y) the amounts of income retained on which it has paid
corporate income tax. Newcastle intends to make timely distributions so that it
is not subject to the 4% excise tax.
It is possible that Newcastle, from time to time, may not have sufficient
cash to meet the distribution requirements due to timing differences between (a)
the actual receipt of cash, including receipt of distributions from its
subsidiaries, and (b) the inclusion of items in income by Newcastle for federal
income tax purposes. See, for example, the discussion below of excess inclusion
income under "-- Taxable Mortgage Pools." Other sources of non-cash taxable
income include real estate and securities that have been financed through
securitization structures, such as the CBO structure (as described above under
"Newcastle Investment Corp. -- Our Investments"), which require some or all of
available cash flows to be used to service borrowings, loans or mortgage backed
securities we hold that have been issued at a discount and require the accrual
of taxable economic interest in advance of its receipt in cash, and distressed
loans on which we may be required to accrue taxable interest income even though
the borrower is unable to make current servicing payments in cash. In the event
that such timing differences occur, in order to meet the distribution
requirements, it might be necessary to arrange for short-term, or possibly
long-term, borrowings, or to pay dividends in the form of taxable in-kind
distributions of property.
Newcastle may be able to rectify a failure to meet the distribution
requirements for a year by paying "deficiency dividends" to stockholders in a
later year, which may be included in Newcastle's deduction for dividends paid
for the earlier year. In this case, Newcastle may be able to avoid losing its
REIT status or being taxed on amounts distributed as deficiency dividends.
However, Newcastle will be required to pay interest and a penalty based on the
amount of any deduction taken for deficiency dividends.
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FAILURE TO QUALIFY
If Newcastle fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, Newcastle would be subject to tax,
including any applicable alternative minimum tax, on its taxable income at
regular corporate rates. Distributions to stockholders in any year in which
Newcastle is not a REIT would not be deductible by Newcastle, nor would they be
required to be made. In this situation, to the extent of current and accumulated
earnings and profits, all distributions to stockholders will be taxable as
ordinary income, and, subject to limitations of the Internal Revenue Code,
corporate distributees may be eligible for the dividends received deduction.
Unless Newcastle is entitled to relief under specific statutory provisions,
Newcastle would also be disqualified from re-electing to be taxed as a REIT for
the four taxable years following the year during which qualification was lost.
It is not possible to state whether, in all circumstances, Newcastle would be
entitled to this statutory relief. The rule against re-electing REIT status
following a loss of such status could also apply to Newcastle if Newcastle
Investment Holdings fails to qualify as a REIT, and Newcastle is treated as a
successor to Newcastle Investment Holdings for federal income tax purposes.
PROHIBITED TRANSACTIONS
Net income derived from a prohibited transaction is subject to a 100%
excise tax. The term "prohibited transaction" generally includes a sale or other
disposition of property (other than foreclosure property) that is held primarily
for sale to customers in the ordinary course of a trade or business. Newcastle
intends to conduct its operations so that no asset owned by Newcastle or its
pass-through subsidiaries will be held for sale to customers, and that a sale of
any such asset will not be in the ordinary course of Newcastle's business.
Whether property is held "primarily for sale to customers in the ordinary course
of a trade or business" depends, however, on the particular facts and
circumstances. No assurance can be given that any property sold by Newcastle
will not be treated as property held for sale to customers, or that Newcastle
can comply with certain safe-harbor provisions of the Internal Revenue Code that
would prevent such treatment.
FORECLOSURE PROPERTY
Foreclosure property is real property and any personal property incident to
such real property (i) that is acquired by a REIT as the result of the REIT
having bid in the property at foreclosure, or having otherwise reduced the
property to ownership or possession by agreement or process of law, after there
was a default (or default was imminent) on a lease of the property or a mortgage
loan held by the REIT and secured by the property, (ii) for which the related
loan or lease was acquired by the REIT at a time when default was not imminent
or anticipated, and (iii) for which such REIT makes a proper election to treat
the property as foreclosure property. REITs generally are subject to tax at the
maximum corporate rate (currently 35%) on any net income from foreclosure
property, including any gain from the disposition of the foreclosure property,
other than income that would otherwise be qualifying income for purposes of the
75% gross income test. Any gain from the sale of property for which a
foreclosure property election has been made will not be subject to the 100%
excise tax on gains from prohibited transactions described above, even if the
property would otherwise constitute inventory or dealer property in the hands of
the selling REIT. Newcastle does not anticipate that it will receive any income
from foreclosure property that is not qualifying income for purposes of the 75%
gross income test, but, if Newcastle does receive any such income, it intends to
make an election to treat the related property as foreclosure property.
FOREIGN INVESTMENTS
Newcastle and its subsidiaries currently hold and may acquire additional
investments and, accordingly pay taxes, in foreign countries. Taxes paid by
Newcastle in foreign jurisdictions may not be passed-through to, or used by, its
stockholders as a foreign tax credit or otherwise. Newcastle's foreign
investments may also generate foreign currency gains and losses. Foreign
currency gains are treated as income that does not qualify under the 95% or 75%
income tests, unless certain technical requirements are met. No assurance can be
given that these technical requirements will be met in the case of any foreign
currency gains
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recognized by Newcastle directly or through pass-through subsidiaries, and will
not adversely affect Newcastle's ability to satisfy the REIT qualification
requirements.
DERIVATIVES AND HEDGING TRANSACTIONS
Newcastle and its subsidiaries have, from time to time, and may in the
future enter into hedging transactions with respect to interest rate exposure on
one or more of their assets or liabilities. Any such hedging transactions could
take a variety of forms, including the use of derivative instruments such as
interest rate swap contracts, interest rate cap or floor contracts, futures or
forward contracts, and options. To the extent that Newcastle or a pass-through
subsidiary enters into such a contract to reduce interest rate risk on
indebtedness incurred to acquire or carry real estate assets, any periodic
income from the instrument, or gain from the disposition of it, would be
qualifying income for purposes of the REIT 95% gross income test, but not for
the 75% gross income test. To the extent that Newcastle hedges with other types
of financial instruments or in other situations (for example, hedges against
fluctuations in the value of foreign currencies), the resultant income will be
treated as income that does not qualify under the 95% or 75% income tests unless
certain technical requirements are met. Newcastle intends to structure any
hedging transactions in a manner that does not jeopardize its status as a REIT.
Newcastle may conduct some or all of its hedging activities (including hedging
activities relating to currency risk) through a TRS or other corporate entity,
the income from which may be subject to federal income tax, rather than
participating in the arrangements directly or through pass-through subsidiaries.
No assurance can be given, however, that Newcastle's hedging activities will not
give rise to income that does not qualify for purposes of either or both of the
REIT income tests, and will not adversely affect Newcastle's ability to satisfy
the REIT qualification requirements.
TAXABLE MORTGAGE POOLS
An entity, or a portion of an entity, may be classified as a taxable
mortgage pool ("TMP") under the Internal Revenue Code if (1) substantially all
of its assets consist of debt obligations or interests in debt obligations, (2)
more than 50% of those debt obligations are real estate mortgages or interests
in real estate mortgages as of specified testing dates, (3) the entity has
issued debt obligations (liabilities) that have two or more maturities, and (4)
the payments required to be made by the entity on its debt obligations
(liabilities) "bear a relationship" to the payments to be received by the entity
on the debt obligations that it holds as assets. Under regulations issued by the
U.S. Treasury Department, if less than 80% of the assets of an entity (or a
portion of an entity) consist of debt obligations, these debt obligations are
considered not to comprise "substantially all" of its assets, and therefore the
entity would not be treated as a TMP. Newcastle currently holds an interest in
two TMPs, and its future financing and securitization arrangements may give rise
to other TMPs, with the consequences as described in the next paragraph.
Where an entity, or a portion of an entity, is classified as a TMP, it is
generally treated as a taxable corporation for federal income tax purposes. In
the case of a REIT, or a portion of a REIT, or a disregarded subsidiary of a
REIT, that is a TMP, however, special rules apply. The TMP is not treated as a
corporation that is subject to corporate income tax, and the TMP classification
does not directly affect the tax status of the REIT. Rather, the consequences of
the TMP classification would, in general, except as described below, be limited
to the stockholders of the REIT. The Treasury Department has not yet issued
regulations to govern the treatment of stockholders as described below. A
portion of the REIT's income from the TMP arrangement, which might be non-cash
accrued income, could be treated as "excess inclusion income". This income would
nonetheless be subject to the distribution requirements that apply to the REIT,
and could therefore adversely affect its liquidity. See "-- Annual Distribution
Requirements". Moreover, the REIT's excess inclusion income would be allocated
among its stockholders. A stockholder's share of excess inclusion income (i)
would not be allowed to be offset by any net operating losses otherwise
available to the stockholder, (ii) would be subject to tax as unrelated business
taxable income in the hands of most types of stockholders that are otherwise
generally exempt from federal income tax, and (iii) would result in the
application of U.S. federal income tax withholding at the
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maximum rate (30%), without reduction for any otherwise applicable income tax
treaty, to the extent allocable to most types of foreign stockholders. See
"Taxation of Stockholders". To the extent that excess inclusion income is
allocated to a tax-exempt stockholder of a REIT that is not subject to unrelated
business income tax (such as government entities), the REIT would be taxable on
this income at the highest applicable corporate tax rate (currently 35%). The
manner in which excess inclusion income would be allocated among shares of
different classes of stock is not clear under current law. Tax-exempt investors,
foreign investors and taxpayers with net operating losses should carefully
consider the tax consequences described above and are urged to consult their tax
advisors.
If a subsidiary partnership of Newcastle, not wholly-owned by Newcastle
directly or through one or more disregarded entities, were a TMP, the foregoing
rules would not apply. Rather, the partnership that is a TMP would be treated as
a corporation for federal income tax purposes, and would potentially be subject
to corporate income tax. In addition, this characterization would alter
Newcastle's REIT income and asset test calculations, and could adversely affect
its compliance with those requirements. Newcastle believes that it has no
subsidiary partnerships that are or will become TMPs, and intends to monitor the
structure of any TMPs in which it has an interest to ensure that they will not
adversely affect its status as a REIT.
TAX ASPECTS OF INVESTMENTS IN AFFILIATED ENTITIES
PARTNERSHIPS
General. Newcastle may hold investments through entities that are
classified as partnerships for federal income tax purposes. In general,
partnerships are "pass-through" entities that are not subject to federal income
tax. Rather, partners are allocated their proportionate shares of the items of
income, gain, loss, deduction and credit of a partnership, and are potentially
subject to tax on these items, without regard to whether the partners receive a
distribution from the partnership. Newcastle will include in its income its
proportionate share of these partnership items for purposes of the various REIT
income tests and in the computation of its REIT taxable income. Moreover, for
purposes of the REIT asset tests, Newcastle will include its proportionate share
of assets held by subsidiary partnerships. See "Taxation of Newcastle -- Effect
of Subsidiary Entities -- Ownership of Partnership Interests."
Entity Classification. The investment by Newcastle in partnerships
involves special tax considerations, including the possibility of a challenge by
the IRS of the status of any of Newcastle's subsidiary partnerships as a
partnership, as opposed to an association taxable as a corporation, for federal
income tax purposes (for example, if the IRS were to assert that a subsidiary
partnership is a TMP). See "Taxation of Newcastle -- Taxable Mortgage Pools". If
any of these entities were treated as an association for federal income tax
purposes, it would be taxable as a corporation and therefore could be subject to
an entity-level tax on its income. In such a situation, the character of the
assets of Newcastle and items of gross income of Newcastle would change and
could preclude Newcastle from satisfying the REIT asset tests or the gross
income tests as discussed in "Taxation of Newcastle -- Asset Tests" and
"-- Income Tests," and in turn could prevent Newcastle from qualifying as a
REIT. See "Taxation of Newcastle -- Failure to Qualify," above, for a discussion
of the effect of the failure of Newcastle to meet these tests for a taxable
year. In addition, any change in the status of any of Newcastle's subsidiary
partnerships for tax purposes might be treated as a taxable event, in which case
Newcastle could have taxable income that is subject to the REIT distribution
requirements without receiving any cash.
Tax Allocations with Respect to Partnership Properties. Under the Internal
Revenue Code and the Treasury regulations, income, gain, loss and deduction
attributable to appreciated or depreciated property that is contributed to a
partnership in exchange for an interest in the partnership must be allocated for
tax purposes in a manner such that the contributing partner is charged with, or
benefits from, the unrealized gain or unrealized loss associated with the
property at the time of the contribution. The amount of the unrealized gain or
unrealized loss is generally equal to the difference between the fair market
value of the contributed property at the time of contribution, and the adjusted
tax basis of such property at the time of contribution (a "book-tax
difference"). Such allocations are solely for federal income tax purposes and do
not affect the book capital accounts or other economic or legal arrangements
among the partners.
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To the extent that any subsidiary partnership of Newcastle acquires
appreciated (or depreciated) properties by way of capital contributions from its
partners, allocations would need to be made in a manner consistent with these
requirements. Where a partner contributes cash to a partnership at a time that
the partnership holds appreciated (or depreciated) property, the Treasury
regulations provide for a similar allocation of these items to the other (i.e.
non-contributing) partners. These rules may apply to the contribution by
Newcastle to any subsidiary partnerships of the cash proceeds received in
offerings of its stock. As a result, partners, including Newcastle, in
subsidiary partnerships, could be allocated greater or lesser amounts of
depreciation and taxable income in respect of a partnership's properties than
would be the case if all of the partnership's assets (including any contributed
assets) had a tax basis equal to their fair market values at the time of any
contributions to that partnership. This could cause Newcastle to recognize, over
a period of time, taxable income in excess of cash flow from the partnership,
which might adversely affect Newcastle's ability to comply with the REIT
distribution requirements discussed above.
TAXATION OF STOCKHOLDERS
TAXATION OF TAXABLE DOMESTIC STOCKHOLDERS
Distributions. Provided that Newcastle qualifies as a REIT, distributions
made to its taxable domestic stockholders out of current or accumulated earnings
and profits, and not designated as capital gain dividends, will be taken into
account by them as ordinary income and will not be eligible for the dividends
received deduction for corporations. Distributions that are designated as
capital gain dividends will be taxed to stockholders as long-term capital gains,
to the extent that they do not exceed the actual net capital gain of Newcastle
for the taxable year, without regard to the period for which the stockholder has
held its stock. A similar treatment will apply to long-term capital gains
retained by Newcastle, to the extent that Newcastle elects the application of
provisions of the Internal Revenue Code that treat stockholders of a REIT as
having received, for federal income tax purposes, undistributed capital gains of
the REIT, while passing through to stockholders a corresponding credit for taxes
paid by the REIT on such retained capital gains. Corporate stockholders may be
required to treat up to 20% of some capital gain dividends as ordinary income.
Long-term capital gains are generally taxable at maximum federal rates of 20% in
the case of stockholders who are individuals, and 35% for corporations. Capital
gains attributable to the sale of depreciable real property held for more than
12 months are subject to a 25% maximum federal income tax rate for taxpayers who
are individuals, to the extent of previously claimed depreciation deductions.
In determining the extent to which a distribution constitutes a dividend
for tax purposes, Newcastle's earnings and profits generally will be allocated
first to distributions with respect to the Series B Preferred Stock, on a pro
rata basis, and then to Newcastle's common stock. If Newcastle has net capital
gains and designates some or all of its distributions as capital gain dividends
to that extent, the capital gain dividends will be allocated among different
classes of stock in proportion to the allocation of earnings and profits as
described above.
Distributions in excess of current and accumulated earnings and profits
will not be taxable to a stockholder to the extent that they do not exceed the
adjusted basis of the stockholder's shares in respect of which the distributions
were made, but rather, will reduce the adjusted basis of these shares. To the
extent that such distributions exceed the adjusted basis of a stockholder's
shares, they will be included in income as long-term capital gain, or short-term
capital gain if the shares have been held for one year or less. In addition, any
dividend declared by Newcastle in October, November or December of any year and
payable to a stockholder of record on a specified date in any such month will be
treated as both paid by Newcastle and received by the stockholder on December 31
of such year, provided that the dividend is actually paid by Newcastle before
the end of January of the following calendar year.
To the extent that a REIT has available net operating losses and capital
losses carried forward from prior tax years, such losses may reduce the amount
of distributions that must be made in order to comply with the REIT distribution
requirements. See "Taxation of Newcastle -- Annual Distribution Requirements."
Such losses, however, are not passed through to stockholders and do not offset
income of
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stockholders from other sources, nor would they affect the character of any
distributions that are actually made by a REIT, which are generally subject to
tax in the hands of stockholders to the extent that the REIT has current or
accumulated earnings and profits.
If excess inclusion income from a taxable mortgage pool is allocated to any
Newcastle stockholder, that income will be taxable in the hands of the
stockholder and would not be offset by any net operating losses of the
stockholder that would otherwise be available. See "Taxation of
Newcastle -- Taxable Mortgage Pools."
Dispositions of Newcastle Stock. In general, capital gains recognized by
individuals and other non-corporate stockholders upon the sale or disposition of
shares of Newcastle stock will be subject to a maximum federal income tax rate
of 20% if the Newcastle stock is held for more than 12 months, and will be taxed
at ordinary income rates of up to 39.6% (38.6% for 2003) if the Newcastle stock
is held for 12 months or less. Gains recognized by stockholders that are
corporations are subject to federal income tax at a maximum rate of 35%, whether
or not classified as long-term capital gains. Capital losses recognized by a
stockholder upon the disposition of Newcastle stock held for more than one year
at the time of disposition will be considered long-term capital losses, and are
generally available only to offset capital gain income of the stockholder but
not ordinary income (except in the case of individuals, who may offset up to
$3,000 of ordinary income each year). In addition, any loss upon a sale or
exchange of shares of Newcastle stock by a stockholder who has held the shares
for six months or less, after applying holding period rules, will be treated as
a long-term capital loss to the extent of distributions received from Newcastle
that are required to be treated by the stockholder as long-term capital gain.
Redemptions. A redemption of the Series B Preferred Stock will be treated
under Section 302 of the Internal Revenue Code as a dividend, generally taxable
at ordinary income tax rates (to the extent of Newcastle's current and
accumulated earnings and profits), unless the redemption satisfies one or more
of the tests set forth in Section 302(b) of the Internal Revenue Code that
enable the redemption to be treated as a sale or exchange of the redeemed Series
B Preferred Stock. A redemption will satisfy such tests if it (i) is
"substantially disproportionate" with respect to the holder, (ii) results in a
"complete termination" of the holder's stock interest in any Newcastle, or (iii)
is "not essentially equivalent to a dividend" with respect to the holder, all
within the meaning of Section 302(b) of the Internal Revenue Code. In
determining whether any of these tests have been met, shares considered to be
owned by the holder by reason of certain constructive ownership rules set forth
in the Internal Revenue Code, as well as shares actually owned, must generally
be taken into account. Because the determination as to whether any of the
alternative tests of Section 302(b) of the Internal Revenue Code is satisfied
with respect to any particular holder of the Series B Preferred Stock will
depend upon the facts and circumstances as of the time the determination is
made, prospective investors are advised to consult their tax advisors to
determine such tax treatment.
If a redemption of the Series B Preferred Stock is treated as a
distribution that is taxable as a dividend, the amount of the distribution would
be measured by the amount of cash and the fair market value of any property
received by the stockholders. The stockholder's adjusted tax basis in such
redeemed Series B Preferred Stock would, in that case, be transferred to the
holder's remaining stockholdings in Newcastle. If, however, the stockholder has
no remaining stockholdings in Newcastle, such basis may, under certain
circumstances, be transferred to a related person, or it may be lost entirely.
TAXATION OF FOREIGN STOCKHOLDERS
The following is a summary of certain United States federal income and
estate tax consequences of the ownership and disposition of Newcastle stock
applicable to non-U.S. holders of Newcastle stock. A "non-U.S. holder" is any
person other than:
(a) a citizen or resident of the United States,
(b) a corporation or partnership created or organized in the United
States or under the laws of the United States, or of any state thereof, or
the District of Columbia,
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(c) an estate, the income of which is includable in gross income for
U.S. federal income tax purposes regardless of its source, or
(d) a trust if a United States court is able to exercise primary
supervision over the administration of such trust and one or more United
States fiduciaries have the authority to control all substantial decisions
of the trust. The discussion is based on current law and is for general
information only. The discussion addresses only selective and not all
aspects of United States federal income and estate taxation.
Ordinary Dividends. The portion of dividends received by non-U.S. holders
payable out of the earnings and profits of Newcastle which are not attributable
to capital gains of Newcastle and which are not effectively connected with a
U.S. trade or business of the non-U.S. holder will be subject to U.S.
withholding tax at the rate of 30%, unless reduced by treaty. Reduced treaty
rates are not available to the extent that income is excess inclusion income
allocated to the foreign stockholder. See "Taxation of Newcastle -- Taxable
Mortgage Pools".
In general, non-U.S. holders will not be considered to be engaged in a U.S.
trade or business solely as a result of their ownership of Newcastle stock. In
cases where the dividend income from a non-U.S. holder's investment in Newcastle
stock is, or is treated as, effectively connected with the non-U.S. holder's
conduct of a U.S. trade or business, the non-U.S. holder generally will be
subject to U.S. tax at graduated rates, in the same manner as domestic
stockholders are taxed with respect to such dividends, and may also be subject
to the 30% branch profits tax in the case of a non-U.S. holder that is a
corporation.
