NE WC A STLE IN V ESTM ENT COR P.
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ANNUAL
REPORT
financial highlights
(in thousands except per share data)
O P E R AT I N G DATA
Interest income
Other income
Interest expense
Other expenses
Income from continuing operations
Income (loss) from discontinued operations
Net income
Preferred dividends
Income available for common stockholders
Net income per share of common stock, diluted
Income from continuing operations per share of common stock, after preferred dividends, diluted
Funds from operations (FFO)(A)
FFO per share of common stock, diluted(A)
Weighted average number of shares of common stock outstanding, diluted
B A L A N C E S H E E T DATA
Real estate securities, available for sale
Real estate related loans, net
Residential mortgage loans, net
Operating real estate, net
Total assets
Debt obligations
Preferred stock
Common stockholders’ equity
S U P P L E M E N TA L B A L A N C E S H E E T DATA
Weighted average credit rating of real estate securities and real estate related loans portfolio
Common shares outstanding
Book value per share of common stock
S TO C K P E R F O R M A N C E DATA
Closing share price on December 31, 2003
Closing share price on December 31, 2004
Closing share price on March 31, 2005
Dividends declared for the year ended December 31, 2004
Dividends declared for the quarter ended March 31, 2005, annualized
$ 226,674
41,429
138,847
34,859
94,397
4,018
98,415
(6,094)
92,321
2.46
2.35
86,201
2.30
37,558
$
$
$
$
$
$ 3,369,496
$ 591,890
$ 654,784
$
57,193
$ 4,932,720
$ 4,021,396
$
62,500
$ 734,215
BBB–
39,859
$
18.42
$
$
$
$
$
27.10
31.78
29.60
2.425
2.500
(A)- We believe Funds from Operations (FFO) is one appropriate measure of the operating performance of real estate companies because it provides
investors with information regarding our ability to service debt and make capital expenditures. We also believe that FFO is an appropriate supplemental
disclosure of operating performance for a REIT due to its widespread acceptance and use within the REIT and analyst communities. 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 accounting principles generally accepted in the United States (“GAAP”)), excluding extraordinary items, plus depreciation
of our operating real estate, and after adjustments for unconsolidated subsidiaries. We consider gains and losses on resolution of our investments to be
a normal part of our recurring operations and, therefore, do not exclude such gains and losses when arriving at FFO. Adjustments for unconsolidated
subsidiaries are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating activities in accordance with
GAAP and therefore should not be considered an alternative to net income as an indicator of 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.
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NCT
181.1%
Morgan Stanley
REIT Index
94.9%
Russell 2000
93.8%
NASDAQ
87.0%
NAREIT
(mortgage)
74.5%
NAREIT
70.2%
S&P 500
50.8%
Total Return
IPO to December 31, 2004
NEWCASTLE INVESTMENT CORP. (NYSE: NCT) is a publicly traded real estate invest-
ment and finance company that invests in real estate securities and other real estate-related
assets. The Company seeks to deliver stable dividends and attractive risk-adjusted returns to
stockholders through prudent asset selection and the use of innovative financing structures,
which reduce interest rate and financing risks.
letter to our shareholders
2004 was another strong year for Newcastle. Our business grew and prospered at
every level—funds from operations, net income and dividends all increased markedly
from last year. Our capital base grew—book value increased 21% from $15.20 per
share to $18.42 per share. Our market capitalization grew to $1.3 billion, a 49%
increase since 2003.
Newcastle’s business plan is guided by basic fundamental principles—build long-term shareholder
value by consistently delivering steady returns and stable and growing dividends to shareholders. Since
our inception, we have grown our annualized dividend from $1.60 to $2.50 per share and have consis-
tently delivered mid-teens returns on equity quarter after quarter.
Newcastle’s core business is to invest in a portfolio of real estate debt securities and loans. As the
business has grown, our portfolio has become increasingly diversified. Our securities and loan portfolio
ended the year at $3.8 billion, comprised of 455 securities and loans with an average investment size of
approximately $8 million, up from $2.4 billion one year ago. Our portfolio is not only one of the most
diversified in the industry but we also have a terrific track record, with no defaults experienced in any of
our investments to date.
p.2
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Newcastle Investment Corp. and Subsidiaries
206%
Our assets have grown by 206%
over the last 24 months.
TOTAL ASSETS
($ in billions)
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Since our business is a “net spread” business, we are always focused on the most efficient cost of
financing. Our goal is to secure match funded financing which minimizes our interest rate and refinanc-
ing risks. As a result of our investment and financing philosophies, the exposure of our earnings to
changes in interest rates is quite low. In fact, an increase in interest rates would result in a positive change
in earnings. So long as our portfolio continues to perform from a credit standpoint, we expect to be able
to pay a stable dividend even in a much higher interest rate environment.
As we begin 2005, we continue to see significant investment opportunities. Here in the U.S., the
capital markets have become the dominant financier of commercial real estate. CMBS domestic new issu-
ance in 2004 was $93 billion, up over 19% from 2003. REIT debt new issuance was $16 billion for the
year, up over 60% from the prior year. Overall credit spreads remain tight, but so long as the new issu-
ance markets stay active, we expect to see a continued supply of new investment opportunities.
We remain focused on the Company’s growth and continued development in our business. As we
look ahead, the cornerstones of our business are unchanged—invest in a highly diversified real estate
related debt portfolio, take modest credit risk, employ match funded financing structures and stay nimble
to our ever-changing market environment.
We are excited about the coming years. Thank you for your support and commitment.
WESLEY R. EDENS
Chairman and Chief Executive Officer
p.3
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invest
What Does Newcastle Own?
Newcastle ended the year with a $4.9 billion diversified
investment portfolio. As of December 31, 2004, the
Company primarily owns:
• Real Estate Securities—commercial mortgage backed
securities (CMBS), senior unsecured REIT debt issued
by property REITs, real estate related asset backed secu-
rities (ABS) and agency residential mortgage backed
securities (RMBS).
75% of our assets
• Real Estate Related Loans—B-notes, mezzanine loans,
bank loans and real estate loans.
9% of our assets
• Operating Real Estate—direct and indirect interests in
operating real estate.
2% of our assets
• Residential Mortgage Loans—residential mortgage
loans, including manufactured housing loans.
13% of our assets
What Does It Mean to Own a Highly Diversified
Investment Portfolio?
Fundamental to our investment philosophy is diversifica-
tion as a means to minimize the risk of capital loss as well
as to enhance our financing terms. Newcastle’s $3.8 billion
real estate securities and related loan portfolio, which
represents 84% of our total assets, consists of 455 different
securities and loans. The average investment size in the
securities and related loan portfolio is $8 million and our
largest single investment is $87 million. Newcastle’s diver-
sified portfolio generates a secure and stable income
stream that will continue to benefit from diversification as
we make new investments.
Credit Spreads Have Been Tightening, What Does
That Mean to Newcastle?
Credit spreads are highly relevant to our business since
Newcastle is a “net spread” business. That means we earn
income based on the spread between the yield on our
investments and the cost of our borrowings.
Since a significant portion of our portfolio is match funded
and “locked-in,” we will continue to benefit from the net
spread earned on those investments regardless of changes
in credit spreads.
For new investments, asset spread tightening needs to be
accompanied by liability spread tightening in order to
achieve our targeted returns. In Newcastle’s case, while
credit spreads on real estate securities tightened in 2004,
we were able to tighten the spreads on our liabilities.
Newcastle was able to invest $250 million of capital in
2004 at net returns similar to our historical net returns.
Newcastle’s 2004 FFO return on average invested com-
mon equity was 15.8%,(1) only modestly lower than 16.4%
in 2003.
(1) Return excluding the reversal of accumulated depreciation from the
sale of certain real estate properties.
p.4
Newcastle Investment Corp. and Subsidiaries
INVEST
Diversified Portfolio
Our primary investment objective is to acquire a highly diversified portfolio of invest-
ments secured by real estate that has moderate credit risk and sufficient liquidity.
Fundamental to our investment philosophy is diversification as a means to minimize the
risk of capital loss as well as to enhance our financing terms. We buy real estate securi-
ties, real estate related loans, operating real estate and residential mortgage loans.
MATCH FUND
Match Interest Rates
and Maturities
MANAGE ASSETS
Ongoing Credit
Surveillance
p.5
match fund
What Kind of Leverage Does Newcastle Utilize?
What Is Match Funded Financing?
We finance our investments to increase returns to share-
holders. The specific amount of debt is generally based
upon asset type, credit rating and portfolio diversification.
For example, we generally use more leverage on a higher
rated pool of diverse securities than on lower rated pools.
As of December 31, 2004, our debt to equity ratio was
approximately 5 to 1. We utilize multiple forms of financ-
ing including collateralized bond obligations (CBOs),
which represent 66% of our outstanding debt, other secu-
ritizations, and term financings, as well as short term
financing in the form of repurchase agreements.
Our financing strategy focuses on the use of match funded
financing structures. This means that we seek to match
the maturities of our financial obligations with the maturi-
ties of our investments to minimize the risk that we have
to refinance our liabilities prior to the maturities of our
assets, and to reduce the impact of changing interest rates
on our cash flow and earnings. In addition, we match fund
interest rates with like-kind debt (i.e., fixed-rate assets are
financed with fixed-rate debt, and floating rate assets are
financed with floating rate debt), directly or through the
use of hedges such as interest rate swaps and caps, or
through a combination of these strategies.
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EFFECT ON NET INCOME PER SHARE
FROM INCREASES IN INTEREST RATES
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INVEST
Diversified Portfolio
For Newcastle,
• Approximately 75% of our invest-
ments, when measured by face
amount, were match funded and
• Our real estate securities and real
estate related loan portfolio and
their respective liabilities had a
weighted average life of 5.37 years
and 5.72 years.
Newcastle Investment Corp. and Subsidiaries
MATCH FUND
Match Interest Rates
and Maturities
Maturity of
Investments
Maturity of
Financings
Type of
Interest
Received
Type of
Interest
Paid
MANAGE ASSETS
Ongoing Credit
Surveillance
p.7
manage assets
What Is the Credit Quality of Newcastle’s Investment
Portfolio?
The majority of Newcastle’s portfolio is invested in real
estate securities and real estate related loans, representing
84% of our total assets. Our securities and related loan
portfolio had an average credit quality of BBB– and 70%
of these investments were rated investment grade.
We target investments that are generally rated or have an
implied rating of A to BB with first loss credit protection.
For example, our CMBS and ABS investments have
approximately 10% first loss credit support. Credit support
is the amount of subordinated interest in an asset that will
absorb losses before our investment in such asset incurs
any principal loss.
How Does Newcastle Manage Credit Risk to Avoid
Credit Losses?
Newcastle manages credit risk in three ways:
(1) Maintain a diversified portfolio;
(2) Buy moderately credit sensitive investments with first
loss credit protection; and
(3) Actively manage the portfolio.
As previously mentioned, Newcastle’s real estate securi-
ties and related loan portfolio consists of 455 different
securities and loans which are broadly diversified by
issuer, asset type, industry and geography.
In order to minimize credit risk and maximize shareholder
returns, we actively monitor the status of each individual
investment in our portfolio. We are constantly updating
the probability of receipt of interest and principal pay-
ments over the life of the investment. Our goal is to main-
tain a portfolio that generates relatively high and recurring
income streams with a low probability of principal loss.
Key to our strategy is to utilize financing structures that
offer us the flexibility to buy and sell certain investments
to manage credit risk and, subject to limitations, to opti-
mize returns over the term of the financing.
Newcastle actively manages credit expo-
sure through portfolio diversification and
ongoing asset selection and surveillance.
Ability to Manage
Flexibility
• Sell credit-risk securities
• Buy securities to opportunistically
enhance results
p.8
MANAGE ASSETS
Ongoing Credit
Surveillance
selected financial data 10
management’s discussion and analysis of
financial condition and results of operations 12
consolidated balance sheets 30
consolidated statements of income 31
consolidated statements of stockholders’ equity
and redeemable preferred stock 32
consolidated statements of cash flow 34
notes to consolidated financial statements 36
report of independent registered public
accounting firm 61
report on internal control over financial reporting of
independent registered public accounting firm 62
management’s report on internal control over
financial reporting 63
market for registrant’s common equity,
related stockholder matters 64
Newcastle Investment Corp. and Subsidiaries
p.9
selected financial data
(in thousands, except per share data)
The following table sets forth certain selected operating information on a historical basis. As such, it includes the historical results
of operations of the assets and liabilities distributed to Newcastle Investment Holdings which are not part of our continuing operations,
and therefore the information set forth for periods prior to the commencement of our operations in July 2002 is not indicative of our
ongoing operations.
The selected historical consolidated financial information set forth below as of December 31, 2004, 2003, 2002, 2001 and 2000 and
for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 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 this annual report.
OPERATING DATA
Revenues
Interest income
Other income
Expenses
Interest expense
Other expense
Equity in earnings (losses) of unconsolidated subsidiaries
Income taxes on related taxable subsidiaries
Income from continuing operations
Income (loss) from discontinued operations
Net income
Preferred dividends and related accretion
Income available for common stockholders
Net income per share of common stock, diluted
Income from continuing operations per share
of common stock, after preferred dividends
and related accretion, diluted
Weighted average number of shares of common
stock outstanding, diluted
Year Ended December 31,
2004
2003
2002
(2)
2001
(1)
2000
(1)
$ 226,674
31,472
$ 134,672
29,382
$
73,214
28,161
$
48,806
59,921
$
258,146
164,054
101,375
108,727
138,847
34,859
173,706
12,465
(2,508)
94,397
4,018
98,415
(6,094)
92,321
2.46
$
$
79,084
27,055
106,139
862
—
58,777
(2,659)
56,118
(4,773)
51,345
1.96
$
$
46,375
23,605
69,980
362
—
31,757
(262)
31,495
(1,162)
30,333
1.68
$
$
32,550
42,249
74,799
2,807
—
36,735
6,936
43,671
(2,540)
41,131
2.49
$
$
$
$
51,531
44,197
95,728
33,986
27,601
61,587
(980)
—
33,161
9,699
42,860
(2,084)
40,776
2.16
$
2.35
$
2.06
$
1.69
$
2.07
$
1.64
37,558
26,141
18,090
16,493
18,892
Dividends declared per share of common stock
$
2.425
$
1.950
$
2.050
$
2.000
$
1.500
(1) Represents the operations of our predecessor.
