UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended     December 31, 2006              
 
or

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from     to    
 
Commission File Number:      001-31458                                                                   
 
 
Newcastle Investment Corp.
(Exact name of registrant as specified in its charter)

Maryland
 
81-0559116
(State or other jurisdiction of incorporation
 
(I.R.S. Employer Identification No.)
or organization)
 
 
 

 
1345 Avenue of the Americas, New York, NY 
10105
(Address of principal executive offices)
(Zip Code)
       
  

Registrant’s telephone number, including area code: (212) 798-6100 

Securities registered pursuant to Section 12 (b) of the Act:

Title of each class:
Name of exchange on which registered:
Common Stock, $0.01 par value per share
New York Stock Exchange (NYSE)
9.75% Series B Cumulative Redeemable Preferred
 
Stock, $0.01 par value per share
New York Stock Exchange (NYSE)
8.05% Series C Cumulative Redeemable Preferred
 
Stock, $0.01 par value per share
New York Stock Exchange (NYSE)

Securities registered pursuant to Section 12 (g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

x Yes      o No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

o Yes      x No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes       o No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K o


 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
 
Large Accelerated Filer x Accelerated Filer o Non-accelerated Filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). (Check One):

o Yes      x No

The aggregate market value of the voting common stock held by non-affiliates as of June 30, 2006 (computed based on the closing price on such date as reported on the NYSE) was: $1.0 billion.
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date.

Common stock, $0.01 par value per share: 48,137,099 outstanding as of February 16, 2007.

DOCUMENTS INCORPORATED BY REFERENCE:

1.  
Portions of the Registrant’s definitive proxy statement for the Registrant’s 2007 annual meeting, to be filed within 120 days after the close of the Registrant’s fiscal year, are incorporated by reference into Part III of this Annual Report on Form 10-K.
 

 
CAUTIONARY STATEMENTS

This report 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, the stability of our earnings, and our 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, our ability to take advantage of opportunities in additional asset classes at attractive risk-adjusted prices, our ability to deploy capital accretively, the risks that default and recovery rates on our loan portfolios exceed our underwriting estimates, the relationship between yields on assets which are paid off and yields on assets in which such monies can be reinvested, the relative spreads between the yield on the assets we invest in and the cost of financing, changes in economic conditions generally and the real estate and bond markets specifically; adverse changes in the financing markets we access affecting our ability to finance our investments, or in a manner that maintains our historic net spreads; changes in interest rates and/or credit spreads, as well as the success of our hedging strategy in relation to such changes; the quality and size of the investment pipeline and the rate at which we can invest our cash, including cash inside our CBOs; impairments in the value of the collateral underlying our investments and the relation of any such impairments to our judgments as to whether changes in the market value of our securities, loans or real estate are temporary or not and whether circumstances bearing on the value of such assets warrant changes in carrying values; legislative/regulatory changes; completion of pending investments; the availability and cost of capital for future investments; competition within the finance and real estate industries; and other risks detailed from time to time below and in our other SEC reports.

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 report. The factors noted above 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 Financial Condition and Results of Operations - Application of 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 report to conform these statements to actual results.
 

 
NEWCASTLE INVESTMENT CORP.
FORM 10-K
 
INDEX

 
   
Page
 
PART I
 
Item 1.
Business
1
Item 1A.
Risk Factors
12
Item 1B.
Unresolved Staff Comments
23
Item 2.
Properties
23
Item 3.
Legal Proceedings
23
Item 4.
Submission of Matters to a Vote of Security Holders
23
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
 
 
Purchases of Equity Securities
23
Item 6.
Selected Financial Data
25
Item 7.
Management’s Discussion and Analysis of Financial Condition and
 
 
Results of Operations
27
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
47
Item 8.
Financial Statements and Supplementary Data
52
 
Report of Independent Registered Public Accounting Firm
53
 
Report on Internal Control over Financial Reporting of Independent Registered
 
 
Public Accounting Firm
54
 
Consolidated Balance Sheets as of December 31, 2006 and December 31, 2005
55
 
Consolidated Statements of Income for the years ended December 31, 2006, 2005
 
 
and 2004
56
 
Consolidated Statements of Stockholders’ Equity for the years ended
 
 
December 31, 2006, 2005 and 2004
57
   
 
 
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005
 
 
and 2004
59
 
Notes to Consolidated Financial Statements
61
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
96
Item 9A.
Controls and Procedures
96
 
Management’s Report on Internal Control over Financial Reporting
96
Item 9B.
Other Information
97
PART III
 
Item 10.
Directors, Executive Officers and Corporate Governance
98
Item 11.
Executive Compensation
98
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related
 
 
Stockholder Matters
98
Item 13.
Certain Relationships and Related Transactions, and Director Independence
98
Item 14.
Principal Accountant Fees and Services
98
PART IV
 
Item 15.
Exhibits; Financial Statement Schedules
99
 
Signatures
100


 
PART I
Item 1. Business.

Overview

Newcastle Investment Corp. (“Newcastle”) is a real estate investment and finance company. We invest with the objective of producing long term, stable returns under varying interest rate and credit cycles, with a moderate amount of credit risk. Newcastle invests in real estate securities, loans and other real estate related assets. In addition, we consider other opportunistic investments which capitalize on our manager’s expertise and which we believe present attractive risk/return profiles and are consistent with our investment guidelines. We seek to deliver stable dividends and attractive risk-adjusted returns to our stockholders through prudent asset selection, active management and the use of match funded financing structures, when appropriate, which reduces our interest rate and financing risks. We make money by optimizing our “net spread,” the difference between the yield on our investments and the cost of financing these investments. We emphasize asset quality, diversification, match funded financing and credit risk management.

Our investment activities cover four distinct categories:

1) Real Estate Securities:
We underwrite and acquire a diversified portfolio of moderately credit sensitive real estate securities, including commercial mortgage backed securities (CMBS), senior unsecured REIT debt issued by property REITs, real estate related asset backed securities (ABS) and agency residential mortgage backed securities (RMBS). We generally target investments rated A through BB, except for our agency RMBS which are generally considered AAA rated. As of December 31, 2006, our investments in real estate securities represented 74.6% of our assets.
   
2) Real Estate Related Loans:
We acquire and originate loans to well capitalized real estate owners with strong track records and compelling business plans, including B-notes, mezzanine loans, bank loans, and real estate loans. As of December 31, 2006, our investments in real estate related loans represented 11.0% of our assets.
   
3) Residential Mortgage Loans:
We acquire residential mortgage loans, including manufactured
 
housing loans and subprime mortgage loans, that we believe will produce attractive risk-adjusted returns. As of December 31, 2006, our investments in residential mortgage loans represented 13.7% of our assets.
   
4) Operating Real Estate:
We acquire direct and indirect interests in operating real estate. As of December 31, 2006, our investments in operating real estate represented 0.6% of our assets.

In addition, Newcastle had uninvested cash and other miscellaneous net assets which represented 0.1% of our assets at December 31, 2006.

Underpinning our investment activities is a disciplined approach to acquiring, financing and actively managing our assets. Our principal objective is to acquire a highly diversified portfolio of debt investments secured by real estate that has moderate credit risk and sufficient liquidity. Newcastle primarily utilizes a match funded financing strategy, when appropriate, in order to minimize refinancing and interest rate risks. This means that we seek both to match the maturities of our debt obligations with the maturities of our investments, in order to minimize the risk that we have to refinance our liabilities prior to the maturities of our assets, and to match the interest rates on our investments with like-kind debt (i.e. floating or fixed), in order to reduce the impact of changing interest rates on our earnings. Finally, we actively manage credit exposure through portfolio diversification and ongoing asset selection and surveillance. Newcastle, through its manager, has a dedicated team of senior investment professionals experienced in real estate capital markets, structured finance and asset management. We believe that these critical skills position us well not only to make prudent investment decisions but also to monitor and manage the credit profile of our investments.

Newcastle’s stock is traded on the New York Stock Exchange under the symbol “NCT”. Newcastle is a real estate investment trust for federal income tax purposes and is externally managed and advised by an affiliate of Fortress Investment Group LLC, or Fortress. Fortress is a global alternative investment and asset management firm with over $30 billion in assets under management as of December 31, 2006. Fortress, which was founded in 1998, became the first global alternative asset manager listed on the New York Stock Exchange (NYSE: FIG) in February 2007. We believe that our manager’s expertise and significant business relationships with participants in the fixed income, structured finance and real estate industries has enhanced our access to investment opportunities which may not be broadly marketed. For its services, our manager receives a management fee and incentive compensation pursuant to a management agreement. Our manager, through its affiliates, and principals of Fortress owned 2.9 million shares of our common stock and our manager, through its affiliates, had options to purchase an additional 1.4 million shares of our common stock, which were issued in connection with our equity offerings, representing approximately 8.7% of our common stock on a fully diluted basis, as of February 16, 2007.
 
1

 
Our Strategy

Newcastle’s investment strategy focuses predominantly on debt investments secured by real estate. We do not have specific policies as to the allocation among type of real estate related assets or investment categories since our investment decisions depend on changing market conditions. Instead, we focus on relative value and in-depth risk/reward analysis with an emphasis on asset quality, liquidity and diversification. Our focus on relative value means that assets which may be unattractive under particular market conditions may, if priced appropriately to compensate for risks such as projected defaults and prepayments, become attractive relative to other available investments. We utilize a match funded financing strategy, when appropriate, and active credit risk management to optimize our returns.