Non-Dividend Distributions. Unless Newcastle stock constitutes a U.S. real
property interest (a "USRPI"), distributions by Newcastle which are not
dividends out of the earnings and profits of Newcastle will not be subject to
U.S. income tax. If it cannot be determined at the time at which a distribution
is made whether or not the distribution will exceed current and accumulated
earnings and profits, the distribution will be subject to withholding at the
rate applicable to dividends. However, the non-U.S. holder may seek a refund
from the IRS of any amounts withheld if it is subsequently determined that the
distribution was, in fact, in excess of Newcastle's current and accumulated
earnings and profits. If Newcastle stock constitutes a USRPI, as described
below, distributions by Newcastle in excess of the sum of its earnings and
profits plus the stockholder's basis in its Newcastle stock will be taxed under
the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA") at the rate
of tax, including any applicable capital gains rates, that would apply to a
domestic stockholder of the same type (e.g., an individual or a corporation, as
the case may be), and the collection of the tax will be enforced by a refundable
withholding at a rate of 10% of the amount by which the distribution exceeds the
stockholder's share of Newcastle's earnings and profits.
Capital Gain Dividends. Under FIRPTA, a distribution made by Newcastle to
a non-U.S. holder, to the extent attributable to gains from dispositions of
USRPIs held by Newcastle directly or through pass-through subsidiaries ("USRPI
capital gains"), will be considered effectively connected with a U.S. trade or
business of the non-U.S. holder and will be subject to U.S. income tax at the
rates applicable to U.S. individuals or corporations, without regard to whether
the distribution is designated as a capital gain dividend. In addition,
Newcastle will be required to withhold tax equal to 35% of the amount of
dividends to the extent the dividends constitute USRPI capital gains.
Distributions subject to FIRPTA may also be subject to a 30% branch profits tax
in the hands of a non-U.S. holder that is a corporation.
Dispositions of Newcastle Stock. Unless Newcastle stock constitutes a
USRPI, a sale of the stock by a non-U.S. holder generally will not be subject to
U.S. taxation under FIRPTA. The stock will not be treated as a USRPI if less
than 50% of Newcastle's assets throughout a prescribed testing period consist of
interests in real property located within the United States, excluding, for this
purpose, interests in real property solely in a capacity as a creditor.
Even if the foregoing test is not met, Newcastle stock nonetheless will not
constitute a USRPI if Newcastle is a "domestically-controlled REIT." A
domestically-controlled REIT is a REIT in which, at all times during a specified
testing period, less than 50% in value of its shares is held directly or
indirectly
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by non-U.S. holders. Newcastle believes that it is, and it expects to continue
to be, a domestically-controlled REIT and, therefore, the sale of Newcastle
stock should not be subject to taxation under FIRPTA. Because Newcastle stock is
publicly traded, however, no assurance can be given that Newcastle will be a
domestically-controlled REIT.
In the event that Newcastle does not constitute a domestically-controlled
REIT, a non-U.S. holder's sale of stock nonetheless will generally not be
subject to tax under FIRPTA as a sale of a USRPI, provided that (a) the stock
owned is of a class that is "regularly traded," as defined by applicable
Treasury Department regulations, on an established securities market, and (b)
the selling non-U.S. holder held 5% or less of Newcastle's outstanding stock of
that class at all times during a specified testing period.
If gain on the sale of stock of Newcastle were subject to taxation under
FIRPTA, the non-U.S. holder would be subject to the same treatment as a U.S.
stockholder with respect to such gain, subject to applicable alternative minimum
tax and a special alternative minimum tax in the case of non-resident alien
individuals, and the purchaser of the stock could be required to withhold 10% of
the purchase price and remit such amount to the IRS.
Gain from the sale of Newcastle stock that would not otherwise be subject
to FIRPTA will nonetheless be taxable in the United States to a non-U.S. holder
in two cases: (a) if the non-U.S. holder's investment in the Newcastle stock is
effectively connected with a U.S. trade or business conducted by such non-U.S.
holder, the non-U.S. holder will be subject to the same treatment as a U.S.
stockholder with respect to such gain, or (b) if the non-U.S. holder is a
nonresident alien individual who was present in the United States for 183 days
or more during the taxable year and has a "tax home" in the United States, the
nonresident alien individual will be subject to a 30% tax on the individual's
capital gain.
Estate Tax. Newcastle stock owned or treated as owned by an individual who
is not a citizen or resident (as specially defined for U.S. federal estate tax
purposes) of the United States at the time of death will be includable in the
individual's gross estate for U.S. federal estate tax purposes, unless an
applicable estate tax treaty provides otherwise, and may therefore be subject to
U.S. federal estate tax.
TAXATION OF TAX-EXEMPT STOCKHOLDERS
Tax-exempt entities, including qualified employee pension and profit
sharing trusts and individual retirement accounts, generally are exempt from
federal income taxation. However, they are subject to taxation on their
unrelated business taxable income ("UBTI"). While many investments in real
estate generate UBTI, the IRS has ruled that dividend distributions from a REIT
to a tax-exempt entity do not constitute UBTI. Based on that ruling, and
provided that (1) a tax-exempt stockholder has not held its Newcastle stock as
"debt financed property" within the meaning of the Internal Revenue Code (i.e.
where the acquisition or holding of the property is financed through a borrowing
by the tax-exempt stockholder), and (2) the Newcastle stock is not otherwise
used in an unrelated trade or business, distributions from Newcastle and income
from the sale of the Newcastle stock should not give rise to UBTI to a
tax-exempt stockholder. To the extent, however, that Newcastle (or a part of
Newcastle, or a disregarded subsidiary of Newcastle) is a TMP, or if Newcastle
holds residual interests in a REMIC, a portion of the dividends paid to a
tax-exempt stockholder that is allocable to excess inclusion income may be
subject to tax as UBTI. See "Taxation of Newcastle -- Taxable Mortgage Pools".
Tax-exempt stockholders that are social clubs, voluntary employee benefit
associations, supplemental unemployment benefit trusts, and qualified group
legal services plans exempt from federal income taxation under sections
501(c)(7), (c)(9), (c)(17) and (c)(20) of the Internal Revenue Code,
respectively, are subject to different UBTI rules, which generally will require
them to characterize distributions from Newcastle as UBTI.
In certain circumstances, a pension trust that owns more than 10% of
Newcastle's stock could be required to treat a percentage of the dividends from
Newcastle as UBTI, if Newcastle is a "pension-held REIT". Newcastle will not be
a pension-held REIT unless either (A) one pension trust owns more than 25% of
the value of Newcastle's stock, or (B) a group of pension trusts, each
individually holding more
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than 10% of the value of Newcastle's stock, collectively owns more than 50% of
such stock. The restrictions on ownership and transfer of Newcastle's stock as
discussed above should prevent a tax-exempt entity from owning more than 10% of
the value of Newcastle's stock, or Newcastle from becoming a pension-held REIT.
TAX-EXEMPT STOCKHOLDERS ARE URGED TO CONSULT THEIR TAX ADVISOR REGARDING
THE FEDERAL, STATE, LOCAL AND FOREIGN TAX CONSEQUENCES OF AN INVESTMENT IN
NEWCASTLE.
OTHER TAX CONSIDERATIONS
LEGISLATIVE OR OTHER ACTIONS AFFECTING REITS
The rules dealing with federal income taxation are constantly under review
by persons involved in the legislative process and by the IRS and the Treasury
Department. Changes to the federal tax laws and interpretations of federal tax
laws could adversely affect an investment in Newcastle. Recently, President Bush
announced his 2003 Economic Plan, which includes a proposal that would eliminate
the taxation of corporate dividends at the stockholder level to the extent that
the corporation paying the dividends has paid tax on its income. Bills have been
introduced in Congress that would, if enacted, implement this proposal. While
this proposal would not directly affect the taxation of REITs or their
stockholders, it could make an investment in a REIT comparatively less
attractive than an investment in other corporations due to the fact that
dividends paid by REITs would continue to be taxable to stockholders in the same
manner as under current law. Moreover, enactment of this proposal could
adversely affect the attractiveness of real estate generally relative to
alternative investments. Accordingly, if the President's plan is enacted in its
proposed form, it could adversely affect the price of our stock. As of the date
of this prospectus, it is not clear whether this proposal, or any similar
proposal, will be enacted.
STATE, LOCAL AND FOREIGN TAXES
Newcastle and its subsidiaries and stockholders may be subject to state,
local or foreign taxation in various jurisdictions, including those in which it
or they transact business, own property or reside. Newcastle owns properties
located in a number of jurisdictions, and may be required to file tax returns in
some or all of those jurisdictions. The state, local or foreign tax treatment of
Newcastle and its stockholders may not conform to the federal income tax
treatment discussed above. Newcastle will pay foreign property taxes, and
dispositions of foreign property or operations involving, or investments in,
foreign property may give rise to foreign income or other tax liability. Any
foreign taxes incurred by Newcastle do not pass through to stockholders as a
credit against their United States federal income tax liability. Prospective
investors should consult their tax advisors regarding the application and effect
of state, local and foreign income and other tax laws on an investment in
Newcastle stock.
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ERISA CONSIDERATIONS
A plan fiduciary considering an investment in the securities should
consider, among other things, whether such an investment might constitute or
give rise to a prohibited transaction under ERISA, the tax Internal Revenue Code
or any substantially similar federal, state or local law. ERISA and the Internal
Revenue Code impose restrictions on:
- employee benefit plans as defined in Section 3(3) of ERISA,
- plans described in Section 4975(e)(1) of the Internal Revenue Code,
including retirement accounts and Keogh Plans,
- entities whose underlying assets include plan assets by reason of a
plan's investment in such entities, and
- persons who have certain specified relationships to a plan described as
"parties in interest" under ERISA and "disqualified persons" under the
tax code.
REGULATION UNDER ERISA AND THE TAX CODE
ERISA imposes certain duties on persons who are fiduciaries of a plan.
Under ERISA, any person who exercises any authority or control over the
management or disposition of a plan's assets is considered to be a fiduciary of
that plan. Both ERISA and the tax code prohibit certain transactions involving
"plan assets" between a plan and parties in interest or disqualified persons.
Violations of these rules may result in the imposition of an excise tax or
penalty
The term "plan assets" is not defined by ERISA or the tax code. However, a
plan's assets may be deemed to include an interest in the underlying assets of
an entity if the plan acquires an "equity interest" in such an entity such as
the shares. In that event, the operations of such an entity could result in a
prohibited transaction under ERISA and the tax code.
REGULATION ISSUED BY THE DEPARTMENT OF LABOR
The Department of Labor issued a regulation that provides exceptions to
this rule. Under this regulation, if a plan acquires a "publicly-offered
security," the issuer of the security is not deemed to hold plan assets. A
publicly-offered security is a security that:
- is freely transferable,
- is part of a class of securities that is owned by 100 or more investors
independent of the issuer and of one another, and
- is either:
(i) part of a class of securities registered under Section 12(b) or
12(g) of the Exchange Act, or
(ii) sold to the plan as part of an offering of securities to the
public pursuant to an effective registration statement under the Securities
Act and the class of securities of which such security is part is
registered under the Exchange Act within the requisite time.
THE SHARES OF SERIES B PREFERRED STOCK AS "PUBLICLY-OFFERED SECURITIES"
It is anticipated that the shares of our Series B Preferred Stock being
offered here will meet the criteria of publicly-offered securities. Although no
assurances can be given, the Underwriters expect that:
- there will be no restrictions imposed on the transfer of interests in our
preferred stock,
- our preferred stock will be held by at least 100 independent investors at
the conclusion of the offering, and
120
- our preferred stock will be sold as part of an offering pursuant to an
effective registration statement under the Securities Act and then will
be timely registered under the Exchange Act.
Accordingly, our charter provides that, prior to the date the preferred
stock qualifies as a class of "publicly offered securities" (within the meaning
of Department of Labor Regulation Section 2510.3-101(a)(2)), (a) no plan
investor may acquire shares of our stock without our prior written consent; and
(b) any transfers to plan investors that would increase the aggregate plan
investors, ownership of shares of our stock to a level that meets or exceeds 25%
or more of the value of any class of our stock will be void ab initio. If any
transfer of shares of our stock to plan investors occurs which, if effective,
would result in plan investors beneficially or constructively owning, in the
aggregate, shares of our stock in excess or in violation of the above transfer
or ownership limitations, then that number of shares of our stock, the
beneficial or constructive ownership of which otherwise would cause such plan
investors to violate such limitations shall be automatically transferred to the
Trust (as defined above in "Restrictions on Ownership and Transfer") to be held,
subject to certain adjustments, in accordance with the provisions detailed above
in "Restrictions on Ownership and Transfer."
OTHER EXCEPTIONS IN THE REGULATIONS
In addition, the regulation provides another exception for Plan investments
in a "venture capital operating company" or a "real estate operating company."
To be a "venture capital operating company," an entity must have at least 50% of
its assets (other than short term investments pending long-term commitment or
distribution to investors), valued at cost, invested in "venture capital
investments," which are defined as companies in the business of selling goods or
services (other than the investment of capital) with respect to which the entity
has or obtains management rights. To be a "real estate operating company," an
entity must have at least 50% of its assets (other than short term investments
pending long-term commitment or distribution to investors), valued at cost,
invested in real estate that is managed or developed and with respect to which
such entity has the right to substantially participate directly in the
management and development. We believe that we constitute either a "venture
capital operating company" or a "real estate operating company" for purposes of
the regulations.
EXEMPTIONS TO PROHIBITED TRANSACTIONS
If the shares of preferred stock fail to meet the criteria of
publicly-offered securities, or we fail to be a venture capital operating
company or a real estate operating company, our assets may be deemed to include
assets of plans that are stockholders. In that event, transactions involving our
assets and parties in interest or disqualified persons with respect to such
plans might be prohibited under ERISA and the tax code unless a statutory or
administrative exemption exist and the plan satisfies all conditions for such
exemptive relief.
There are five class exemptions issued by the Department of Labor that
could apply in the event of a prohibited transaction. These Department of Labor
Prohibited Transaction Class Exemptions apply to:
- plan asset transactions determined by independent qualified professional
asset managers (PTE 84-14),
- certain transactions involving bank collective investment funds (PTE
91-38),
- certain transactions involving insurance company pooled separate accounts
(PTE 90-1),
- certain transactions involving insurance company general accounts (PTE
95-60), and
- plan asset transactions determined by in-house asset manager (PTE 96-23).
However, there is no assurance that these exemptions or any other exemption
will apply, even if all of the conditions specified are satisfied.
121
SPECIAL CONSIDERATIONS FOR INSURANCE COMPANIES
An insurance company considering an investment should consider whether its
general account may be deemed to include assets of the plans investing in the
general account, for example, through the purchase of an annuity contract. In
John Hancock Mutual Life Insurance Co. v. Harris Trust and Savings Bank, 510
U.S. 86 (1993), the United States Supreme Court held that assets held in an
insurance company's general account may be deemed to be plan assets under
certain circumstances In that event, the insurance company might be treated as a
party in interest under such plans. However, PTE 95-60 may exempt some or all of
the transactions that could occur as the result of the acquisition of the
preferred stock by an insurance company general account. Therefore, insurance
company investors should analyze whether John Hancock and PTE 95-60 or any other
exemption may have an impact with respect to their purchase of the preferred
stock.
In addition, regulations were issued pursuant to Section 401(c) of ERISA
relating to the status of the assets of insurance company general accounts under
ERISA and Section 4975 of the tax code with respect to insurance policies issued
on or before December 31, 1998 that are supported by an insurer's general
account. As a result of these regulations, assets of an insurance company
general account will not be treated as "plan assets" for purposes of the
fiduciary responsibility provisions of ERISA and Section 4975 of the Internal
Revenue Code to the extent such assets relate to contracts issued to employee
benefit plans on or before December 31, 1998 and the insurer satisfies various
conditions. The plan asset status of insurance company separate accounts is
unaffected by new Section 401(c) of ERISA, and separate account assets continue
to be treated as the plan assets of any such plan invested in a separate
account.
GENERAL INVESTMENT CONSIDERATIONS
Prospective fiduciaries of a plan considering the purchase of preferred
stock should consult with their legal advisors concerning the impact of ERISA
and the tax code and the potential consequences of making an investment in the
certificates with respect to their specific circumstances. Each plan fiduciary
should take into account, among other considerations:
- whether the fiduciary has the authority to make the investment,
- the composition of the plan's portfolio with respect to diversification
by type of asset,
- the plan's funding objectives,
- the tax effects of the investment,
- whether the assets of the trust which are represented by such interests
would be considered plan assets, and
- whether, under the general fiduciary standards of investment prudence and
diversification an investment in certificates of any series is
appropriate for the plan taking into account the overall investment
policy of the plan and the composition of the plan's investment
portfolio.
Certain employee benefit plans, such as governmental plans and certain
church plans are not subject to the provisions of Title I of ERISA and Section
4975 of the tax code. Accordingly, assets of such plans may be invested in the
preferred stock without regard to the ERISA considerations described here,
subject to the provisions of any other applicable federal and state law. It
should be noted that any such plan that is qualified and exempt from taxation
under the tax code is subject to the prohibited transaction rules set forth in
the tax code.
122
UNDERWRITING
We and the underwriters for this offering named below have entered into an
underwriting agreement concerning the shares of the Series B Preferred Stock
being offered. The underwriters' obligations are several and not joint, which
means that each underwriter is required to purchase a specified number of
shares, but is not responsible for the commitment of any other underwriter to
purchase shares. Subject to the terms and conditions of the underwriting
agreement, each underwriter has severally agreed to purchase the number of
shares of Series B Preferred Stock set forth opposite its name below.
UNDERWRITERS NUMBER OF SHARES
- ------------ ----------------
Bear, Stearns & Co. Inc..................................... 1,000,000
Advest, Inc. ............................................... 500,000
BB&T Capital Markets, a division of Scott & Stringfellow,
Inc. ..................................................... 500,000
Stifel, Nicolaus & Company, Incorporated ................... 500,000
---------
Total.................................................. 2,500,000
=========
The underwriting agreement provides that the obligations of the
underwriters are conditional and may be terminated at their discretion based on
their assessment of the state of the financial markets. The obligations of the
underwriters may also be terminated upon the occurrence of the events specified
in the underwriting agreement. The underwriters are severally committed to
purchase all of the Series B Preferred Stock being offered if any shares are
purchased, other than those shares covered by the over-allotment option
described below.
We have granted the underwriters an option to purchase up to 375,000
additional shares of Series B Preferred Stock to be sold in this offering at the
public offering price, less the underwriting discounts and commissions set forth
on the cover page of this prospectus. The underwriters may exercise this option
solely to cover over-allotments, if any. This option may be exercised, in whole
or in part, at any time within 30 days after the date of this prospectus. To the
extent the option is exercised, the underwriters will be severally committed,
subject to certain conditions, to purchase the additional shares of Series B
Preferred Stock in proportion to their respective commitments as indicated in
the table above.
The underwriters have reserved for sale, at the public offering price,
110,000 shares of Series B Preferred Stock for our officers and directors,
officers and employees of the manager and their families, and other persons
associated with us who express an interest in purchasing shares of Series B
Preferred Stock in this offering. The number of shares available for sale to the
general public in the offering will be reduced to the extent these persons
purchase reserved shares. Any reserved shares not purchased by these persons
will be offered by the underwriters to the general public on the same terms as
the other shares offered in this offering.
The following table provides information regarding the per share and total
underwriting discounts and commissions that we will pay to the underwriters in
connection with this offering. These amounts are shown assuming both no exercise
and full exercise of the underwriters' option to purchase up to an additional
375,000 shares of the Series B Preferred Stock.
PER SHARE TOTAL
------------------------------- --------------------------------
WITHOUT WITH WITHOUT WITH
OVER-ALLOTMENT OVER-ALLOTMENT OVER-ALLOTMENT OVER-ALLOTMENT
-------------- -------------- -------------- ---------------
Underwriting discounts and
commissions payable by us... $0.7875 $0.7875 $1,968,750 $2,264,063
We estimate that the total expenses of this offering payable by us,
excluding underwriting discounts and commissions, will be approximately
$467,500.
The underwriters propose to offer the Series B Preferred Stock directly to
the public initially at the public offering price set forth on the cover page of
this prospectus and to selected dealers at such price less a concession not to
exceed $0.50 per share. The underwriters may allow, and such selected dealers
may reallow a concession not to exceed $0.45 per share. The shares of Series B
Preferred Stock will be available for delivery, when, as and if accepted by the
underwriters and subject to prior sale and to
123
withdrawal, cancellation or modification of the offering without notice. The
underwriters reserve the right to reject any order for purchase of the shares in
whole or in part. After the commencement of this offering, the underwriters may
change the public offering price and other selling terms.
We have agreed in the underwriting agreement to indemnify the underwriters
against certain liabilities, including liabilities under the Securities Act and,
where such indemnification is unavailable, to contribute to payments that the
underwriters may be required to make in respect of such liabilities.
The Series B Preferred Stock is a new issue of securities and, prior to the
Series B Preferred Stock being accepted for listing on the NYSE, there will be
no established trading market for the Series B Preferred Stock. The NYSE has
authorized, subject to official notice of issuance, the listing of the shares of
the Series B Preferred Stock under the symbol "NCT PrB." We expect that trading
on the NYSE will commence within 30 days after the initial delivery of the
Series B Preferred Stock. In order to meet the requirements for listing the
Series B Preferred Stock on the NYSE, the underwriters have undertaken to sell
(i) Series B Preferred Stock to ensure a minimum of 100 beneficial holders with
a minimum of 100,000 shares of Series B Preferred Stock outstanding and (ii)
sufficient shares of Series B Preferred Stock so that following this offering,
the Series B Preferred Stock has a minimum aggregate market value of $2 million.
The underwriters have advised us that prior to the commencement of listing on
the NYSE they intend to make a market in the Series B Preferred Stock, but are
not obligated to do so and may discontinue market making at any time without
notice. No assurance can be given as to the liquidity of the trading market for
the Series B Preferred Stock.
In order to facilitate this offering of the Series B Preferred Stock, the
underwriters may engage in transactions that stabilize, maintain or otherwise
affect the market price of the Series B Preferred Stock in accordance with
Regulation M under the Exchange Act.