(2) Includes the operations of our predecessor through the date of commencement of our operations, July 12, 2002.
p.10
BALANCE SHEET DATA
Real estate securities, available for sale
Real estate related loans, net
Residential mortgage loans, net
Operating real estate, net
Cash and cash equivalents
Total assets
Debt
Stockholders’ equity
SUPPLEMENTAL BALANCE SHEET DATA
Common shares outstanding
Book value per share of common stock, subsequent
As of December 31,
2004
2003
2002
2001
2000
$ 3,369,496
591,890
654,784
57,193
37,911
4,932,720
4,021,396
796,715
$ 2,192,727
402,784
586,237
102,995
60,403
3,550,299
2,924,552
539,363
$ 1,025,010
26,417
258,198
113,652
45,463
1,574,828
1,217,007
284,241
$ 501,509
20,662
—
524,834
31,360
1,262,509
897,390
310,545
$ 550,220
106,957
—
540,539
10,575
1,331,671
975,656
300,655
39,859
31,375
23,489
16,489
16,500
to initial public offering
$
18.42
$
15.20
$
12.10
N/A
N/A
OTHER DATA
Cash flow provided by (used in):
Operating activities
Investing activities
Financing activities
Funds from operations (FFO) (1)
Year Ended December 31,
2004
2003
2002
2001
2000
$
77,890
$ (1,319,699)
$ 1,219,317
86,201
$
$
37,592
$ (1,652,682)
$ 1,630,030
54,380
$
$
21,557
$ (682,691)
$ 675,237
37,633
$
$
34,448
$ 106,053
$ (119,716)
48,264
$
$
24,823
$ 151,632
$ (180,225)
53,523
$
(1) We believe FFO is one appropriate measure of the operating performance of real estate companies because it provides investors with information regard-
ing our ability to service debt and make capital expenditures. We also believe that FFO is an appropriate supplemental disclosure of operating performance
for a REIT due to its widespread acceptance and use within the REIT and analyst communities. Furthermore, FFO is used to compute our incentive com-
pensation to our manager. FFO, for our purposes, represents net income available for common stockholders (computed in accordance with GAAP), exclud-
ing extraordinary items, plus depreciation of our operating real estate, and after adjustments for unconsolidated subsidiaries. We consider gains and losses
on resolution of our investments to be a normal part of our recurring operations and, therefore, do not exclude such gains and losses when arriving at FFO.
Adjustments for unconsolidated subsidiaries are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating
activities in accordance with GAAP and therefore should not be considered an alternative to net income as an indicator of 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,
2004
2003
2002
2001
2000
CALCULATION OF FUNDS FROM OPERATIONS (FFO)
Income available for common stockholders
Operating real estate depreciation
Accumulated depreciation on operating real estate sold
Other—Fund I (1)
$
92,321
2,199
(8,319)
—
$
51,345
3,035
—
—
$
30,333
7,994
(2,847)
2,153
$
41,131
12,909
—
(5,776)
$
40,776
12,621
—
126
Funds from operations (FFO)
$
86,201
$
54,380
$
37,633
$
48,264
$
53,523
(1) Related to an investment retained by our predecessor.
Newcastle Investment Corp. and Subsidiaries
p.11
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 this annual report.
G E N E R A L
We 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 and manufactured housing 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, 2004, our
debt to equity ratio was approximately 5.0 to 1. 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, and term loans, as well as short-term financing in the form of repurchase agreements.
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 collateralized bond obligations,
known as 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.
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, liquidity, diversification, match-funded financing and credit risk management.
We were formed in June 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. 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 Holdings and not contributed to us are accounted for as if they were distributed at their
historical book basis through a spin-off to Holdings. Our operations commenced in July 2002. In May 2003, Holdings distributed to its stock-
holders all of the shares of our common stock that it held, and it no longer owns any of our common equity. As of December 31, 2004,
approximately 2.3 million of such shares were held by an affiliate of our manager, and its principals. In addition, an affiliate of our manager
held options to purchase approximately 1.5 million shares of our common stock at December 31, 2004.
The analysis in this section treats us as the successor to Holdings and therefore includes historical information, through the date of the
commencement of our operations, regarding operations of Holdings which were distributed to them and therefore are unrelated to our ongoing
operations. Transactions completed by Holdings related to investments retained by Holdings (not contributed to us) are referred to as being
completed by our predecessor.
The following table presents information on shares of our common stock issued since our formation:
Shares Issued
Range of Issue Prices (1)
Net Proceeds (millions)
Year
Formation
2002
2003
2004
16,488,517
7,000,000
7,886,316
8,484,648
N/A
$13.00
$20.35–$22.85
$26.30–$31.40
December 31, 2004
39,859,481
January 2005
3,879,000
$29.60
N/A
$ 80.0
$ 163.4
$ 224.3
$ 105.4
(1) Excludes shares issued pursuant to the exercise of options and shares issued to our independent directors.
We are organized and conduct our operations to qualify as a REIT for federal income tax purposes. As such, we will generally not be
subject to 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) operating
real estate and (iii) residential mortgage loans. We have retroactively combined two business segments which were previously reported
separately: real estate securities and real estate related loans. Management no longer reviews disaggregated, discrete financial information on
these two investment categories since, among other reasons, they are cross-financed and share common credit risk characteristics. Holdings,
our predecessor, conducted its business through three primary segments: (1) real estate securities and real estate related loans, (2) operating
real estate, primarily credit leased operating real estate and (3) its investment in Fortress Investment Fund LLC (“Fund I”). Holdings’
p.12
investments in real estate securities and a portion of its investments in operating real estate were contributed to us. The operating real
estate and real estate related loans distributed to Holdings have been treated as discontinued operations, because they constituted a component
of an entity, while the other operations distributed to Holdings, including the investment in Fund I, have not been treated as such, because they
did not constitute a component of an entity as defined in SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.”
In addition to certain of the investments distributed to Holdings as described above, 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 this annual report.
Revenues attributable to each segment are disclosed below (unaudited) (in thousands).
Real Estate
Securities and Real
Estate Related Loans
$ 225,236
$ 134,348
$ 83,259
Operating
Real Estate
$ 13,222
$ 16,234
$ 13,116
Residential
Mortgage
Loans
$ 19,135
$ 12,892
$ 1,281
Fund I
Unallocated
Total
$ —
$ —
$ 3,287
$ 553
$ 580
$ 432
$ 258,146
$ 164,054
$ 101,375
For the Year Ended
December 31, 2004
December 31, 2003
December 31, 2002
TA X AT I O N
We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended (the
“Code”), and we intend to continue to operate in such a manner. Our current and continuing qualification as a REIT depends on our ability
to meet various tax law requirements, including, among others, requirements relating to the sources of our income, the nature of our assets,
the composition of our stockholders, and the timing and amount of distributions that we make.
As a REIT, we will generally not be subject to U.S. federal corporate income tax on our net income that is currently distributed to stock-
holders. We may, however, nevertheless be subject to certain state, local and foreign income and other taxes, and to U.S. federal income and
excise taxes and penalties in certain situations, including taxes on our undistributed income. In addition, our stockholders may be subject to
state, local or foreign taxation in various jurisdictions, including those in which they or we transact business or reside. The state, local and
foreign tax treatment of us and our stockholders may not conform to the U.S. federal income tax treatment.
If, in any taxable year, we fail to satisfy one or more of the various tax law requirements, we could fail to qualify as a REIT. In addition,
if Holdings failed to qualify as a REIT and we are treated as a successor to Holdings, this could cause us to likewise fail to qualify as a REIT. If
we fail to qualify as a REIT for a particular tax year, our income in that year would be subject to U.S. federal corporate income tax (including
any applicable alternative minimum tax), and we may need to borrow funds or liquidate certain investments in order to pay the applicable tax,
and we would not be compelled by the Code to make distributions. Unless entitled to relief under certain statutory provisions, we would also
be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost.
Although we currently intend to operate in a manner designed to qualify as a REIT, it is possible that future economic, market, legal, tax
or other developments may cause us to fail to qualify as a REIT, or may cause our board of directors to revoke the REIT election.
A P P L I CAT I O N O F C R I T I CA L AC C O U N T I N G P O L I C I E S
Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of finan-
cial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from
these estimates. A summary of our significant accounting policies is presented in Note 2 to our consolidated financial statements, which appear
in this annual report. The following is a summary of our accounting policies that are most effected by judgments, estimates and assumptions.
Variable Interest Entities
In December 2003, Financial Accounting Standards Board Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities”
was issued as a modification of FIN 46. FIN 46R, which became effective in the first quarter of 2004, clarified the methodology for
determining whether an entity is a variable interest entity (“VIE”) and the methodology for assessing who is the primary beneficiary of a
VIE. VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A VIE is
required to be consolidated by its primary beneficiary, and only its primary beneficiary, which is defined as the party who will absorb a
majority of the VIE’s expected losses or receive a majority of the expected residual returns as a result of holding variable interests.
We have historically consolidated our existing CBO transactions (the “CBO Entities) because we own the entire equity interest in each of
them, representing a substantial portion of their capitalization, and we control the management and resolution of their assets. We have determined
that certain of the CBO Entities are VIEs and that we are the primary beneficiary of each of these VIEs and will therefore continue to consolidate
them. We have also determined that the application of FIN 46R did not result in a change in our accounting for any other entities which were previously
Newcastle Investment Corp. and Subsidiaries
p.13
management’s discussion and analysis of financial condition
and results of operations (continued)
consolidated. However, it did cause us to consolidate one entity which was previously not consolidated, ICH CMO, as described below under
“Liquidity and Capital Resources.” We will continue to analyze future CBO entities, as well as other investments, pursuant to the requirements of
FIN 46R. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve subjective probability
weighting of subjectively determined possible cash flow scenarios. The result could be the consolidation of an entity acquired or formed in the
future that would otherwise not have been consolidated or the non-consolidation of such an entity that would otherwise have been consolidated.
Valuation and Impairment of Securities
We have classified our real estate securities as available for sale. As such, they are carried at fair value with net unrealized gains or losses
reported as a component of accumulated other comprehensive income. Fair value is based primarily upon broker quotations, as well as
counterparty quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof.
These quotations are subject to significant variability based on market conditions, such as interest rates and credit spreads. Changes in market
conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant increase or
decrease in our book equity. We must also assess whether unrealized losses on securities, if any, reflect a decline in value which is other than
temporary and, accordingly, write the impaired security down to its value through earnings. For example, a decline in value is deemed to be
other than temporary if it is probable that we will be unable to collect all amounts due according to the contractual terms of a security which
was not impaired at acquisition. Temporary declines in value generally result from changes in market factors, such as market interest rates
and credit spreads, or from certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our
ability to collect amounts contractually due. Significant judgment is required in this analysis. To date, no such write-downs have been made.
Revenue Recognition on Securities
Income on these securities is recognized using a level yield methodology based upon a number of assumptions that are subject to
uncertainties and contingencies. Such assumptions include the expected disposal date of such security and the rate and timing of principal and
interest receipts (which may be subject to prepayments, delinquencies and defaults). These uncertainties and contingencies are difficult to
predict and are subject to future events, and economic and market conditions, which may alter the assumptions.
Valuation of Derivatives
Similarly, our derivative instruments are carried at fair value pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133
“Accounting for Derivative Instruments and Hedging Activities,” as amended. Fair value is based on counterparty quotations. To the extent
they qualify as hedges under SFAS No. 133, net unrealized gains or losses are reported as a component of accumulated other comprehensive
income; otherwise, they are reported as a component of current income. Fair values of such derivatives are subject to significant variability
based on many of the same factors as the securities discussed above. The results of such variability could be a significant increase or decrease
in our book equity and/or earnings.
Impairment of Loans
We purchase, directly and indirectly, real estate related, commercial mortgage and residential mortgage loans, including manufactured
housing loans, to be held for investment. We must periodically evaluate each of these loans or loan pools for possible impairment. Impairment
is indicated when it is deemed probable that we will be unable to collect all amounts due according to the contractual terms of the loan, or,
for loans acquired at a discount for credit losses, when it is deemed probable that we will be unable to collect as anticipated. Upon determination
of impairment, we would establish a specific valuation allowance with a corresponding charge to earnings. Significant judgment is required
both in determining impairment and in estimating the resulting loss allowance. In 2003, a loss allowance of $0.1 million was recorded with
respect to the residential mortgage loans in our portfolio. No other loan impairments have been recorded to date.
Revenue Recognition on Loans
Income on these loans is recognized similarly to that on our securities and is subject to similar uncertainties and contingencies.
Impairment of Operating Real Estate
We own operating real estate held for investment. We review our operating real estate for impairment annually or whenever events or
changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Upon determination of impairment, we would
record a write-down of the asset, which would be charged to earnings. Significant judgment is required both in determining impairment and
in estimating the resulting write-down. To date, we have determined that no write-downs have been necessary on the operating real estate in
our portfolio. In addition, when operating real estate is classified as held for sale, it must be recorded at the lower of its carrying amount or
fair value less costs of sale. Significant judgment is required in determining the fair value of such properties. In December 2003, we classified
five properties as held for sale and recorded a loss of $1.5 million; these properties were sold in June 2004. In March 2004, we classified one
property as held for sale, which did not result in a loss; this property was still held at December 31, 2004. In December 2004, we sold two
properties at a gain of $5.3 million. In January 2005, we classified one property as held for sale, which did not result in a loss.
p.14
R E S U LT S O F O P E R AT I O N S
Our independent operations commenced in July 2002 and our initial public offering was completed in October 2002. In addition, we had one
offering of preferred stock and two offerings of common stock during 2003 as well as three offerings of common stock in 2004. These events
resulted in additional capital being deployed to our investments which, in turn, resulted in changes to our results of operations. Furthermore,
the results of operations described below include the operations of our predecessor through July 12, 2002, the date of the commencement of
our operations. Therefore, many items discussed below prior to such date will not have a continuing impact on our operations.