The following table summarizes our investment portfolio at December 31, 2006 and December 31, 2005:
 
   
December 31, 2006
 
December 31, 2005
 
 
 
Face Amount
 
% Total
 
Face Amount
 
% Total
 
Real Estate Securities and Related Loans
 
$
6,196,179
   
71.7
%
$
4,802,172
   
76.1
%
Agency RMBS
   
1,177,779
   
13.6
%
 
697,530
   
11.0
%
Total Real Estate Securities and Related Loans
   
7,373,958
   
85.3
%
 
5,499,702
   
87.1
%
Residential Mortgage Loans
   
812,561
   
9.4
%
 
610,970
   
9.7
%
Other
                         
Subprime Loans Subject to Future Repurchase
   
299,176
   
3.5
%
 
-
   
0.0
%
Investment in Joint Venture
   
38,469
   
0.4
%
 
38,164
   
0.6
%
ICH Loans
   
123,390
   
1.4
%
 
165,514
   
2.6
%
Total Portfolio
 
$
8,647,554
   
100.0
%
$
6,314,350
   
100.0
%
 
The table excludes operating real estate of $33.8 million at December 31, 2006 and $20.2 million at December 31, 2005.

Asset Quality and Diversification at December 31, 2006

Total real estate securities and related loans of $7.4 billion face amount, representing 85.3% of the total portfolio
Asset Quality
o  
$6.0 billion or 81.5% of this portfolio is rated by third parties, or had an implied AAA rating, with a weighted average rating of BBB+.
o  
$1.4 billion or 18.5% of this portfolio is not rated by third parties but had a weighted average loan to value ratio of 68.6%.
o  
63% of this portfolio has an investment grade rating (BBB- or higher).
o  
The weighted average credit spread (i.e., the yield premium on our investments over the comparable US Treasury or LIBOR) for the core real estate securities and related loans of $6.2 billion (excluding agency RMBS) was 2.56%.
Diversity
o  
Our real estate securities and loans are diversified by asset type, industry, location and issuer.
o  
This portfolio had 635 investments. The largest investment was $179.5 million and the average investment size was $11.6 million.
o  
Our real estate securities are supported by pools of underlying loans. For instance, our CMBS investments had over 21,000 underlying loans.

Residential mortgage loans of $0.8 billion face amount, representing 9.4% of the total portfolio
Asset Quality
o  
These residential loans are to high quality borrowers with an average Fair Isaac Corp. credit score (“FICO”) of 697.
o  
Approximately $142.3 million face amount were held in securitized form, of which 95.7% was rated investment grade.
Diversity
o  
Our residential and manufactured housing loans were well diversified with 491 and 18,343 loans, respectively.
 
2

 
Financing Strategy and Match Funded Discipline

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. As of December 31, 2006, our debt to equity ratio was approximately 7.5 to 1. On a pro forma basis, our debt to equity ratio would have been 6.7 to 1 if the trust preferred securities we issued in March 2006 were considered equity for purposes of this computation. Also, on a pro forma basis, our debt to equity ratio would have been 6.9 to 1 after adjustment for the common stock issued in January 2007. We utilize leverage for the sole purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates.

We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize multiple forms of financing including collateralized bond obligations (CBOs), which represent 57% of our debt obligations, other securitizations, term loans (including total rate of return swaps), a credit facility and trust preferred securities, as well as short term financing in the form of repurchase agreements and asset backed commercial paper.

Our manager may elect for us to bear a level of refinancing risk on a short term or longer term basis, such as is the case with investments financed with repurchase agreements or asset backed commercial paper (ABCP), when based on all of the relevant factors, bearing such risk is advisable. As of December 31, 2006, approximately 25% of our debt obligations were in the form of repurchase agreements including repurchase agreements subject to ABCP.

We attempt to reduce interim refinancing risk and to minimize exposure to interest rate fluctuations through the use of match funded financing structures, when appropriate, whereby we seek (i) to match the maturities of our debt obligations with the maturities of our assets and (ii) to match the interest rates on 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 interest rate swaps, caps or other financial instruments, or through a combination of these strategies. This allows us 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 our earnings. As of December 31, 2006, a 100 basis point change in short term interest rates would impact our earnings by approximately $0.2 million per annum.

Credit Risk Management

Credit risk refers to each individual borrower’s ability to make required interest and principal payments on the scheduled due dates. We believe, based on our due diligence process, that our investments offer attractive risk-adjusted returns with long term principal protection under a variety of default and loss scenarios. We minimize credit risk by actively monitoring our investments, their underlying credit quality, loan to value ratio and, where appropriate, repositioning our investments to upgrade their credit quality and yield. A significant portion of our investments are financed with collateralized bond obligations, known as CBOs. Our CBO financings offer us structural flexibility to buy and sell certain investments to manage risk and, subject to certain limitations, to optimize returns.

Further, the expected yield on our real estate securities, which comprise a significant portion of our assets, is sensitive to the performance of the underlying loans, the first risk of default and loss is borne by the more subordinated securities or other features of the securitization transaction, in the case of commercial mortgage and asset backed securities, and the issuer’s underlying equity and subordinated debt, in the case of senior unsecured REIT debt securities.
 
3

 
Formation

We were formed in June 2002 as a subsidiary of Newcastle Investment Holdings Corp. Prior to our initial public offering, Newcastle Investment Holdings contributed to us certain assets and related liabilities in exchange for approximately 16.5 million shares of our common stock. For accounting purposes, this transaction is presented as a reverse spin-off, whereby 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 in July 2002. In May 2003, Newcastle Investment Holdings distributed to its stockholders all of the shares of our common stock that it owned, and it no longer owns any of our equity.

The following table presents information on shares of our common stock issued since our formation:
 
Year
 
Shares Issued
 
Range of Issue
Prices per Share (1)
 
Net Proceeds
(millions)
 
               
Formation
   
16,488,517
   
N/A
   
N/A
 
2002
   
7,000,000
 
 
$13.00
 
$
80.0
 
2003
   
7,886,316
 
 
$20.35-$22.85
 
$
163.4
 
2004
   
8,484,648
 
 
$26.30-$31.40
 
$
224.3
 
2005
   
4,053,928
 
 
$29.60
 
$
108.2
 
2006
   
1,800,408
 
 
$29.42
 
$
51.2
 
December 31, 2006
   
45,713,817
   
 
       
January 2007
   
2,420,000
 
 
$31.30
 
$
75.0
 
 
(1)
Excludes prices of shares issued pursuant to the exercise of options and of shares issued to Newcastle's independent directors.
 
Our Investing Activities

Information regarding our business segments is provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 3 to our consolidated financial statements which appear in “Financial Statements and Supplementary Data.”
 
The following is a description of our investments as of December 31, 2006.

Real Estate Securities

We own a diversified portfolio of moderately credit sensitive real estate securities, which was comprised of the following at December 31, 2006 (dollars in thousands):
 

               
Weighted Average
 
Asset Type
 
Current Face Amount
 
Carrying Value
 
Number of
Securities
 
S&P
Equivalent
Rating
 
Yield
 
Maturity
(Years)
 
CMBS-Conduit
 
$
1,469,298
 
$
1,452,789
   
202
   
BBB
   
6.51
%
 
6.93
 
CMBS-Large Loan
   
714,617
   
719,225
   
53
   
BBB-
   
7.02
%
 
2.62
 
CMBS-CDO
   
23,500
   
21,958
   
2
   
BB
   
12.03
%
 
7.68
 
CMBS- B-Note
   
282,677
   
276,190
   
41
   
BB
   
7.51
%
 
6.02
 
Unsecured REIT Debt
   
1,004,540
   
1,025,040
   
101
   
BBB-
   
6.06
%
 
6.17
 
ABS-Manufactured Housing
   
80,839
   
77,700
   
9
   
BBB-
   
7.79
%
 
6.54
 
ABS-Home Equity
   
729,292
   
710,331
   
124
   
BBB+
   
7.89
%
 
2.70
 
ABS-Franchise
   
76,777
   
76,707
   
22
   
BBB
   
8.21
%
 
4.80
 
Agency RMBS
   
1,177,779
   
1,176,358
   
35
   
AAA
   
5.19
%
 
4.27
 
Subtotal/Average (A)
   
5,559,319
   
5,536,298
   
589
   
BBB+
   
6.50
%
 
5.04
 
Residual interest (B)
   
44,930
   
44,930
   
1
   
NR
   
18.77
%
 
2.52
 
Total/Average
 
$
5,604,249
 
$
5,581,228
   
590
   
BBB+
   
6.60
%
 
5.02
 
 
(A)
Implied AAA rating.
(B)
Represents the retained equity from securitization of subprime mortgage loans as described in "Residential Mortgage Loans" below.
 