The underwriters may over-allot shares of the Series B Preferred Stock in
connection with this offering, thus creating a short position for their own
account. Short sales involve the sale by the underwriters of a greater number of
shares than they are committed to purchase in this offering. A short position
may involve either "covered" short sales or "naked" short sales. Covered short
sales are sales made in an amount not greater than the underwriters'
over-allotment option to purchase additional shares of the Series B Preferred
Stock as described above. The underwriters may close out any covered short
position by either exercising their over-allotment option or purchasing shares
in the open market. In determining the source of shares to close the covered
short position, the underwriters will consider, among other things, the price of
shares available for purchase in the open market as compared to the price at
which they may purchase shares from us through the over-allotment option. Naked
short sales are sales in excess of the over-allotment option. The underwriters
must close out any naked short position by purchasing shares in the open market.
A naked short position is more likely to be created if the underwriters are
concerned that there may be downward pressure on the price of the Series B
Preferred Stock in the open market after pricing that could adversely affect
investors who purchase in this offering.
Accordingly, to cover these short sales positions or to stabilize the
market price of the Series B Preferred Stock, the underwriters may bid for, and
purchase, shares of the Series B Preferred Stock in the open market. These
transactions may be effected on the NYSE or otherwise. Additionally, the
representatives, on behalf of the underwriters, may also reclaim selling
concessions allowed to an underwriter or dealer. Similar to other purchase
transactions, the underwriters' purchases to cover the syndicate short sales or
to stabilize the market price of our Series B Preferred Stock may have the
effect of raising or maintaining the market price of our Series B Preferred
Stock or preventing or mitigating a decline in the market price of our Series B
Preferred Stock. As a result, the price of the Series B Preferred Stock may be
higher than the price that might otherwise exist in the open market. No
representation is made as to the magnitude or effect of any such stabilization
or other activities. The underwriters are not required to engage in these
activities and, if commenced, may discontinue any of these activities at any
time.
From time to time, some of the underwriters and/or their affiliates have
engaged in, and may in the future engage in, investment banking and other
commercial dealings in the ordinary course of business with us and our
affiliates for which they have received, and expect to receive, customary fees
and commissions for these transactions. Bear, Stearns & Co. Inc. served as
managing underwriter for our initial
124
public offering in October 2002. We used the net proceeds of that offering to
purchase a portfolio of mortgage loans from EMC Mortgage Corporation ("EMC"), an
affiliate of Bear Stearns. In February 2003, we sold a portion of our existing
mortgage loan portfolio to EMC and we purchased other mortgage loans from EMC.
We financed both mortgage loan purchases through an affiliate of Bear Stearns.
We are also party to an agreement with Bear Stearns in connection with our
proposed third CBO issuance for which Bear Stearns will receive customary fees.
See "Newcastle Investment Corp. -- Our Investments." In addition, Bear Stearns
Private Equity Opportunity Fund II, LP has committed to invest $10 million in
Fortress Investment Fund. In September 2002, we sold to Bear Stearns for $37.9
million an aggregate of $62.3 million face amount of bonds that we held that
were issued by the various affiliates of Newcastle Investment Holdings that hold
indirectly the GSA portfolio.
LEGAL MATTERS
Certain legal matters will be passed upon for us by Skadden, Arps, Slate,
Meagher & Flom LLP, New York, New York, and Piper Rudnick LLP, Baltimore,
Maryland and for the underwriters by Sidley Austin Brown & Wood LLP, New York,
New York. Sidley Austin Brown & Wood LLP has represented us in the past and
continues to represent us on a regular basis on a variety of matters.
EXPERTS
The consolidated financial statements of Newcastle Investment Corp. and
subsidiaries at December 31, 2002 and 2001 and for each of the three years in
the period ended December 31, 2002 appearing in this prospectus and registration
statement have been audited by Ernst & Young LLP, independent auditors, as set
forth in their report thereon appearing elsewhere herein, and are included in
reliance upon such report given on the authority of such firm as experts in
accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed a registration statement, of which this prospectus is a part,
on Form S-11 with the Securities and Exchange Commission (the "Commission")
relating to this offering. This prospectus does not contain all of the
information in the registration statement and the exhibits and financial
statements included with the registration statement. References in this
prospectus to any of our contracts, agreements or other documents are not
necessarily complete, and you should refer to the exhibits attached to the
registration statement for copies of the actual contracts, agreements or
documents. You may read and copy the registration statement, the related
exhibits and other material we file with the Commission at the Commission's
public reference room in Washington, D.C. at Room 1024, Judiciary Plaza, 450
Fifth Street, N.W., Washington, D.C. 20549. You can also request copies of those
documents, upon payment of a duplicating fee, by writing to the Commission.
Please call the Commission at 1-800-SEC-0330 for further information on the
operation of the public reference rooms. The Commission also maintains an
internet site that contains reports, proxy and information statements and other
information regarding issuers that file with the Commission. The website address
is http://www.sec.gov. You may also request a copy of these filings, at no cost,
by writing or telephoning us as follows: Newcastle Investment Corp., c/o
Fortress Investment Group, 1251 Avenue of the Americas, New York, NY 10020,
Attention: Secretary or (212) 798-6100.
We are subject to the informational requirements of the Exchange Act and,
in accordance with the Exchange Act, file reports, proxy and information
statements and other information with the Commission. Such annual, quarterly and
special reports, proxy and information statements and other information can be
inspected and copied at the locations set forth above. We report our financial
statements on a year ended December 31. We furnish our stockholders with annual
reports containing consolidated financial statements audited by our independent
certified public accountants and with quarterly reports containing unaudited
consolidated financial statements for each of the first three quarters of each
fiscal year.
Our website is under construction and is expected to be complete in the
second quarter of 2003. Our internet address will be
http://www.newcastleinv.com. We will make available, free of charge through a
link on our site, our annual reports on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and amendments to such reports, if any, as
filed with the SEC as soon as reasonably practicable after such filing.
125
INDEX TO FINANCIAL STATEMENTS
TABLE OF CONTENTS
INDEX TO FINANCIAL STATEMENTS:
Report of Independent Auditors'............................. F-2
Consolidated Balance Sheets as of December 31, 2002 and
December 31, 2001......................................... F-3
Consolidated Statements of Income for the years ended
December 31, 2002, 2001 and 2000.......................... F-4
Consolidated Statements of Stockholders' Equity and
Redeemable Preferred Stock for the years ended December
31, 2002, 2001 and 2000................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000.......................... F-7
Notes to Consolidated Financial Statements.................. F-8
F-1
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
Newcastle Investment Corp.
We have audited the accompanying consolidated balance sheets of Newcastle
Investment Corp. and subsidiaries (the "Company") as of December 31, 2002 and
2001, and the related consolidated statements of income, stockholders' equity
and redeemable preferred stock, and cash flows for each of the three years in
the period ended December 31, 2002. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of the Newcastle
Investment Corp. and subsidiaries at December 31, 2002 and 2001, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2002 in conformity with accounting
principles general accepted in the United States.
As discussed in Note 2 to the consolidated financial statements, in 2001
the Company adopted Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities," as amended by
Statement of Financial Accounting Standards No. 138, "Accounting for Derivative
Instruments and Certain Hedging Activities."
/s/ ERNST & YOUNG LLP
February 11, 2003, except for note 12 as to
which the date is February 28, 2003
New York, NY
F-2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 DECEMBER 31, 2001
----------------- -----------------
(DOLLARS IN THOUSANDS,
EXCEPT SHARE DATA)
ASSETS
Real estate securities, available for sale -- Note 4...... $1,069,892 $ 522,258
CBO III deposit -- Note 4................................. 37,777 --
Operating real estate, net -- Note 5...................... 113,652 524,834
Real estate held for sale -- Note 5....................... 3,471 --
Marketable securities, available for sale -- Note 4....... 11,209 14,467
Loans and mortgage pools receivable, net -- Note 6........ 258,198 10,675
Investments in unconsolidated subsidiaries -- Note 3...... -- 73,208
Cash and cash equivalents................................. 45,463 31,360
Restricted cash........................................... 10,380 34,508
Due from affiliates -- Note 10............................ -- 11,334
Deferred costs, net....................................... 6,489 17,988
Receivables and other assets.............................. 16,036 21,487
---------- ----------
TOTAL ASSETS.............................................. $1,572,567 $1,262,119
========== ==========
LIABILITIES, MINORITY INTEREST, REDEEMABLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY
LIABILITIES
CBO bonds payable -- Note 8............................... $ 868,497 $ 445,514
Other bonds payable -- Note 8............................. 37,389 319,303
Notes payable -- Note 8................................... 62,952 111,116
Repurchase agreements -- Note 8........................... 248,169 1,457
Credit facility -- Note 8................................. -- 20,000
Derivative liabilities -- Note 7.......................... 54,095 11,732
Dividends payable......................................... 9,161 8,882
Due to affiliates -- Note 10.............................. 1,335 --
Accrued expenses and other liabilities.................... 6,728 10,633
---------- ----------
TOTAL LIABILITIES......................................... 1,288,326 928,637
---------- ----------
Commitments and contingencies -- Notes 9, 10 and 11......... -- --
MINORITY INTEREST........................................... -- 2,527
Redeemable preferred stock, $.01 par value, 100,000,000
shares authorized, 1,020,517 shares issued and
outstanding at December 31, 2001....................... -- 20,410
STOCKHOLDERS' EQUITY
Common stock, $.01 par value, 500,000,000 shares
authorized, 23,488,517 and 16,488,517 shares issued and
outstanding at December 31, 2002 and 2001,
respectively........................................... 235 165
Additional paid-in capital................................ 290,935 309,356
Dividends in excess of earnings........................... (13,966) (7,767)
Accumulated other comprehensive income -- Note 2.......... 7,037 8,791
---------- ----------
TOTAL STOCKHOLDERS' EQUITY................................ 284,241 310,545
---------- ----------
TOTAL LIABILITIES, MINORITY INTEREST, REDEEMABLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY......................... $1,572,567 $1,262,119
========== ==========
See notes to consolidated financial statements.
F-3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000
----------------- ----------------- -----------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
REVENUES:
Interest and dividend income.............. $ 73,082 $ 48,913 $ 50,985
Rental and escalation income.............. 19,874 20,053 20,433
Gain on settlement of investments......... 11,417 8,438 20,836
Management fee from affiliate -- Note 3... 4,470 8,941 8,941
Incentive income from affiliate -- Note
3...................................... (1,218) 28,709 --
Other income.............................. 18 68 728
----------- ----------- -----------
107,643 115,122 101,923
----------- ----------- -----------
EXPENSES:
Interest expense.......................... 49,527 35,863 36,897
Property operating expense................ 8,631 8,695 8,957
Loan servicing expense.................... 655 254 265
General and administrative expense........ 2,914 1,568 3,272
Management fees to affiliate -- Notes 3
and 10................................. 9,250 14,687 15,587
Preferred incentive return to
affiliate -- Notes 3 and 10............ 2,856 17,188 --
Depreciation and amortization............. 3,199 3,574 2,926
----------- ----------- -----------
77,032 81,829 67,904
----------- ----------- -----------
INCOME BEFORE EQUITY IN EARNINGS OF
UNCONSOLIDATED SUBSIDIARIES............... 30,611 33,293 34,019
Equity in earnings of unconsolidated
subsidiaries -- Note 3.................... 362 2,807 (980)
----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS........... 30,973 36,100 33,039
Income (loss) from discontinued
operations -- Note 5...................... 522 7,571 9,821
----------- ----------- -----------
NET INCOME.................................. 31,495 43,671 42,860
Preferred dividends and related accretion... (1,162) (2,540) (2,084)
----------- ----------- -----------
INCOME AVAILABLE FOR COMMON STOCKHOLDERS.... $ 30,333 $ 41,131 $ 40,776
=========== =========== ===========
NET INCOME PER SHARE OF COMMON STOCK, BASIC
AND DILUTED............................... $ 1.68 $ 2.49 $ 2.16
=========== =========== ===========
Income from continuing operations per share
of common stock, after preferred dividends
and related accretion, basic and
diluted................................... $ 1.65 $ 2.03 $ 1.64
=========== =========== ===========
Income (loss) from discontinued operations
per share of common stock, basic and
diluted................................... $ 0.03 $ 0.46 $ 0.52
=========== =========== ===========
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON
STOCK OUTSTANDING, BASIC.................. 18,080,298 16,492,708 18,892,232
=========== =========== ===========
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON
STOCK OUTSTANDING, DILUTED................ 18,090,052 16,492,708 18,892,232
=========== =========== ===========
DIVIDENDS DECLARED PER SHARE OF COMMON
STOCK..................................... $ 2.05 $ 2.00 $ 1.50
=========== =========== ===========
See notes to consolidated financial statements.
F-4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
REEDEEMABLE ACCUM.
PREFERRED STOCK COMMON STOCK ADDITIONAL DIVIDENDS OTHER TOTAL
--------------------- ------------------- PD. IN IN EXCESS COMP. STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL OF EARNINGS INCOME EQUITY
---------- -------- ---------- ------ ---------- ----------- ----------- -------------
(DOLLARS IN THOUSANDS)
Stockholders'
Equity -- December 31,
2001..................... 1,020,517 $ 20,410 16,488,517 $165 $309,356 $ (7,767) $ 8,791 $ 310,545
Dividends declared by
predecessor prior to
commencement of our
operations............... -- -- -- -- -- (20,949) -- (20,949)
Distribution to predecessor
upon commencement of our
operations............... -- -- -- -- (98,378) -- (11,075) (109,453)
Dividends declared to
predecessor after
commencement of our
operations, but prior to
our initial public
offering................. -- -- -- -- -- (7,584) -- (7,584)
Redemption of redeemable
preferred stock.......... (1,020,517) (20,410) -- -- -- -- -- --
Initial public offering of
shares of common stock... -- -- 7,000,000 70 79,957 -- -- 80,027
Dividends declared
subsequent to our initial
public offering.......... -- -- -- -- -- (9,161) -- (9,161)
Comprehensive income:
Net income............... -- -- -- -- -- 31,495 -- 31,495
Unrealized gain on
securities............. -- -- -- -- -- -- 62,170 62,170
Realized (gain) on
securities:
reclassification
adjustment............... -- -- -- -- -- -- (4,364) (4,364)
Foreign currency
translation............ -- -- -- -- -- -- 4,387 4,387
Foreign currency
translation:
reclassification
adjustment............. -- -- -- -- -- -- (496) (496)
Unrealized (loss) on
derivatives designated as
cash flow hedges......... -- -- -- -- -- -- (52,102) (52,102)
Realized (gain) on
derivatives designated
as cash flow hedges:
reclassification
adjustment............. -- -- -- -- -- -- (274) (274)
---------
Total comprehensive
income................. 40,816
---------- -------- ---------- ---- -------- -------- -------- ---------
Stockholders'
Equity -- December 31,
2002..................... -- $ -- 23,488,517 $235 $290,935 $(13,966) $ 7,037 $ 284,241
========== ======== ========== ==== ======== ======== ======== =========
Stockholders'
Equity -- December 31,
2000..................... 1,020,517 $ 20,167 16,499,765 $165 $309,551 $ (7,666) $ (1,395) $ 300,655
Dividends declared......... -- -- -- -- -- (43,529) -- (43,529)
Redemption of common
stock.................... -- -- (11,248) -- (195) -- -- (195)
Accretion of redeemable
preferred stock.......... -- 243 -- -- -- (243) -- (243)
Transition
adjustment -- deferred
hedge gains and losses... -- -- -- -- -- -- 4,064 4,064
Comprehensive income:
Net income............... -- -- -- -- -- 43,671 -- 43,671
Unrealized gain on
securities............. -- -- -- -- -- -- 19,695 19,695
Unrealized loss on
securities:
reclassification
adjustment............. -- -- -- -- -- -- 954 954
Foreign currency
translation............ -- -- -- -- -- -- (3,198) (3,198)
Foreign currency
translation:
reclassification
adjustment............. -- -- -- -- -- -- 29 29
Unrealized (loss) on
derivatives designated
as cash flow hedges.... -- -- -- -- -- -- (11,563) (11,563)
Unrealized loss
derivatives designated
as cash flow hedges:
reclassification
adjustment............. -- -- -- -- -- -- 205 205
---------
Total comprehensive
income................. 49,793
---------- -------- ---------- ---- -------- -------- -------- ---------
Stockholders'
Equity -- December 31,
2001..................... 1,020,517 $ 20,410 16,488,517 $165 $309,356 $ (7,767) $ 8,791 $ 310,545
========== ======== ========== ==== ======== ======== ======== =========
F-5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND REDEEMABLE PREFERRED
STOCK -- (CONTINUED)
REEDEEMABLE ACCUM.
PREFERRED STOCK COMMON STOCK ADDITIONAL DIVIDENDS OTHER TOTAL
--------------------- ------------------- PD. IN IN EXCESS COMP. STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL OF EARNINGS INCOME EQUITY
---------- -------- ---------- ------ ---------- ----------- ----------- -------------
(DOLLARS IN THOUSANDS)
Stockholders'
Equity -- December 31,
1999..................... -- $ -- 20,916,739 $209 $388,045 $(31,236) $ (2,345) $ 354,673
Dividends declared......... -- -- -- -- -- (18,436) -- (18,436)
Redemption of common
stock.................... -- -- (2,210,540) (22) (32,204) -- -- (32,226)
Exchange of redeemable
preferred stock for
common stock............. 2,370,516 46,312 (2,206,434) (22) (46,290) -- -- (46,312)
Redemption of redeemable
preferred stock.......... (1,349,999) (26,999) -- -- -- -- -- --
Accretion of redeemable
preferred stock.......... -- 854 -- -- -- (854) -- (854)
Comprehensive income:
Net income............... -- -- -- -- -- 42,860 -- 42,860
Unrealized gain on
securities............. -- -- -- -- -- -- 2,828 2,828
Unrealized loss on
securities:
reclassification
adjustment............. -- -- -- -- -- -- 509 509
Foreign currency
translation............ -- -- -- -- -- -- (2,644) (2,644)
Foreign currency
translation:
reclassification
adjustment............. -- -- -- -- -- -- 257 257
---------
Total comprehensive
income................. 43,810
---------- -------- ---------- ---- -------- -------- -------- ---------
Stockholders'
equity -- December 31,
2000..................... 1,020,517 $ 20,167 16,499,765 $165 $309,551 $ (7,666) $ (1,395) $ 300,655
========== ======== ========== ==== ======== ======== ======== =========
See notes to consolidated financial statements.
F-6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000
----------------- ----------------- -----------------
(DOLLARS IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................ $ 31,495 $ 43,671 $ 42,860
Adjustments to reconcile net income to net cash provided
by operating activities (inclusive of amounts related to
discontinued operations):
Depreciation and amortization........................... 8,603 13,996 13,183
Accretion of discount and other amortization............ (4,767) (3,284) (2,739)
Equity in earnings of unconsolidated subsidiaries....... (362) (2,807) 980
Accrued incentive income from affiliate................. 1,218 (11,715) --
Minority interest....................................... 14 (83) 748
Deferred rent........................................... (1,353) (1,964) (2,544)
Gain on settlement of investments....................... (9,619) (10,386) (21,763)
Change in:
Restricted cash......................................... (3,186) 1,308 537
Receivables and other assets............................ (4,449) 2,687 (627)
Accrued expenses and other liabilities.................. 5,469 (555) (5,582)
Due from affiliates..................................... (1,506) 3,580 (230)
--------- -------- ---------
Net cash provided by operating activities:............ 21,557 34,448 24,823
--------- -------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase and improvement of operating real estate......... (2,250) (4,495) (1,520)
Proceeds from sale of operating real estate............... 42,492 -- --
Acquisitions of and advances on loans..................... (259,697) -- (33,770)
Repayments of loan and security principal................. 15,217 75,324 62,891
Proceeds from settlement of loans and foreclosed real
estate.................................................. 372 29,069 22,239
Contributions to unconsolidated subsidiaries.............. (19,991) (25,829) (57,042)
Distributions from unconsolidated subsidiaries............ 8,265 25,814 11,170
Purchase of real estate securities........................ (695,354) (73,365) (10,799)
Proceeds from sale of real estate securities.............. 276,704 105,722 10,543
Deposit on real estate securities......................... (37,125) (23,631) --
Payment of deferred transaction costs..................... (508) (5,150) (1,319)
Settlement of foreign exchange future contracts........... -- -- (137)
Purchase of marketable securities......................... (10,816) (7,680) (29,935)
Proceeds from sale of marketable securities............... -- 10,274 179,311
--------- -------- ---------
Net cash provided by (used in) investing
activities:......................................... (682,691) 106,053 151,632
--------- -------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under repurchase agreements.................... 246,712 10,000 --
Repayments of repurchase agreements....................... -- (24,837) (104,314)
Borrowings under notes payable............................ 62,952 -- --
Repayments of notes payable............................... (119,670) (4,157) (541)
Issuance of CBO bonds payable............................. 438,787 18,418 --
Repayments of CBO bonds payable........................... (17,742) -- --
Issuance of other bonds payable........................... 37,001 -- --
Repayments of other bonds payable......................... (8,151) (64,175) (17,899)
Draws under credit facility............................... 20,000 21,000 74,000
Repayments of credit facility............................. (1,750) (34,000) (41,000)
Minority interest distributions........................... -- (5,090) (1,485)
Proceeds from initial public offering..................... 91,000 -- --
Costs related to initial public offering.................. (10,185) -- --
Redemption of common stock................................ -- (195) (32,226)
Redemption of redeemable preferred stock.................. (20,410) -- (27,000)
Dividends paid............................................ (27,522) (34,796) (28,893)
Distribution of cash to predecessor....................... (12,423) -- --
Payment of deferred financing costs....................... (3,362) (1,884) (867)
--------- -------- ---------
Net cash provided by (used in) financing activities... 675,237 (119,716) (180,225)
--------- -------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........ 14,103 20,785 (3,770)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD.............. 31,360 10,575 14,345
--------- -------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD.................... $ 45,463 $ 31,360 $ 10,575
========= ======== =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for interest expense.......... $ 56,365 $ 61,640 $ 66,141
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:
Common stock dividends declared but not paid.............. $ 9,161 $ 8,244 $ --
Redeemable preferred stock dividends declared but not
paid.................................................... $ -- $ 638 $ 149
Issuance of redeemable preferred stock in exchange for
common stock............................................ $ -- $ -- $ (46,312)
Repurchase agreements assumed............................. $ -- $ -- $ 94,776
Transfer of interest in unconsolidated subsidiary......... $ -- $ -- $ 5,169
Loan foreclosures......................................... $ -- $ -- $ (5,169)
Contribution of assets to unconsolidated subsidiary....... $ (1,454) $ -- $ --
Deposit used in acquisition of CBO collateral............. $ 23,631 $ -- $ --
Distribution of non-cash assets and liabilities to
predecessor............................................. $ (97,030) $ -- $ --
* See notes to consolidated financial statements.