The following table summarizes the changes in our results of operations from year-to-year (dollars in thousands):
Interest income
Rental and escalation income
Gain on settlement of investments
Management fee from affiliate
Incentive income from affiliate
Interest expense
Property operating expense
Loan and security servicing expense
General and administrative expense
Management fee to affiliate
Incentive compensation to affiliate
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries
Year-to-Year
Increase (Decrease)
Year-to-Year
Percent Change
Explanation
2004/2003 2003/2002 2004/2003 2003/2002 2004/2003 2003/2002
$92,002
(2,701)
4,791
—
—
59,763
(538)
903
1,444
4,152
1,733
110
9,095
$61,458
2,683
1,790
(4,470)
1,218
32,709
891
1,499
838
(2,782)
3,370
(366)
500
68.3%
(16.7)%
36.4%
—
—
75.6%
(6.9)%
41.9%
45.2%
64.2%
27.8%
9.2%
1,055.1%
83.9%
19.8%
15.7%
N/A
N/A
70.5%
12.9%
228.9%
35.6%
(30.1)%
118.0%
(23.5)%
138.1%
(1)
(2)
(3)
(4)
(4)
(1)
(2)
(1)
(5)
(6)
(6)
(7)
(8)
(1)
(2)
(3)
(4)
(4)
(1)
(2)
(1)
(5)
(6)
(6)
(7)
(8)
Income from continuing operations
$35,620
$27,020
60.6%
85.1%
(1) Changes in interest income and expense are primarily due to our acquisition of interest-bearing assets and related financings, as follows:
Real estate security and loan portfolios (A)
ABS—manufactured housing portfolio
Residential mortgage loan portfolio
ICH CMO loan portfolio
Other real estate related loans
Other
Year-to-Year Increase (Decrease)
Interest Income
Interest Expense
2004/2003
2003/2002
2004/2003
2003/2002
$43,682
14,211
7,113
13,870
9,332
3,794
$41,551
733
11,004
4,988
593
2,589
$31,856
4,824
4,701
11,878
3,528
2,976
$28,039
205
5,504
4,074
230
(5,343)
$92,002
$61,458
$59,763
$32,709
(A) Represents our second through our sixth CBO financings and the acquisition of the related collateral.
Changes in loan and security servicing expense are also primarily due to these acquisitions.
(2) These changes are primarily the result of the effect of the sale of certain properties and the termination of a lease, offset by foreign currency fluctuations.
(3) These changes are primarily a result of the volume of sales of real estate securities. Sales of real estate securities are based on a number of factors including credit, asset type
and industry and can be expected to increase or decrease from time to time. Periodic fluctuations in the volume of sales of securities is dependent upon, among other things,
management’s assessment of credit risk, asset concentration, portfolio balance and other factors.
(4) These items relate to our predecessor’s investment in Fund I, prior to its distribution to Holdings.
(5) The increases in general and administrative expense are primarily a result of our increased size, resulting from our equity issuances during this period, as well as due to
increased professional fees related to our compliance with the Sarbanes-Oxley Act of 2002.
(6) Excluding management fees and incentive compensation which were passed through our predecessor to our manager and which related to our predecessor’s investment in Fund
I, the changes in management fees and incentive compensation were as follows:
Year-to-Year
Increase (Decrease)
2004/2003
2003/2002
Management fee to affiliate
Incentive compensation to affiliate
$4,152
$1,733
$1,688
$2,761
The increases in management fees are a result of our increased size resulting from our equity issuances during these periods. The increases in incentive compensation are
primarily a result of our increased earnings.
(7) The 2003/2002 decrease in depreciation and amortization is primarily the result of the distribution of depreciable assets to Holdings. The 2004/2003 increase is primarily due
to foreign currency fluctuations.
(8) The increase in earnings from unconsolidated subsidiaries are primarily a result of our late 2003 acquisition of an interest in an LLC which owns a portfolio of real estate
related loans and our early 2004 acquisition of an interest in an LLC which owns a portfolio of convenience and retail gas stores. Note that the amounts shown are net of income
taxes on related taxable subsidiaries.
Newcastle Investment Corp. and Subsidiaries
p.15
management’s discussion and analysis of financial condition
and results of operations (continued)
L I Q U I D I T Y A N D CA PI TA L R E S O U R C E S
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund
and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code,
we must distribute annually at least 90% of our REIT taxable income. Our primary sources of funds for liquidity consist of net cash provided
by operating activities, borrowings under loans and the issuance of debt and equity securities. Our debt obligations are generally secured
directly by our investment assets.
We expect that our cash on hand and our cash flow provided by operations will satisfy our liquidity needs with respect to our current
investment portfolio over the next twelve months. However, we currently expect to seek additional capital in order to grow our investment
portfolio. We have an effective shelf registration statement with the SEC which allows us to issue various types of securities, such as common
stock, preferred stock, depository shares, debt securities and warrants, from time to time, up to an aggregate of $750 million, of which
approximately $448 million remained available as of December 31, 2004.
We expect to meet our long-term liquidity requirements, specifically the repayment of our debt obligations, through additional borrowings
and the liquidation or refinancing of our assets at maturity. We believe that the value of these assets is, and will continue to be, sufficient to
repay our debt at maturity under either scenario. Our ability to meet our long-term liquidity requirements relating to capital required for the
growth of our investment portfolio is subject to obtaining additional equity and debt financing. Decisions by investors and lenders to enter
into such transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance
with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’ and lenders’ policies
and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. We maintain access to a broad
array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital.
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 core business strategy is dependent upon our ability to finance our real estate securities and other real
estate related assets with match-funded debt 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.
We expect to meet our short-term liquidity requirements generally through our cash flow provided by operations, as well as investment
specific borrowings. In addition, at December 31, 2004, we had an unrestricted cash balance of $37.9 million. Our cash flow provided by
operations differs from our net income due to four primary factors: (i) accretion of discount or premium on our real estate securities and
loans, discount on our debt obligations, deferred financing costs and interest rate cap premiums, and deferred hedge gains and losses,
(ii) gains and losses from sales of assets financed with CBOs, (iii) depreciation of our operating real estate and (iv) straight-lined rental
income. Proceeds from the sale of assets which serve as collateral for our CBO financings, including gains thereon, are required to be
retained in the CBO structure until the related bonds are retired and are therefore not available to fund current cash needs.
Our match-funded investments are financed long-term and their credit status is continuously monitored; therefore, these investments are
expected to generate a generally stable current return, subject to limited interest rate fluctuations. See “Quantitative and Qualitative Disclosures
About Market Risk—Interest Rate Exposure” below. Our remaining investments, financed with short-term repurchase agreements, are also
subject to refinancing risk upon the maturity of the related debt. See “Debt Obligations” below.
With respect to our operating real estate, we expect to incur expenditures of approximately $0.5 million relating to tenant improvements
in connection with the inception of leases and capital expenditures during the year ending December 31, 2005.
With respect to one of our real estate related loans, we were committed to fund up to an additional $22.7 million at December 31, 2004,
subject to certain conditions to be met by the borrower.
p.16
Debt Obligations
The following table presents certain information regarding our debt obligations and related hedges as of December 31, 2004 (unaudited)
(dollars in thousands):
Month
Issued
Current
Face
Amount
Carrying
Value
Unhedged
Weighted
Average
Funding Cost
Final
Stated
Maturity
Weighted
Average
Funding
Cost (1)
Weighted
Average
Maturity
(Years)
Face
Amount of
Floating
Rate Debt
Collateral
Carrying
Value
Debt Obligation/Collateral
CBO Bonds Payable
Real estate securities
Collateral
Weighted
Average
Maturity
(Years)
Face
Amount of
Floating
Rate
Collateral Hedges Owned
Aggregate
Notional
Amount of
Currently
Effective
Hedges
and loans
July 1999
$ 436,895
$ 432,893
4.08% (2)
July 2038
4.85%
4.21
$ 341,895
$ 587,861
6.04
$
— Two swaps, one cap
$ 328,699
Real estate securities
and loans
Apr. 2002
444,000
440,427
3.67% (2)
Apr. 2037
6.18%
5.38
372,000
505,927
6.16
84,733 One swap, one cap
290,000
Real estate securities
and loans
Mar. 2003
472,000
467,905
3.68% (2)
Mar. 2038
4.45%
7.31
427,800
499,813
5.60
144,682 One swap, one cap
276,060
Real estate securities
and loans
Sept. 2003
460,000
455,115
3.28% (2)
Sept. 2038
4.32%
7.87
442,500
497,524
4.93
233,990 One swap, one cap
192,500
Real estate securities
and loans
Mar. 2004
414,000
410,018
3.31% (2)
Mar. 2039
3.85%
7.63
382,750
449,244
6.01
217,652
One swap
165,300
Real estate securities
and loans
Sept. 2004
454,500
450,152
3.16% (2)
Sept. 2039
3.90%
8.20
442,500
499,867
6.46
252,886
One swap
189,373
2,681,395 2,656,510
4.59%
6.78
2,409,445 3,040,236
5.87
933,943
1,441,932
Other Bonds Payable
Bell Canada portfolio (3)
ICH CMO loans (4)
Notes Payable
Apr. 2002
(4)
42,885
42,422
179,844
179,844
7.02%
6.61% (2)
Apr. 2012
7.02%
Aug. 2030
6.61%
1.43
2.79
—
57,193
3,684
202,674
N/A
2.86
222,729
222,266
6.69%
2.53
3,684
259,867
Real estate related loan
Real estate related loan (5)
Nov. 2003
Feb. 2004
67,523
40,000
67,523 LIBOR+1.50% Nov. 2006
40,000 LIBOR+1.50% Feb. 2005
3.92%
4.26%
1.64
0.17
67,523
40,000
83,909
50,000
1.64
2.13
—
3,684
3,684
83,909
50,000
None
None
None
None
Residential
mortgage loans (6)
Repurchase Agreements (6)
Residential
mortgage loans (7)
ABS—manufactured
housing (8)
Agency RMBS (9)
Real estate securities
Real estate related loans (10)
Nov. 2004
544,477
544,477 LIBOR+0.15% Nov. 2007
2.46%
2.10
544,477
583,922
3.76
575,759
None
652,000
652,000
2.72%
1.93
652,000
717,831
3.40
709,668
Rolling
67,382
67,382 LIBOR+0.43% Mar. 2005
2.99%
0.25
67,382
70,862
4.49
69,622
None
Rolling
Rolling
Rolling
Rolling
103,738
195,754
67,471
103,738 LIBOR+0.64% Mar. 2005
195,754 LIBOR+0.13% Jan. 2005
67,471 LIBOR+0.61% Oct. 2005
4.29%
3.81%
3.29%
56,275
56,275 LIBOR+0.95% Oct. 2005
3.34%
0.17
0.08
0.22
0.69
103,738
195,754
67,471
146,309
201,528
91,771
56,275
73,500
5.11
3.35
3.73
1.87
—
—
32,609
73,500
Eight swaps
Three swaps
Two swaps
None
490,620
490,620
3.67%
0.21
490,620
583,970
3.80
175,731
—
—
—
—
—
—
—
—
95,700
195,409
21,295
—
312,404
Total debt obligations
$ 4,046,744 $ 4,021,396
4.29%
4.97
$ 3,555,749 $ 4,601,904
$ 1,823,026
$ 1,754,336
Including the effect of applicable hedges.
(1)
(2) Weighted average, including floating and fixed rate classes.
(3) Denominated in Canadian dollars.
(4) See discussion below.
(5) Maturity date extended in January 2005 from February 2005 to February 2006.
(6) Subject to potential mandatory prepayments based on collateral value.
(7) The counterparty on this repo is Bear Stearns Mortgage Capital Corporation.
(8) The counterparty on these repos is Greenwich Capital Markets Inc.
(9) The counterparty on this repo is Bank of America Securities LLC.
(10) The counterparty on these repos is Deutsche Bank AG.
Newcastle Investment Corp. and Subsidiaries
p.17
management’s discussion and analysis of financial condition
and results of operations (continued)
Our long-term debt obligations existing at December 31, 2004 (gross of $25.3 million of discounts) have contractual maturities as follows
(unaudited) (in millions):
2005
2006
2007
2008
2009
Thereafter
Total
$ 535,870
62,273
544,477
—
—
2,904,124
$ 4,046,744
Certain of the debt obligations included above are obligations of our consolidated subsidiaries which own the related collateral. In some
cases, including the CBO and Other Bonds Payable, such collateral is not available to other creditors of ours.
In connection with the sale of two classes of CBO bonds, we entered into two interest rate swaps and three interest rate cap agreements
that do not qualify for hedge accounting.
In November 2001, we sold the retained subordinated $17.5 million Class E Note from our first CBO to a third party. The Class E Note
bore interest at a fixed rate of 8.0% and had a stated maturity of June 2038. The sale of the Class E Note represented an issuance of debt
and was recorded as additional CBO bonds payable. In April 2002, a wholly-owned subsidiary of ours repurchased the Class E Note. The
repurchase of the Class E Note represented a repayment of debt and was recorded as a reduction of CBO bonds payable. The Class E Note is
included in the collateral for our second CBO. The Class E Note is eliminated in consolidation.
One class of the CBO bonds, with a $395.0 million face amount, was issued subject to remarketing procedures and related agreements
whereby such bonds are remarketed and sold on a periodic basis. These bonds are fully insured by a third party with respect to the timely
payment of interest and principal thereon.