 
The loans underlying our real estate securities were diversified by industry as follows at December 31, 2006:

       
Industry
   
% of Face Amount
 
Residential
   
29.50
%
Retail
   
16.22
%
Office
   
15.02
%
Subprime Residential
   
13.81
%
Lodging
   
6.57
%
Industrial
   
2.00
%
Health Care
   
1.81
%
Other
   
15.07
%
 
4

 
Real Estate Related Loans

We directly owned the following real estate related loans at December 31, 2006 (dollars in thousands):
 
Loan Type
 
Current
Face Amount
 
Carrying
Value
 
Loan Count
 
Weighted Avg. Yield
 
Weighted Avg.
Maturity (Years)
 
B-Notes
 
$
248,240
 
$
246,798
   
9
   
7.98
%
 
2.71
 
Mezzanine Loans (1)
   
906,907
   
904,686
   
22
   
8.61
%
 
2.67
 
Bank Loans
   
233,793
   
233,895
   
6
   
7.75
%
 
3.92
 
Whole Loans
   
61,240
   
61,703
   
3
   
12.63
%
 
1.81
 
ICH Loans
   
123,390
   
121,834
   
70
   
7.77
%
 
1.10
 
Total
 
$
1,573,570
 
$
1,568,916
   
110
   
8.48
%
 
2.71
 
 
(1)
One of these loans has an $8.9 million contractual exit fee. Newcastle will begin to accrue this fee if and when management believes it is probable that such exit fee will be received.

We also indirectly owned the following interests in real estate related loans at December 31, 2006:

Joint Venture
In 2003, we co-invested, on equal terms, in a joint venture alongside an affiliate of our manager which acquired a pool of franchise loans collateralized by fee and leasehold interests and other assets. We, and our manager’s affiliate, each own an approximately 38% interest in the joint venture. The remaining approximately 24% interest is owned by a third party financial institution. Our investment totaled $10.2 million at December 31, 2006 and is reflected as an investment in an unconsolidated subsidiary on our consolidated balance sheet.

Our relative interest in these franchise loans is summarized as follows (dollars in thousands):
 
Current
Face
Amount
 
Carrying
Value
 
Loan Count
 
Weighted
Avg.
Yield
 
$
 19,878
 
$
10,249
   
57
   
15.30
%
 
Loans Financed via Total Rate of Return Swaps
We have entered into total rate of return swaps with major investment banks to finance certain loans whereby we receive the sum of all interest, fees and any positive change in value amounts (the total return cash flows) from a reference asset with a specified notional amount, and pay interest on such notional plus any negative change in value amounts from such asset. These agreements are recorded in Derivative Assets and treated as non-hedge derivatives for accounting purposes and are therefore marked to market through income. Net interest received is recorded to Interest Income and the mark to market is recorded to Other Income. If we owned the reference assets directly, they would not be marked to market through income. Under the agreements, we are required to post an initial margin deposit to an interest bearing account and additional margin may be payable in the event of a decline in value of the reference asset. Any margin on deposit (recorded in Restricted Cash), less any negative change in value amounts, will be returned to us upon termination of the contract.

As of December 31, 2006, Newcastle held an aggregate of $299.7 million notional amount of total rate of return swaps on 8 reference assets on which it had deposited $46.8 million of margin. These total rate of return swaps had an aggregate fair value of approximately $1.3 million, a weighted average receive interest rate of LIBOR + 2.59%, a weighted average pay interest rate of LIBOR + 0.63%, and a weighted average swap maturity of 1.5 years.
 
5

 
Residential Mortgage Loans

We own portfolios of residential mortgage loans, including manufactured housing loans and subprime mortgage loans, on properties located in the U.S. The following table sets forth certain information with respect to our residential mortgage loan portfolios at December 31, 2006 (dollars in thousands):
 
Loan Type
 
Current
Face
Amount
 
Carrying
Value
 
Loan Count
 
Weighted Avg.
Yield (1)
 
Weighted Avg.
Maturity (Years) (2)
 
Residential loans
 
$
168,649
 
$
172,839
   
491
   
6.42
%
 
2.79
 
Manufactured housing loans
   
643,912
   
636,258
   
18,343
   
8.48
%
 
6.02
 
Total
 
$
812,561
 
$
809,097
   
18,834
   
8.03
%
 
5.35
 
Subprime mortgage loans
                               
subject to future repurchase
 
$
299,176
 
$
288,202
                   
 
(1)
Loss adjusted.
(2)
Weighted average maturity was calculated based on a constant prepayment rate (CPR) of approximately 30% for residential loans and 9% for manufactured housing loans.
 
In March 2006, we acquired a portfolio of approximately 11,300 residential mortgage loans to subprime borrowers (the “Subprime Portfolio”) for $1.50 billion. The loans are being serviced by Nationstar Mortgage, LLC (formerly known as Centex Home Equity Company, LLC) for a servicing fee equal to 0.50% per annum on the unpaid principal balance of the Subprime Portfolio. At March 31, 2006, these loans were considered “held for sale” and carried at the lower of cost or fair value. A write down of $4.1 million was recorded to Provision for Losses, Loans Held for Sale in March 2006 with respect to these loans, related to market factors. Furthermore, the acquisition of loans held for sale is considered an operating activity for statement of cash flow purposes. An offsetting cash inflow from the sale of such loans (as described below) was recorded as an operating cash flow in April 2006. This acquisition was initially funded with an approximately $1.47 billion repurchase agreement which bore interest at LIBOR + 0.50%. We entered into an interest rate swap in order to hedge our exposure to the risk of changes in market interest rates with respect to the financing of the Subprime Portfolio. This swap did not qualify as a hedge for accounting purposes and was therefore marked to market through income. An unrealized mark to market gain of $5.5 million was recorded to Other Income in connection with this swap in March 2006.

In April 2006, through Newcastle Mortgage Securities Trust 2006-1 (the “Securitization Trust”), we closed on a securitization of the Subprime Portfolio. The Securitization Trust is not consolidated by us. We sold the Subprime Portfolio and the related interest rate swap to the Securitization Trust. The Securitization Trust issued $1.45 billion of debt (the “Notes”). We retained $37.6 million face amount of the low investment grade Notes and all of the equity issued by the Securitization Trust. The Notes have a stated maturity of March 25, 2036. As holder of the equity of the Securitization Trust, we have the option to redeem the Notes once the aggregate principal balance of the Subprime Portfolio is equal to or less than 20% of such balance at the date of the transfer. The proceeds from the securitization were used to repay the repurchase agreement described above.

The transaction between us and the Securitization Trust qualified as a sale for accounting purposes, resulting in a net gain of approximately $40,000 being recorded in April 2006. We, as holder of the equity of the Securitization Trust, have the option to redeem the Notes once the aggregate principal balance of the Subprime Portfolio is equal to or less than 20% of such balance at the date of the transfer. This 20% portion of the loans which is subject to future repurchase by us was not treated as being sold and is classified as “held for investment” subsequent to the completion of the securitization. Following the securitization, we held the following interests in the Subprime Portfolio, all valued at the date of securitization: (i) the $62.4 million equity of the Securitization Trust, recorded in Real Estate Securities, Available for Sale, (ii) the $33.7 million of retained bonds ($37.6 million face amount), recorded in Real Estate Securities, Available for Sale, which have been financed with a $28.0 million repurchase agreement, and (iii) subprime mortgage loans subject to future repurchase of $286.3 million and related financing in the amount of 100% of such loans.
 
6

 
Operating Real Estate

The following table sets forth certain information with respect to our operating real estate as of December 31, 2006
(dollars, others than per square foot amounts, in thousands):
 
Property Address
 
Use
 
Net Rentable
Sq Ft
 
Major tenants
 
% of Total
Sq Ft
Leased
 
Tenant Net
Rentable
Sq Ft
 
Annual Rent
 
                           
                           
100 Dundas St. (1) (3)
   
Office
   
312,874
   
Bell Canada (2)
 
59.1
%
 
184,829
 
$
1,294
 
London, ON
               
A total of 4 tenants
   
1.5
%
 
4,668
   
26
 
                       
60.6
%
 
189,497
   
1,320
 
                                       
                                       
Apple Valley I
   
Office
   
54,927
   
A total of 8 tenants
   
65.0
%
 
35,702
   
504
 
1430 Oak Court
                                     
Beavercreek, OH
                                     
                                       
Apple Valley II
   
Office
   
29,916
   
1 tenant
   
100.0
%
 
29,916
   
478
 
4020 Executive Drive
                                     
Beavercreek, OH
                                     
                                       
Apple Valley III
   
Office
   
45,299
   
1 tenant
   
77.0
%
 
34,878
   
558
 
4021-29 Executive Drive
                                     
Beavercreek, OH
                                     
                                       
Dayton Towne Center
   
Retail
   
33,485
   
A total of 5 tenants
   
75.2
%
 
25,197
   
153
 
1880 Needmore Drive
                                     
Dayton, OH
                                     
                                       
Airport Corporate Center
   
Office
   
46,614
   
A total of 7 tenants
   
50.3
%
 
23,468
   
301
 
303 Corporate Center Dr
                                     
Vandalia, OH
                                     
                                       
2 River Place
   
Office
   
42,286
   
Vacant
   
0.0
%
 
-
   
-
 
Dayton, OH
                                     
                                       
Totals
         
565,401
         
59.9
%
 
338,658
 
$
3,314
 
 
(1)
Monetary amounts for the Canadian property are in U.S. dollars based on December 31, 2006 Canadian dollar exchange ratio of 1.1659.
(2)
This lease charges an administration fee of up to 15% of the operating expenses reimbursable by the tenant.
(3)
The parking garage income for approximately 185 parking stalls is not included in the annual rent.
 