F-7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000
(TABLES IN THOUSANDS, EXCEPT PER SHARE DATA)
1. ORGANIZATION
Newcastle Investment Corp. and subsidiaries ("Newcastle") is a Maryland
corporation that was formed in June 2002 as a wholly owned subsidiary of
Newcastle Investment Holdings Corp. ("Newcastle Holdings") for the purpose of
separating the real estate securities and credit leased real estate businesses
from Newcastle Holdings' other investments. Newcastle conducts its business
through three primary segments: (i) real estate securities, (ii) revenue
producing real estate, primarily credit leased real estate, and (iii) real
estate loans.
In July 2002, Newcastle Holdings contributed to Newcastle certain assets
and liabilities in exchange for 16,488,517 shares of Newcastle's common stock.
However, for accounting purposes this transaction is presented as a reverse
spin-off. Under a reverse spin-off, Newcastle is treated as the continuing
entity and the assets that were retained by Newcastle Holdings and not
contributed to Newcastle are accounted for as if they were distributed at their
historical book basis through a spin-off to Newcastle Holdings. Newcastle's
operations commenced on July 12, 2002. At December 31, 2002 Newcastle Holdings
held approximately 70% of Newcastle's outstanding shares of common stock.
In October 2002, Newcastle sold 7 million shares of its common stock in a
public offering (the "IPO") at a price to the public of $13.00 per share, for
net proceeds of approximately $80 million after deducting the underwriters'
discount and other offering expenses. A portion of the proceeds of this offering
were used to purchase a portfolio of mortgage loans and to make additional
investments, including a deposit on a portfolio of real estate securities.
Subsequent to this offering, Newcastle has 23,488,517 shares of common stock
outstanding.
Newcastle is organized and conducts its operations to qualify as a real
estate investment trust ("REIT") for federal income tax purposes. As such,
Newcastle will generally not be subject to federal income tax on that portion of
its income that is distributed to stockholders if it distributes at least 90% of
its REIT taxable income to its stockholders by prescribed dates and complies
with various other requirements.
Newcastle has entered into a management agreement (the "Management
Agreement") with Fortress Investment Group LLC (the "Manager"), an affiliate,
under which the Manager advises Newcastle on various aspects of its business and
manages its day-to-day operations, subject to the supervision of Newcastle's
board of directors. For its services, the Manager receives an annual management
fee and a preferred incentive return, both as defined in the Management
Agreement. The Manager also manages Newcastle Holdings. For a further discussion
of the Management Agreement, see Note 10.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
BASIS OF ACCOUNTING -- The accompanying consolidated financial statements
are prepared in accordance with accounting principles generally accepted in the
United States ("GAAP") and include the accounts of Newcastle and its
consolidated subsidiaries. All significant intercompany transactions and
balances have been eliminated. Newcastle consolidates those entities in which it
has an investment of 50% or more and has control over significant operating,
financial and investing decisions of the entity.
In January 2003, the Financial Accounting Standards Board issued
Interpretation No. 46 "Consolidation of Variable Interest Entities" which
explains how to identify variable interest entities and how to assess whether to
consolidate such entities. This interpretation becomes effective in June 2003.
Newcastle has not yet determined whether any of its consolidated or
unconsolidated subsidiaries represent
F-8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
variable interest entities pursuant to such interpretation. Such a determination
could result in a change in Newcastle's consolidation policy related to such
subsidiaries and the impact of such a change could be material to Newcastle's
financial condition and results of operations on a gross basis; no material
effect on net assets or net income would be expected.
The consolidated financial statements include the accounts of Newcastle and
its consolidated subsidiaries, subsequent to the date of commencement of its
operations, and also include the accounts of its predecessor, Newcastle
Holdings, prior to such date.
Newcastle Holdings is a Maryland corporation that invested in real
estate-related assets on a global basis. Its primary businesses were (1)
investing in marketable real estate-related securities, (2) investing in
commercial properties leased to third parties, (3) investing in Fortress
Investment Fund LLC ("Fund I") and (4) investing in distressed, sub-performing
and performing residential and commercial mortgage loans, or portfolios thereof,
and related properties acquired in foreclosure or by deed-in-lieu of
foreclosure.
Newcastle Holdings' investments in real estate securities and a portion of
its investments in revenue-producing real estate were transferred to Newcastle;
its other investments are treated as having been distributed to Newcastle
Holdings from Newcastle in July 2002 pursuant to the reverse spin-off
presentation. The real estate (GSA Portfolio-see Note 5) and real estate loans
operations treated as being distributed to Newcastle Holdings have been
accounted for as discontinued operations, because they constituted a component
of an entity, while the other operations treated as being distributed to
Newcastle Holdings, including the investment in Fund I, have not been accounted
for as such, because they did not constitute a component of an entity as defined
in Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for
the Impairment or Disposal of Long-Lived Assets."
For entities over which Newcastle Holdings exercised significant influence,
but which did not meet the requirements for consolidation, Newcastle Holdings
used the equity method of accounting whereby it recorded its share of the
underlying income of such entities. Minority interest represented the ownership
in certain consolidated subsidiaries held by entities other than Newcastle
Holdings. Newcastle does not have any subsidiaries that qualify for the equity
method of accounting, nor does it have any minority interest ownership.
RISKS AND UNCERTAINTIES -- In the normal course of business, Newcastle
encounters primarily two significant types of economic risk: credit and market.
Credit risk is the risk of default on Newcastle's securities, loans, leases, and
derivatives that results from a borrower's, lessee's or derivative
counterparty's inability or unwillingness to make contractually required
payments. Market risk reflects changes in the value of investments in
securities, loans and real estate or in derivatives due to changes in interest
rates, spreads or other market factors, including the value of the collateral
underlying loans and securities and the valuation of real estate held by
Newcastle. Concentrations of risks include the leasing of a substantial portion
of Newcastle's operating real estate to two tenants as described in Note 5.
Management believes that the carrying values of its investments are reasonable
taking into consideration these risks along with estimated collateral values,
payment histories, and other borrower information.
Newcastle invests in real estate located outside of the United States.
Newcastle's international operations are subject to the same risks associated
with its United States operations as well as additional risks, such as
fluctuations in foreign currency exchange rates, unexpected changes in
regulatory requirements, heightened risk of political and economic instability,
potential adverse tax consequences and the burden of complying with a wide
variety of foreign laws.
Additionally, Newcastle is subject to significant tax risks. If Newcastle
were to fail to qualify as a REIT in any taxable year, Newcastle would be
subject to federal income tax on its taxable income at regular corporate rates,
which could be material. In addition, if Newcastle Holdings fails to qualify as
a
F-9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
REIT and Newcastle is treated as a successor to Newcastle Holdings, this could
cause Newcastle to likewise fail to qualify as a REIT. Unless entitled to relief
under certain provisions of the Internal Revenue Code (the "Code"), Newcastle
could also be disqualified from taxation as a REIT for the four taxable years
following any year during which it may have failed to qualify as a REIT.
USE OF ESTIMATES -- The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenue and expenses during the reporting period. Actual results could differ
from those estimates.
FEDERAL INCOME TAXES -- Newcastle expects to qualify as a REIT under the
Code. A REIT will generally not be subject to federal income taxation on that
portion of its income that is distributed to stockholders if it distributes at
least 90% of its REIT taxable income by prescribed dates and complies with
certain other requirements. Since Newcastle distributed 100% of its 2002 taxable
income, no provision has been made for federal income taxes in the accompanying
consolidated financial statements.
Distributions relating to 2002 amounted to $0.85 per share of common stock.
Of this amount, approximately $0.577 was taxable in 2002 and $0.273 relates to
2003 for tax purposes. Distributions relating to 2002 were taxable as follows:
DIVIDENDS ORDINARY CAPITAL RETURN OF
PER SHARE INCOME GAINS CAPITAL
--------- -------- ------- ---------
2002............................................ $0.577 100% --% --%
The distributions disclosed above do not include the distributions made by
our predecessor, Newcastle Holdings. Newcastle Holdings made per share
distributions of $1.50 in 2000, $2.00 in 2001, and $1.20 in 2002 prior to the
commencement of our operations. Newcastle Holdings also elected to be taxed as a
REIT.
EARNINGS PER SHARE -- Newcastle is required to present both basic and
diluted earnings per share ("EPS"). Basic EPS is calculated by dividing net
income available for common stockholders by the weighted average number of
shares of common stock outstanding during each period. Diluted EPS is calculated
by dividing net income available for common stockholders by the weighted average
number of shares of common stock outstanding plus the additional dilutive effect
of common stock equivalents during each period. Newcastle's common stock
equivalents are its stock options (Note 9). Based upon the treasury stock
method, Newcastle did not have any dilutive common stock equivalents during 2001
or 2000. During 2002, based on the treasury stock method, Newcastle had 9,754
dilutive common stock equivalents resulting from its outstanding options. Net
income available for common stockholders is equal to net income less preferred
dividends and accretion of the discount on the Series A Preferred, which was
fully redeemed in June 2002.
COMPREHENSIVE INCOME -- Comprehensive income is defined as the change in
equity of a business enterprise during a period from transactions and other
events and circumstances, excluding those resulting from investments by and
distributions to owners. For Newcastle's purposes, comprehensive income
represents net income, as presented in the statements of operations, adjusted
for net foreign currency translation adjustments and unrealized gains or losses
on marketable securities held for sale and derivatives designated as cash flow
hedges. Accumulated other comprehensive income at December 31, 2002 and 2001
represented $1.8 million and $5.6 million of net foreign currency translation
loss adjustments, respectively, $69.8 million and $21.7 million of net
unrealized gains on marketable securities, respectively, and $61.0 million and
$7.3 million of net unrealized losses on derivatives designated as cash flow
hedges, respectively.
F-10
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
REVENUE RECOGNITION
MORTGAGE LOANS RECEIVABLE AND REAL ESTATE SECURITIES -- Newcastle invests
in mortgage loans and securities secured by loans or loan portfolios.
Furthermore, Newcastle Holdings invested in sub- and non-performing loans and
loan portfolios. Mortgage loans receivable are presented in the consolidated
balance sheet net of any unamortized discount (or gross of any unamortized
premium) and an allowance for loan losses. Discounts or premiums are accreted
into interest income on an effective yield or "interest" method, based upon a
comparison of actual collections and expected collections, through the expected
maturity date of the loan or security. Income is not accrued on non-performing
loans; cash received on such loans is treated as income to the extent of
interest previously accrued. Interest income with respect to non-discounted
loans is recognized on an accrual basis. Deferred fees and costs are recognized
as interest income over the terms of the loans using the interest method. Upon
settlement of loans and securities, the excess (or deficiency) of net proceeds
over the net carrying value of the loan or security is recognized as a gain (or
loss) in the period of settlement.
ALLOWANCE FOR MORTGAGE LOAN LOSSES -- Newcastle periodically evaluates
loans for impairment. Mortgage loans are considered to be impaired, for
financial reporting purposes, when it is probable that Newcastle will be unable
to collect all principal or interest when due according to the contractual terms
of the original loan agreements, or, for loans purchased at a discount for
credit losses, when Newcastle determines that it is probable that it would be
unable to collect as anticipated. Upon determination of impairment, Newcastle
establishes specific valuation allowances, through provisions for losses, based
on the estimated fair value of the underlying real estate collateral using a
discounted cash flow analysis. The allowance for each loan is maintained at a
level believed adequate by management to absorb probable losses. It is
Newcastle's policy to establish an allowance for uncollectible interest on
performing loans that are past due more than 90 days or sooner when, in the
judgment of management, the probability of collection of interest is deemed to
be insufficient to warrant further accrual. Upon such a determination, those
loans are placed on non-accrual status and deemed to be non-performing. Actual
losses may differ from Newcastle's estimates.
RENTAL AND ESCALATION INCOME -- Contractual minimum rental income is
recognized on a straight-line basis over the terms of the related operating
leases. The excess of straight-line rents above contractual amounts was $1.4
million, $2.0 million and $2.5 million during 2002, 2001 and 2000, respectively.
Expense recoveries are included in rental and escalation income.
MANAGEMENT FEE AND INCENTIVE INCOME FROM AFFILIATE -- These income items
relate to Newcastle Holdings' investment in Fund I which was not transferred to
Newcastle and is not part of our ongoing operations. For a further discussion of
this income, see Note 3.
EXPENSE RECOGNITION
INTEREST EXPENSE -- Newcastle finances its investments using both fixed-
and floating-rate financing structures, including repurchase agreements,
mortgages, securitizations, and other financing vehicles. Certain of this debt
has been issued at discounts. Discounts are accreted into interest expense on
the interest method through the expected maturity date of the financing.
DEFERRED COSTS -- Deferred costs consist primarily of costs incurred in
obtaining financing (amortized over the term of such financing using the
interest method). During 2002, 2001 and 2000, approximately $1.4 million, $1.9
million and $2.5 million of financing costs were amortized into interest
expense, respectively.
DERIVATIVES AND HEDGING ACTIVITIES -- In January 2001, Newcastle adopted
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as
amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and
Certain Hedging Activities." SFAS No. 133, as
F-11
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
amended, establishes accounting and reporting standards for derivative
instruments. Specifically, SFAS No. 133 requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
position and to measure those instruments at fair value. Additionally, the fair
value adjustments will affect either stockholders' equity or net income
depending on whether the derivative instrument qualifies as a hedge for
accounting purposes and, if so, the nature of the hedging activity.
For those derivative instruments that are designated and qualify as hedging
instruments, a company must designate the hedging instrument, based upon the
exposure being hedged, as either a cash flow hedge, a fair value hedge or a
hedge of a net investment in a foreign operation.
Derivative transactions are entered into by Newcastle solely for
risk-management purposes, except for the CBO III deposit as described in Note 4.
The decision of whether or not a given transaction/position (or portion thereof)
is hedged is made on a case-by-case basis, based on the risks involved and other
factors as determined by senior management, including restrictions imposed by
the Internal Revenue Code among others. In determining whether to hedge a risk,
Newcastle may consider whether other assets, liabilities, firm commitments and
anticipated transactions already offset or reduce the risk. All transactions
undertaken as hedges are entered into with a view towards minimizing the
potential for economic losses that could be incurred by Newcastle. Generally,
all derivatives entered into are intended to qualify as hedges under GAAP,
unless specifically stated otherwise. To this end, terms of hedges are matched
closely to the terms of hedged items.
Description of the risks being hedged:
1) Interest rate risk, existing positions -- Newcastle generally
hedges the aggregate risk of interest rate fluctuations with respect to its
borrowings, regardless of the form of such borrowings, which require
payments based on a variable interest rate index. Newcastle generally
intends to hedge only the risk related to changes in the benchmark interest
rate (LIBOR or a Treasury rate).
In order to reduce such risks, Newcastle may enter into swap
agreements whereby Newcastle would receive floating rate payments in
exchange for fixed rate payments, effectively converting the borrowing to
fixed rate. Newcastle may also enter into cap agreements whereby, in
exchange for a fee, Newcastle would be reimbursed for interest paid in
excess of a certain cap rate.
2) Interest rate risk, anticipated transactions -- Newcastle may hedge
the aggregate risk of interest rate fluctuations with respect to
anticipated transactions, primarily anticipated borrowings. The primary
risk involved in an anticipated borrowing is that interest rates may
increase between the date the transaction becomes probable and the date of
consummation. Newcastle generally intends to hedge only the risk related to
changes in the benchmark interest rate (LIBOR or a Treasury rate).
In order to "lock in" the rate on the date of forecast, Newcastle may
enter into swap agreements whereby Newcastle would receive fixed rate
payments in exchange for floating rate payments. The value of such a swap
should vary inversely with the expected proceeds of a given fixed rate
borrowing in the future, assuming the terms of the swap and borrowing are
properly matched. At the date the borrowing occurs, the swap is unwound at
a gain or loss which should equal the change in expected proceeds between
the date of forecast and the date of consummation which result from changes
in market interest rates, effectively hedging such changes. At December 31,
2002, no such derivative transactions were outstanding.
3) Foreign currency rate risk, net investments -- Newcastle may hedge
the aggregate risk of fluctuations in the exchange rate between a foreign
currency, in which Newcastle has made a net investment, and the U.S.
dollar.
F-12
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In order to reduce the risk, Newcastle may maintain a short position
in the applicable foreign currency. The amount of the position would be
equal to the anticipated net equity in the foreign investment at a forward
date, as denominated in the foreign currency. This effectively locks in the
current exchange rate on Newcastle's net equity position for the period of
such position. At December 31, 2002, no such derivative transactions were
outstanding.
Newcastle, including its predecessor Newcastle Holdings, has employed
interest rate swaps primarily in four ways: (i) to hedge fluctuations in the
fair value of the fixed lease payments underlying its revenue-producing real
estate in Canada, (ii) to hedge the anticipated GSA Securitization (Note 8),
which occurred in May 1999, (iii) to hedge the anticipated securitization known
as the CBO I transaction (Note 8), which occurred in July 1999, and (iv) to
hedge its exposure to changes in market interest rates with respect to its
floating rate debt. Approximately, $437.5 million and $195.0 million in
principal amount of Newcastle's floating rate debt were designated as the hedged
items to interest rate swap and cap agreements at December 31, 2002,
respectively.
To qualify for cash flow hedge accounting, interest rate swaps and caps
must meet certain criteria, including (1) the items to be hedged expose
Newcastle to interest rate risk, (2) the interest rate swaps or caps are highly
effective in reducing Newcastle's exposure to interest rate risk, and (3) with
respect to an anticipated transaction, such transaction is probable. Correlation
and effectiveness are periodically assessed based upon a comparison of the
relative changes in the fair values or cash flows of the interest rate swaps and
caps and the items being hedged.
For derivative instruments that are designated and qualify as a cash flow
hedge (i.e. hedging the exposure to variability in expected future cash flows
that is attributable to a particular risk), the effective portion of the gain or
loss, and net payments received or made, on the derivative instrument is
reported as a component of other comprehensive income and reclassified into
earnings in the same period or periods during which the hedged transaction
affects earnings. The remaining gain or loss on the derivative instrument in
excess of the cumulative change in the present value of future cash flows of the
hedged item, if any, is recognized in current earnings during the period of
change. No material ineffectiveness was recorded during the years ended December
31, 2002 and 2001. Prior to the adoption of SFAS No. 133, these hedges were
measured at historical cost which was amortized into interest expense on the
interest method. Periodic net payments received or made on such hedges were also
included in interest expense at such time.
With respect to interest rate swaps which were designated as hedges of the
fair value of lease payments, periodic net payments and any gain or loss from
fluctuations in the fair value of the interest rate swaps were capitalized as
adjustments to deferred rent and are being recognized over the term of the
leases as adjustments to rental income. Pursuant to SFAS No. 133, such net
amounts were reclassified to accumulated other comprehensive income at January
1, 2001. Newcastle's hedge of such payments was terminated in 1999. As of
December 31, 2002 and 2001, $1.5 million and $1.6 million of such losses were
deferred, net of amortization, respectively.
With respect to interest rate swaps which have been designated as hedges of
anticipated refinancings, periodic net payments were recognized currently as
adjustments to interest expense; any gain or loss from fluctuations in the fair
value of the interest rate swaps was recorded as a deferred hedging gain or loss
and treated as a component of the anticipated transaction at the time of such
transaction. Pursuant to SFAS No. 133, such net amounts were reclassified to
accumulated other comprehensive income at January 1, 2001. In the event the
anticipated refinancing failed to occur as expected, the deferred hedging credit
or charge was recognized currently in income. Newcastle's hedges of such
refinancings were terminated upon the consummation of such refinancings. As of
December 31, 2002 and 2001, $1.4 million and $9.1 million of such gains were
deferred, net of amortization, respectively.
F-13
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SFAS No. 133 has resulted in a change in Newcastle's method of accounting
for interest rate caps and swaps used as hedges. As a result of this change,
Newcastle recorded a transition gain adjustment to other comprehensive income of
approximately $4.1 million on January 1, 2001. During the years ended December
31, 2002 and 2001, Newcastle recorded an aggregate $52.4 million and $11.4
million of loss to other comprehensive income and an aggregate of $4.6 million
and $4.7 million of gain to earnings, as an adjustment to interest expense,
respectively, related to such hedges. Newcastle expects to reclassify
approximately $3.9 million of net loss on derivative instruments from
accumulated other comprehensive income to earnings during the next twelve months
due to differences in the present value of net interest payments associated with
interest rate swaps and to changes in fair value associated with interest rate
caps.
With respect to interest rate swaps and caps that have not been designated
as hedges, any net payments under, or fluctuations in the fair value of, such
swaps and caps has been recognized currently in income.