We enter into short-term warehouse agreements with major investment banks for the right to purchase commercial mortgage backed
securities, unsecured REIT debt, real estate related loans and asset backed securities for our real estate securities portfolios, prior to their
being financed with CBOs. These agreements are treated as non-hedge derivatives for accounting purposes and are therefore marked to market
through current income. If the related CBO is not consummated, except as a result of our gross negligence, willful misconduct or breach of
contract, we would be required to pay the Net Loss, if any, as defined, up to the related deposit, less any Excess Carry Amount, as defined,
earned on such deposit. Although we currently anticipate completing the most recent CBO in the near term, there is no assurance that such
CBO will be consummated or on what terms it will be consummated. The following table summarizes the agreements (in thousands):
December 31, 2004
Income (Loss) Recorded
Collateral
Accumulated (1)
Aggregate
Deposit
Fair Value
$224,928
$24,901
$25,411
Deal Status
Completed
Open
Total
2004
$2,604
510
$3,114
2003
$3,730
—
$3,730
2002
$652
—
$652
(1) Excludes $32.5 million of collateral accumulated on balance sheet and recorded in real estate securities.
In October 2003, pursuant to FIN No. 46R, we consolidated an entity which holds a portfolio of commercial mortgage loans which has
been securitized. This investment, which we refer to as the ICH CMO, was previously treated as a non-consolidated residual interest in such
securitization. We exercise no control over the management or resolution of these assets and our residual investment in this entity was
recorded at $2.9 million prior to its consolidation. The primary effect of the consolidation is the requirement that we reflect the gross loan
assets and gross bonds payable of this entity in our financial statements.
In July 2004, we refinanced $342.5 million of the AAA and AA bonds in our first CBO. $322.5 million of AAA bonds were refinanced
at LIBOR + 0.30% from LIBOR + 0.65% and $20.0 million of AA bonds were refinanced at LIBOR + 0.50% from LIBOR + 0.80%.
During 2004, the note payable on the LIV portfolio of operating real estate was repaid in full.
p.18
In January 2005, we acquired a portfolio of approximately 8,100 manufactured housing loans for an aggregate purchase price of
approximately $308.2 million. The loans, which were all current at the time of acquisition, are primarily fixed rate with a weighted average
coupon of approximately 9.00% and a weighted average remaining term of approximately 5.00 years. Our acquisition was initially funded
with approximately $246.5 million of one-year debt provided by two investment banks which is subject to adjustment based on the market
value and performance of the related portfolio. The debt bears interest at LIBOR + 1.25%. We obtained an interest rate swap in order to hedge
our exposure to the risk of changes in market interest rates with respect to this debt.
Other
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. We structured this transaction through a joint venture with an affiliate of our manager on equal terms. In October 2004, the
investment’s initial financing was refinanced with a nonrecourse term loan ($53.0 million outstanding at December 31, 2004). The term loan
bears interest at a fixed rate of 6.04%, with payments of interest only during the first two years and a 25-year amortization schedule with a
balloon payment due in October 2014. This investment is reflected as an investment in an unconsolidated subsidiary and is included in the
operating real estate segment. At December 31, 2004, we had a $17.8 million investment in this entity.
In November 2004, we entered into a total rate of return swap with a major investment bank, whereby we receive the sum of all interest
(at LIBOR + 2.25%), fees and any positive change in value amounts (the total return cash flows) from a referenced term loan (to a retail mall
REIT) with an initial notional amount of $107.0 million, and pay interest (at LIBOR + 0.50%) on such notional plus any negative change in
value amounts from such loan. This agreement is treated as a non-hedge derivative for accounting purposes and is therefore marked to market
through income. Under the agreement, we were required to post an initial margin deposit equal to 17% of the notional amount and additional
margin may be payable in the event of a decline in value of the referenced term loan. Any margin on deposit, less any negative change in value
payments, will be returned to us upon termination of the contract.
Stockholders’ Equity
Common Stock Offerings—The following table presents information on shares of our common stock issued since our formation.
Year
Formation
2002
2003
2004
Shares Issued
Range of Issue
Prices per Share(1)
Net Proceeds
(millions)
Options Granted
to Manager
16,488,517
7,000,000
7,886,316
8,484,648
N/A
$13.00
$20.35–$22.85
$26.30–$31.40
N/A
$ 80.0
$ 163.4
$ 224.3
N/A
700,000
788,227
837,500
December 31, 2004
39,859,481
January 2005
3,879,000
$29.60
$ 105.4
330,000
(1) Excludes shares issued pursuant to the exercise of options and shares issued to our independent directors.
During 2003 and 2004, our manager assigned, for no value, options to purchase approximately 0.8 million shares of our common stock
to certain of our manager’s employees, of which approximately 0.1 million were exercised in 2004.
As of December 31, 2004, our outstanding options had a weighted average strike price of $21.25 and were summarized as follows:
Held by our manager
Issued to our manager and subsequently assigned to certain of our manager’s employees
Held by directors
Total
1,510,937
707,790
13,000
2,231,727
Preferred Stock—In March 2003, we issued 2.5 million shares ($62.5 million face amount) of 9.75% Series B Cumulative Redeemable
Preferred Stock (the “Series B Preferred”). The Series B Preferred has a $25 liquidation preference, no maturity date and no mandatory
redemption. We have the option to redeem the Series B Preferred beginning in March 2008.
Newcastle Investment Corp. and Subsidiaries
p.19
management’s discussion and analysis of financial condition
and results of operations (continued)
Other Comprehensive Income—During the year ended December 31, 2004, our accumulated other comprehensive income increased due
to the following factors (in thousands):
Accumulated other comprehensive income, December 31, 2003
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized gain on derivatives designated as cash flow hedges
Reclassification of realized loss on derivatives designated as cash flow hedges into earnings
Accumulated other comprehensive income, December 31, 2004
$ 39,413
34,088
(14,574)
1,984
(1,478)
11,973
364
$ 71,770
Our book equity changes as our real estate securities portfolio and derivatives are marked to market each quarter, among other factors.
The primary causes of mark to market changes are changes in interest rates and credit spreads. During the year, the combination of tightening
credit spreads and rising interest rates has resulted in a net increase in unrealized gains on our real estate securities portfolio. In an environment
of widening credit spreads and increasing interest rates, we believe our new investment activities will benefit. While such an environment will
likely result in a decrease in the fair value of our existing securities portfolio and therefore reduce our book equity and ability to realize gains
on such existing securities, it would not directly affect our earnings or our cash flow or our ability to pay a dividend.
In addition, the weakening of the U.S. dollar against both the Canadian dollar and the Euro has resulted in an increase in unrealized gains
on our Canadian and Belgian operating real estate.
Common Dividends Paid
Declared for the Period Ended
Paid
Amount Per Share
September 30, 2002
October 9, 2002
December 31, 2002
March 31, 2003
June 30, 2003
September 30, 2003
December 31, 2003
March 31, 2004
June 30, 2004
September 30, 2004
December 31, 2004
Our Predecessor
October 2002
October 2002
January 2003
April 2003
July 2003
October 2003
January 2004
April 2004
July 2004
October 2004
January 2005
$0.400
$0.060
$0.390
$0.450
$0.500
$0.500
$0.500
$0.600
$0.600
$0.600
$0.625
The following is a discussion of our predecessor’s historical liquidity and capital resources, primarily related to operations distributed
to them.
In May 1999, Holdings closed on the $399.1 million GSA securitization, which financed the GSA portfolio of operating real estate. The
GSA securitization, and related assets, were retained by Holdings.
In November 1999, Holdings obtained the $24.8 million GSA Kansas City mortgage, which was repaid in May 2002 upon the sale of the
related asset.
In July 2000, Holdings entered into a $40 million revolving credit agreement, which bore interest at LIBOR +4.25%. Holdings hedged its
exposure to the risk of changes in market interest rates with respect to the credit agreement by obtaining an interest rate swap. This credit
agreement was retained by Holdings.
Cash Flow
Net cash flow provided by operating activities increased from $37.6 million for the year ended December 31, 2003 to $78.0 million for
the year ended December 31, 2004. It increased from $21.6 million for the year ended December 31, 2002 to $37.6 million for the year
ended December 31, 2003. These changes resulted from the acquisition and settlement of our investments as described above, including the
distribution of investments to Holdings.
p.20
Investing activities used $(1,319.7) million, $(1,652.7) million and $(682.7) million during the years ended December 31, 2004, 2003 and
2002, respectively. Investing activities consisted primarily of the acquisition of properties and the investments made in real estate securities
and loans, net of proceeds from the sale or settlement of investments.
Financing activities provided $1,219.3 million, $1,630.0 million and $675.2 million during the years ended December 31, 2004, 2003 and
2002, respectively. The equity issuances, borrowings and debt issuances described above served as the primary sources of cash flow from
financing activities. Offsetting uses included the payment of related deferred financing costs, the purchase of hedging instruments, the
payment of dividends, the redemption of common and preferred stock and the repayment of debt as described above.
See the consolidated statements of cash flows in our consolidated financial statements included in this annual report for a reconciliation
of our cash position (including our predecessor’s cash position prior to the commencement of our operations) for the periods described herein.
I N T E R E S T R AT E, C R E D I T A N D S P R E A D R I S K
We are subject to interest rate, credit and spread risk with respect to our investments.
Our primary interest rate exposures relate to our real estate securities, loans and floating rate debt obligations, as well as our interest rate
swaps and caps. Changes in the general level of interest rates can effect our net interest income, which is the difference between the interest
income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges.
Changes in the level of interest rates also can effect, among other things, our ability to acquire real estate securities and loans, the value of
our real estate securities, loans and derivatives, and our ability to realize gains from the settlement of such assets.
Our general financing strategy focuses on the use of match-funded structures. This means that we seek to match the maturities of our
debt obligations with the maturities of our investments to minimize the risk that we have to refinance our liabilities prior to the maturities of
our assets, and to reduce the impact of changing interest rates on our earnings. In addition, we generally match-fund interest rates on our
investments with like-kind debt (i.e., fixed rate assets are financed with fixed rate debt and floating rate assets are financed with floating rate
debt), directly or through the use of interest rate swaps, caps or other financial instruments, or through a combination of these strategies,
which allows us to reduce the impact of changing interest rates on our earnings. See “Quantitative and Qualitative Disclosures About Market
Risk—Interest Rate Exposure” below.
Real Estate Securities
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, and as interest rates decrease, the value of such securities will increase. In general, we would expect that over time,
decreases in the value of our real estate securities portfolio attributable to interest rate changes will be offset to some degree by increases in
the value of our swaps, and vice versa. However, the relationship between spreads on securities and spreads on swaps may vary from time to
time, resulting in a net aggregate book value increase or decline. Our real estate securities portfolio is largely financed to maturity through
long-term CBO financings that are not redeemable as a result of book value changes. Accordingly, unless there is a material impairment in
value that would result in a payment not being received on a security, changes in the book value of our securities portfolio will not directly
affect our recurring earnings or our ability to pay a dividend.
The commercial mortgage and asset backed securities we invest in are generally junior in right of payment of interest and principal to one
or more senior classes, but benefit from the support of one or more subordinate classes of securities or other form of credit support within a
securitization transaction. The senior unsecured REIT debt securities we invest in reflect comparable credit risk. 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 these securities offer attractive risk-adjusted returns with long-term principal protection under a variety of default and
loss scenarios. While the expected yield on these securities is sensitive to the performance of the underlying assets, the more subordinated
securities or other features of the securitization transaction, in the case of commercial mortgage and asset backed securities, and the issuer’s
underlying equity and subordinated debt, in the case of senior unsecured REIT debt securities, are designed to bear the first risk of default
and loss. We further minimize credit risk by actively monitoring our real estate securities portfolio and the underlying credit quality of our
holdings and, where appropriate, repositioning our investments to upgrade the credit quality and yield on our investments. While we have not
experienced any significant credit losses, 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.
Our real estate securities portfolio is diversified by asset type, industry, location and issuer. At December 31, 2004, we had 455 real estate
securities and loans, excluding the ICH CMO loans as described above. Our largest investment in a real estate security or real estate related
loan was $86.7 million and our average investment size was $8.1 million at December 31, 2004. Furthermore, our real estate securities are
Newcastle Investment Corp. and Subsidiaries
p.21
management’s discussion and analysis of financial condition
and results of operations (continued)
supported by pools of underlying loans. For instance, our CMBS investments had 16,341 underlying loans at December 31, 2004. We expect
that this diversification also helps to minimize the risk of capital loss. At December 31, 2004, our real estate securities and real estate related
loans (excluding the ICH loans as described above) had an overall weighted average credit rating of approximately BBB–, and approximately
70% had an investment grade rating (BBB– or higher).
Our real estate securities are also subject to spread risk. Our fixed rate securities are valued based on a market credit spread over the rate
payable on fixed rate U.S. Treasuries of like maturity. In other words, their value is dependent on the yield demanded on such securities by
the market based on their credit relative to U.S. Treasuries. Excessive supply of such securities combined with reduced demand will generally
cause the market to require a higher yield on such securities, resulting in the use of a higher (or “wider”) spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities. Under such conditions, the value of our 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
effected similarly by changes in LIBOR spreads. Such changes in the market value of our real estate securities portfolio may effect our net
equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our
ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital. If the value of
our securities subject to repurchase agreements were to decline, it could affect our ability to refinance such loans upon the maturity of the
related repurchase agreements. See “Quantitative and Qualitative Disclosures About Market Risk—Credit Spread Curve Exposure” below.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also effect
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 spreads.