Schedule of lease expirations (dollars in thousands):
 
Year
 
Square Feet of
Expiring Leases
 
Annual Rent of
Expiring Leases (1)
 
% of Gross Annual
Rent represented by
Expiring Leases
 
2007
   
68,918
 
$
885
   
26.7
%
2008
   
23,828
   
336
   
10.1
%
2009
   
8,528
   
113
   
3.4
%
2010
   
15,103
   
136
   
4.2
%
2011
   
30,964
   
495
   
14.9
%
2012
   
191,317
   
1,349
   
40.7
%
Leased total
   
338,658
 
$
3,314
   
100.0
%
Vacant
   
226,743
             
Total
   
565,401
             

7

We also indirectly owned the following interest in operating real estate at December 31, 2006:

Joint Venture

In March 2004, we purchased a 49% interest in a portfolio of convenience and retail gas stores located throughout the southeastern and southwestern regions of the U.S. The properties are subject to a sale-leaseback arrangement under long term triple net leases with a 15 year minimum term. Circle K Stores Inc. (“Tenant”), an indirect wholly owned subsidiary of Alimentation Couche-Tard Inc. (“ACT”), is the counterparty under the leases. ACT guarantees the obligations of Tenant under the leases. We structured this transaction through a joint venture in two limited liability companies with a private investment fund managed by an affiliate of our manager, pursuant to which it co-invested on equal terms. One company held assets available for sale, the last of which was sold in September 2005, and one holds assets for investment. In October 2004, the investment’s initial financing was refinanced with a non-recourse term loan ($52.9 million outstanding at December 31, 2006), which bears interest at a fixed rate of 6.04%. The required payments under the loan consist of interest only during the first two years, followed by a 25-year amortization schedule with a balloon payment due in October 2014. At December 31, 2006, we had a $12.5 million investment in this entity.

Our Financing and Hedging Activities

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. As of December 31, 2006, our debt to equity ratio was approximately 7.5 to 1. On a pro forma basis, our debt to equity ratio would have been 6.7 to 1 if the trust preferred securities we issued in March 2006 were considered equity for purposes of this computation. Also, on a pro forma basis, our debt to equity ratio would have been 6.9 to 1 after adjustment for the common stock issued in January 2007. We utilize leverage for the sole purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates.

We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize multiple forms of financing including collateralized bond obligations (CBOs), other securitizations, term loans (including total rate of return swaps), a credit facility and trust preferred securities, as well as short term financing in the form of repurchase agreements and asset backed commercial paper.

Our manager may elect for us to bear a level of refinancing risk on a short term or longer term basis, such as is the case with investments financed with repurchase agreements and repurchase agreements subject to asset backed commercial paper, when, based on all of the relevant factors, bearing such risk is advisable.

We attempt to reduce interim refinancing risk and to minimize exposure to interest rate fluctuations through the use of match funded financing structures, when appropriate, whereby we seek (i) to match the maturities of our debt obligations with the maturities of our assets and (ii) to match the interest rates on 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 interest rate swaps, caps or other financial instruments, or through a combination of these strategies. This allows us 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 our earnings.

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 elects 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. We have extensive experience in hedging with these types of instruments. We engage in hedging for the purpose of protecting against interest rate risk and not for the purpose of speculating on changes in interest rates.

Further details regarding our hedging activities are presented in “Quantitative and Qualitative Disclosures About Market Risk-Fair Value.”
8



Debt Obligations

The following table presents certain summary information regarding our debt obligations and related hedges as of December 31, 2006 (unaudited) (dollars in thousands):
 
Debt Obligation
 
 
Current
Face
Amount
 
Carrying
Value
 
 
Weighted Average
Funding
Cost (1)
 
 
Weighted Average Maturity
(Years)
 
Face
Amount
of
Floating
Rate Debt
 
Collateral
Carrying
Value
 
Collateral Weighted Average Maturity
(Years)
 
Face
Amount
of Floating Rate Collateral
 
Aggregate
Notional
Amount of
Current Hedges
 
                                       
CBO Bonds Payable
 
$
4,340,166
 
$
4,313,824
   
5.73
%
 
5.83
 
$
4,047,216
 
$
4,944,086
   
5.05
 
$
1,724,873
 
$
2,168,565
 
Other Bonds Payable
   
679,891
   
675,844
   
6.63
%
 
2.26
   
579,952
   
758,092
   
5.23
   
80,936
   
575,083
 
Notes Payable
   
128,866
   
128,866
   
5.68
%
 
0.74
   
128,866
   
145,819
   
2.79
   
142,301
   
-
 
Repurchase Agreements
   
760,346
   
760,346
   
5.92
%
 
0.08
   
760,346
   
953,383
   
2.77
   
823,901
   
112,087
 
Repurchase Agreements
                                                       
subject to ABCP
   
1,143,749
   
1,143,749
   
4.97
%
 
0.08
   
1,143,749
   
1,176,358
   
4.27
   
-
   
1,087,385
 
Credit Facility
   
93,800
   
93,800
   
7.08
%
 
0.85
   
93,800
   
-
   
-
   
-
   
-
 
Junior Subordinated
                                                       
Notes Payable
   
100,100
   
100,100
   
7.72
%
 
29.25
   
-
   
-
   
-
   
-
   
-
 
Subtotal debt obligations
 
$
7,246,918
 
$
7,216,529
   
5.76
%
 
4.15
 
$
6,753,929
 
$
7,977,738
   
4.63
 
$
2,772,011
 
$
3,943,120
 
Financing on Subprime
                                                       
Mortgage Loans Subject
                                                       
to Future Repurchase
   
299,176
   
288,202
                                           
Total debt obligations
 
$
7,546,094
 
$
7,504,731
                                           
 
(1) Including the effect of applicable hedges.
 
Further details regarding our debt obligations are presented in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

Investment Guidelines

Our general investment guidelines, adopted by our board of directors, include:

·  
no investment is to be made which would cause us to fail to qualify as a REIT;
 
·  
no investment is to be made which would cause us to be regulated as an investment company;
 
·  
no more than 20% of our total equity, determined as of the date of such investment, is to be invested in any single asset;
 
·  
our leverage is not to exceed 90% of the sum of our total debt and our total equity; and
 
·  
we are not to 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.

In addition, 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 or any of its affiliates. These investment guidelines may be changed by our board of directors without the approval of our stockholders.

The Management Agreement

We are party to a management agreement with FIG LLC, an affiliate of Fortress Investment Group LLC, dated June 23, 2003, pursuant to which FIG LLC, 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) the financing of our real estate securities and other real estate related assets, (iii) management of our real estate, including arranging for purchases, sales, leases, maintenance and insurance, (iv) the purchase, sale and servicing of loans for us, and (v) 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.

9


We pay our manager an annual management fee equal to 1.5% of our gross equity, as defined in the management agreement. The management agreement provides that we will reimburse our manager for various expenses incurred by our manager or its officers, employees and agents on our behalf, including costs of legal, accounting, tax, auditing, administrative and other similar services rendered for us by providers retained by our manager or, if provided by our 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 our manager to enhance the value of our common stock, our manager is entitled to receive an incentive return (the “Incentive Compensation”) 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) our funds from operations, as defined in the management agreement (before the Incentive Compensation) 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 our initial public offering and the value attributed to the net assets transferred to us by Newcastle Investment Holdings, and in any of our subsequent offerings (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.

The management agreement provides for automatic one year extensions. 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 directors that the management fee earned by our manager is not fair, subject to our manager’s right to prevent such a management fee 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 our manager’s right to receive the Incentive Compensation 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 Compensation to our manager. In addition, if we do not purchase our manager’s Incentive Compensation, our manager may 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.

Policies With Respect to Certain Other Activities

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, or provide guarantees of, our subsidiaries. Although we have no current intentions of doing so, we may repurchase or otherwise reacquire our shares or other securities.

Subject to the percentage ownership 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.

In the event that we determine to raise additional equity capital, our board of directors 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.

Decisions regarding the form and other characteristics of the financing for our investments are made by our manager subject to the general investment guidelines adopted by our board of directors.
 
10


We have financed our assets with the net proceeds of our initial public offering, follow-on offerings, the issuance of preferred stock, long term secured and unsecured borrowings, a credit facility and short term borrowings under repurchase agreements and asset backed commercial paper. In the future, operations may be financed by future offerings of equity securities, as well as short term and long term unsecured and secured borrowings. We expect that, in general, we will employ leverage consistent with the type of assets acquired and the desired level of risk in various investment environments. Our governing documents do not explicitly limit the amount of leverage that we may employ. Instead, the general investment guidelines adopted by our board of directors limits total leverage to a maximum 9.0 to 1 debt to equity ratio. At December 31, 2006, 2005 and 2004, our debt to equity ratio was approximately 7.5 to 1, 5.7 to 1, and 5.0 to 1, respectively. Our policy relating to the maximum leverage we may utilize may be changed by our board of directors at any time in the future.

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 Applicable Environmental Laws

Properties we own or may acquire are or would be subject to various foreign, 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 that properties we own or acquire will be in compliance in all material respects with all foreign, federal, state and local laws, ordinances and regulations regarding hazardous or toxic substances or petroleum products.

Employees

We are party to a management agreement with FIG LLC, an affiliate of Fortress Investment Group LLC, pursuant to which they advise us regarding investments, risk management, and other aspects of our business, and manage our day-to-day operations. As a result, we have no employees. From time to time, certain of our officers may enter into written agreements with us that memorialize the provision of certain services; these agreements do not provide for the payment of any cash compensation to such officers from us. The employees of FIG LLC are not a party to any collective bargaining agreement.

Corporate Governance and Internet Address

We emphasize the importance of professional business conduct and ethics through our corporate governance initiatives. Our board of directors consists of a majority of independent directors; the audit, nominating and corporate governance, and compensation committees of our board of directors are composed exclusively of independent directors. We have adopted corporate governance guidelines, and our manager has adopted a code of business conduct and ethics, which delineate our standards for our officers and directors, and employees of our manager.