Newcastle's derivative financial instruments contain credit risk to the
extent that its bank counterparties may be unable to meet the terms of the
agreements. Newcastle minimizes such risk by limiting its counterparties to
major financial institutions with good credit ratings. In addition, the
potential risk of loss with any one party resulting from this type of credit
risk is monitored. Management does not expect any material losses as a result of
default by other parties. Newcastle does not require collateral.
MANAGEMENT FEES AND PREFERRED INCENTIVE RETURN TO AFFILIATE -- These
represent amounts due to the Manager pursuant to the Management Agreement as
well as amounts due to the Manager related to Newcastle Holdings' investment in
Fund I, which were passed through Newcastle Holdings' income statement on a
gross basis through the date of the commencement of our operations. For further
information on the Management Agreement, see Note 10. For further information
the Fund I related expenses, see Note 3.
BALANCE SHEET MEASUREMENT
INVESTMENT IN MARKETABLE SECURITIES -- Newcastle has classified its
investment in marketable securities, including the real estate securities which
serve as collateral for its CBO transactions, as available for sale. Securities
available for sale are carried at market value with the net unrealized gains or
losses reported as a separate component of accumulated other comprehensive
income. At disposition, the net realized gain or loss is determined on the basis
of the cost of the specific investments and is included in earnings. Unrealized
losses on securities are charged to earnings if they reflect a decline in value
that is other than temporary.
INVESTMENT IN REAL ESTATE -- Investment in real estate is recorded at cost
less accumulated depreciation. Depreciation is computed on a straight-line
basis. Buildings are depreciated over 40 years. Major improvements are
capitalized and depreciated over their estimated useful lives. Fees and costs
incurred in the successful negotiation of leases are deferred and amortized on a
straight-line basis over the terms of the respective leases. Expenditures for
repairs and maintenance are expensed as incurred. Foreclosed real estate, held
for sale, is recorded in Receivables and Other Assets at the lower of its cost
or fair value less cost to sell and is not depreciated. Newcastle adopted SFAS
No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" in
2002. Pursuant to such pronouncement, Newcastle reviews its real estate assets
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. No material impairment was
recorded during 2002, 2001 or 2000. SFAS No. 144 also specifies that long-lived
assets to be disposed of by sale, which meet certain criteria, should be
reclassified to Real Estate Held for Sale and measured at the lower of its
carrying amount or fair value. The results of operations for such an asset,
assuming such asset qualifies as a "component of an entity" as defined in SFAS
No. 144, are retroactively reclassified to Income (Loss) from Discontinued
Operations for all periods presented.
F-14
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOREIGN CURRENCY OPERATIONS -- Assets and liabilities relating to foreign
operations are translated using exchange rates as of the end of each reporting
period. The results of Newcastle's foreign operations are translated at the
weighted average exchange rate for each reporting period. Translation
adjustments are included as a component of accumulated other comprehensive
income.
Foreign exchange contracts may, from time to time, be used to hedge
Newcastle's net investments in its foreign operations. Gains and losses on
foreign exchange contracts which qualify as hedges of net investments in foreign
operations as well as changes in the market value of these instruments are
included in accumulated other comprehensive income. Upon sale or liquidation of
its investment in a foreign operation, the related amount in accumulated other
comprehensive income is reclassified to transaction gain or loss in the period
of such liquidation.
Transaction gains and losses that arise from exchange rate fluctuations on
transactions denominated in a currency other than the functional currency,
except those transactions which qualify as a hedge, are included currently in
income.
CASH AND CASH EQUIVALENTS AND RESTRICTED CASH -- Newcastle considers all
highly liquid short-term investments with maturities of 90 days or less when
purchased to be cash equivalents. Restricted cash consisted of amounts held by
third parties in margin accounts of $1.6 million and $1.6 million at December
31, 2002 and 2001, respectively, related to certain derivative hedge agreements,
restricted property operating accounts of $1.6 million and $8.4 million at
December 31, 2002 and 2001, respectively, cash held by trustees related to
certain of Newcastle's investments of $7.2 million and $0.9 million at December
31, 2002 and 2001, respectively, and cash held as a deposit on the real estate
securities used as collateral for the CBO II transaction (Note 4) of $23.6
million at December 31, 2001. Substantially all amounts on deposit with major
financial institutions exceed insured limits.
STOCK OPTIONS -- Newcastle accounts for stock options granted to
non-employees in accordance with SFAS No. 123, "Accounting for Stock-Based
Compensation." The fair value of the options issued as compensation to the
Manager for its efforts in raising capital for Newcastle Holdings was recorded
in 1998 as an increase in stockholders' equity with an offsetting reduction of
capital proceeds received. No options were issued in 2001, 2000 or 1999. The
fair value of the options issued as compensation to the Manager for its efforts
in raising capital for Newcastle was recorded in 2002 as an increase in
stockholders' equity with an offsetting reduction of capital proceeds received.
3. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through three primary segments: real estate
securities, revenue-producing real estate and real estate loans. Details of
Newcastle's investments in such segments can be found in Notes 4, 5 and 6,
respectively.
Newcastle Holdings conducted its business in four primary segments: real
estate securities, revenue-producing real estate, real estate loans, and its
investment in Fund I.
The real estate securities segment was retained by Newcastle. The
revenue-producing real estate segment, which comprised three portfolios of
properties, was split as follows: the Bell Canada (Canadian) and LIV (Belgian)
portfolios were retained by Newcastle while the GSA (U.S.) portfolio was
distributed to Newcastle Holdings. The real estate loans and Fund I segments
were distributed to Newcastle Holdings. Certain amounts have been reclassified
from the Unallocated segment to the Fund I segment; such amounts did not effect
net income or total assets in either segment.
The unallocated portion consists primarily of interest on short-term
investments, general and administrative expenses, management fees and preferred
incentive return pursuant to the Management Agreement, and interest on Newcastle
Holdings' credit facility.
F-15
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Summary financial data on Newcastle's segments is given below, together
with a reconciliation to the same data for Newcastle as a whole (including its
predecessor, through the date of the commencement of our operations, as
described in Note 1) (in thousands):
REAL ESTATE REAL ESTATE
SECURITIES REAL ESTATE LOANS FUND I UNALLOCATED TOTAL
----------- ----------- ----------- ------- ----------- ----------
DECEMBER 31 2002 AND THE
YEAR THEN ENDED
Gross revenues............ $ 83,259 $ 19,384 $ 1,281 $ 3,287 $ 432 $ 107,643
Operating expenses........ (586) (9,245) (141) (3,861) (10,473) (24,306)
---------- -------- -------- ------- -------- ----------
Operating income (loss)... 82,673 10,139 1,140 (574) (10,041) 83,337
Interest expense.......... (40,805) (5,728) (658) -- (2,336) (49,527)
Depreciation and
amortization............ -- (2,769) -- (329) (101) (3,199)
Equity in earnings of
unconsolidated
subsidiaries............ -- -- -- 303 59 362
---------- -------- -------- ------- -------- ----------
Income (loss) from
continuing operations... 41,868 1,642 482 (600) (12,419) 30,973
Income (loss) from
discontinued
operations.............. -- 1,021 (499) -- -- 522
---------- -------- -------- ------- -------- ----------
Net Income (Loss)......... $ 41,868 $ 2,663 $ (17) $ (600) $(12,419) $ 31,495
========== ======== ======== ======= ======== ==========
Revenue derived from non-
US sources:
Canada.................. $ -- $ 14,015 $ -- $ -- $ -- $ 14,015
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 5,402 $ -- $ -- $ -- $ 5,402
========== ======== ======== ======= ======== ==========
Italy................... $ -- $ -- $ 180 $ -- $ -- $ 180
========== ======== ======== ======= ======== ==========
Total assets.............. $1,138,767 $128,831 $259,381 $ -- $ 45,588 $1,572,567
========== ======== ======== ======= ======== ==========
Long-lived assets outside
the US:
Canada.................. $ -- $ 56,939 $ -- $ -- $ -- $ 56,939
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 71,892 $ -- $ -- $ -- $ 71,892
========== ======== ======== ======= ======== ==========
F-16
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
REAL ESTATE REAL ESTATE
SECURITIES REAL ESTATE LOANS FUND I UNALLOCATED TOTAL
----------- ----------- ----------- ------- ----------- ----------
DECEMBER 31, 2001 AND THE
YEAR THEN ENDED
Gross revenues............ $ 54,961 $ 20,249 $ -- $38,297 $ 1,615 $ 115,122
Operating expenses........ (253) (9,352) -- (23,295) (9,492) (42,392)
---------- -------- -------- ------- -------- ----------
Operating income (loss)... 54,708 10,897 -- 15,002 (7,877) 72,730
Interest expense.......... (26,880) (5,779) -- -- (3,204) (35,863)
Depreciation and
amortization............ -- (2,567) -- (560) (447) (3,574)
Equity in earnings
(losses) of
unconsolidated
subsidiaries............ -- -- -- 5,360 (2,553) 2,807
---------- -------- -------- ------- -------- ----------
Income (loss) from
continuing operations... 27,828 2,551 -- 19,802 (14,081) 36,100
Income (loss) from
discontinued
operations.............. -- 5,380 2,191 -- -- 7,571
---------- -------- -------- ------- -------- ----------
Net Income (Loss)......... $ 27,828 $ 7,931 $ 2,191 $19,802 $(14,081) $ 43,671
========== ======== ======== ======= ======== ==========
Revenue derived from non-
US sources:
Canada.................. $ -- $ 16,092 $ (17) $ -- $ -- 16,075
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 7,219 $ -- $ -- $ -- 7,219
========== ======== ======== ======= ======== ==========
Italy................... $ -- $ -- $ 764 -- $ -- 764
========== ======== ======== ======= ======== ==========
Total assets.............. $ 567,492 $565,481 $ 12,920 $97,562 $ 18,664 $1,262,119
========== ======== ======== ======= ======== ==========
Long-lived assets outside
the US:
Canada.................. $ -- $ 51,060 $ -- $ -- $ -- $ 51,060
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 68,399 $ -- $ -- $ -- $ 68,399
========== ======== ======== ======= ======== ==========
F-17
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
REAL ESTATE REAL ESTATE
SECURITIES REAL ESTATE LOANS FUND I UNALLOCATED TOTAL
----------- ----------- ----------- ------- ----------- ----------
DECEMBER 31, 2000 AND THE
YEAR THEN ENDED
Gross revenues............ $ 46,893 $ 20,640 $ -- $ 8,941 $ 25,449 $ 101,923
Operating expenses........ (361) (9,669) -- (8,941) (9,110) (28,081)
---------- -------- -------- ------- -------- ----------
Operating income.......... 46,532 10,971 -- -- 16,339 73,842
Interest expense.......... (29,671) (5,470) -- -- (1,756) (36,897)
Depreciation and
amortization............ -- (2,411) -- -- (515) (2,926)
Equity in earnings
(losses) of
unconsolidated
subsidiaries............ -- -- -- 1,044 (2,024) (980)
---------- -------- -------- ------- -------- ----------
Income from continuing
operations.............. 16,861 3,090 -- 1,044 12,044 33,039
Income from discontinued
operations.............. -- 4,186 5,635 -- -- 9,821
---------- -------- -------- ------- -------- ----------
Net Income................ $ 16,861 $ 7,276 $ 5,635 $ 1,044 $ 12,044 $ 42,860
========== ======== ======== ======= ======== ==========
Revenue derived from non-
US sources:
Canada.................. $ -- $ 16,742 $ (103) $ -- $ -- $ 16,639
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 7,022 $ -- $ -- $ -- $ 7,022
========== ======== ======== ======= ======== ==========
Italy................... $ -- $ -- $ 2,171 $ -- $ -- $ 2,171
========== ======== ======== ======= ======== ==========
Total assets.............. $ 560,929 $576,728 $112,507 $50,694 $ 30,228 $1,331,086
========== ======== ======== ======= ======== ==========
Long lived assets outside
the U.S.:
Canada.................. $ -- $ 55,404 $ -- $ -- $ -- $ 55,404
========== ======== ======== ======= ======== ==========
Belgium................. $ -- $ 72,615 $ -- $ -- $ -- $ 72,615
========== ======== ======== ======= ======== ==========
UNCONSOLIDATED SUBSIDIARIES
Newcastle does not have any unconsolidated subsidiaries which it accounts
for under the equity method. Newcastle Holdings held three such investments,
none of which were transferred to Newcastle, which are described below. Such
investments are included in Newcastle's financial statements through the date of
the commencements of Newcastle's operations.
F-18
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes the activity affecting the equity held by
Newcastle in unconsolidated subsidiaries:
FORTRESS INVESTMENT
AUSTIN HOLDINGS FUND LLC TOTAL
--------------- ------------------- --------
Balance 12/31/00.................................... $ 12,733 $ 50,694 $ 63,427
Contributions to unconsolidated subsidiaries........ 5,413 20,416 25,829
Distributions from unconsolidated subsidiaries...... (10,616) (15,198) (25,814)
Equity in earnings of unconsolidated subsidiaries... (2,553) 5,360 2,807
Equity in OCI of unconsolidated subsidiaries........ -- 7,074 7,074
Transfer of investment in exchange for notes from
Fund I co-investors............................... -- (3,555) (3,555)
Costs incurred related to investment in the
venture........................................... -- 3,440 3,440
-------- -------- --------
Balance 12/31/01.................................... $ 4,977 $ 68,231 $ 73,208
Contributions to unconsolidated subsidiaries........ 3,237 16,754 19,991
Contribution of assets to unconsolidated
subsidiaries...................................... 1,454 -- 1,454
Distributions from unconsolidated subsidiaries...... (522) (7,743) (8,265)
Equity in earnings of unconsolidated subsidiaries... 59 303 362
Equity in OCI of unconsolidated subsidiaries........ -- (15) (15)
Other............................................... -- (329) (329)
Distribution to Newcastle Holdings.................. (9,205) (77,201) (86,406)
-------- -------- --------
Balance 12/31/02.................................... $ -- $ -- $ --
======== ======== ========
Summarized financial information related to Newcastle's unconsolidated
subsidiaries through the date of their distribution to Newcastle Holdings was as
follows (in thousands):
INCLUDED IN UNALLOCATED SEGMENT
------------------------------------------------------------------------------------------------
FORTRESS INVESTMENT
AUSTIN HOLDINGS FIC MANAGEMENT INC. FUND LLC(A)
------------------------------ ------------------------------ ------------------------------
12/31/02 12/31/01 12/31/00 2/31/02 12/31/01 12/31/00 12/31/02 12/31/01 12/31/00
-------- -------- -------- -------- -------- -------- -------- -------- --------
Assets......................... $ 7,947 $21,259 $ -- $ -- $612,083 $434,009
Liabilities.................... (2,353) (7,207) -- -- -- --
Minority interest.............. (352) (590) -- -- -- --
----- ------- ------- ----- ----- ----- ------- -------- --------
Equity......................... $ 5,242 $13,462 $ -- $ -- $612,083 $434,009
===== ======= ======= ===== ===== ===== ======= ======== ========
Equity held by Newcastle(B).... $ 4,977 $12,733 $ -- $ -- $ 68,231 $ 50,694
===== ======= ======= ===== ===== ===== ======= ======== ========
2002 2001 2000 2002 2001 2000 2002 2001 2000
-------- -------- -------- -------- -------- -------- -------- -------- --------
Revenues....................... $ 585 $(1,370) $ 2,675 $ -- $ -- $ 234 $ 9,740 $141,475 $ 21,894
Expenses....................... (477) (1,302) (5,001) -- -- (523) (4,470) (9,941) (8,941)
Minority interest.............. (45) (16) 484 -- -- -- -- -- --
----- ------- ------- ----- ----- ----- ------- -------- --------
Net income (loss).............. $ 63 $(2,688) $(1,842) $ -- $ -- $(289) $ 5,270 $131,534 $ 12,953
===== ======= ======= ===== ===== ===== ======= ======== ========
Newcastle's equity in net
income (loss)................ $ 59 $(2,553) $(1,749) $ -- $ -- $(275) $ 303 $ 5,360 $ 1,044
===== ======= ======= ===== ===== ===== ======= ======== ========
F-19
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- ---------------
(A) Fortress Investment Fund LLC's summary financial information is presented on
a fair value basis, consistent with its internal basis of accounting, while
Newcastle's equity is presented on a GAAP basis. Newcastle's equity in net
income excludes its incentive income.
(B) Newcastle also had a $3.2 million receivable from Austin at December 31,
2001.
FUND I
The managing member of Fund I is Fortress Fund MM LLC (the "Fund I Managing
Member"), which is owned jointly, through subsidiaries, by Newcastle Holdings,
approximately 94%, and the Manager, approximately 6%, in each case through Class
A membership interests. A separate class of membership interests in the Fund I
Managing Member, designated as Class B, reflects the entitlement to the
incentive return payable by Fund I, as described below, which is owned 50% by
the Manager and 50% by Newcastle Holdings. Newcastle Holdings and its
affiliates, including the Fund I Managing Member, have committed to contribute
an aggregate of $100 million, or approximately 11.5% of Fund I's total committed
capital, to Fund I; in the aggregate, Newcastle Holdings and 21 unaffiliated
investors (collectively, the "Fund I Investors") have committed approximately
$872.8 million (the "Capital Commitment") to Fund I over the three years ending
April 28, 2003. Newcastle Holdings has committed to fund 100% of the capital
commitments of its affiliates, including the Fund I Managing Member (which has
committed $8.7 million or approximately 1% of Fund I's total committed capital),
to Fund I. Fund I, which is a Delaware limited liability company, is owned
through membership interests issued in direct proportion to capital committed.
The Fund I Managing Member is entitled to receive an annual management fee
of up to 1.5% (inclusive of an administrative fee of up to 0.5%) of Fund I's
invested capital or total equity commitments. Newcastle Holdings is not charged
management and administrative fees for its investment in Fund I. Pursuant to an
agreement with the Fund I Managing Member and the Manager, the Manager is
entitled to 100% of the management fee paid by Fund I to the Fund I Managing
Member. Since the management fees paid to the Manager flow through Newcastle
Holdings through its ownership of the Fund I Managing Member, they are reflected
as gross amounts in both Management Fee from Affiliate and Management Fee to
Affiliate, although they have no effect on net income.
The Fund I Managing Member is entitled to an incentive return (the
"Incentive Return") generally equal to 20% of Fund I's returns, as defined,
subject to: 1) a 10% preferred return payable to the Fund I Investors and 2) a
clawback provision which requires amounts previously distributed as Incentive
Return to be returned to Fund I if, upon liquidation of Fund I, the amounts
ultimately distributed to each Fund I Investor do not meet a 10% preferred
return to the Fund I Investors. Fund I is managed by the Manager pursuant to the
Fund I Managing Member's operating agreement and a management agreement between
the Manager and the Fund I Managing Member. In accordance with those documents,
(a) the Manager is entitled to 100% of the management fee payable by Fund I, (b)
the Manager is entitled to 50% of the Incentive Return payable by Fund I, (c)
Newcastle Holdings is entitled to 50% of the Incentive Return payable by Fund I,
and (d) Newcastle Holdings is entitled to receive 100% of the investment income
or loss attributable to the capital invested in Fund I by the Fund I Managing
Member. The Manager of Fund I also manages Newcastle and Newcastle Holdings.
Newcastle Holdings consolidated the financial results of the Fund I Managing
Member because Newcastle Holdings owned substantially all of the voting interest
in the Fund I Managing Member. As a result, Newcastle's consolidated financial
statements reflect all of the Incentive Return payable to the Fund I Managing
Member, including the 50% portion payable to the Manager which was treated as
Preferred Incentive Return to Affiliates.
In January 2000, Newcastle Holdings transferred, in exchange for cash,
approximately $51.2 million of preferred equity securities, acquired in December
1999, to Fund I at their market value, which approximated their book value,
resulting in no gain or loss being recorded. During 2002 (through the date
F-20
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of commencement of Newcastle's operations), 2001 and 2000, Newcastle Holdings
invested approximately $18.0 million, $21.5 million and $47.2 million,
respectively, in Fund I. During 2002 (through the date of commencement of
Newcastle's operations) and 2001, Newcastle Holdings received $7.8 million and
$16.3 million of distributions from Fund I, respectively, excluding Incentive
Return. Newcastle Holdings accounted for its investment in Fund I under the
equity method. During 2002, 2001 and 2000, the Manager earned $4.5 million, $8.9
million and $9.2 million of management and administrative fees from Fund I,
respectively, through its agreement with the Fund I Managing Member.
The Incentive Return is payable on an asset-by-asset basis, as realized.
Accordingly, an Incentive Return may be paid to the Fund I Managing Member in
connection with a particular Fund I investment if and when such investment
generates proceeds to Fund I in excess of the capital called with respect to
such investment, plus a 10% preferred return thereon. If upon liquidation of
Fund I the aggregate amount paid to the Fund I Managing Member as Incentive
Return exceeds the amount actually due to the Fund I Managing Member (that is,
amounts that should instead have been paid to Fund I Investors) after taking
into account the aggregate return to Fund I Investors, the excess is required to
be returned by the Fund I Managing Member (that is "clawed back") to Fund I.
Newcastle Holdings is responsible to pay to Fund I the amount of any excess
return to be clawed back to the extent not funded by the Fund I Managing Member.
The Manager, in turn, is responsible for the clawback of any excess return
received by it. Newcastle Holdings believes that the Manager has the ability to
meet this obligation. Newcastle Holdings received a credit against management
fees otherwise payable by it under its management agreement with the Manager for
management fees and any Incentive Return paid to the Manager by Fund I allocable
to Newcastle Holdings' investment in Fund I. This credit was reflected as
increased return to Newcastle Holdings from Fund I, in Equity in Earnings
(Losses) from Unconsolidated Subsidiaries, because: (a) Newcastle Holdings,
unlike the other Fund I Investors, did not pay a management fee to Fund I and
its allocation of income from Fund I was calculated gross of any management
fees, and (b) Newcastle Holdings received payments from the Manager of amounts
paid to the Manager by Fund I representing the Incentive Return allocable to
Newcastle Holdings' investment in Fund I, of which $0.5 million was received in
January 2002.