Loans
Similar to our real estate securities portfolio, we are subject to credit and spread risk with respect to our real estate related, commercial
mortgage and residential mortgage loan portfolios. However, unlike our real estate securities portfolio, our loans do not benefit from the
support of junior classes of securities, but rather bear the first risk of default and loss. We believe that this credit risk is mitigated through our
due diligence process and periodic reviews of the borrower’s payment history, delinquency status, and the relationship of the loan balance to
the underlying property value. At December 31, 2004, our residential mortgage loan portfolio was characterized by high credit quality
borrowers with a weighted average FICO score of 722 at origination, and had a weighted average loan to value ratio of 72.5%. As of
December 31, 2004, approximately $575.8 million of our residential mortgage loans were held in securitized form, of which over 95% of the
principal balance was AAA rated.
Our loan portfolios are diversified by geographic location and by borrower. We believe that this diversification also helps to minimize the
risk of capital loss.
Our loan portfolios are also subject to spread risk. Our floating rate loans are valued based on a market credit spread to LIBOR. The
value of these loans is dependent upon 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 bench-
mark rate (usually the applicable LIBOR yield). Our fixed rate loans are valued based on a market credit spread over U.S. Treasuries and are
effected 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 losses incurred with respect to our loan portfolios would affect us in the same way as similar losses on our real estate
securities portfolio as described above, except that our loan portfolios are not marked to market.
O F F - B A L A N C E S H E E T A R R A N G E M E N T S
As of December 31, 2004, we had the following material off-balance sheet arrangements:
• The $25.4 million carrying value of our deposit on our seventh real estate securities portfolio, as described above under “Liquidity and
Capital Resources.” Except as a result of our gross negligence, willful misconduct or breach of contract, our potential loss is limited to the
amount shown, which is included in our consolidated balance sheet.
• A guarantee of certain payments under an interest rate swap which may be entered into in 2007 in connection with the securitization of the
Bell Canada portfolio, if the related bonds are not fully repaid by such date. We believe the fair value of this guarantee is negligible at
December 31, 2004.
p.22
At this time, we do not anticipate a substantial risk of incurring a loss with respect to any of the arrangements.
We are also party to a total return swap which is treated as a non-hedge derivative. For further information on this investment, see
“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”
C O N T R AC T UA L O B L I G AT I O N S
As of December 31, 2004, we had the following material contractual obligations (payments in thousands):
Contract
Terms
CBO bonds payable
Other bonds payable
Notes payable
Repurchase agreements
Interest rate swaps, treated as hedges
Real estate securities portfolio deposit
Non-hedge derivative obligations
CBO IV wrap agreement
CBO IV backstop agreement
CBO IV remarketing agreement
Management agreement
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
Described under “Quantitative and Qualitative Disclosures About Market Risk”
The largest tranche of our CBO IV bonds, the $395.0 million face amount of Class I-MM bonds, was issued
subject to remarketing procedures and related agreements whereby such bonds are remarketed and sold on a
periodic basis. The Class I-MM bonds are fully insured by a third party with respect to the timely payment
of interest and principal thereon, pursuant to a financial guaranty insurance policy (“wrap”). We pay annual
fees of 0.12% of the outstanding face amount of the Class I-MM bonds under this agreement.
In connection with the remarketing procedures described above, a backstop agreement has been created
whereby a third party financial institution is required to purchase the Class I-MM bonds at the end of any
remarketing period if such bonds could not be resold in the market by the remarketing agent. We pay annual
fees of 0.20% of the outstanding face amount of the Class I-MM bonds under this agreement.
In connection with the remarketing procedures described above, the remarketing agent is paid an annual fee
of 0.05% of the outstanding face amount of the Class I-MM bonds under the remarketing agreement.
Our manager is paid an annual management fee of 1.5% of our gross equity, as defined, an expense
reimbursement, and incentive compensation equal to 25% of our FFO above a certain threshold. For more
information on this agreement, as well as historical amounts earned, see Note 10 to our audited consolidated
financial statements included in this annual report.
Contract
CBO bonds payable
Other bonds payable
Notes payable
Repurchase agreements
Interest rate swaps, treated as hedges
Non-hedge derivative obligations
CBO IV wrap agreement
CBO IV backstop agreement
CBO IV remarketing agreement
Management agreement
Actual
Payments
2004(1)
$
58,896
60,475
114,678
887,429
53,066
4,117
482
803
200
12,062
Fixed and Determinable Payments Due by Period (2)
2005
2006–2007 2008–2009 Thereafter
Total
$
— $
—
45,250
490,620
(3)
—
—
606,750
—
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
$ —
—
—
—
(3)
(3)
(3)
(3)
(3)
(3)
$ 2,681,395
222,729
—
—
(3)
$ 2,681,395
222,729
652,000
490,620
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
(3)
Total
$ 1,192,208 $ 535,870 $ 606,750
$ —
$ 2,904,124 $ 4,046,744
(1) Includes all payments made under the respective agreements. The management agreement payments shown include $10.4 million of management fees and expense reimburse-
ments and $1.7 million of incentive compensation.
(2) Represents debt principal due based on contractual maturities.
(3) These contracts do not have fixed and determinable payments.
Newcastle Investment Corp. and Subsidiaries
p.23
management’s discussion and analysis of financial condition
and results of operations (continued)
I N F L AT I O N
We believe that our risk of increases in market interest rates on our floating rate debt as a result of inflation is largely offset by our use
of match-funding and hedging instruments as described above. See “Quantitative and Qualitative Disclosure About Market Risk—Interest
Rate Exposure” below.
Substantially all of our office leases provide for separate escalations of real estate taxes and operating expenses over a base amount,
and/or increases in the base rent based on changes in a Belgian index with respect to the LIV portfolio. We believe that inflationary increases
in expenses will generally be offset by the expense reimbursements and contractual rent increases described above.
F U N D S F R O M O P E R AT I O N S
We believe funds from operations (FFO) is one appropriate measure of the operating performance of real estate companies because
it provides investors with information regarding our ability to service debt and make capital expenditures. We also believe that FFO is an
appropriate supplemental disclosure of operating performance for a REIT due to its widespread acceptance and use within the REIT and
analyst communities. 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. 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 are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating activities
in accordance with GAAP and therefore should not be considered an alternative to net income as an indicator of our operating performance
or as an alternative to cash flow as a measure of liquidity and is not necessarily indicative of cash available to fund cash needs. Our calculation
of FFO may be different from the calculation used by other companies and, therefore, comparability may be limited.
Funds from operations (FFO) is calculated as follows (unaudited) (in thousands):
Income available for common stockholders
Operating real estate depreciation
Accumulated depreciation on operating real estate sold
Other—Fund I (1)
Funds from operations (FFO)
(1) Related to an investment retained by our predecessor.
For the Year Ended December 31,
2004
2003
2002
$92,321
2,199
(8,319)
—
$51,345
3,035
—
—
$30,333
7,994
(2,847)
2,153
$86,201
$54,380
$37,633
Funds from operations was derived from our segments as follows (unaudited) (in thousands):
Book Equity
December 31, 2004 (1)
Average Invested
Common Equity for
the Year Ended
December 31, 2004 (2)
FFO for
the Year Ended
December 31, 2004
Return on Invested
Common Equity (ROE)
for the Year Ended
December 31, 2004 (3)
ROE for
the Year Ended
December 31, 2003 (3)
Real estate securities and
real estate related loans
Residential mortgage loans
Operating real estate
Unallocated (1)
Total (2)
Preferred stock
Accumulated depreciation
Accumulated other
comprehensive income
Net book equity
$625,703
46,291
68,279
(69,330)
670,943
62,500
(8,498)
71,770
$796,715
$502,731
35,682
60,021
(2,037)
$596,397
$ 103,245
5,953
5,533
(28,530)
$ 86,201
20.5%
16.7%
9.2%
N/A
14.5%
23.2%
25.7%
12.2%
N/A
16.4%
(1) Unallocated FFO represents $(6,094) of preferred dividends and $(22,436) of corporate general and administrative expense, management fees and incentive compensation.
(2) Invested common equity is equal to book equity excluding preferred stock, accumulated depreciation and accumulated other comprehensive income.
(3) FFO divided by average invested common equity.
p.24
R E L AT E D PA R T Y T R A N S AC T I O N S
In November 2003, we and a private investment fund managed by an affiliate of our manager co-invested and each indirectly own an
approximately 38% interest in a limited liability company that acquired a pool of franchise loans from a third party financial institution. Our
investment in this entity, reflected as an investment in an unconsolidated subsidiary on our consolidated balance sheet, was approximately
$23.5 million at December 31, 2004. The remaining approximately 24% interest in the limited liability company is owned by the above-
referenced third party financial institution.
In January 2004, we purchased, in a private placement from an underwriter, $31.5 million face amount of B and BB rated securities of
Global Signal Trust I, a special purpose vehicle established by Global Signal Inc. Two of our directors are the CEO and President of Global
Signal, Inc., respectively. A private equity fund managed by an affiliate of our manager owns a significant portion of Global Signal Inc.’s
common stock. Approximately $418.0 million face amount of Global Signal Trust I securities were issued in 7 classes, rated AAA though B,
of which the B and BB classes constituted $73.0 million. The balance of the B and BB securities was sold on identical terms to a private
investment fund managed by an affiliate of our manager and to a large third party mutual fund complex. The proceeds of the offering were
utilized by Global Signal Inc. to repay an existing credit facility, to pay an extraordinary dividend of approximately $140 million to its stock-
holders of which approximately $67 million was paid to the above-referenced private equity fund, and for general working capital purposes.
In December 2004, through our warehouse, we placed a deposit of approximately $2.6 million on $17.0 million of BB rated securities of
Global Signal Trust II, a special purpose vehicle established by Global Signal, Inc. Pursuant to an underwritten 144A offering, approximately
$293.8 million of Global Signal Trust II securities were issued in 7 classes, rated AAA through BB–, of which the BB class constituted
approximately $35.4 million.
In March 2004, we and a private investment fund managed by an affiliate of our manager co-invested and each indirectly own an
approximately 49% interest in two limited liability companies that have acquired, in a sale-leaseback transaction, a portfolio of convenience
and retail gas stores from a public company. The properties are subject to a number of master leases, the initial term of which in each case is
a minimum of 15 years. This investment was financed with nonrecourse debt at the limited liability company level and our investment in this
entity, reflected as an investment in an unconsolidated subsidiary on our consolidated balance sheet, was approximately $17.8 million at
December 31, 2004.
In December 2004, we and a private investment fund managed by an affiliate of our manager each made an initial investment in a new
real estate related loan with a maximum loan amount of $128 million, subject to being drawn down under certain conditions. The loan is
secured by a first mortgage on a large development project and related assets. We own a 27.3% interest in the loan and the private investment
fund owns a 72.7% interest in the loan. Major decisions require the unanimous approval of holders of interests in the loan while for other
decisions, holders of interests in the loan vote based on their percentage interest therein. We and our affiliated investment fund are each
entitled to transfer all or any portion of our respective interests in the loan to third parties. Our investment in this loan was approximately
$11.9 million at December 31, 2004.
In January 2005, we entered into a servicing agreement with a portfolio company of a private equity fund advised by an affiliate of our
manager for them to service a portfolio of manufactured housing loans. As compensation under the servicing agreement, the portfolio
company will receive, on a monthly basis, a net servicing fee equal to 1.00% per annum on the unpaid principal balance of the loans being
serviced. We acquired a portfolio of such loans in January 2005 at a cost of $308.2 million.
In each instance described above, affiliates of our manager have an investment in the applicable affiliated fund and receive from the fund,
in addition to management fees, incentive compensation if the fund’s aggregate investment returns exceed certain thresholds.
Q UA N T I TAT I V E A N D Q UA L I TAT I V E D I S C LO S U R E S A B O U T M A R K E T R I S K .
Market risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates, commodity
prices and equity prices. The primary market risks that we are exposed to are interest rate risk, credit spread risk and foreign currency
exchange rate risk. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and interna-
tional economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabilities and related
derivative positions are for non-trading purposes only. For a further understanding of how market risk may effect our financial position
or operating results, please refer to the “Application of Critical Accounting Policies” section of “Management’s Discussion and Analysis of
Financial Condition and Results of Operations.”
Newcastle Investment Corp. and Subsidiaries
p.25
management’s discussion and analysis of financial condition
and results of operations (continued)
Interest Rate Exposure
Our primary interest rate exposures relate to our real estate securities, loans and floating rate debt obligations, as well as our interest rate
swaps and caps. Changes in the general level of interest rates can effect our net interest income, which is the difference between the interest
income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges.
Changes in the level of interest rates also can effect, among other things, our ability to acquire real estate securities and loans, the value of our
real estate securities, loans and derivatives, and our ability to realize gains from the settlement of such assets. While our strategy is to utilize
interest rate swaps, caps and match-funded financings in order to limit the effects of changes in interest rates on our operations, there can be
no assurance that our profitability will not be adversely affected during any period as a result of changing interest rates. As of December 31,
2004, a 100 basis point increase in short-term interest rates would increase our earnings by approximately $0.7 million per annum.
While we have not experienced any significant credit losses, 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 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, and as interest rates decrease, the value of such securities will increase. In general, we would expect that over time,
decreases in the value of our real estate securities portfolio attributable to interest rate changes will be offset to some degree by increases in
the value of our swaps, and vice versa. However, the relationship between spreads on securities and spreads on swaps may vary from time to
time, resulting in a net aggregate book value increase or decline. Our real estate securities portfolio is largely financed to maturity through
long-term CBO financings that are not redeemable as a result of book value changes. Accordingly, unless there is a material impairment in
value that would result in a payment not being received on a security, changes in the book value of our portfolio will not directly affect our
recurring earnings or our ability to pay a dividend. As of December 31, 2004, a 100 basis point change in short-term interest rates would
impact our net book value by approximately $47.0 million.