Our internet address is http://www.newcastleinv.com. We 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.

Our site also contains our code of business conduct and ethics, senior officer code of ethics, corporate governance guidelines, and the charters of the audit committee, nominating and corporate governance committee and compensation committee of our board of directors.
 
11

 
Item 1A. Risk Factors
 
Risks relating to our management, business and company include, specifically:

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 paid 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. Furthermore, we are dependent on the services of certain key employees of our manager whose continued service is not guaranteed, and the loss of such services could temporarily adversely affect our operations.

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, our management agreement with our manager was not negotiated at arm's-length and its terms, including fees payable, may not be as favorable to us as if it had been negotiated with an unaffiliated third party.
 
There are conflicts of interest inherent in our relationship with our manager insofar as our manager and its affiliates including investment funds, private investment funds, or businesses managed by our manager, invest in real estate securities, real estate related loans and operating real estate and whose investment objectives overlap with our investment objectives. Certain investments appropriate for Newcastle may also be appropriate for one or more of these other investment vehicles. Members of our board of directors and employees of our manager who are our officers may serve as officers and/or directors of these other entities. In addition, our manager or its affiliates may have investments in and/or earn fees from such other investment vehicles which are larger than their economic interests in Newcastle and which may therefore create an incentive to allocate investments to such other investment vehicles. Our manager or its affiliates may determine, in their discretion, to make a particular investment through another investment vehicle rather than through Newcastle and have no obligation to offer to Newcastle the opportunity to participate in any particular investment opportunity. Accordingly, it is possible that we may not be given the opportunity to participate at all in certain investments made by our affiliates that meet our investment objectives.

Our management agreement with our manager generally does not limit or restrict our manager or its affiliates from engaging in any business or managing other pooled investment vehicles that invest in investments that meet our
investment objectives, except that under our management agreement neither our manager nor any entity controlled by or under common control with our manager is permitted to raise or sponsor any new pooled investment vehicle whose investment policies, guidelines or plan targets as its primary investment category investment in United States dollar-denominated credit sensitive real estate related securities reflecting primarily United States loans or assets. Our manager intends to engage in additional real estate related management and investment opportunities in the future which may compete with us for investments.

The ability of our manager and its officers and employees to engage in other business activities, subject to the terms of our management agreement with our manager, may reduce the time our manager spends managing Newcastle. In addition, we may engage in material transactions with our manager or another entity managed by our manager or one of its affiliates, including certain co-investments which present a conflict of interest, subject to our investment guidelines.

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 investment portfolio.
 
12

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 management fee payable 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.

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 periodically review our investment guidelines and our investment portfolio. However, our board does not review each proposed investment or our financing. 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.

Decisions to make investments in entirely new asset categories present risks which may be difficult for us to adequately assess and could therefore reduce the stability of our dividends or have adverse effects on our financial condition. A change in our investment strategy may increase our exposure to interest rate and real estate market fluctuations.

Our investment strategy may evolve, in light of existing market conditions and investment opportunities, to continue to take advantage of opportunistic investments in real estate and real estate related assets, which may involve additional risks depending upon the nature of such assets and our ability to finance such assets on a short or long term basis. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become relatively attractive under changed market conditions and changes in market conditions may therefore result in changes in the investments we target. Our failure to accurately assess the risks inherent in new asset categories or the financing risks associated with such assets could adversely affect our results of operations and our financial condition.

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 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. Furthermore, competition for investments of the type to be made by us may lead to the returns available from such investments decreasing which may further limit our ability to generate our desired returns. We cannot assure you that other companies will not be formed that compete with us for investments or otherwise pursue investment strategies similar to ours.

Our determination of how much leverage to apply to our investments 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 credit facilities, warehouse facilities, repurchase agreements, mortgage loans on real estate, securitizations, including the issuance of CBOs, private or public offerings of debt by subsidiaries, loans to entities in which we hold, directly or indirectly, interests in pools of properties or loans, and other borrowings. Our investment policies do not limit the amount of leverage we may incur with respect to any specific asset or pool of assets, subject to an overall limit on our use of leverage 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.
 
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We finance certain of our investments with debt (e.g., repurchase agreements) that is subject to margin calls based on a decrease in the value of such investments, which could adversely impact our liquidity and, as a result of the need to post greater margin with respect to existing investments, our return on equity. If we do not have the funds available to or choose not to satisfy any such margin calls, we could be forced to sell the investments at a loss.

Although we seek to match fund our investments to limit refinance risk and lock in net spreads, we do not employ this strategy with respect to certain of our investments, which increases the risks related to refinancing these investments.

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 generally use match funded financing structures, such as CBOs, to finance our investments in real estate securities and loans. However, our manager may elect for us to bear a level of refinancing risk on a short term or longer term basis, such as is the case with investments financed with repurchase agreements or asset backed commercial paper, when, based on all of the relevant factors, bearing such risk is advisable. This is generally the case with respect to the residential mortgage loans and agency RMBS we invest in. The decision not to match fund certain investments exposes us to additional refinancing risks that may not apply to our other investments.

In addition, we anticipate that, in most cases, for any period during which our floating rate assets are not match funded with respect to maturity, the income from such assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Because of this dynamic, interest income from such investments may rise more slowly than the related interest expense, with a consequent decrease in our net income. Interest rate fluctuations resulting in our interest expense exceeding interest income would result in operating losses for us from these investments.

Accordingly, if we do not or are unable to match fund our investments with respect to maturities and interest rates, we will be exposed to the risk that we may not be able to finance or refinance our investments on economically favorable terms or may have to liquidate assets at a loss.

The loans we invest in and the loans underlying the securities and total rate of return swaps 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. 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, manufactured housing loans and subprime 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 may impair borrowers' abilities to repay their loans.

In the event of any default under a 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 loan, which could adversely affect our cash flow from operations. Foreclosure of a loan, particularly a commercial loan, can be an expensive and lengthy process which could negatively affect our anticipated return on the foreclosed loan.
 
Mortgage and asset backed securities are bonds or notes backed by loans and/or other financial assets and include commercial mortgage back securities (CMBS), agency residential mortgage backed securities (RMBS), and real estate related asset backed securities (ABS). The ability of a borrower to repay these loans or other financial assets is dependant upon the income or assets of these borrowers. While we intend to focus on real estate related asset backed securities, there can be no assurance that we will not invest in other types of asset backed securities.
 
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Our investments in mortgage and asset backed securities will also be adversely affected by defaults under the loans underlying such securities. To the extent losses are realized on the loans underlying the securities in which we invest, the company may not recover the amount invested in, or, in extreme cases, any of our investment in, such securities.

Subprime mortgage loans are generally loans to credit impaired borrowers and borrowers that are ineligible to qualify for loans from conventional mortgage sources due to loan size, credit characteristics or documentation standards. Loans to lower credit grade borrowers generally experience higher-than-average default and loss rates than do conforming mortgage loans. Material differences in the defaults, loss severities and/or prepayments on the subprime mortgage loans we acquire (or on the manufactured housing loans we acquire) from what we estimate in connection with our underwriting of the acquisition of such loans would cause reductions in our income and adversely affect our operating results, both with respect to unsecuritized loans and loans that we have securitized or otherwise financed on a long term match funded basis. We cannot assure you that our underwriting criteria will afford adequate protection against the higher risks associated with loans made to lower credit grade borrowers. If we underestimate the extent of losses that our loans will incur, then our business, financial condition, liquidity and results of operations will be adversely impacted.
 
We may not be able to finance our investments on a long term basis on attractive terms, including by means of securitization, which may require us to seek more costly financing for our investments or to liquidate assets.

When we acquire a portfolio of securities and loans which we finance on a short term basis with a view to securitization or other long term financing, we bear the risk of being unable to securitize the assets or otherwise finance them on a long term basis at attractive prices or in a timely matter, or at all. If it is not possible or economical for us to securitize or otherwise finance such assets on a long term basis, we may be unable to pay down our short term credit facilities, or be required to liquidate the assets at a loss in order to do so.

Both during the ramp up phase of a potential CBO financing and following the closing of a CBO financing when we have locked in the liability costs for a CBO during the reinvestment period, the rate at which we are able to acquire eligible investments and changes in market conditions may adversely affect our anticipated returns.

We acquire real estate securities and loans and finance them on a long term basis, typically through the issuance of collateralized bond obligations. We use short term warehouse lines of credit to finance the acquisition of real estate securities and loans until a sufficient quantity of assets are accumulated, at which time we may refinance these lines through a securitization, such as a CBO financing, 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 assets to maximize the efficiency of a collateralized bond obligation financing. 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 other forms of potentially less attractive financing or otherwise to liquidate the assets.

In addition, following each CBO financing we must invest both the net cash raised in the financing as well as cash proceeds of any prepayment or assets which we determine to sell. Until we are able to acquire sufficient assets, our returns will reflect income earned on uninvested cash and, having locked in the cost of liabilities for the particular CBO, the particular CBO’s returns will be at risk of declining to the extent that yields on the assets to be acquired decline.

In general, our ability to acquire appropriate investments depends upon the supply in the market of investments we deem suitable, and changes in various economic factors may affect our determination of what constitutes a suitable investment.

Our returns will be adversely affected when investment held in CBOs are prepaid or sold subsequent to the reinvestment period.