Newcastle Holdings had adopted Method 2 of Emerging Issues Task Force Topic
D-96 which specifies that companies with management arrangements that contain a
performance based incentive return that is not finalized until the end of a
period of time specified in the contract may record such return as revenue in
the amount that would be due under the formula at any point in time as if the
incentive return arrangement was terminated at that date.
Newcastle Holdings recorded as incentive income the amount that would be
due based on the fair value of the assets in Fund I exceeding the required
return at a specific point in time as if the management arrangement was
terminated on that date. Based on this methodology, Newcastle Holdings' net
income in each reporting period reflected changes in the fair value of the
assets in Fund I. As such, Newcastle Holdings accrued $27.5 million of Incentive
Return through the date of the commencement of Newcastle's operations. This
amount was recorded in Incentive Income from Affiliate. The Manager was entitled
to 50% of this income which Newcastle Holdings recorded as Incentive Return to
Affiliates. The Fund I Managing Member has received $8.8 million of such income,
all of which is subject to clawback. Newcastle Holdings received $4.4 million of
such income in cash pertaining to the year ended December 31, 2001, representing
its 50% interest in the Incentive Return paid by Fund I.
AUSTIN
In 1998, Newcastle Holdings and Fortress Principal Investment Group LLC
("FPIG"), an affiliate of the Manager, formed Austin Holdings Corporation
("Austin"). FPIG contributed cash, and Newcastle Holdings contributed its
interest in entities that owned certain assets, primarily non-performing loans
and
F-21
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
foreclosed real estate intended for sale, which were originally acquired as part
of loan pool acquisitions. The assets Newcastle Holdings contributed, and any
income generated from them, were not well suited to be held by a REIT for the
reasons described below. If the assets were treated as inventory held for sale
in the ordinary course of business, any gain from the sale of these assets would
be subject to a 100% excise tax in the hands of a REIT. By holding these assets
indirectly through Austin, a corporate entity, Newcastle Holdings instead
received dividend income from the corporation, which is not subject to the 100%
excise tax, and is treated as qualifying income for purposes of the 95% income
test that applies to REITs. Newcastle Holdings held non-voting preferred stock
of Austin. Newcastle Holdings' preferred stock in Austin represented a 95%
economic ownership interest in Austin, and had a liquidation preference over the
common stockholders. Newcastle Holdings' interest in Austin was accounted for
under the equity method. Newcastle Holdings and Austin elected to treat Austin
as a taxable REIT subsidiary ("TRS") as of January 1, 2001 in order to comply
with the rule that REITs generally may not hold more than 10% of the voting
securities or 10% of the value of securities of any corporation that is not a
TRS. FPIG was the holder of all of the common stock which represents 100% of the
vote and 5% of the economic ownership interest of Austin. FPIG's ownership
interest was funded in part by a $0.7 million loan from Austin in 2001.
Austin also owned 100% of the common stock of Ascend Residential Holdings,
Inc. ("Ascend"). Ascend's primary business was the acquisition, rehabilitation
and sale of single-family residential properties.
FICMI
In May 1999, Newcastle Holdings purchased from Impac Commercial Holdings,
Inc. ("ICH"), a publicly traded mortgage REIT, approximately $12 million of
non-voting Series B Convertible Preferred Stock with a coupon of 8.5%. The
preferred stock was initially convertible into 1,683,635 shares of common stock
of ICH. Subsequently, during 1999 and 2000, Newcastle Holdings purchased 832,400
shares of common stock of ICH. Additionally, FIC Management Inc. ("FICMI"), an
unconsolidated subsidiary of Newcastle Holdings created for this purpose,
purchased the management contract for ICH for $6 million and subcontracted the
management of ICH to the Manager. FICMI was entitled to an incentive fee under
the management agreement, as defined, if certain minimum returns were achieved.
During the third quarter of 2000, FICMI recognized incentive fee income of $0.2
million based on ICH's achievement of such returns. During 2000, ICH reimbursed
the Manager for approximately $0.7 million of expenses pursuant to such
contract, and reimbursed Newcastle Holdings for $0.4 million of such expenses.
FICMI had substantially the same legal structure as Austin. Newcastle Holdings
and FICMI and Fortress Fund MM, Inc. ("FFMMI") have made elections to treat
FICMI and FFMMI as TRS's as of January 1, 2001.
In November 2000 a wholly-owned subsidiary of Newcastle Holdings completed
a tender offer for all of the remaining outstanding common shares of ICH.
Newcastle Holdings' basis in its investment in ICH was approximately $22.1
million at the date of acquisition. In addition, Newcastle Holdings incurred
approximately $44.3 million in connection with its tender offer and assumed
approximately $95.7 million of ICH's liabilities, resulting in total assets
acquired of $162.1 million (including $12.1 million of cash), based on the
"purchase" method of accounting. Subsequent to the acquisition, Newcastle
Holdings sold $108.9 million of the former ICH assets during 2000 for net
proceeds of approximately $130.2 million at a gain of approximately $21.3
million, and repaid approximately $92.8 million of the former ICH liabilities.
The remaining, non-cash ICH assets at December 31, 2002 and 2001 were primarily
included in Marketable Securities Available for Sale (Note 2). Newcastle's
consolidated financial statements include ICH's results of operations for the
period subsequent to the completion of the tender offer.
F-22
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. REAL ESTATE SECURITIES
The following is a summary of Newcastle's real estate securities at
December 31, 2002 and 2001, all of which are classified as available for sale
and are therefore marked to market through other comprehensive income pursuant
to SFAS No. 115 "Accounting for Certain Investments in Debt and Equity
Securities." Unrealized losses that are considered other than temporary are
recognized currently in income. There were no such losses incurred through
December 31, 2002. None of the securities is delinquent.
DECEMBER 31, 2002
GROSS UNREALIZED WEIGHTED AVERAGE
----------------- -----------------------------------
TERM TO
PRINCIPAL AMORTIZED CARRYING MOODY'S MATURITY
BALANCE COST BASIS GAINS LOSSES VALUE RATING COUPON YIELD (YEARS)
---------- ---------- ------- ------- ---------- ------- ------ ----- --------
CBO I
CMBS.................. $ 323,025 $283,991 $26,999 $(3,686) $ 307,304 BB 6.72% 9.50% 7.11
Unsecured REIT debt... 234,562 232,892 21,726 (100) 254,518 BBB 7.41% 7.64% 5.48
---------- -------- ------- ------- ---------- ---- ---- ----- ----
Subtotal -- CBO I..... 557,587 516,883 48,725 (3,786) 561,822 BB+ 7.01% 8.67% 6.43
---------- -------- ------- ------- ---------- ---- ---- ----- ----
CBO II
CMBS.................. 299,051 285,035 17,055 (238) 301,852 BBB- 6.35% 7.26% 7.17
Unsecured REIT debt... 113,357 112,475 8,678 -- 121,153 BBB- 7.81% 7.87% 7.85
Other................. 58,155 56,086 1,172 (1,867) 55,391 AA 7.29% 8.23% 7.89
---------- -------- ------- ------- ---------- ---- ---- ----- ----
Subtotal -- CBO II.... 470,563 453,596 26,905 (2,105) 478,396 BBB 6.28% 7.53% 7.41
---------- -------- ------- ------- ---------- ---- ---- ----- ----
Total Real Estate
Securities*........... $1,028,150 $970,479 $75,630 $(5,891) $1,040,218 BBB- 6.67% 8.14% 6.88
========== ======== ======= ======= ========== ==== ==== ===== ====
Non-CBO Securities --
Rated................. 5,000 3,888 137 -- 4,025 AAA 7.39% 12.11% 8.49
Non-CBO Securities --
Unrated............... 18,953 7,184 -- -- 7,184 N/A 7.40% 18.63% 7.50
---------- -------- ------- ------- ---------- ---- ----- ----
Total Marketable
Securities............ $ 23,953 $ 11,072 $ 137 $ -- $ 11,209 7.40% 16.34% 7.71
========== ======== ======= ======= ========== ==== ===== ====
DECEMBER 31, 2001
GROSS UNREALIZED
PRINCIPAL AMORTIZED ----------------- CARRYING
BALANCE COST BASIS GAINS LOSSES VALUE
--------- ---------- ------- ------- --------
CBO I
CMBS.................................... $316,057 $268,209 $ 9,110 $(5,683) $271,636
Unsecured REIT debt..................... 219,515 216,411 9,238 (258) 225,391
-------- -------- ------- ------- --------
Subtotal -- CBO I*........................ $535,572 $484,620 $18,348 $(5,941) $497,027
======== ======== ======= ======= ========
Non-CBO securities........................ $ 19,326 $ 14,507 $ -- $ (40) $ 14,467
======== ======== ======= ======= ========
- ---------------
* Carrying value excludes restricted cash of $29.7 million and $25.2 million at
December 31, 2002 and 2001, respectively, included in Real Estate Securities
pending its reinvestment in securities. The total carrying value of fixed rate
real estate securities was $961.4 million and $497.0 million, and of variable
F-23
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
rate real estate securities was $78.8 million and $0.0 million, at December
31, 2002 and 2001, respectively.
In July 2002, Newcastle entered into an agreement with a major investment
bank whereby such bank will purchase up to $450 million of commercial mortgage
backed securities, REIT debt, real estate loans and asset backed securities,
subject to Newcastle's right to purchase such securities from them. This
agreement is treated as a non-hedge derivative for accounting purposes and is
therefore marked-to-market through current income; a mark of $0.7 million has
been booked to income through December 31, 2002. These securities are expected
to be included in a securitization transaction in which Newcastle would acquire
the equity interest (the "CBO III Transaction"). As of December 31, 2002,
approximately $342.4 million of the $450 million had been accumulated. If the
CBO III Transaction is not consummated as a result of Newcastle's failure to
acquire the equity interest or otherwise as a result of Newcastle's gross
negligence or willful misconduct, Newcastle would be required to either purchase
such securities or pay the difference between the original purchase price of
such securities and the price at which such securities is sold to a third-party
(a "Collateral Loss"). If the CBO III Transaction fails to close for any other
reason, Newcastle would be required to either purchase such securities or pay
the lesser of the Collateral Loss and its deposit. Although Newcastle currently
anticipates completing the CBO III Transaction during the first quarter of 2003,
there is no assurance that the CBO III Transaction will be consummated. As of
December 31, 2002, Newcastle estimates that the fair value of the securities
purchased by such bank is in excess of the purchase price paid by such bank. In
November and December 2002, Newcastle made deposits aggregating $37.1 million
under such agreement (the "CBO III Deposit").
Newcastle Holdings created $62.3 million face of mezzanine bonds issued by
its subsidiaries which indirectly own the GSA Properties. The bonds are not
entitled to any scheduled interest or amortization prior to their maturity date
in May 2011. None of the bonds are secured by mortgages on the GSA Properties;
the bonds are secured by equity interests in the direct or indirect owners of
the GSA Properties. These bonds, which were included the collateral for the CBO
I and CBO II transactions, were retained by Newcastle. These bonds were sold by
Newcastle at a loss of $0.3 million in September 2002.
The securities denoted "CBO I" and "CBO II" are encumbered by the CBO I and
CBO II securitizations (Note 8), respectively. One of the non-CBO securities was
encumbered by a $1.5 million repurchase agreement at December 31, 2002.
F-24
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. OPERATING REAL ESTATE
The following is a reconciliation of real estate assets and accumulated
depreciation:
ACCUMULATED
OPERATING REAL ESTATE GROSS DEPRECIATION NET
- --------------------- --------- ------------ ---------
Balance at December 31, 2000...................... $ 566,923 $(26,384) $ 540,539
Improvements...................................... 4,495 -- 4,495
Foreign currency translation...................... (7,636) 345 (7,291)
Depreciation...................................... -- (12,909) (12,909)
--------- -------- ---------
Balance at December 31, 2001...................... 563,782 (38,948) 524,834
Improvements...................................... 2,166 -- 2,166
Foreign currency translation...................... 11,998 (737) 11,261
Depreciation...................................... -- (7,994) (7,994)
Cost of real estate sold.......................... (44,548) 2,425 (42,123)
Distribution to Newcastle Holdings................ (404,715) 35,320 (369,395)
Transferred to Real Estate Held for Sale.......... (5,571) 474 (5,097)
--------- -------- ---------
Balance at December 31, 2002...................... $ 123,112 $ (9,460) $ 113,652
========= ======== =========
U.S. Properties................................... $ -- $ -- $ --
Canadian Properties............................... 50,186 (4,386) 45,800
Belgian Properties................................ 72,926 (5,074) 67,852
--------- -------- ---------
Total............................................. $ 123,112 $ (9,460) $ 113,652
========= ======== =========
REAL ESTATE HELD FOR SALE
- --------------------------------------------------
Balance at December 31, 2001...................... $ --
Transferred from Operating Real Estate............ 5,097
Mark-to-market.................................... (1,626)
---------
Balance at December 31, 2002...................... 3,471
=========
U.S. Properties................................... $ --
Canadian Properties............................... 3,471
Belgian Properties................................ --
---------
Total............................................. $ 3,471
=========
All of Newcastle's U.S. properties (the "GSA Properties") were distributed
to Newcastle Holdings prior to the commencement of Newcastle's operations. Such
properties were primarily leased to the General Services Administration of the
U.S. Government.
The Canadian properties are primarily leased to Bell Canada, a wholly-owned
subsidiary of BCE, Inc. and are referred to as the "Bell Canada Portfolio." For
2002, 2001 and 2000, approximately 66.6%, 68.0% and 69.7% of Newcastle's
consolidated rental and escalation income from continuing operations was
attributable to Bell Canada. The Bell Canada leases expire over various dates
through 2007. Each Bell Canada lease contains one five-year lease renewal option
and provides for a significant payment due upon expiration of the lease. These
terminal payments have been included in the calculation of straight-line rental
income assuming that each lease is renewed once. The Bell Canada leases also
provide for the
F-25
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
reimbursement of substantially all operating expenses and property taxes plus an
administrative fee. The Bell Canada Portfolio is encumbered by the Bell Canada
Securitization (Note 8).
The Belgian properties are referred to as the "LIV Portfolio" and are
leased to a variety of tenants, including the European Commission ("EC"). For
2002, 2001 and 2000, approximately 14.2%, 13.0% and 14.9% of Newcastle's
consolidated rental and escalation income from continuing operations was
attributable to the EC. The leases on the Belgian properties provide for annual
increases in base rent based on the change in the Sante Index, as well as
payment of increases in operating expenses and real estate taxes over base year
amounts. The LIV Portfolio is encumbered by the Belgian Mortgage (Note 8).
The following is a schedule of the future minimum rental payments to be
received under non-cancelable operating leases:
2003.............................................. $10,476
2004.............................................. 9,405
2005.............................................. 8,396
2006.............................................. 6,602
2007.............................................. 3,299
Thereafter........................................ 92
-------
$38,270
=======
In May 2002, Newcastle sold one of its GSA Properties with a net basis of
$33.0 million for a net purchase price of approximately $34.1 million, at a gain
of $1.1 million. In May 2002, it sold a Belgian property for gross proceeds of
approximately $8.9 million, at a loss of approximately $1.1 million. Pursuant to
SFAS No. 144, Newcastle has retroactively recorded the operations of such
properties in Income from Discontinued Operations for all periods presented.
In August and November 2002, Newcastle entered into contracts to sell two
commercial properties located in Canada for gross proceeds of approximately $2.6
million, at a loss of approximately $1.6 million including the write off of
accumulated other comprehensive income related to foreign currency translation.
The sales are contracted to occur in April 2003. Pursuant to SFAS No. 144,
Newcastle has reclassified the net carrying value of these properties to Real
Estate Held for Sale and has retroactively recorded the operations of such
properties in Income from Discontinued Operations for all periods presented.
Gross revenues from discontinued operations, which include those
investments distributed to Newcastle Holdings as discussed in Note 2, were
approximately $29.2 million, $67.9 million and $75.8 million in 2002, 2001 and
2000, respectively.
F-26
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table sets forth certain information concerning the real
estate portfolio:
12/31/2002 UNAUDITED
COSTS --------------------------------------------------- ---------
CAPITALIZED GROSS NET NET
TYPE OF INITIAL SUBSEQ. TO CARRYING ACCUM. CARRYING RENTABLE
PROPERTY LOCATION COST(A) ACQ'N(A) AMOUNT DEPR. AMOUNT(B) ENCUMB. OCC. SQ. FT.
- -------- ------------------ -------- ----------- -------- ------ --------- -------- ---- ---------
Off.
Bldg. Etobicoke, ON $ 8,937 $ 654 $ 9,591 $ 932 $ 8,659 $ 8,793 100% 177,214
Off.
Bldg. London, ON 14,630 235 14,865 1,485 13,380 7,686 96% 325,764
Industrial Toronto, ON 25,521 209 25,730 1,969 23,761 18,635 100% 624,786
-------- ------ -------- ------ -------- -------- --- ---------
Subtotal -- Canada 49,088 1,098 50,186 4,386 45,800 35,114 99% 1,127,764
-------- ------ -------- ------ -------- -------- --- ---------
Off.
Bldg. G. Bijgaarden, BEL 9,906 212 10,118 696 9,422 9,701 67% 81,763
Off.
Bldg. Brussels, BEL 27,288 22 27,310 1,810 25,500 29,863 100% 119,781
Off.
Bldg. Brussels, BEL 4,589 376 4,965 444 4,521 4,210 100% 26,651
Off.
Bldg. Waterloo, BEL 7,518 13 7,531 505 7,026 6,235 100% 46,231
Off.
Bldg. Zaventem, BEL 6,725 75 6,800 489 6,311 4,874 67% 65,175
Off.
Bldg. Brussels, BEL 5,477 97 5,574 401 5,173 2,992 55% 28,180
Warehouse Zaventem, BEL 3,719 5 3,724 247 3,477 2,096 100% 55,606
Off.
Bldg. Brussels, BEL 5,079 1,825 6,904 482 6,422 2,981 29% 32,206
-------- ------ -------- ------ -------- -------- --- ---------
Subtotal -- Belgium 70,301 2,625 72,926 5,074 67,852 62,952 81% 455,593
-------- ------ -------- ------ -------- -------- --- ---------
Subtotal -- Operating Real
Estate 119,389 3,723 123,112 9,460 113,652 98,066 94% 1,583,357
-------- ------ -------- ------ -------- -------- --- ---------
Off.
Bldg. Hamilton, ON N/A N/A 2,057 N/A 2,057 1,645 100% 118,787
Off.
Bldg. Kingston, ON N/A N/A 1,414 N/A 1,414 630 100% 45,691
-------- ------ -------- ------ -------- -------- --- ---------
Subtotal -- Real Estate Held
for Sale -- -- 3,471 -- 3,471 2,275 100% 164,478
-------- ------ -------- ------ -------- -------- --- ---------
Totals: $119,389 $3,723 $126,583 $9,460 $117,123 $100,341 94% 1,747,835
======== ====== ======== ====== ======== ======== === =========
UNAUDITED
---------------------
TYPE OF ACQ. YEAR BUILT/
PROPERTY DATE RENOVATED
- -------- ----- ------------
Off.
Bldg. 10/98 1972/1978
Off.
Bldg. 10/98 1980
Industria 10/98 1963/'71/'79
Subtotal
Off.
Bldg. 11/99 1994
Off.
Bldg. 11/99 1973/1995
Off.
Bldg. 11/99 1952/'93/'98
Off.
Bldg. 11/99 1930/1990
Off.
Bldg. 11/99 1975/1990
Off.
Bldg. 11/99 1974/1996
Warehouse 11/99 1986
Off.
Bldg. 11/99 1987/2001
Subtotal
Subtotal
Estate
Off.
Bldg. 10/98 1974
Off.
Bldg. 10/98 1981
Subtotal
for Sal
Totals:
- ---------------
(A) Adjusted for changes in foreign currency exchange rates, which aggregated
$12.0 million of gain and $7.6 million of loss between land, building and
improvements in 2002 and 2001, respectively.
(B) The federal income tax basis for such assets at December 31, 2002 was
approximately equal to their book basis.
F-27
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. REAL ESTATE LOANS
Loans and mortgage pools receivable consisted of the following at December
31, 2002 and 2001.
WTD. AVG. RANGE OF
EFFECTIVE STATED DELINQUENT
INTEREST MATURITY PAYMENT CARRYING
DESCRIPTION RATE DATES TERMS CARRYING AMOUNT FACE AMOUNT AMOUNT ENCUMBRANCE
- ----------- --------- ---------- -------- ------------------- ------------------- ---------- -----------
12/31/02 12/31/02 12/31/02 12/31/02 12/31/01 12/31/02 12/31/01 12/31/02 12/31/02
--------- ---------- -------- -------- -------- -------- -------- ---------- -----------
Whole Loan
Portfolio.......... 3.40% 9/27-11/32 Various $258,198 $ -- $254,201 $ -- $-- $246,712
Loan on Retail
Stores............. N/A N/A N/A -- 6,560 -- 6,560 -- --
Italian Mortgage
Portfolio.......... N/A N/A N/A -- 4,073 -- 17,002 -- --
Other................ N/A N/A N/A -- 42 -- 1,833 -- --
-------- ------- -------- ------- -- --------
Total................ $258,198 $10,675 $254,201 $25,395 $-- $246,712
======== ======= ======== ======= == ========
The following is a reconciliation of loans and mortgage pools receivable.