Our general financing strategy focuses on the use of match-funded structures. This means that we seek to match the maturities of our debt
obligations with the maturities of our investments to minimize the risk that we have to refinance our liabilities prior to the maturities of our
assets, and to reduce the impact of changing interest rates on our earnings. In addition, we generally match-fund interest rates on our invest-
ments with like-kind debt (i.e., fixed rate assets are financed with fixed rate debt and floating rate assets are financed with floating rate debt),
directly or through the use of interest rate swaps, caps, or other financial instruments, or through a combination of these strategies, which
allows us to reduce the impact of changing interest rates on our earnings. Our real estate securities and real estate related loan portfolio,
excluding the ICH CMO loans as described below, and their respective liabilities had a weighted average life of 5.37 years and 5.72 years,
respectively, as of December 31, 2004. 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 swaps are agreements in which a series of interest rate flows are exchanged with a third party (counterparty) over a prescribed
period. The notional amount on which swaps are based is not exchanged. In general, our swaps are “pay fixed” swaps involving the exchange
of floating rate interest payments from the counterparty for fixed interest payments from us. This can effectively convert a floating rate debt
obligation into a fixed rate debt obligation.
Similarly, an interest rate cap or floor agreement is a contract in which we purchase a cap or floor contract on a notional face amount. We
will make an up-front payment to the counterparty for which the counterparty agrees to make future payments to us should the reference rate
(typically one- or three-month LIBOR) rise above (cap agreements) or fall below (floor agreements) the “strike” rate specified in the contract.
Should the reference rate rise above the contractual strike rate in a cap, we will earn cap income; should the reference rate fall below the
contractual strike rate in a floor, we will earn floor income. Payments on an annualized basis will equal the contractual notional face amount
multiplied by the difference between the actual reference rate and the contracted strike rate.
While a REIT may utilize these types of derivative instruments to hedge interest rate risk on its liabilities or for other purposes, such
derivative instruments could generate income that is not qualified income for purposes of maintaining REIT status. As a consequence, we
may only engage in such instruments to hedge such risks within the constraints of maintaining our standing as a REIT. We do not enter into
derivative contracts for speculative purposes nor as a hedge against changes in credit risk.
Our hedging transactions using derivative instruments also involve certain additional risks such as counterparty credit risk, the enforce-
ability of hedging contracts and the risk that unanticipated and significant changes in interest rates will cause a significant loss of basis in the
contract. The counterparties to our derivative arrangements are major financial institutions with high credit ratings with which we and our
p.26
affiliates may also have other financial relationships. As a result, we do not anticipate that any of these counterparties will fail to meet their
obligations. There can be no assurance that we will be able to adequately protect against the foregoing risks and will ultimately realize an
economic benefit that exceeds the related amounts incurred in connection with engaging in such hedging strategies.
Credit Spread Curve Exposure
Our real estate securities are also subject to spread risk. Our fixed rate securities are valued based on a market credit spread over the rate
payable on fixed rate U.S. Treasuries of like maturity. In other words, their value is dependent on the yield demanded on such securities by
the market based on their credit relative to U.S. Treasuries. Excessive supply of such securities combined with reduced demand will generally
cause the market to require a higher yield on such securities, resulting in the use of a higher (or “wider”) spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities. Under such conditions, the value of our 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
effected similarly by changes in LIBOR spreads. Such changes in the market value of our real estate securities portfolio may effect our net
equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our
ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital.
Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also effect
the yield required on our 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 spreads.
Our loan portfolios are also subject to spread risk. Our floating rate loans are valued based on a market credit spread to LIBOR. The
value of these loans is dependent upon 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 bench-
mark rate (usually the applicable LIBOR yield). Our fixed rate loans are valued based on a market credit spread over U.S. Treasuries and are
effected 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 decreases in the value of our loan portfolios due to spread changes would effect us in the same way as similar changes to our real
estate securities portfolio as described above, except that our loan portfolios are not marked to market.
As of December 31, 2004, a 25 basis point movement in credit spreads would impact our net book value by approximately $39.7 million,
but would not directly affect our earnings or cash flow.
Currency Rate Exposure
Our primary foreign currency exchange rate exposures relate to our operating real estate and related leases. Our principal direct currency
exposures are to the Euro and the Canadian Dollar. Changes in the currency rates can adversely impact the fair values and earnings streams
of our non-U.S. holdings. We have attempted to mitigate this impact in part by utilizing local currency-denominated financing on our foreign
investments to partially hedge, in effect, these assets.
We have investments in the LIV portfolio and the Bell Canada portfolio. These properties are financed utilizing debt denominated in
their respective local currencies (the Euro and the Canadian Dollar). The net equity invested in these portfolios at December 31, 2004,
approximately $12.5 million and $22.3 million, respectively, is exposed to foreign currency exchange risk.
Fair Value
For certain of our financial instruments, fair values are not readily available since there are no active trading markets as characterized
by current exchanges between willing parties. Accordingly, fair values can only be derived or estimated for these instruments using various
valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the
risks involved. However, the determination of estimated future cash flows is inherently subjective and imprecise. We note that minor changes
in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values, and that the fair values
reflected below are indicative of the interest rate, credit spread and currency rate environments as of December 31, 2004 and do not take into
consideration the effects of subsequent interest rate, credit spread or currency rate fluctuations.
We note that the values of our investments in real estate securities, loans and derivative instruments, primarily interest rate hedges on our
debt obligations, are sensitive to changes in market interest rates, interest rate spreads, credit spreads and other market factors. The value of
these investments can vary, and has varied, materially from period to period.
Newcastle Investment Corp. and Subsidiaries
p.27
management’s discussion and analysis of financial condition
and results of operations (continued)
Interest Rate and Credit Spread Risk—We held the following interest rate and credit spread risk sensitive instruments at December 31,
2004 (in thousands):
Assets:
Real estate securities, available for sale (1)
Real estate securities portfolio deposit (2)
Real estate related loans (3)
Residential mortgage loans (4)
Interest rate caps, treated as hedges (5)
Total return swap (6)
Liabilities:
CBO bonds payable (7)
Other bonds payable (8)
Notes payable (9)
Repurchase agreements (10)
Interest rate swaps, treated as hedges (11)
Non-hedge derivative obligations (12)
December 31, 2004
Carrying Value
December 31,
2004
2003
Principal
Balance or
Notional
Amount
Weighted
Average
Yield/
Funding Cost
Maturity
Date
Fair Value
December 31,
2004
2003
$3,369,496
25,411
591,890
654,784
3,554
399
$2,192,727
19,541
402,784
586,237
8,294
—
2,656,510
222,266
652,000
490,620
13,239
796
1,793,533
260,674
154,562
715,783
28,881
747
$3,315,253
(2)
594,388
645,381
375,019
(6)
2,681,395
222,729
652,000
490,620
2,011,418
(12)
6.19%
(2)
7.44%
3.71%
N/A
N/A
4.59%
6.69%
2.72%
3.67%
N/A
N/A
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
$3,369,496
25,411
600,528
654,784
3,554
399
2,720,704
227,510
652,000
490,620
13,239
796
$2,192,727
19,541
429,860
586,237
8,294
—
1,836,628
282,014
155,058
715,783
28,881
747
(1)
(2)
(3)
These securities contain various terms, including fixed and floating rates, self-amortizing and interest only. Their weighted average maturity is 5.76 years. The fair value of
these securities is estimated by obtaining third party broker quotations, if available and practicable, and counterparty quotations.
The fair value of the real estate securities portfolio deposit, which is treated as a non-hedge derivative, is estimated by obtaining third party broker quotations on the underly-
ing securities, if available and practicable, and counterparty quotations, including a counterparty quotation on the portion of the fair value resulting from the Excess Carry
Amount, as defined, earned on such deposit. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”
for a further discussion of this deposit.
Represents the following loans:
Name
B-Notes
Mezzanine loans
Bank loans
Real estate loans
ICH CMO loans
Carrying
Value
$133,344
80,052
146,909
28,911
202,674
Loan
Count
23
4
3
2
123
Weighted
Average
Yield
6.44%
5.25%
6.73%
16.55%
8.16%
$591,890
155
7.44%
Weighted Average
Maturity (Years)
Floating Rate
Loans as a % of
Carrying Amount
2.30
1.97
1.99
1.24
2.86
2.32
85.6%
100.0%
100.0%
58.9%
1.8%
61.1%
Fair
Value
$133,617
80,052
146,909
28,911
211,039
$600,528
The fixed rate B-Notes were valued by obtaining counterparty quotations. The rest of the B-Notes as well as the mezzanine loans, bank loans, and real estate loans, with one
exception, bear floating rates of interest and we believe that, for similar financial instruments with comparable credit risks, their effective rates approximate market rates.
Accordingly, the carrying amounts outstanding are believed to approximate fair value. The one fixed rate loan was purchased on December 29, 2004 and therefore its carrying
amount is believed to approximate fair value. The ICH CMO loans were valued by discounting expected future receipts by a rate calculated based on current market conditions
for comparable financial instruments, including market interest rates and credit spreads.
This portfolio of mortgage loans bears a floating rate of interest and has a weighted average maturity of 3.84 years. We believe that, for similar financial instruments
with comparable credit risks, the effective rate on this portfolio approximates a market rate. Accordingly, the carrying amount of this portfolio is believed to approximate fair
value.
(4)
(5) Represents cap agreements as follows:
Notional Balance
Effective Date
Maturity Date
Capped Rate
Strike Rate
Fair Value
$295,400
18,000
8,619
53,000
$375,019
Current
January 2010
December 2010
May 2011
March 2009
October 2015
June 2015
September 2015
1-Month LIBOR
3-Month LIBOR
3-Month LIBOR
1-Month LIBOR
6.50%
8.00%
7.00%
7.50%
$ 585
592
863
1,514
$ 3,554
(6)
The fair value of these agreements is estimated by obtaining counterparty quotations.
Represents a total return swap which is treated as a non-hedge derivative. The fair value of this agreement, which is included in derivative assets, is estimated by obtaining
a counterparty quotation. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for a further
discussion of this swap.
p.28
(7)
(8)
(9)
These bonds were valued by discounting expected future payments by a rate calculated based on current market conditions for comparable financial instruments, including
market interest rates and credit spreads. The weighted average maturity of the CBO bonds payable is 6.78 years. The CBO bonds payable amortize principal prior to maturity
based on collateral receipts, subject to reinvestment requirements.
The Bell Canada bonds were valued, in U.S. dollars at the period end exchange rate, by discounting expected future payments by a rate calculated by imputing a spread over
a market index on the date of borrowing. It amortizes principal periodically with a balloon payment at maturity in April 2012. The ICH CMO bonds were valued by discount-
ing expected future payments by a rate calculated based on current market conditions for comparable financial instruments, including market interest rates and credit spreads.
They amortize principal prior to maturity based on collateral receipts and their final stated maturity is in August 2030.
The LIV mortgage was valued, in U.S. dollars at the period end exchange rate, by discounting expected future payments by a rate calculated by imputing a spread over a
market index on the date of borrowing. It was repaid in December 2004. The first real estate related loan financing matures in November 2006, bears a floating rate of interest
and amortizes principal based on collateral receipts. The second real estate related loan financing matures in February 2006, after an extension, bears a floating rate of inter-
est, and amortizes principal based on collateral receipts. The residential mortgage loan financing matures in November 2007, bears a floating rate of interest, and is subject to
adjustment monthly based on the agreed upon market value of the loan portfolio. We believe that, for similar financial instruments with comparable credit risks, their effective
rates approximate market rates. Accordingly, the carrying amounts outstanding are believed to approximate fair value.
(10) These agreements bear floating rates of interest and we believe that, for similar financial instruments with comparable credit risks, the effective rates approximate market
rates. Accordingly, the carrying amounts outstanding are believed to approximate fair value. These agreements mature in one to ten months.
(11) Represents swap agreements as follows (in thousands):
Notional Balance
Effective Date
Maturity Date
Swapped Rate
Fixed Rate
Fair Value
$
33,299
295,400
290,000
276,060
192,500
165,300
189,373
11,000
7,500
5,500
65,200
6,500
236,582
85,757
81,571
28,081
21,295
20,500
$ 2,011,418
*up to 6.50%
Current
Current
Current
Current
Current
Current
Current
Current
Current
Current
Current
Current
January 2005
Current
Current
Current
Current
Current
July 2005
March 2009
April 2011
March 2013
March 2015
March 2014
September 2014
November 2008
July 2018
November 2018
January 2009
March 2009
February 2014
October 2009
September 2009
December 2009
January 2009
September 2011
1-Month LIBOR
1-Month LIBOR*
3-Month LIBOR
3-Month LIBOR
1-Month LIBOR
3-Month LIBOR
3-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
1-Month LIBOR
6.1755%
3.1250%
5.9325%
3.8650%
4.8880%
3.9945%
4.3731%
3.5400%
4.8300%
4.4800%
3.6500%
3.3360%
4.2070%
3.7150%
3.7090%
3.8290%
3.2900%
4.2225%
$
366
(4,547)
26,181
(7,888)
6,868
(4,708)
(2,534)
(97)
118
28
(405)
(126)
640
(116)
(104)
38
(476)
1
$ 13,239
The fair value of these agreements is estimated by obtaining counterparty quotations. A positive fair value represents a liability.
(12) These are two essentially offsetting interest rate caps and two essentially offsetting interest rate swaps, each with notional amounts of $32.5 million, an interest rate cap with
a notional balance of $17.5 million, and two interest rate swaps with notional amounts of $26.3 million and $2.0 million. The maturity date of the purchased swap is July
2009; the maturity date of the sold swap is July 2014, the maturity date of the $32.5 million caps is July 2038, the maturity date of the $17.5 million cap is July 2009, and the
maturity dates of the latter two interest rate swaps are February 2014 and January 2009, respectively. The fair value of these agreements is estimated by obtaining counter-
party quotations.