Real estate securities and loans are subject to prepayment risk. In addition, we may sell, and realize gains (or losses) on, investments. To the extent such assets were held in CBOs subsequent to the end of the reinvestment period, the proceeds are fully utilized to pay down the related CBOs debt. This causes the leverage on the CBO to decrease, thereby lowering our returns on equity.

Our investments may be subject to impairment charges.
 
We will periodically evaluate our investments for impairment indicators. The judgment regarding the existence of impairment indicators is based on a variety of factors depending upon the nature of the investment and the manner in which the income related to such investment calculated for purposes of our financial statements. If we determine that a significant impairment has occurred, we would be required to make an adjustment to the net carrying value of the investment, which could adversely affect our results of operations and funds from operations in the applicable period.

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Our investments in senior unsecured REIT securities are subject to specific risks relating to the particular REIT issuer 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 operating real estate or real estate related assets and are subject to the inherent risks associated with real estate related investments discussed in this report.

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 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 real estate related loans and other direct and indirect interests in pools of real estate properties or other loans that 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 real estate related loans and other direct and indirect interests in pools of real estate properties or loans.

We invest in mezzanine loans that take the form of subordinated loans secured by second mortgages on the underlying real property or other business assets or revenue streams or loans secured by a pledge of the ownership interests of the entity owning real property or other business assets or revenue streams (or the ownership interest of the parent of such entity). These types of investments involve a higher degree of risk than long term senior lending secured by business assets or income producing real property because the investment may become unsecured as a result of foreclosure by a senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our investment. In addition, mezzanine loans may have higher loan to value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal.

We also invest in mortgage loans (“B” Notes) that while secured by a first mortgage on a single large commercial property or group of related properties are 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. We also invest, directly or indirectly, in pools of real estate properties or loans. However, since each transaction is privately negotiated, these investments 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, while investments in pools of real estate properties or loans may be subject to varying contractual arrangements with third party co-investors in such pools. Further, B Notes typically are secured by a single property, and so reflect the risks associated with significant concentration. These investments also are less liquid than commercial mortgage backed securities.

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Insurance on real estate in which we have interests (including the real estate serving as collateral for our real estate securities and loans) 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 the properties in which we have interests contain customary covenants, including covenants that require property insurance to be maintained in an amount equal to the replacement cost of the properties. There can be no assurance that the lenders under these mortgage loans will not take the position that exclusions from 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 in which we have interests may adversely 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 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 it may be operated, and these restrictions may require expenditures. In connection with the direct or indirect 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 adversely affect our results of operations and financial condition.

Many or our investments are illiquid and this lack of liquidity could significantly impede our ability to vary our portfolio in response to changes in economic and other conditions or to realize the value at which such investments are carried if we are required to dispose of them.

Operating real estate and other direct and indirect investments in real estate and real estate related assets are generally illiquid. Our investments in unconsolidated subsidiaries are also 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. In addition, there are no established trading markets for a majority of our investments. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited.

Our assets are valued based primarily on third party quotations which are subject to significant variability based on market conditions. Certain of our investments, however, are highly illiquid and we will not have access to readily ascertainable market prices when establishing valuations of them. While we will endeavor to determine and establish valuations of our investments based on our manager’s estimate of the fair market value of such investments, if we are required to liquidate all or a portion of our illiquid investments quickly, we may realize significantly less than the amount at which we have previously valued these investments.

Interest rate fluctuations and shifts in the yield curve may cause losses.
 
Our primary interest rate exposures relate to our real estate securities, loans, floating rate debt obligations, interest rate swaps, and interest rate 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 assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate securities and loans at attractive prices, the value of our real estate securities, loans and derivatives and our ability to realize gains from the sale of such assets.

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In the event of a significant rising interest rate environment and/or economic downturn, loan and collateral 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 financing strategy is dependent on our ability to place the match funded debt we use to finance our investments at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted.

Interest rate changes may also impact our net book value as our real estate securities and related hedge derivatives are marked to market each quarter. Our loan investments and debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, which will decrease the book value of our equity.

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 real estate securities and therefore their value. This would have similar effects on our real estate securities portfolio and our financial position and operations to a change in interest rates generally.
 
Our investments in real estate securities and loans are subject to changes in credit spreads which could adversely affect our ability to realize gains on the sale of such investments.

Real estate securities are subject to changes in credit spreads. Fixed rate securities 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 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 real estate securities portfolio would tend to decline. Conversely, if the spread used to value such securities were to decrease, or "tighten," the value of our real estate securities portfolio would tend to increase. Our floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. Such changes in the market value of our real estate securities portfolio may affect 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.

Our loan portfolios are also subject to changes in credit spreads. Our floating rate loans are valued based on a market credit spread to LIBOR. The value of these loans is dependent on the yield demanded by the market based on their credit relative to LIBOR. The value of our floating rate loans 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). Our fixed rate loans are valued based on a market credit spread over U.S. Treasuries and are affected similarly by changes in U.S. Treasury spreads. If the value of our loans subject to repurchase agreements were to decline, it could affect our ability to refinance such loans upon the maturity of the related repurchase agreements. Any credit or spread related losses incurred with respect to our loans would affect us in the same way as similar losses on our real estate securities portfolio as described above, except that our loans are not marked to market.

In addition, widening credit spreads will generally result in a decrease in the mark to market value of certain investments which are treated as derivatives on our balance sheet, such as total rate of return swaps. Since changes in the value of such assets are reflected in our income statement, this would result in a decrease in our net income. To the extent that we choose to make increasing investments in real estate related assets by means of entering into total rate of return swaps, our net income will become more susceptible to decreases stemming from credit spread changes.

Our hedging transactions may limit our gains or result in losses.
 
We use derivatives to hedge our interest rate exposure 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. We have 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.

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There are limits to the ability of hedging strategy to protect us completely against interest rate risks. When rates change, we expect the gain or loss on derivatives to be offset by a related but inverse change in the value of the items, generally our liabilities, which we hedge. We cannot assure you, however, that our use of derivatives will offset the risks related to changes in interest rates. We cannot assure you that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses.

In managing our hedge instruments, we consider the effect of the expected hedging income on the REIT qualification tests that limit the amount of gross income that a REIT may receive from hedging. The REIT provisions of the Internal Revenue Code limit our ability to hedge. We need to carefully monitor, and may have to limit, our hedging strategy to assure that we do not realize hedging income, or hold hedges having a value, in excess of the amounts which would cause us to fail the REIT gross income and asset tests.

Accounting for derivatives under GAAP is extremely complicated. Any failure by us to account for our derivatives properly in accordance with GAAP in our financial statements could adversely affect our earnings.

Prepayment rates can increase, adversely affecting yields on certain investments, including our residential mortgage loans.

The value of our assets may be affected by prepayment rates on our residential mortgage loans and other floating rate assets. Prepayment rates 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 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 floating rate assets may, because of the risk of prepayment, benefit less than fixed rate assets from declining interest rates. Conversely, in periods of rising interest rates, prepayments on 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.

In addition, when market conditions lead us to increase the portion of our CBO investments that are comprised of floating rate securities, the risk of assets inside our CBOs prepaying increases. Since our CBO financing costs are locked in, reinvestment of such prepayment proceeds at lower yields than the initial investments, as a result of changes in the interest rate or credit spread environment, will result in a decrease of the return on our equity and therefore our net income.

Risks Relating to Our Taxation as a REIT

Our failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our stockholders.

We operate in a manner intended to qualify as a REIT for federal income tax purposes. 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, and the tax treatment of participation interests that we hold in mortgage loans and mezzanine loans, may be uncertain in some circumstances, which could affect the application of the REIT qualification requirements. 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 Corp., a former stockholder of the Company, failed to qualify as a REIT, and we are treated as a successor to Newcastle Investment Holdings for federal income tax purposes.

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Dividends payable by REITs do not qualify for the reduced tax rates.

Tax law changes in 2003 reduced the maximum tax rate for dividends payable to individuals from 35% to 15% (through 2010). Dividends payable by REITs, however, are generally not eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock. In addition, the relative attractiveness of real estate in general may be adversely affected by the newly favorable tax treatment given to corporate dividends, which could affect the value of our real estate assets negatively.

REIT distribution requirements could adversely affect our ability to execute our business plan.

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 may generate substantial mismatches between taxable income and available cash. As a result, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms or (iii) 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. If we fail to obtain debt or equity capital in the future, it could limit our ability to grow, which could adversely affect the value of our common stock.

The stock ownership limit imposed by the Internal Revenue Code for REITs and our charter may inhibit market activity in our stock and restrict our business combination opportunities.

In order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year after our first year. Our charter, with certain exceptions, authorizes our board of directors to take the actions that are necessary and desirable to preserve our qualification as a REIT. Unless exempted by our board of directors, no person may own more than 8% of the aggregate value of our outstanding capital stock, treating classes and series of our stock in the aggregate, or more than 25% of the outstanding shares of our Series B Preferred Stock or Series C Preferred Stock. Our board may grant an exemption in its sole discretion, subject to such conditions, representations and undertakings as it may determine in its sole discretion. These ownership limits could delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders. Our board has granted limited exemptions to an affiliate of our manager, a third party group of funds managed by Cohen & Steers, and certain affiliates of these entities.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes, such as mortgage recording taxes. Any of these taxes would decrease cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold some of our assets through taxable REIT subsidiaries. Such subsidiaries will be subject to corporate level income tax at regular rates.

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.
 
To qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. We also may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to make certain attractive investments.