MARKET
DISCOUNT)/ LOSS CARRYING
FACE AMOUNT PREMIUM ALLOWANCE AMOUNT
----------- ---------- --------- --------
Balance 12/31/00......................... $129,621 $(1,095) $(21,569) $106,957
Collections of principal................. (70,801) -- -- (70,801)
Cost of loans sold....................... (32,986) 1,095 6,741 (25,150)
Foreign currency translation............. (439) -- 108 (331)
-------- ------- -------- --------
Balance 12/31/01......................... 25,395 -- (14,720) 10,675
Purchases/advances....................... 255,550 4,147 -- 259,697
Collections of principal................. (7,909) -- -- (7,909)
Cost of loans sold....................... -- -- (267) (267)
Accretion................................ -- (150) -- (150)
Foreign currency translation............. 432 -- (210) 222
Transfer to unconsolidated subsidiary.... (17,355) -- 13,329 (4,026)
Distribution to Newcastle Holdings....... (1,912) -- 1,868 (44)
-------- ------- -------- --------
Balance 12/31/02......................... $254,201 $ 3,997 $ -- $258,198
======== ======= ======== ========
The average carrying amount of Newcastle Holdings' real estate loans was
approximately $54.5 million and $11.8 million during 2002 and 2001,
respectively, on which Newcastle Holdings earned approximately $1.4 million and
$1.6 million of gross revenues, respectively.
All of Newcastle's real estate loans and loan portfolios owned at such time
were transferred to Newcastle Holdings prior to the commencement of Newcastle's
operations.
In November 2002, Newcastle invested $13.5 million of equity in a portfolio
of mortgage loans. This portfolio is encumbered by a repurchase agreement (Note
8).
7. FAIR VALUE OF FINANCIAL INSTRUMENTS
For certain of Newcastle's financial instruments, principally loans
receivable and debt, fair values are not readily available since there are no
active trading markets as characterized by current exchanges between willing
parties. Accordingly, fair values can only be derived or estimated using various
valuation
F-28
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
techniques, such as computing the present value of estimated future cash flows
using discount rates commensurate with the risks involved. However, the
determination of estimated future cash flows is inherently subjective and
imprecise. It should be noted that minor changes in assumptions or estimation
methodologies can have a material effect on these derived or estimated fair
values, and that the fair values reflected below are indicative of the interest
rate environments as of December 31, 2002 and do not take into consideration the
effects of subsequent interest rate fluctuations.
The carrying amounts and estimated fair values of Newcastle's financial
instruments at December 31, 2002 are as follows:
CARRYING PRINCIPAL BALANCE OR ESTIMATED FAIR
AMOUNT NOTIONAL AMOUNT VALUE
---------- -------------------- --------------
Assets:
Real estate securities, available for sale...... $1,069,892 $1,028,150 $1,069,892
CBO III deposit................................. 37,777 See below 37,777
Marketable securities, available for sale....... 11,209 23,953 11,209
Mortgage loans.................................. 258,198 254,201 258,198
Interest rate caps, treated as hedges, net(A)... 4,638 213,035 4,638
Liabilities:
CBO bonds payable............................... 868,497 881,500 868,497
Other bonds payable............................. 37,389 38,173 36,784
Notes payable................................... 62,952 62,952 58,970
Repurchase agreements........................... 248,169 248,169 248,169
Interest rate swaps, treated as hedges,
net(B)....................................... 51,110 437,465 51,110
Non-hedge derivative obligations(C)............. 745 See below 745
- ---------------
(A) Included in Deferred Costs, Net. The longest cap maturity is October 2015.
(B) Included in Derivative Liabilities. The longest swap maturity is April
2011.
(C) Included in Derivative Liabilities. The longest maturity is July 2038.
The methodologies used and key assumptions made to estimate fair value are
as follows:
REAL ESTATE SECURITIES, AVAILABLE FOR SALE -- The fair value of the REIT
unsecured loans and CMBS is estimated by obtaining third party independent
broker quotations, if available and practicable, or counterparty quotations.
CBO III DEPOSIT -- The fair value of the CBO III Deposit is based on a
counterparty quotation. The CBO III deposits is more fully described in Note 4.
MARKETABLE SECURITIES, AVAILABLE FOR SALE -- The fair value of these
securities is generally based upon broker quotations. The fair value of two
securities acquired from ICH, for which quoted market prices are not readily
available, is estimated by means of price/yield analyses based on Newcastle's
expected disposition strategies for such assets. Such assets include Newcastle's
interest in a securitization executed by ICH (the "CMO Asset"). The CMO Asset
has an estimated value of $3.3 million at December 31, 2002 based on a discount
rate of 20% and estimated credit losses of $4.9 million. Increasing such
estimated discount rate and credit losses to 25% and $6.5 million, respectively,
would decrease the estimated value by $0.6 million and $0.5 million,
respectively. The gross securitized assets underlying the CMO Asset aggregate
$262.5 million (of which $2.8 million was delinquent) at December 31, 2002,
subject to $251.3 million of debt.
F-29
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
MORTGAGE LOANS -- This portfolio of mortgage loans bears a floating rate of
interest. We believe that for similar financial instruments with comparable
credit risks, the effective rate on this portfolio approximates the market rate.
Accordingly, the carrying amount of this portfolio is believed to approximate
fair value.
INTEREST RATE CAP AND SWAP AGREEMENTS -- The fair value of these agreements
is estimated by obtaining counterparty quotations.
CBO AND OTHER BONDS PAYABLE -- For those bonds bearing floating rates at
spreads over market indices, representing approximately $710.7 million of the
carrying amount of the CBO Bonds Payable, management believes that for similar
financial instruments with comparable credit risks, the effective rates
approximate market rates.
Accordingly, the carrying amount outstanding on these bonds is believed to
approximate fair value. For those bonds bearing fixed interest rates, values
were obtained by discounting expected future payments by a rate calculated by
inputing a spread over a market index on the date of borrowing.
NOTES PAYABLE -- The Belgian Mortgage was valued by discounting expected
future payments by a rate calculated by imputing a spread over a market index on
the date of borrowing.
REPURCHASE AGREEMENTS -- These agreements bear floating rates of interest
and management believes that for similar financial instruments with comparable
credit risks, the effective rates approximate market rates. Accordingly, the
carrying amounts outstanding are believed to approximate fair value.
NON-HEDGE DERIVATIVE OBLIGATIONS -- These obligations are valued by
reference to current counterparty quotations. These obligations represent two
essentially offsetting interest rate caps and two essentially offsetting
interest rate swaps, each with notional amounts of $32.5 million, an interest
rate cap with a notional amount of $17.5 million, and an interest rate cap with
a notional amount of approximately $61.6 million.
F-30
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. DEBT OBLIGATIONS
The following table presents certain information regarding Newcastle's debt
obligations:
CARRYING AMOUNT FACE AMOUNT
--------------------- --------------------- 12/31/02 STATED
ISSUE 12/31/02 12/31/01 12/31/02 12/31/01 INTEREST RATE MATURITY
- ----- ---------- -------- ---------- -------- ------------------- ---------
CBO I Bonds............... $ 429,363 $445,514 $ 437,500 $455,000 See Below July 2038
CBO II Bonds.............. 439,134 -- 444,000 -- See Below April
2037
---------- -------- ---------- --------
Total CBO bonds........... 868,497 445,514 881,500 455,000
---------- -------- ---------- --------
Bell Canada
Securitization.......... 37,389 -- 38,173 -- See Below April
2012
GSA Securitization........ -- 319,303 -- 360,029 (B) (B)
---------- -------- ---------- --------
Total other bonds......... 37,389 319,303 38,173 360,029
---------- -------- ---------- --------
Bell Canada Mortgage...... -- 31,412 -- 31,412 Repaid Repaid
Belgian Mortgage.......... 62,952 55,149 62,952 55,149 5.32% Nov. 2006
GSA KC Mortgage........... -- 24,555 -- 24,555 Repaid Repaid
---------- -------- ---------- --------
Total notes payable....... 62,952 111,116 62,952 111,116
---------- -------- ---------- --------
CMBS Repo................. 1,457 1,457 1,457 1,457 LIBOR+1.35% (2.77%) One Month
Mortgage Loan Repo(A)..... 246,712 -- 246,712 -- LIBOR+0.37% (1.80%) May 2003
---------- -------- ---------- --------
Total repurchase
agreements.............. 248,169 1,457 248,169 1,457
---------- -------- ---------- --------
Credit facility........... -- 20,000 -- 20,000 (B) (B)
---------- -------- ---------- --------
Total debt obligations.... $1,217,007 $897,390 $1,230,794 $947,602
========== ======== ========== ========
- ---------------
(A) The counterparty on this repo is Bear Stearns Mortgage Capital Corporation.
(B) Distributed to Newcastle Holdings prior to the commencement of Newcastle's
operations.
In July 1999, Newcastle completed a transaction ("CBO I") whereby a
portfolio of real estate securities (Note 4) was contributed to a consolidated
subsidiary which issued $437.5 million fare amount of investment grade senior
securities and $62.5 million face amount of non- investment grade subordinated
securities in a private placement. As a result of CBO I, the existing repurchase
agreement on such real estate securities was repaid. At December 31, 2002, the
subordinated securities were retained by Newcastle and the senior securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of 3.99%, had an expected weighted average life of
approximately 5.26 years. Two classes of the senior securities bear floating
interest rates. Newcastle has obtained an interest rate swap and cap in order to
hedge its exposure to the risk of changes in market interest rates with respect
to these securities, at an initial cost of approximately $14.3 million. CBO I's
weighted average effective interest rate, including the effect of such hedges,
was 5.63% at December 31, 2002. In addition, in connection with the sale of two
classes of securities, Newcastle entered into two interest rate swaps and three
interest rate cap agreements that do not qualify for hedge accounting. Changes
in the values of these instruments have been recorded currently in income.
In November 2001, Newcastle sold the retained subordinated $17.5 million
Class E Note from CBO I for approximately $18.5 million. The Class E Note bore
interest at a fixed rate of 8.0% and had a stated maturity of June 2038. The
sale of the Class E Note represents an issuance of debt and was recorded as
additional CBO Bonds Payable. In April 2002, a wholly-owned subsidiary of
Newcastle repurchased the Class E Note. The re-purchase of the Class E Note
represented a repayment of debt and was recorded as a reduction of CBO Bonds
Payable. The Class E Note is included in the collateral for CBO II. The Class E
Note is eliminated in consolidation.
F-31
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In April 2002, Newcastle completed its second CBO securitization ("CBO II")
whereby a portfolio of real estate securities (Note 4) was contributed to a
consolidated subsidiary which issued $444.0 million face amount of investment
grade senior securities and $56.0 million face amount of non-investment grade
subordinated securities in a private placement. At December 31, 2002, the
subordinated securities were retained by Newcastle and the senior securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of approximately 3.48%, had an expected weighted average life
of approximately 7.36 years. One class of the senior securities bears a floating
interest rate. Newcastle has obtained an interest rate swap and cap in order to
hedge its exposure to the risk of changes in market interest rates with respect
to this security, at an initial cost of $1.2 million. CBO II's weighted average
effective interest rate, including the effect of such hedges, was 6.16% at
December 31, 2002.
In April 2002, Newcastle refinanced the existing debt on the Bell Canada
Portfolio (the "Bell Canada Mortgage") through a securitization transaction (the
"Bell Canada Securitization"). At December 31, 2002, the outstanding securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of approximately 7.07%, had an expected weighted average life
of approximately 2.75 years. In connection with this securitization, Newcastle
guaranteed certain payments under an interest rate swap to be entered into in
2007, if the Bell Canada Securitization is not fully repaid by such date.
Newcastle believes the fair value of this guarantee is negligible at December
31, 2002.
In May 1999, Newcastle Holdings financed the GSA Properties (Note 5)
through a secruitization (the "GSA Securitization") which bore interest at a
weighted average effective rate of 7.04%. The GSA Securitization was distributed
to Newcastle Holdings prior to the commencement of Newcastle's operations.
In November 1999, Newcastle financed the LIV Portfolio (Note 5) with a
mortgage and a related interest rate cap. In November 2001, Newcastle extended
the term of this mortgage, modified the rate, and obtained a new interest rate
cap related thereto. In November 2002, Newcastle refinanced the LIV Portfolio
with a new mortgage (the "Belgian Mortgage") which bears a fixed rate of
interest.
One of the GSA Properties was financed with a mortgage (the "GSA KC
Mortgage") which was repaid in May 2002 upon sale of the related asset.
In November 2002, Newcastle purchased a portfolio of mortgage loans (Note
6) subject to a repurchase agreement (the "Mortgage Loan Repo").
In July 2000, Newcastle Holdings entered into a $40 million revolving
credit agreement (the "Credit Facility"). Newcastle Holdings hedged its exposure
to the risk of changes in market interest rates with respect to the Credit
Facility by entering into an interest rate swap. The credit facility and related
swap were distributed to Newcastle Holdings prior to the commencement of
Newcastle's operations.
Newcastle's debt obligations, including its repurchase agreements, notes
payable, credit facility, CBO and other bonds payable, matures as follows (gross
of discounts of $13.8 million):
2003........................................................ $ 251.8 million
2004........................................................ 2.0 million
2005........................................................ 1.7 million
2006........................................................ 58.4 million
2007........................................................ 0.0 million
Thereafter.................................................. 916.9 million
----------------
$1,230.8 million
================
F-32
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. STOCK OPTION PLAN
In October 2002, Newcastle (with the approval of the board of directors)
adopted a nonqualified stock option plan (the "Newcastle Option Plan") for
non-employee directors and the Manager. The non-employee directors were granted
options in 2002 to acquire an aggregate of 4,000 shares of common stock at a
price of $13 per share, which were fully exercisable upon issuance. The fair
value of such options was not material at the date of grant. For the purpose of
compensating the Manager for its successful efforts in raising capital for
Newcastle, the Manager was granted options in 2002 representing the right to
acquire 700,000 shares of common stock at an exercise price per share of common
stock equal to $13, with such price subject to adjustment as necessary to
preserve the value of such options in connection with the occurrence of certain
events (including capital dividends and capital distributions made by
Newcastle). The 700,000 shares represented an amount equal to 10% of the shares
of common stock of Newcastle sold in its initial public offering in 2002.
The options granted to the Manager were fully vested on the date of grant
and one thirtieth of the options become exercisable on the first day of each of
the following thirty calendar months, or earlier upon the occurrence of certain
events, such as a change in control of Newcastle Holdings or the termination of
the Management Agreement. The options expire in 2012.
The fair value of the options granted to the Manager at the date of grant
was approximately $0.4 million. Newcastle estimated this value by reference to a
volatility estimate of 15%, based on a range of volatilities for our competition
provided by an investment bank, along with management's best judgement, together
with a dividend yield of 13.85%, an expected life assumption of 10 years, and a
risk-free rate assumption of 4.05%. Since the Newcastle Option Plan has
characteristics significantly different from those of traded options, and since
the volatility assumption is subject to significant judgment and variability,
the actual value of the options could vary materially from management's
estimate.
In June 1998, Newcastle Holdings (with the approval of the board of
directors) adopted a nonqualified stock option plan (the "Newcastle Holdings
Option Plan") for non-employee directors and the Manager. The non-employee
directors were granted options in 1998 to acquire an aggregate of 6,000 shares
of common stock at a price of $20 per share, which were fully exercisable upon
issuance. The fair value of such options was not material at the date of grant.
For the purpose of compensating the Manager for its successful efforts in
raising capital for Newcastle Holdings, the Manager was granted options in 1998
representing the right to acquire 2,091,673 shares of common stock at an
exercise price per share of common stock equal to $20, with such price subject
to adjustment as necessary to preserve the value of such options in connection
with the occurrence of certain events (including capital dividends and capital
distributions made by Newcastle Holdings). The 2,091,673 shares represented an
amount equal to 10% of the shares of common stock and units of Newcastle
Holdings outstanding after Newcastle Holdings' stock issuances in 1998. All of
the options granted in 1998 represent options in Newcastle Holdings and not in
Newcastle.
The options granted to the Manager in 1998 were fully vested upon issuance
and were exercisable beginning on June 5, 1999. From and after such date, one
thirtieth of the options became exercisable on the first day of each of the
following thirty calendar months. The options expire on June 5, 2008.
The fair value of the 1998 options granted to the Manager at the date of
grant was approximately $3.6 million. Newcastle Holdings estimated this value by
reference to the volatility and dividend yields of the Morgan Stanley REIT Index
that were approximately 15.4% and 7.1%, respectively, together with an expected
life assumption of 5 years, and a risk-free rate assumption of 4.88%. Since
Newcastle Holdings' common stock is not publicly traded and the Newcastle
Holdings Option Plan has characteristics significantly different from those of
traded options, the actual value of the options could vary materially from
management's estimate.
F-33
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. MANAGEMENT AGREEMENT AND RELATED PARTY TRANSACTIONS
Newcastle entered into the Management Agreement with the Manager in June
2002, which provides for an initial term of one year with automatic one-year
extensions, subject to certain termination rights. After the initial one year
term, the Manager's performance will be reviewed annually and the Management
Agreement may be terminated by Newcastle by payment of a termination fee, as
defined in the Management Agreement, equal to the amount of management fees
earned by the Manager during the twelve consecutive calendar months immediately
preceding the termination, upon the affirmative vote of at least two-thirds of
the independent directors, or by a majority vote of the holders of common stock.
Pursuant to the Management Agreement, the Manager, under the supervision of
Newcastle's board of directors, will formulate investment strategies, arrange
for the acquisition of assets, arrange for financing, monitor the performance of
Newcastle's assets and provide certain advisory, administrative and managerial
services in connection with the operations of Newcastle. For performing these
services, Newcastle will pay the Manager an annual management fee equal to 1.5%
of the gross equity of Newcastle, as defined. Newcastle Holdings' management
agreement with the Manager contained substantially the same terms.
The Management Agreement provides that Newcastle will reimburse the Manager
for various expenses incurred by the Manager or its officers, employees and
agents on Newcastle's behalf, including costs of legal, accounting, tax,
auditing, administrative and other similar services rendered for Newcastle by
providers retained by the Manager or, if provided by the Manager's employees, in
amounts which are no greater than those which would be payable to outside
professionals or consultants engaged to perform such services pursuant to
agreements negotiated on an arm's-length basis.
To provide an incentive for the Manager to enhance the value of the common
stock, the Manager is entitled to receive a quarterly incentive return (the
"Preferred Incentive Return") on a cumulative, but not compounding, basis in an
amount equal to the product of (A) 25% of the dollar amount by which (1) (a) the
Funds from Operations, as defined (before the Preferred Incentive Return) of
Newcastle per share of common stock (based on the weighted average number of
shares of common stock outstanding) plus (b) gains (or losses) from debt
restructuring and from sales of property and other assets per share of common
stock (based on the weighted average number of shares of common stock
outstanding), exceed (2) an amount equal to (a) the weighted average of the
price per share of common stock in the IPO and the value attributed to the net
assets transferred by Newcastle Holdings, and in any subsequent offerings by
Newcastle (adjusted for prior capital dividends or capital distributions)
multiplied by (b) a simple interest rate of 10% per annum (divided by four to
adjust for quarterly calculations) multiplied by (B) the weighted average number
of shares of common stock outstanding. An affiliate of the Manager was entitled
to a similar incentive return from Newcastle Holdings.
AMOUNTS EARNED (INCURRED)
----------------------------------------------
2002 2001 1999
------------- -------------- -------------
Management Fee to Manager......................... ($4.3 million) ($4.8 million) ($5.1 million)
Expense Reimbursements to Manager................. ($0.5 million) ($0.9 million) ($1.6 million)
Preferred Incentive Return to Manager............. ($3.5 million) ($2.8 million) --
Management Fee from Fund to Managing Member....... $4.5 million $8.9 million $8.9 million
Management Fee from Managing Member to Manager.... ($4.5 million) ($8.9 million) ($8.9 million)
Incentive Return from Fund to Managing Member..... ($1.2 million) $28.8 million --
Incentive Return from Managing Member to
Manager......................................... $0.6 million ($14.4 million) --
Newcastle Holdings had an investment in Fund I and an investment in Austin,
which were accounted for under the equity method. Newcastle Holdings also owned
an investment in the Managing Member of Fund I, which was consolidated. As a
result of this investment, Newcastle Holdings was entitled to an Incentive
Return from Fund I. The Manager of Newcastle and Newcastle Holdings also manages
Fund I.
F-34
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Newcastle Holdings received a credit against management fees otherwise payable
under its management agreement with the Manager for management fees and any
Incentive Return paid to the Manager by Fund I in connection with Newcastle
Holdings' investment in Fund I. This credit was reflected as increased return
from Fund I, in Equity in Earnings (Losses) from Unconsolidated Subsidiaries,
because it was structured as a reduced burden on Newcastle Holdings' return from
Fund I as follows: (a) Newcastle Holdings, unlike the other Fund I Investors,
did not pay a management fee to Fund I and its allocation of income from Fund I
was calculated gross of any management fees, and (b) Newcastle Holdings received
payments from the Manager to reimburse it for its share of Incentive Return paid
to the Manager by Fund I, of which $0.5 million was received in January 2002.
For a more complete discussion of these relationships, see Note 3.
In January 2001, an employee co-investment program was adopted whereby
certain employees of the Manager and of Fortress Registered Investment Trust's
("FRIT") operating subsidiary would have the opportunity to invest in Fund I by
purchasing part of Newcastle Holdings' investment. FRIT is Fund I's investment
vehicle. The purpose of the program was to align the interests of FRIT's
employees and the employees of the Manager with those of Fund I's Investors,
including Newcastle Holdings, and to enable the Manager and FRIT to retain such
employees and provide them with appropriate incentives and rewards for their
performance. These employees were integral to the success of Newcastle Holdings
and Fund I. Certain of the employees of the Manager were officers of Newcastle
Holdings and Fund I and/or provided management services to Newcastle Holdings
and Fund I. No employees of Fund I were officers of Newcastle Holdings or
provided management services to Newcastle Holdings. Newcastle Holdings set aside
$10.0 million of its commitment to Fund I for this program, of which $6.9
million was allocated, prior to the distribution of this investment to Newcastle
Holdings, and financed approximately 80% of the employee investments via
non-recourse loans through Austin, which were secured by such employees'
interest in Fund I. The remaining 20% was funded by cash payments from each of
the employees. The loans, which were included in Due from Affiliates, bore
interest at 10%, which was payable currently from distributions from Fund I, and
matured upon liquidation of Fund I. The principal balance of, and any unpaid
interest on, these loans was payable at maturity. At December 31, 2001, Austin
was owed $3.2 million of principal and less than $0.1 million of interest in
connection with this financing. The Manager would fund up to $0.1 million of the
purchase price of these commitments on behalf of employees.