Currency Risk—We held the following currency rate risk sensitive balances at December 31, 2004 (unaudited) (U.S. dollars; in
thousands, except exchange rates):
Carrying
Amount
(USD)
Local
Currency
Current
Exchange
Rate to USD
Effect of a 5%
Negative Change
in Euro Rate
Effect of a 5%
Negative Change
in CAD Rate
Assets:
LIV portfolio
Bell Canada portfolio
LIV other, net
Bell Canada other, net
Liabilities:
Bell Canada bonds
Total at December 31, 2004
Total at December 31, 2003
$12,376
57,193
156
7,542
Euro
CAD
Euro
CAD
0.7378
1.2019
0.7378
1.2019
42,422
CAD
1.2019
$ (619)
N/A
(8)
N/A
N/A
$ (627)
$ (277)
N/A
$ (2,860)
N/A
(377)
2,121
$ (1,116)
$ (1,045)
USD refers to U.S. dollars; CAD refers to Canadian dollars.
Newcastle Investment Corp. and Subsidiaries
p.29
consolidated balance sheets
(dollars in thousands, except share data)
ASSETS
Real estate securities, available for sale—Note 4
Real estate securities portfolio deposit—Note 4
Real estate related loans, net—Note 5
Investments in unconsolidated subsidiaries—Note 3
Operating real estate, net—Note 6
Real estate held for sale—Note 6
Residential mortgage loans, net—Note 5
Cash and cash equivalents
Restricted cash
Derivative assets—Note 7
Deferred costs, net
Receivables and other assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
CBO bonds payable—Note 8
Other bonds payable—Note 8
Notes payable—Note 8
Repurchase agreements—Note 8
Derivative liabilities—Note 7
Dividends payable
Due to affiliates—Note 10
Accrued expenses and other liabilities
Commitments and contingencies—Notes 9, 10 and 11
Stockholders’ Equity
Preferred stock, $0.01 par value, 100,000,000 shares authorized,
2,500,000 shares of Series B Cumulative Redeemable Preferred Stock,
liquidation preference $25.00 per share, issued and outstanding
Common stock, $0.01 par value, 500,000,000 shares authorized, 39,859,481 and
31,374,833 shares issued and outstanding at December 31, 2004 and 2003, respectively
Additional paid-in capital
Dividends in excess of earnings—Note 2
Accumulated other comprehensive income—Note 2
See notes to consolidated financial statements.
p.30
December 31,
2004
2003
$3,369,496
25,411
591,890
41,230
57,193
12,376
654,784
37,911
77,974
27,122
2,043
35,290
$2,192,727
19,541
402,784
30,640
102,995
29,404
586,237
60,403
70,103
25,512
2,010
27,943
$4,932,720
$3,550,299
$2,656,510
222,266
652,000
490,620
39,661
25,928
8,963
40,057
$1,793,533
260,674
154,562
715,783
49,675
16,703
2,445
17,561
4,136,005
3,010,936
—
—
62,500
62,500
399
676,015
(13,969)
71,770
796,715
314
451,806
(14,670)
39,413
539,363
$4,932,720
$3,550,299
consolidated statements of income
(dollars in thousands, except share data)
Revenues
Interest income
Rental and escalation income
Gain on settlement of investments, net
Management fee from affiliate—Note 3
Incentive income from affiliate—Note 3
Expenses
Interest expense
Property operating expense
Loan and security servicing expense
General and administrative expense
Management fee to affiliate—Notes 3 and 10
Incentive compensation to affiliate—Notes 3 and 10
Depreciation and amortization
Income before equity in earnings of unconsolidated subsidiaries
Equity in earnings of unconsolidated subsidiaries—Note 3
Income taxes on related taxable subsidiaries—Note 12
Income from continuing operations
Income (loss) from discontinued operations—Note 6
Net Income
Preferred dividends and related accretion
Income Available for Common Stockholders
Net Income Per Share of Common Stock
Basic
Diluted
Income from continuing operations per share of common stock,
after preferred dividends and related accretion
Basic
Diluted
Income (loss) from discontinued operations per share of common stock
Basic
Diluted
Weighted Average Number of Shares of Common Stock Outstanding
Basic
Diluted
Dividends Declared Per Share of Common Stock
See notes to consolidated financial statements.
Year Ended December 31,
2004
2003
2002
$ 226,674
13,502
17,970
—
—
$ 134,672
16,203
13,179
—
—
$ 73,214
13,520
11,389
4,470
(1,218)
258,146
164,054
101,375
138,847
7,281
3,057
4,638
10,620
7,959
1,304
79,084
7,819
2,154
3,194
6,468
6,226
1,194
173,706
106,139
84,440
12,465
(2,508)
94,397
4,018
98,415
(6,094)
57,915
862
—
58,777
(2,659)
56,118
(4,773)
46,375
6,928
655
2,356
9,250
2,856
1,560
69,980
31,395
362
—
31,757
(262)
31,495
(1,162)
$ 92,321
$ 51,345
$ 30,333
$
$
2.50
2.46
$
$
1.98
1.96
$
$
1.68
1.68
$
$
$
$
2.39
2.35
$
$
2.08
2.06
$
$
1.69
1.69
0.11
$
(0.10)
$
(0.01)
0.11
$
(0.10)
$
(0.01)
36,943,752 25,898,288 18,080,298
37,557,790 26,140,777 18,090,052
$ 2.425
$ 1.950
$ 2.050
Newcastle Investment Corp. and Subsidiaries
p.31
consolidated statements of stockholders’ equity and redeemable preferred stock
For the Years Ended December 31, 2004, 2003 and 2002
(dollars in thousands)
Preferred Stock
Common Stock
Stockholders’ Equity—December 31, 2003
Dividends declared
Issuance of common stock
Issuance of common stock to directors
Exercise of common stock options
Comprehensive income:
Net income
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized gain on derivatives designated as cash flow hedges
Reclassification of realized loss on derivatives designated as cash flow hedges into earnings
Shares
2,500,000
—
—
—
—
—
—
—
—
—
—
—
Amount
$ 62,500
—
—
—
—
—
—
—
—
—
—
—
Amount
$ 314
Shares
31,374,833
—
8,375,000
2,148
107,500
Total comprehensive income
Stockholders’ Equity—December 31, 2004
Stockholders’ Equity—December 31, 2002
Dividends declared
Issuance of preferred stock
Issuance of common stock
Issuance of common stock to directors
Exercise of common stock options
Comprehensive income:
Net income
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized (loss) on derivatives designated as cash flow hedges
Total comprehensive income
Stockholders’ Equity—December 31, 2003
2,500,000
$ 62,500
39,859,481
$ 399
$ 676,015
$ (13,969)
—
—
2,500,000
—
—
—
—
—
—
—
—
—
$ —
—
62,500
—
—
—
—
—
—
—
—
—
2,500,000
$ 62,500
31,374,833
$ 314
$ 451,806
$ (14,670)
$ 39,413
$ 539,363
Redeemable Preferred Stock
Stockholders’ Equity—December 31, 2001
Dividends declared by predecessor prior to commencement of our operations
Distribution to predecessor upon commencement of our operations
Dividends declared to predecessor after commencement of our operations,
but prior to our initial public offering
Redemption of redeemable preferred stock
Initial public offering of shares of common stock
Dividends declared subsequent to our initial public offering
Comprehensive income:
Net income
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized (loss) on derivatives designated as cash flow hedges
Reclassification of realized (gain) on derivatives designated as cash flow hedges into earnings
Total comprehensive income
Stockholders’ Equity—December 31, 2002
See notes to consolidated financial statements.
p.32
1,020,517
—
—
—
(1,020,517)
—
—
—
—
—
—
—
—
—
—
$ 20,410
—
—
—
(20,410)
—
—
—
—
—
—
—
—
—
$ —
23,488,517
$ 235
$ 290,935
$ (13,966)
$ 7,037
$ 284,241
Additional
Paid-In
Capital
$ 451,806
222,721
1,428
—
60
—
—
—
—
—
—
—
—
30
35
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
(2,436)
163,242
(98,378)
79,957
Dividends
in Excess
of Earnings
$ (14,670)
(97,714)
98,415
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
$ (13,966)
(56,822)
56,118
$ (7,767)
(20,949)
(7,584)
(9,161)
31,495
Accumulated Other
Comprehensive
Income
$ 39,413
34,088
(14,574)
1,984
(1,478)
11,973
364
$ 71,770
$ 7,037
23,670
(13,185)
4,653
396
16,842
$ 8,791
(11,075)
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
62,170
(4,364)
4,387
(496)
(52,102)
(274)
Total
Stockholders’
Equity
$ 539,363
(97,714)
222,805
60
1,429
98,415
34,088
(14,574)
1,984
(1,478)
11,973
364
130,772
$ 796,715
$ 284,241
(56,822)
60,064
163,321
30
35
56,118
23,670
(13,185)
4,653
396
16,842
88,494
$ 310,545
(20,949)
(109,453)
(7,584)
—
80,027
(9,161)
31,495
62,170
(4,364)
4,387
(496)
(52,102)
(274)
40,816
—
84
—
1
—
—
—
—
—
—
—
—
—
79
—
—
—
—
—
—
—
—
—
—
—
—
70
—
—
—
—
—
—
—
—
23,488,517
$ 235
$ 290,935
16,488,517
$ 165
$ 309,356
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
7,882,276
1,540
2,500
7,000,000
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized gain on derivatives designated as cash flow hedges
Reclassification of realized loss on derivatives designated as cash flow hedges into earnings
Stockholders’ Equity—December 31, 2003
Dividends declared
Issuance of common stock
Issuance of common stock to directors
Exercise of common stock options
Comprehensive income:
Net income
Unrealized gain on securities
Total comprehensive income
Stockholders’ Equity—December 31, 2004
Stockholders’ Equity—December 31, 2002
Dividends declared
Issuance of preferred stock
Issuance of common stock
Issuance of common stock to directors
Exercise of common stock options
Comprehensive income:
Net income
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized (loss) on derivatives designated as cash flow hedges
Total comprehensive income
Stockholders’ Equity—December 31, 2003
Stockholders’ Equity—December 31, 2001
Dividends declared by predecessor prior to commencement of our operations
Distribution to predecessor upon commencement of our operations
Dividends declared to predecessor after commencement of our operations,
but prior to our initial public offering
Redemption of redeemable preferred stock
Initial public offering of shares of common stock
Dividends declared subsequent to our initial public offering
Comprehensive income:
Net income
Unrealized gain on securities
Reclassification of realized (gain) on securities into earnings
Foreign currency translation
Reclassification of realized foreign currency translation into earnings
Unrealized (loss) on derivatives designated as cash flow hedges
Reclassification of realized (gain) on derivatives designated as cash flow hedges into earnings
Total comprehensive income
Stockholders’ Equity—December 31, 2002
See notes to consolidated financial statements.