20

The “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.

Certain of our securitizations have resulted in the creation of taxable mortgage pools for federal income tax purposes. As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we would generally not be adversely affected by the characterization of the securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as foreign stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the taxable mortgage pool. In addition, to the extent that our stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of our income from the taxable mortgage pool. In that case, we may reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax.

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 adversely affect us and the market price for our stock.

ERISA may restrict investments by plans in our common stock.

A plan fiduciary considering an investment in our common 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.
 
Maryland takeover statutes may prevent a change of our control. This could depress our stock price.
 
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 certain mergers, consolidations, share exchanges, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities or a liquidation or dissolution. An interested stockholder is defined as:
 
·  
any person who beneficially owns 10% or more of the voting power of the corporation's outstanding shares; or
 
·  
an affiliate or associate of a 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 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 or she otherwise would have become an interested stockholder.
 
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 voting together as a single group; 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 voting together as a single voting group.
 
The business combination statute may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer, including potential acquisitions that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.

21

Our authorized, but unissued common and preferred stock may prevent a change in our control.

Our charter authorizes us to issue additional authorized but unissued shares of our common stock or preferred stock. In addition, our board of directors may classify or reclassify any unissued shares of common stock or preferred stock and may set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board may establish a series of preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.

Our stockholder rights plan could inhibit a change in our control.

We have adopted a stockholder rights agreement. Under the terms of the rights agreement, in general, if a person or group acquires more than 15% of the outstanding shares of our common stock, all of our other common stockholders will have the right to purchase securities from us at a discount to such securities' fair market value, thus causing substantial dilution to the acquiring person. The rights agreement may have the effect of inhibiting or impeding a change in control not approved by our board of directors and, therefore, could adversely affect our stockholders' ability to realize a premium over the then-prevailing market price for our common stock in connection with such a transaction. In addition, since our board of directors can prevent the rights agreement from operating, in the event our board approves of an acquiring person, the rights agreement gives our board of directors significant discretion over whether a potential acquirer's efforts to acquire a large interest in us will be successful. Because the rights agreement contains provisions that are designed to assure that the executive officers, our manager and its affiliates will never, alone, be considered a group that is an acquiring person, the rights agreement provides the executive officers, our manager and its affiliates with certain advantages under the rights agreement that are not available to other stockholders.

Our staggered board and other provisions of our charter and bylaws may prevent a change in our control.
 
Our board of directors is divided into three classes of directors. Directors of each class are chosen for three-year terms upon the expiration of their current terms, and each year one class of directors is elected by the stockholders. The staggered terms of our directors may reduce the possibility of a tender offer or an attempt at a change in control, even though a tender offer or change in control might be in the best interest of our stockholders. In addition, our charter and bylaws also contain other provisions that may delay or prevent a transaction or a change in control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.
 
22


Item 1B. Unresolved Staff Comments

We have no unresolved staff comments.
 
Item 2. Properties.
 
Our direct investments in properties are described under “Business - Our Investing Activities.”

Our manager leases principal executive and administrative offices located at 1345 Avenue of the Americas, New York, New York 10105, 46th floor. Its telephone number is (212) 798-6100.

Item 3. Legal Proceedings.

We are not a party to any material legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of our security holders during the fourth quarter of 2006.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.

Our common stock has been listed and is 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, low and last sale prices in dollars on the NYSE for our common stock and the distributions we declared with respect to the periods indicated.
 

2006
 
High
 
Low
 
Last Sale
 
Distributions
Declared
First Quarter
 
$27.50
 
$23.34
 
$23.92
 
$0.625
Second Quarter
 
$26.30
 
$22.16
 
$25.32
 
$0.650
Third Quarter
 
$28.58
 
$24.60
 
$27.41
 
$0.650
Fourth Quarter
 
$32.59
 
$26.78
 
$31.32
 
$0.690
                 
2005
 
High
 
Low
 
Last Sale
 
Distributions
Declared
First Quarter
 
$31.95
 
$29.27
 
$29.60
 
$0.625
Second Quarter
 
$32.31
 
$28.25
 
$30.15
 
$0.625
Third Quarter
 
$31.25
 
$27.00
 
$27.90
 
$0.625
Fourth Quarter
 
$27.96
 
$24.74
 
$24.85
 
$0.625

We intend to continue to declare quarterly distributions on our common stock. No assurance, however, can be given as to the amounts or timing of future distributions as such distributions are subject to our earnings, financial condition, capital requirements and such other factors as our board of directors deems relevant.
 
On February 16, 2007, the closing sale price for our common stock, as reported on the NYSE, was $31.50. As of February 16, 2007, there were approximately 113 record holders of our common stock. This figure does not reflect the beneficial ownership of shares held in nominee name.

23


Equity Compensation Plan Information

The following table summarizes the total number of outstanding securities in the incentive plan and the number of securities remaining for future issuance, as well as the weighted average exercise price of all outstanding securities as of December 31, 2006.
 
Plan Category
 
Number of Securities to be
Issued Upon Exercise of Outstanding Options
 
Weighted Average
Exercise Price of
Outstanding Options
 
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans
Equity Compensation Plans Approved
           
by Security Holders:
           
Newcastle Investment Corp. Nonqualified
           
Stock Option and Incentive Award Plan
 
1,883,807 (1)
 
$25.89
 
7,148,169 (2)
Equity Compensation Plans Not Approved
 
 
       
by Security Holders:
 
 
       
None
 
N/A
 
N/A
 
N/A
 
(1)
Includes options for (i) 1,278,014 shares held by an affiliate of our manager; (ii) 591,793 shares granted to our manager and assigned to certain of the manager’s employees; and (iii) an aggregate of 14,000 shares held by our directors, other than Mr. Edens.
 
(2)
The maximum available for issuance is equal to 10% 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. The number of securities remaining available for future issuance is net of an aggregate of 8,104 shares of our common stock awards to our directors, other than Mr. Edens, representing the aggregate annual automatic stock awards to each such director for 2003 through 2006, and of 959,920 shares issued to certain of our directors and employees of our manager upon the exercise of previously granted options.

24


Item 6. Selected Financial Data.

The selected historical consolidated financial information set forth below as of December 31, 2006, 2005, 2004, 2003 and 2002 and for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 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 Financial Condition and Results of Operations” and our consolidated financial statements and notes thereto included in “Financial Statements and Supplementary Data.”

Selected Consolidated Financial Information
(in thousands, except per share data)
 
   
Year Ended December 31,
 
 
 
2006
 
2005
 
2004
 
2003
 
2002
 
Operating Data
                 
(1)
 
Revenues
                     
Interest income
 
$
530,006
 
$
348,516
 
$
225,761
 
$
133,183
 
$
73,620
 
Other income
   
22,603
   
29,697
   
23,908
   
18,901
   
18,716
 
     
552,609
   
378,213
   
249,669
   
152,084
   
92,336
 
Expenses
                               
Interest expense
   
374,269
   
226,446
   
136,398
   
76,877
   
44,238
 
Other expense
   
56,608
   
42,529
   
29,259
   
20,828
   
18,197
 
     
430,877
   
268,975
   
165,657
   
97,705
   
62,435
 
                                 
Income before equity in earnings of unconsolidated subsidiaries
   
121,732
   
109,238
   
84,012
   
54,379
   
29,901
 
                                 
Equity in earnings of unconsolidated subsidiaries, net
   
5,968
   
5,609
   
9,957
   
862
   
362
 
 
                               
Income from continuing operations
   
127,700
   
114,847
   
93,969
   
55,241
   
30,263
 
Income from discontinued operations
   
223
   
2,108
   
4,446
   
877
   
1,232
 
Net income
   
127,923
   
116,955
   
98,415
   
56,118
   
31,495
 
Preferred dividends and related accretion
   
(9,314
)
 
(6,684
)
 
(6,094
)
 
(4,773
)
 
(1,162
)
Income available for common stockholders
 
$
118,609
 
$
110,271
 
$
92,321
 
$
51,345
 
$
30,333
 
Net income per share of common stock, diluted
 
$
2.67
 
$
2.51
 
$
2.46
 
$
1.96
 
$
1.68
 
Income from continuing operations per share of common stock,
                               
after preferred dividends, diluted
 
$
2.67
 
$
2.46
 
$
2.34
 
$
1.93
 
$
1.61
 
Weighted average number of shares of common stock
                               
outstanding, diluted
   
44,417
   
43,986
   
37,558
   
26,141
   
18,090
 
Dividends declared per share of common stock-NCT
 
$
2.615
 
$
2.500
 
$
2.425
 
$
1.950
 
$
0.850
 
Dividends declared per share of common stock-predecessor
                         
$
1.200
 
 
                       
   
As Of December 31,
 
 
 
2006
 
2005
 
2004
 
2003
 
2002
 
Balance Sheet Data
                     
Real estate securities, available for sale
 
$
5,581,228
 
$
4,554,519
 
$
3,369,496
 
$
2,192,727
 
$
1,025,010
 
Real estate related loans, net
   
1,568,916
   
615,551
   
591,890
   
402,784
   
26,417
 
Residential mortgage loans, net
   
809,097
   
600,682
   
654,784
   
586,237
   
258,198
 
Operating real estate, net
   
29,626
   
16,673
   
57,193
   
102,995
   
113,652
 
Cash and cash equivalents
   
5,371
   
21,275
   
37,911
   
60,403
   
45,463
 
Total assets
   
8,604,392
   
6,209,699
   
4,932,720
   
3,550,299
   
1,574,828
 
Debt
   
7,504,731
   
5,212,358
   
4,021,396
   
2,924,552
   
1,217,007
 
Total liabilities
   
7,602,412
   
5,291,696
   
4,136,005
   
3,010,936
   
1,288,326
 
Common stockholders' equity
   
899,480
   
815,503
   
734,215
   
476,863
   
284,241
 
Preferred stock
   
102,500
   
102,500
   
62,500
   
62,500
   
-
 
                                 
Supplemental Balance Sheet Data
                               
Common shares outstanding
   
45,714
   
43,913
   
39,859
   
31,375
   
23,489
 
Book value per share of common stock
 
$
19.68
 
$
18.57
 
$
18.42
 
$
15.20
 
$
12.10
 
                                 
(1) Includes the operations of our predecessor through the date of commencement of our operations, July 12, 2002.