At December 31, 2002, Due To Affiliates is comprised $1.0 million of
Incentive Return payable and $0.3 million of management fees and expense
reimbursements payable.
11. COMMITMENTS AND CONTINGENCIES
CBO III DEPOSIT -- Newcastle has the option to purchase certain real estate
securities from an investment bank. To the extent that such securities decline
in value, Newcastle must either purchase such securities or lose an amount equal
to the lesser of such decline or its deposit. See Note 4.
GUARANTEE OF SWAP PAYMENTS -- In connection with the Bell Canada
Securitization, Newcastle has guaranteed certain payments under an interest rate
swap to be entered into in 2007, if the Bell Canada Securitization is not fully
repaid by such date. Newcastle believes the fair value of this guarantee is
negligible at December 31, 2002.
STOCKHOLDER RIGHTS AGREEMENT -- Newcastle has adopted a stockholder rights
agreement (the "Rights Agreement"). Pursuant to the terms of the Rights
Agreement, Newcastle will attach to each share of common stock one preferred
stock purchase right (a "Right"). Each Right entitles the registered holder to
purchase from Newcastle a unit consisting of one one-hundredth of a share of
Series A Junior Participation Preferred Stock, par value $0.01 per share, at a
purchase price of $70 per unit. Initially, the Rights are not exercisable and
are attached to and transfer and trade with the outstanding shares of
F-35
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
common stock. The Rights will separate from the common stock and will become
exercisable upon the acquisition or tender offer to acquire a 15% beneficial
ownership interest by an acquiring person, as defined. The effect of the Rights
Agreement will be to dilute the acquiring party's beneficial interest. Until a
Right is exercised, the holder thereof, as such, will have no rights as a
stockholder of Newcastle.
LITIGATION -- Newcastle is a defendant in legal actions from transactions
conducted in the ordinary course of business. Management, after consultation
with legal counsel, believes the ultimate liability, if any, arising from such
actions which existed at December 31, 2002 will not materially affect
Newcastle's consolidated results of operations or financial position.
ENVIRONMENTAL COSTS -- As a commercial real estate owner, Newcastle is
subject to potential environmental costs. At December 31, 2002, management of
Newcastle is not aware of any environmental concerns that would have a material
adverse effect on Newcastle's consolidated financial position or results of
operations.
DEBT COVENANTS -- Newcastle's debt obligations contain various customary
loan covenants. Such covenants do not, in management's opinion, materially
restrict Newcastle's investment strategy or ability to raise capital. Newcastle
is in compliance with all of its loan covenants at December 31, 2002.
12. SUBSEQUENT EVENTS
In February 2003, Newcastle sold its entire position in agency eligible
residential mortgage loans (a portion of its mortgage loan portfolio) with an
aggregate unpaid principal balance of approximately $159.0 million for gross
proceeds of approximately $162.6 million at a gain of approximately $0.7
million. As a result of the sale, the existing repurchase agreement allocated to
the agency eligible loans was satisfied for approximately $153.9 million.
Simultaneously, approximately $207.4 million of non-agency/jumbo residential
mortgage loans were purchased for a price of approximately $210.2 million. In
connection with this purchase, the outstanding balance of the existing
repurchase agreement was increased by a net of $45.9 million, after the
repayment described above.
13. SUMMARY PRO FORMA CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
The unaudited pro forma consolidated statements of income are presented as
if the distribution to Newcastle Holdings and the commencement of Newcastle's
operations had been consummated on January 1, 2002 and 2001, respectively. The
historical results of operations of the assets and liabilities treated as being
distributed to Newcastle Holdings for the period prior to the commencement of
Newcastle's operations have been presented as discontinued operations for those
operations that constitute a component of an entity. Of the assets treated as
being distributed to Newcastle Holdings, the GSA portfolio and the mortgage
loans qualify as a component of an entity. The remaining operations (the
"Eliminated Operations") related to the other assets and the liabilities treated
as being distributed to Newcastle Holdings which are not a component of an
entity have been eliminated.
The unaudited pro forma consolidated statements of income are presented for
comparative purposes only, and are not necessarily indicative of what
Newcastle's actual consolidated results of operations would have been for the
periods presented, nor do they purport to represent the results of any future
periods. In the opinion of management, all adjustments necessary to present
fairly the unaudited pro forma financial information have been made.
F-36
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 2002
DISTRIBUTED TO
NEWCASTLE
HOLDINGS
--------------
ELIMINATED
HISTORICAL(A) OPERATIONS PRO FORMA
------------- -------------- ---------
REVENUES
Interest and dividend income........................... $ 73,082 $ (226)(B) $ 72,856
Rental and escalation income........................... 19,874 -- 19,874
Gain (loss) on settlement of investments............... 11,417 29(B) 11,446
Management fee from affiliate.......................... 4,470 (4,470)(B) --
Incentive income from affiliate........................ (1,218) 1,218(B) --
Other income........................................... 18 (3)(B) 15
-------- ------- --------
107,643 (3,452) 104,191
-------- ------- --------
EXPENSES
Interest expense....................................... 49,527 (2,336)(B) 47,191
Property operating expense............................. 8,631 -- 8,631
Loan servicing expense................................. 655 -- 655
General and administrative expense..................... 2,914 (100)(B) 2,814
Management fees to affiliate........................... 9,250 (5,345)(C) 3,905
Preferred incentive return to affiliate................ 2,856 (827)(C) 2,029
Depreciation and amortization.......................... 3,199 (430)(B) 2,769
-------- ------- --------
77,032 (9,038) 67,994
-------- ------- --------
INCOME BEFORE EQUITY IN EARNINGS OF UNCONSOLIDATED
SUBSIDIARIES......................................... 30,611 5,586 36,197
Equity in earnings (losses) of unconsolidated
subsidiaries......................................... 362 (362)(B) --
-------- ------- --------
INCOME FROM CONTINUING OPERATIONS...................... $ 30,973 $ 5,224 $ 36,197
======== ======= ========
Income from continuing operations per share of common
stock, basic and diluted............................. $ 1.71 $ 1.95
======== ========
Weighted average number of shares of common stock
outstanding, basic................................... 18,080 18,560(D)
======== ========
Weighted average number of shares of common stock
outstanding, diluted................................. 18,090 18,570(D)
======== ========
- ---------------
(A) Historical amounts were derived from Newcastle's consolidated financial
statements as of and for the year ended December 31, 2002.
F-37
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(B) Adjustments represent historical results of operations related to other
investments treated as being distributed to Newcastle Holdings, which have
been eliminated, as they will have no continuing impact on Newcastle's
operations, as follows:
RELATED INVESTMENT
-------------------------------------------
FORTRESS
AUSTIN INVESTMENT
HOLDINGS FUND ICH(I) CORPORATE TOTAL
-------- ---------- ------- --------- -------
Interest and dividend
income................. $ -- $ (35) $-- $ (191) $ (226)
Gain on settlement of
investments............ -- -- 29 -- 29
Management fee from
affiliate.............. -- (4,470) -- -- (4,470)
Incentive income from
affiliate.............. -- 1,218 -- -- 1,218
Other income............. -- -- -- (3) (3)
Interest expense......... -- -- -- (2,336)(ii) (2,336)
General and
administrative
expense................ -- -- -- (100)(iii) (100)
Depreciation and
amortization........... -- (329) -- (101)(iv) (430)
Equity in earnings of
unconsolidated
subsidiaries........... (59) (303) -- -- (362)
- ---------------
(i) Relates to assets acquired in the ICH transaction which were sold
prior to the commencement of Newcastle's operations.
(ii) Represents interest on Newcastle Holdings' line of credit.
(iii) Represents data processing expenses, state and local taxes, and
professional fees related directly to entities and assets treated
as being distributed to Newcastle Holdings.
(iv) Represents depreciation of furniture, fixtures and equipment
treated as being distributed to Newcastle Holdings.
(C) Management fees related to the Fund I Managing Member's agreement with Fund
I ($4.5 million) have been eliminated as they will have no continuing impact
on Newcastle's operations. Management fees related to Newcastle Holdings'
management agreement with the Manager have been allocated pro rata between
continuing operations and operations related to assets distributed to
Newcastle Holdings, based on pro forma equity; incentive return has been
allocated based on the investments which generated such return. Newcastle
notes that it will not be responsible for management fees or incentive
return related to the investments or equity distributed to Newcastle
Holdings. The actual management fee charged to Newcastle is based upon
actual equity, as defined. Accordingly, management fees have been allocated
between the operations treated as being distributed to Newcastle Holdings
and Newcastle's continuing operations based upon the same methodology.
(D) Includes approximately 0.5 million shares of common stock deemed to be
issued for pro forma statement of income purposes only, which would generate
incremental proceeds sufficient to offset Newcastle Holdings' dividends in
excess of earnings for the period from January 1, 2002 through July 12, 2002
of $6.7 million.
F-38
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 2001
DISTRIBUTED
TO NEWCASTLE
HOLDINGS
--------------
ELIMINATED PRO
HISTORICAL(A) OPERATIONS FORMA
------------- -------------- ---------
REVENUES
Interest and dividend income............................ $48,913 $ (1,204)(B) $47,709
Rental and escalation income............................ 20,053 -- 20,053
Gain (loss) on settlement of investments................ 8,438 (1,033)(B) 7,405
Management fee from affiliate........................... 8,941 (8,941)(B) --
Incentive income from affiliate......................... 28,709 (28,709)(B) --
Other income............................................ 68 (25)(B) 43
------- -------- -------
115,122 (39,912) 75,210
------- -------- -------
EXPENSES
Interest expense........................................ 35,863 (3,204)(B) 32,659
Property operating expense.............................. 8,695 -- 8,695
Loan servicing expense.................................. 254 (11) 243
General and administrative expense...................... 1,568 (338)(B) 1,230
Management fees to affiliate............................ 14,687 (11,045)(C) 3,642
Preferred incentive return to affiliate................. 17,188 (17,188)(C) --
Depreciation and amortization........................... 3,574 (1,007)(B) 2,567
------- -------- -------
81,829 (32,793) 49,036
------- -------- -------
INCOME BEFORE EQUITY IN EARNINGS OF UNCONSOLIDATED
SUBSIDIARIES.......................................... 33,293 (7,119) 26,174
Equity in earnings (losses) of unconsolidated
subsidiaries.......................................... 2,807 (2,807)(B) --
------- -------- -------
INCOME FROM CONTINUING OPERATIONS....................... $36,100 $ (9,926) $26,174
======= ======== =======
Income from continuing operations per share of common
stock, basic and diluted.............................. $ 2.19 $ 1.54
======= =======
Weighted average number of shares of common stock
outstanding, basic and diluted........................ 16,493 16,973(D)
======= =======
- ---------------
(A) Historical amounts were derived from Newcastle's consolidated financial
statements as of and for the year ended December 31, 2001.
F-39
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(B) Adjustments represent historical results of operations related to other
investments treated as being distributed to Newcastle Holdings, which have
been eliminated, as they will have no continuing impact on Newcastle's
operations, as follows:
RELATED INVESTMENT
-------------------------------------------
FORTRESS
AUSTIN INVESTMENT
HOLDINGS FUND ICH(I) CORPORATE TOTAL
-------- ---------- ------- --------- -------
Interest and dividend
income.................. $ -- $ (647) $ -- $ (557)(ii) $(1,204)
Gain on settlement of
investments............. -- -- (1,984) 951(iii) (1,033)
Management fee from
affiliate............... -- (8,941) -- -- (8,941)
Incentive income from
affiliate............... -- (28,709) -- -- (28,709)
Other income.............. -- -- -- (25) (25)
Interest expense.......... -- -- -- (3,204)(vi) (3,204)
General and administrative
expense................. -- -- -- (338)(v) (338)
Depreciation and
amortization............ -- (560) -- (447)(vi) (1,007)
Equity in earnings of
unconsolidated
subsidiaries............ 2,553 (5,360) -- -- (2,807)
-----------------------
(i) Relates to assets acquired in the ICH transaction which were sold
prior to the commencement of Newcastle's operations.
(ii) Represents interest on corporate cash balances and dividends on
equity investments sold prior to the commencement of Newcastle's
operations.
(iii) Represents a loss on the sale of equity investments sold prior to
the commencement of Newcastle's operations.
(iv) Represents interest on Newcastle Holdings' line of credit.
(v) Represents data processing expenses, state and local taxes, and
professional fees related directly to entities and assets treated
as being distributed to Newcastle Holdings.
(vi) Represents depreciation of furniture, fixtures and equipment
treated as being distributed to Newcastle Holdings.
(C) Management fees related to the Fund I Managing Member's agreement with Fund
I ($8.9 million) have been eliminated as they will have no continuing impact
on Newcastle's operations. Management fees related to Newcastle Holdings'
management agreement with the Manager have been allocated pro rata between
continuing operations and operations related to assets distributed to
Newcastle Holdings, based on pro forma equity; incentive return has been
allocated based on the investments which generated such return. Newcastle
notes that it will not be responsible for management fees or incentive
return related to the investments or equity distributed to Newcastle
Holdings. The actual management fee charged to Newcastle is based upon
actual equity, as defined. Accordingly, management fees have been allocated
between the operations treated as being distributed to Newcastle Holdings
and Newcastle's continuing operations based upon the same methodology.
(D) Includes approximately 0.5 million shares of common stock deemed to be
issued for pro forma statement of income purposes only, which would generate
incremental proceeds sufficient to offset Newcastle Holdings' dividends in
excess of earnings for the period from January 1, 2002 through July 12, 2002
of $6.7 million.
F-40
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SUMMARY QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED)
The following is unaudited summary information on Newcastle's quarterly
operations. The distribution of investments, and related liabilities, to
Newcastle Holdings and the commencement of Newcastle's independent operations
occurred at the beginning of the quarter ended September 30, 2002. Therefore,
periods prior to this quarter are not reflective of Newcastle's ongoing
operations nor are they comparable to subsequent quarters.
QUARTER QUARTER QUARTER YEAR
ENDED ENDED ENDED QUARTER ENDED
3/31/02(A) 6/30/02(A) 9/30/02(A) ENDED 12/31/02
---------- ---------- ---------- 12/31/02 --------
-------
Gross Revenues....................... $ 9,951 $ 39,086 $ 27,841 $30,765 $107,643
Operating expenses................... (868) (13,115) (4,447) (5,876) (24,306)
------- -------- -------- ------- --------
Operating income..................... 9,083 25,971 23,394 24,889 83,337
Interest expense..................... (8,069) (13,440) (13,483) (14,535) (49,527)
Depreciation and amortization........ (850) (938) (695) (716) (3,199)
Equity in earnings of unconsolidated
subsidiaries....................... (452) 814 -- -- 362
------- -------- -------- ------- --------
Income (loss) from continuing
operations......................... (288) 12,407 9,216 9,638 30,973
Income (loss) from discontinued
operations......................... 1,159 981 (1,712) 94 522
Preferred dividends and related
accretion.......................... (638) (524) -- -- (1,162)
------- -------- -------- ------- --------
Income available for common
stockholders....................... $ 233 $ 12,864 $ 7,504 $ 9,732 $ 30,333
======= ======== ======== ======= ========
Net Income per share of common stock,
basic and diluted.................. $ 0.01 $ 0.78 $ 0.46 $ 0.43 $ 1.68
======= ======== ======== ======= ========
Income (loss) from continuing
operations per share of common
stock, after preferred dividends
and related accretion, basic and
diluted............................ $ (0.06) $ 0.73 $ 0.56 $ 0.42 $ 1.65
======= ======== ======== ======= ========
Income (loss) from discontinued
operations per share of common
stock, basic and diluted........... $ 0.07 $ 0.05 $ (0.10) $ 0.01 $ 0.03
======= ======== ======== ======= ========
Weighted average number of shares of
common stock outstanding, basic.... 16,489 16,489 16,489 22,804 18,080
======= ======== ======== ======= ========
Weighted average number of shares of
common stock outstanding,
diluted............................ 16,489 16,489 16,489 22,843 18,090
======= ======== ======== ======= ========
F-41
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
QUARTER QUARTER QUARTER YEAR
ENDED ENDED ENDED QUARTER ENDED
3/31/02(A) 6/30/02(A) 9/30/02(A) ENDED 12/31/02
---------- ---------- ---------- 12/31/02 --------
-------
Gross Revenues....................... $26,531 $ 20,828 $ 47,622 $20,141 $115,122
Operating expenses................... (6,737) (5,827) (22,243) (7,585) (42,392)
------- -------- -------- ------- --------
Operating income..................... 19,794 15,001 25,379 12,556 72,730
Interest expense..................... (9,823) (8,691) (8,546) (8,803) (35,863)
Depreciation and amortization........ (831) (887) (910) (946) (3,574)
Equity in earnings of unconsolidated
subsidiaries....................... (346) 1,471 760 922 2,807
------- -------- -------- ------- --------
Income from continuing operations.... 8,794 6,894 16,683 3,729 36,100
Income (loss) from discontinued
operations......................... 2,902 1,647 1,513 1,509 7,571
Preferred dividends and related
accretion.......................... (630) (634) (638) (638) (2,540)
------- -------- -------- ------- --------
Income available for common
stockholders....................... $11,066 $ 7,907 $ 17,558 $ 4,600 $ 41,131
======= ======== ======== ======= ========
Net Income per share of common stock,
basic and diluted.................. $ 0.67 $ 0.48 $ 1.06 $ 0.28 $ 2.49
======= ======== ======== ======= ========
Income from continuing operations per
share of common stock, after
preferred dividends and related
accretion, basic and diluted....... $ 0.49 $ 0.38 $ 0.97 $ 0.19 $ 2.03
======= ======== ======== ======= ========
Income (loss) from discontinued
operations per share of common
stock, basic and diluted........... $ 0.18 $ 0.10 $ 0.09 $ 0.09 $ 0.46
======= ======== ======== ======= ========
Weighted average number of shares of
common stock outstanding, basic and
diluted............................ 16,500 16,494 16,489 16,489 16,493
======= ======== ======== ======= ========
- ---------------
(A) The Income Available for Common Stockholders shown agrees with Newcastle's
quarterly report(s) on Form 10-Q as filed with the Securities and Exchange
Commission. However, individual line items vary from such report(s) due to
the operations of properties sold, or classified as held for sale, during
the current period being retroactively reclassified to Income from
Discontinued Operations for all periods presented (see Note 5).
F-42
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PROSPECTIVE INVESTORS MAY RELY ONLY ON THE INFORMATION CONTAINED IN THIS
PROSPECTUS. NEITHER NEWCASTLE, NOR ANY UNDERWRITER HAS AUTHORIZED ANYONE TO
PROVIDE PROSPECTIVE INVESTORS WITH DIFFERENT OR ADDITIONAL INFORMATION. THIS
PROSPECTUS IS NOT AN OFFER TO SELL NOR IS IT SEEKING AN OFFER TO BUY THESE
SECURITIES IN ANY JURISDICTION WHERE THE OFFER OR SALE IS NOT PERMITTED. THE
INFORMATION CONTAINED IN THIS PROSPECTUS IS CORRECT ONLY AS OF THE DATE OF THIS
PROSPECTUS, REGARDLESS OF THE TIME OF THE DELIVERY OF THIS PROSPECTUS OR ANY
SALE OF THESE SECURITIES.
------------------------
TABLE OF CONTENTS
------------------------
PAGE
----
Prospectus Summary............................ 1
Risk Factors.................................. 11
Cautionary Statement Regarding Forward-
Looking Statements.......................... 22
Use of Proceeds............................... 23
Ratio of Earnings to Combined Fixed Charges
and Preferred Share Distributions........... 23
Price Range of Common Stock and
Distributions............................... 23
Capitalization................................ 25
Selected Pro Forma Consolidated Financial
Information................................. 26
Selected Historical Consolidated Financial
Information................................. 29
Management's Discussion and Analysis of Pro
Forma Financial Condition and Results of
Operations.................................. 33
Management's Discussion and Analysis of
Historical Financial Condition and Results
of Operations............................... 43
Newcastle Investment Corp. ................... 50
Fortress Investment Group and Our Management
Agreement................................... 71
Management.................................... 79
Certain Relationships and Related Party
Transactions................................ 84
Security Ownership of Certain Beneficial
Owners and Management....................... 85
Description of Series B Preferred Stock....... 87
Description of Capital Stock.................. 95
Important Provisions of Maryland Law and of
Our Charter and Bylaws...................... 101
Federal Income Tax Considerations............. 104
ERISA Considerations.......................... 120
Underwriting.................................. 123
Legal Matters................................. 125
Experts....................................... 125
Where You Can Find More Information........... 125
Index to Financial Statements................. F-1
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Newcastle Logo
NEWCASTLE
INVESTMENT CORP.
2,500,000 SHARES
9.75% SERIES B CUMULATIVE REDEEMABLE PREFERRED STOCK
LIQUIDATION PREFERENCE $25.00 PER SHARE
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PROSPECTUS
------------------------
BEAR, STEARNS & CO. INC.
ADVEST, INC.
BB&T CAPITAL MARKETS
STIFEL, NICOLAUS & COMPANY
INCORPORATED
MARCH 13, 2003
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