25


   
Year Ended December 31,
 
 
 
2006
 
2005
 
2004
 
2003
 
2002
 
Other Data
                     
Cash Flow provided by (used in):
                     
Operating activities
 
$
16,322
 
$
98,763
 
$
90,355
 
$
38,454
 
$
21,919
 
Investing activities
   
(1,963,058
)
 
(1,334,746
)
 
(1,332,164
)
 
(1,659,026
)
 
(683,053
)
Financing activities
   
1,930,832
   
1,219,347
   
1,219,317
   
1,635,512
   
675,237
 
Funds from Operations (FFO) (1)
   
119,421
   
104,031
   
86,201
   
54,380
   
37,633
 
 
(1)
We believe FFO is one appropriate measure of the operating performance of real estate companies. 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. Furthermore, FFO is used to compute our incentive compensation to our manager. FFO, for our purposes, represents net income available for common stockholders (computed in accordance with GAAP), excluding extraordinary items, plus depreciation of our operating real estate, 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 our liquidity and is not necessarily indicative of cash available to fund cash needs. Our calculation of FFO may be different from the calculation used by other companies and, therefore, comparability may be limited.
 
   
Year Ended December 31,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
Calculation of Funds From Operations (FFO):
                     
Income available for common stockholders
 
$
118,609
 
$
110,271
 
$
92,321
 
$
51,345
 
$
30,333
 
Operating real estate depreciation
   
812
   
702
   
2,199
   
3,035
   
7,994
 
Accumulated depreciation on operating real estate sold
   
-
   
(6,942
)
 
(8,319
)
 
-
   
(2,847
)
Other (1)
   
-
   
-
   
-
   
-
   
2,153
 
Funds from operations (FFO)
 
$
119,421
 
$
104,031
 
$
86,201
 
$
54,380
 
$
37,633
 
 
(1) Related to an investment retained by our predecessor
 
26


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following should be read in conjunction with our consolidated financial statements and notes thereto included in “Financial Statements and Supplementary Data.”

General

Newcastle Investment Corp. is a real estate investment and finance company. We invest in real estate securities, loans and other real estate related assets. In addition, we consider other opportunistic investments which capitalize on our manager’s expertise and which we believe present attractive risk/return profiles and are consistent with our investment guidelines. We seek to deliver stable dividends and attractive risk-adjusted returns to our stockholders through prudent asset selection, active management and the use of match funded financing structures, when appropriate, which reduces our interest rate and financing risks. Our objective is to maximize the difference between the yield on our investments and the cost of financing these investments while hedging our interest rate risk. We emphasize asset quality, diversification, match funded financing and credit risk management.

We currently own a diversified portfolio of moderately credit sensitive real estate debt investments including securities and loans. Our portfolio of real estate securities includes commercial mortgage backed securities (CMBS), senior unsecured debt issued by property REITs, real estate related asset backed securities (ABS) and agency residential mortgage backed securities (RMBS). Mortgage backed securities are interests in or obligations secured by pools of mortgage loans. We generally target investments rated A through BB, except for our agency RMBS which are generally considered AAA rated. We also own, directly and indirectly, interests in loans and pools of loans, including real estate related loans, commercial mortgage loans, residential mortgage loans, manufactured housing loans and subprime residential loans. We also own, directly and indirectly, interests in operating real estate.

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. As of December 31, 2006, our debt to equity ratio was approximately 7.5 to 1. On a pro forma basis, our debt to equity ratio would have been 6.7 to 1 if the trust preferred securities we issued in March 2006 were considered equity for purposes of this computation. Also, on a pro forma basis, our debt to equity ratio would have been 6.9 to 1 after adjustment for the common stock issued in January 2007.

We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize a multiple forms of financing including collateralized bond obligations (CBOs), other securitizations, term loans, credit facility and trust preferred securities, as well as short term financing in the form of repurchase agreements and asset backed commercial paper.

We seek to match fund our investments with respect to interest rates and maturities in order to minimize the impact of interest rate fluctuations on earnings and reduce the risk of refinancing our liabilities prior to the maturity of the investments. We seek to finance a substantial portion of our real estate securities and loans through the issuance of debt securities in the form of CBOs, which are obligations issued in multiple classes secured by an underlying portfolio of securities. Our CBO financings offer us the structural flexibility to buy and sell certain investments to manage risk and, subject to certain limitations, to optimize returns.

Market Considerations

Our ability to maintain our dividends and grow our business is dependent on our ability to invest our capital on a timely basis at yields which exceed our cost of capital. The primary market factor that bears on this is credit spread.

Generally speaking, tightening credit spreads increase the unrealized gains on our current investments and reduce our financing costs, but reduce the yields available on potential new investments, while widening credit spreads reduce the unrealized gains on our current investments (or cause unrealized losses) and increase our financing costs, but increase the yields available on potential new investments.

In 2004 credit spreads on real estate securities tightened to historical lows, before widening in 2005. In 2006, these spreads tightened once again. This tightening of credit spreads and increasing interest rates caused the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income, and therefore our book value per share to increase on a net basis from December 31, 2003 to December 31, 2006.

In addition, trends in market interest rates continue to also affect our operations, although to a lesser degree due to our match funded financing strategy. Interest rates had been historically low throughout 2004, before rising in 2005 and continuing to increase in 2006.

Interest rates, as well as property values and other factors, influence the prepayment rates on our investments. Higher prepayment rates can hinder our ability to deploy capital in a timely manner, thereby reducing our return on equity, which occurred in 2005.
27

 
We continue to pursue opportunistic investments within our investment guidelines that offer a more attractive risk adjusted return, including investments in subprime mortgage loans and manufactured housing loans which we expect to generate a net, loss adjusted yield in the high teens.

If credit spreads widen and interest rates continue to increase, we expect that our new investment activities will benefit and our earnings will increase, although our net book value per share and the ability to realize gains from existing investments may decrease.

Certain aspects of these effects are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate, Credit and Spread Risk” as well as in “Quantitative and Qualitative Disclosures About Market Risk.”

Formation and Organization

We were formed in 2002 as a subsidiary of Newcastle Investment Holdings Corp. (referred to herein as Holdings). Prior to our initial public offering, Holdings contributed to us certain assets and liabilities in exchange for approximately 16.5 million shares of our common stock. Our operations commenced in July 2002. In May 2003, Holdings distributed to its stockholders all of the shares of our common stock that it held, and it no longer owns any of our common equity.

The following table presents information on shares of our common stock issued since our formation:
 
Year
 
Shares Issued
 
Range of
Issue Prices (1)
 
Net Proceeds
(millions)
 
Formation
   
16,488,517
   
N/A
   
N/A
 
2002
   
7,000,000
 
 
$13.00
 
$
80.0
 
2003
   
7,886,316
 
 
$20.35-$22.85
 
$
163.4
 
2004
   
8,484,648
 
 
$26.30-$31.40
 
$
224.3
 
2005
   
4,053,928
 
 
$29.60
 
$
108.2
 
2006
   
1,800,408
 
 
$29.42
 
$
51.2
 
December 31, 2006
   
45,713,817
             
January 2007
   
2,420,000
 
 
$31.30
 
$
75.0
 
 
(1)
Excludes prices of shares issued pursuant to the exercise of options and of shares issued to Newcastle's independent directors.
 
As of December 31, 2006, approximately 2.9 million of our shares of common stock were held by our manager, through its affiliates, and principals of Fortress. In addition, our manager, through its affiliates, held options to purchase approximately 1.3 million shares of our common stock at December 31, 2006.

We are organized and conduct our operations to qualify as a REIT for U.S. federal income tax purposes. As such, we will generally not be subject to U.S. federal income tax on that portion of our income that is distributed to stockholders if we distribute at least 90% of our REIT taxable income to our stockholders by prescribed dates and comply with various other requirements.

We conduct our business by investing in three primary business segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans and (iii) operating real estate.

Our discontinued operations include the operations of properties which have been sold or classified as Real Estate Held for Sale pursuant to SFAS No. 144. For more information on these properties, see Note 6 of our consolidated financial statements which appear in “Financial Statements and Supplementary Data.” Net proceeds from the sales of such properties have been redeployed to other investments which better meet our strategic objectives.
 
Revenues attributable to each segment are disclosed below (unaudited) (in thousands).


For the Year Ended
 
Real Estate Securities and
Real Estate
Related Loans
 
Residential Mortgage Loans
 
Operating
Real Estate
 
Unallocated
 
Total
 
December 31, 2006
 
$
441,965
 
$
105,621
 
$
5,117
 
$
(94
)
$
552,609