Preferred Stock
Shares
2,500,000
Amount
$ 62,500
2,500,000
$ —
62,500
Redeemable Preferred Stock
1,020,517
$ 20,410
(1,020,517)
(20,410)
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
Common Stock
Shares
31,374,833
—
8,375,000
2,148
107,500
—
—
—
—
—
—
—
Amount
$ 314
—
84
—
1
—
—
—
—
—
—
—
Additional
Paid-In
Capital
$ 451,806
—
222,721
60
1,428
—
—
—
—
—
—
—
Dividends
in Excess
of Earnings
$ (14,670)
(97,714)
—
—
—
98,415
—
—
—
—
—
—
2,500,000
$ 62,500
39,859,481
$ 399
$ 676,015
$ (13,969)
23,488,517
—
—
7,882,276
1,540
2,500
—
—
—
—
—
—
$ 235
—
—
79
—
—
—
—
—
—
—
—
$ 290,935
—
(2,436)
163,242
30
35
—
—
—
—
—
—
$ (13,966)
(56,822)
—
—
—
—
56,118
—
—
—
—
—
Accumulated Other
Comprehensive
Income
$ 39,413
—
—
—
—
—
34,088
(14,574)
1,984
(1,478)
11,973
364
$ 71,770
$ 7,037
—
—
—
—
—
—
23,670
(13,185)
4,653
396
16,842
Total
Stockholders’
Equity
$ 539,363
(97,714)
222,805
60
1,429
98,415
34,088
(14,574)
1,984
(1,478)
11,973
364
130,772
$ 796,715
$ 284,241
(56,822)
60,064
163,321
30
35
56,118
23,670
(13,185)
4,653
396
16,842
88,494
2,500,000
$ 62,500
31,374,833
$ 314
$ 451,806
$ (14,670)
$ 39,413
$ 539,363
16,488,517
—
—
—
—
7,000,000
—
—
—
—
—
—
—
—
$ 165
—
—
—
—
70
—
—
—
—
—
—
—
—
$ 309,356
—
(98,378)
—
—
79,957
—
—
—
—
—
—
—
—
$ (7,767)
(20,949)
—
(7,584)
—
—
(9,161)
31,495
—
—
—
—
—
—
$ 8,791
—
(11,075)
—
—
—
—
—
62,170
(4,364)
4,387
(496)
(52,102)
(274)
$ 310,545
(20,949)
(109,453)
(7,584)
—
80,027
(9,161)
31,495
62,170
(4,364)
4,387
(496)
(52,102)
(274)
40,816
—
$ —
23,488,517
$ 235
$ 290,935
$ (13,966)
$ 7,037
$ 284,241
Newcastle Investment Corp. and Subsidiaries
p.33
consolidated statements of cash flow
(dollars in thousands)
Cash Flows from Operating Activities
Net income
Adjustments to reconcile net income to net cash provided by operating
activities (inclusive of amounts related to discontinued operations):
Depreciation and amortization
Accretion of discount and other amortization
Equity in earnings of unconsolidated subsidiaries
Accrued incentive (income) loss from affiliate
Non-cash incentive compensation to affiliate
Deferred rent
Gain on settlement of investments
Unrealized gain on non-hedge derivatives
Non-cash directors’ compensation
Change in:
Restricted cash
Receivables and other assets
Due to affiliates
Accrued expenses and other liabilities
Net cash provided by operating activities:
Cash Flows from Investing Activities
Purchase of real estate securities
Proceeds from sale of real estate securities
Deposit on real estate securities (treated as a derivative)
Purchase of loans
Proceeds from settlement of loans
Repayments of loan and security principal
Purchase and improvement of operating real estate
Proceeds from sale of operating real estate
Contributions to unconsolidated subsidiaries
Distributions from unconsolidated subsidiaries
Payment of deferred transaction costs
Year Ended December 31,
2004
2003
2002
$
98,415
$
56,118
$ 31,495
2,253
1,898
(12,465)
—
—
(1,380)
(22,029)
(3,332)
60
(8,137)
(5,431)
6,518
21,520
77,890
(1,426,762)
193,246
(80,311)
(631,728)
124,440
428,091
(141)
71,871
(26,789)
28,664
(280)
3,085
(3,761)
(862)
—
—
(1,853)
(11,789)
(3,696)
30
(2,564)
(9,403)
1,110
11,177
37,592
(1,407,948)
255,030
(59,676)
(685,311)
164,404
105,848
(576)
5,331
(30,871)
1,087
—
8,603
(4,767)
(362)
1,218
14
(1,353)
(9,619)
—
—
(3,186)
(4,449)
(1,506)
5,469
21,557
(689,255)
276,704
(37,125)
(276,612)
372
15,217
(2,250)
42,492
(19,991)
8,265
(508)
Net cash provided by (used in) investing activities
(1,319,699)
(1,652,682)
(682,691)
p.34
Cash Flows from Financing Activities
Issuance of CBO bonds payable
Repayments of CBO bonds payable
Issuance of other bonds payable
Repayments of other bonds payable
Borrowings under notes payable
Repayments of notes payable
Borrowings under repurchase agreements
Repayments of repurchase agreements
Draws under credit facility
Repayments of credit facility
Issuance of common stock
Costs related to issuance of common stock
Exercise of common stock options
Issuance of preferred stock
Costs related to issuance of preferred stock
Redemption of preferred stock
Dividends paid
Distribution of cash to predecessor
Purchase of derivative assets
Payment of deferred financing costs
Year Ended December 31,
2004
2003
2002
$ 859,719
(604)
—
(41,759)
614,106
(119,407)
654,254
(879,417)
—
—
222,805
—
1,429
—
—
—
(88,489)
—
—
(3,320)
$ 921,503
—
—
(6,413)
80,000
(906)
663,120
(195,506)
—
—
168,610
(5,289)
35
62,500
(2,436)
—
(49,280)
—
(5,482)
(426)
$ 438,787
(17,742)
37,001
(8,151)
62,952
(119,670)
246,712
—
20,000
(1,750)
91,000
(10,185)
—
—
—
(20,410)
(27,522)
(12,423)
(1,200)
(2,162)
Net cash provided by (used in) financing activities
1,219,317
1,630,030
675,237
Net Increase (Decrease) in Cash and Cash Equivalents
Cash and Cash Equivalents, Beginning of Period
Cash and Cash Equivalents, End of Period
Supplemental Disclosure of Cash Flow Information
Cash paid during the period for interest expense
Cash paid during the period for income taxes
Supplemental Schedule of Non-Cash Investing and Financing Activities
Common stock dividends declared but not paid
Preferred stock dividends declared but not paid
Deposits used in acquisition of real estate securities (treated as derivatives)
Contribution of assets to unconsolidated subsidiary
Distribution of non-cash assets and liabilities to predecessor
Consolidation of ICH CMO
See notes to consolidated financial statements.
(22,492)
60,403
14,940
45,463
14,103
31,360
$
37,911
$
60,403
$ 45,463
$ 135,172
2,639
$
$
$
80,522
—
$ 56,365
—
$
$
$
$
$
$
$
24,912
1,016
75,824
—
—
—
15,687
$
1,016
$
81,492
$
—
$
$
—
$ 221,773
9,161
$
$
—
$ 23,631
1,454
$
$ 97,030
—
$
Newcastle Investment Corp. and Subsidiaries
p.35
notes to consolidated financial statements
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
1. O R G A N I Z AT I O N
Newcastle Investment Corp. (and its subsidiaries, “Newcastle”) is a Maryland corporation that was formed in June 2002. Newcastle
conducts its business through three primary segments: (i) real estate securities and real estate related loans, (ii) operating real estate, and
(iii) residential mortgage loans.
Newcastle was formed as a subsidiary of Newcastle Investment Holdings Corp. (“Holdings”). Prior to Newcastle’s initial public offering,
Holdings contributed to Newcastle certain assets and liabilities in exchange for approximately 16.5 million shares of Newcastle’s common
stock. For accounting purposes, this transaction is presented as a reverse spin-off, whereby Newcastle is treated as the continuing entity and
the assets that were retained by Holdings and not contributed to Newcastle are accounted for as if they were distributed at their historical
book basis through a spin-off to Holdings. Newcastle’s operations commenced in July 2002. In May 2003, Holdings distributed to its
stockholders all of the shares of Newcastle’s common stock that it held, and it no longer owns any of Newcastle’s common equity.
The following table presents information on shares of Newcastle’s common stock issued subsequent to its formation:
Shares Issued
Range of Issue Prices (1)
Net Proceeds (millions)
Year
Formation
2002
2003
2004
16,488,517
7,000,000
7,886,316
8,484,648
N/A
$13.00
$20.35–$22.85
$26.30–$31.40
December 31, 2004
39,859,481
January 2005
3,879,000
$29.60
N/A
$ 80.0
$ 163.4
$ 224.3
$ 105.4
(1) Excludes shares issued pursuant to the exercise of options and shares issued to our independent directors.
In March 2003, Newcastle issued 2.5 million shares ($62.5 million face amount) of its 9.75% Series B Cumulative Redeemable Preferred
Stock (the “Series B Preferred”) in a public, registered offering for net proceeds of approximately $60.1 million. The Series B Preferred is
non-voting, has a $25 per share liquidation preference, no maturity date and no mandatory redemption. Newcastle has the option to redeem
the Series B Preferred beginning in March 2008.
Newcastle is organized and conducts its operations to qualify as a real estate investment trust (“REIT”) for federal income tax purposes.
As such, Newcastle will generally not be subject to federal income tax on that portion of its income that is distributed to stockholders if it
distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.
Newcastle is party to a management agreement (the “Management Agreement”) with Fortress Investment Group LLC (the “Manager”),
an affiliate, under which the Manager advises Newcastle on various aspects of its business and manages its day-to-day operations, subject to
the supervision of Newcastle’s board of directors. For its services, the Manager receives an annual management fee and incentive compensation,
both as defined in the Management Agreement. The Manager also manages, among other entities, Holdings and Fortress Investment Fund
LLC (“Fund I”). For a further discussion of the Management Agreement, see Note 10.
2. S U M M A R Y O F S I G N I F I CA N T AC C O U N T I N G P O L I C I E S
General
Basis of Accounting—The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted
accounting principles (“GAAP”). The consolidated financial statements include the accounts of Newcastle and its consolidated subsidiaries,
subsequent to the date of commencement of its operations, and also include the accounts of its predecessor, Holdings, prior to such date. All
significant intercompany transactions and balances have been eliminated. Newcastle consolidates those entities in which it has an investment
of 50% or more and has control over significant operating, financial and investing decisions of the entity.
In January 2003, Financial Accounting Standards Board Interpretation (“FIN”) No. 46 “Consolidation of Variable Interest Entities,”
which explains how to identify variable interest entities and how to assess whether to consolidate such entities, was issued. As a result of this
FIN, Newcastle consolidated the ICH CMO (Note 5).
In December 2003, FIN No. 46R “Consolidation of Variable Interest Entities” was issued as a modification of FIN 46. FIN 46R, which
became effective in the first quarter of 2004, clarified the methodology for determining whether an entity is a variable interest entity
(“VIE”) and the methodology for assessing who is the primary beneficiary of a VIE. VIEs are defined as entities in which equity investors
do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. A VIE is required to be consolidated by its primary beneficiary, and
only its primary beneficiary, which is defined as the party who will absorb a majority of the VIE’s expected losses or receive a majority of
the expected residual returns as a result of holding variable interests. The application of FIN 46R did not result in a change in our accounting
for any entities.
p.36
For entities over which Newcastle exercises significant influence, but which do not meet the requirements for consolidation, Newcastle
uses the equity method of accounting whereby it records its share of the underlying income of such entities. Newcastle owns an equity method
investment in two limited liability companies (Note 3) which are investment companies and therefore maintain their financial records on a
fair value basis. Newcastle has retained such accounting relative to its investments in such companies pursuant to the Emerging Issues Task
Force (“EITF”) Issue No. 85-12 “Retention of Specialized Accounting for Investments in Consolidation.”
Holdings was a Maryland corporation that invested in real estate related assets. Its primary businesses were investing in (1) real estate
securities and real estate related loans, (2) operating real estate, primarily credit leased operating real estate and (3) Fund I. Holdings’
investments in real estate securities and a portion of its investments in operating real estate were transferred to Newcastle in connection with
its organization. The operating real estate (GSA Portfolio—Note 6) and real estate related loans distributed to Holdings have been treated as
discontinued operations, because they constituted a component of an entity, while the other operations distributed to Holdings, including the
investment in Fund I, have not been treated as such, because they did not constitute a component of an entity as defined in Statement of
Financial Accounting Standards (“SFAS”) No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.”
Certain prior year amounts have been reclassified to conform to the current year presentation.
Risks and Uncertainties—In the normal course of business, Newcastle encounters primarily two significant types of economic risk:
credit and market. Credit risk is the risk of default on Newcastle’s securities, loans, leases, and derivatives that results from a borrower’s,
lessee’s or derivative counterparty’s inability or unwillingness to make contractually required payments. Market risk reflects changes in the
value of investments in securities, loans and real estate or in derivatives due to changes in interest rates, spreads or other market factors,
including the value of the collateral underlying loans and securities and the valuation of real estate held by Newcastle. Management believes
that the carrying values of its investments are reasonable taking into consideration these risks along with estimated collateral values, payment
histories, and other borrower information.
Newcastle invests in real estate located outside of the United States. Newcastle’s non-U.S. investments are subject to the same risks
associated with its United States investments as well as additional risks, such as fluctuations in foreign currency exchange rates, unexpected
changes in regulatory requirements, heightened risk of political and economic instability, difficulties in managing non-U.S. investments,
potentially adverse tax consequences and the burden of complying with a wide variety of foreign laws.
Additionally, Newcastle is subject to significant tax risks. If Newcastle were to fail to qualify as a REIT in any taxable year, Newcastle
would be subject to U.S. federal corporate income tax (including any applicable alternative minimum tax), which could be material. In addi-
tion, if Holdings failed to qualify as a REIT and Newcastle is treated as a successor to Holdings, this could cause Newcastle to likewise fail
to qualify as a REIT. Unless entitled to relief under certain statutory provisions, Newcastle would also be disqualified from treatment as a
REIT for the four taxable years following the year during which qualification is lost.
Use of Estimates—The preparation of financial statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the finan-
cial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Federal Income Taxes and Dividends—Newcastle is organized and conducts its operations to qualify as a REIT under the Internal
Revenue Code of 1986, as amended (the “Code”). A REIT will generally not be subject to U.S. federal corporate income tax on that portion
of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed
dates and complies with various other requirements.
Since Newcastle distributed 100% of its 2004, 2003 and 2002 REIT taxable income, no provision has been made for U.S. federal corporate
income taxes in the accompanying consolidated financial statements, except in connection with Newcastle’s taxable REIT subsidiary (“TRS”).
Newcastle holds one of its investments in a TRS (Note 12). Newcastle records income taxes related to this TRS using the asset and liability
method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and their respective bases.
Distributions relating to 2004, 2003 and 2002 were taxable as follows:
Book Basis
Dividends Per Share (A)
Tax Basis
Dividends Per Share (A)
2004
2003
2002
$2.425
$1.950
$0.850
$2.432
$1.843
$0.577
Ordinary
Income
76.60%
77.66%
100.00%
Capital
Gains
23.40%
22.34%
None
Return
of Capital
None
None
None
(A) The excess of book basis dividends over tax basis dividends is carried forward to the next year for tax purposes.
The distributions disclosed above do not include the distributions made by our predecessor, Holdings. Holdings made per share distribu-
tions of $1.20 in 2002 prior to the commencement of our operations. Holdings also elected to be taxed as a REIT.
Dividends in Excess of Earnings includes $(14.5) million related to the operations of our predecessor.
Newcastle Investment Corp. and Subsidiaries
p.37
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
Earnings Per Share—Newcastle is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by
dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding during each
period. Diluted EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of
common stock outstanding plus the additional dilutive effect of common stock equivalents during each period. Newcastle’s common stock
equivalents are its stock options (Note 9). During 2004, 2003 and 2002, based on the treasury stock method, Newcastle had 614,038, 242,489
and 9,754 dilutive common stock equivalents, respectively, resulting from its outstanding options. Net income available for common stock-
holders is equal to net income less preferred dividends, and less the accretion of the discount on Holdings’ Series A Preferred which was fully
redeemed in June 2002.
Comprehensive Income—Comprehensive income is defined as the change in equity of a business enterprise during a period from
transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. For Newcastle’s
purposes, comprehensive income represents net income, as presented in the statements of income, adjusted for net foreign currency translation
adjustments and unrealized gains or losses on securities available for sale and derivatives designated as cash flow hedges. The following table
summarizes our accumulated other comprehensive income:
Net unrealized gains on securities
Net unrealized (losses) on derivatives designated as cash flow hedges
Net foreign currency translation adjustments
Accumulated other comprehensive income
Revenue Recognition
December 31,
2004
2003
$ 99,875
(31,862)
3,757
$ 80,361
(44,199)
3,251
$ 71,770
$ 39,413
Real Estate Securities and Loans Receivable—Newcastle invests in securities, including commercial mortgage backed securities, senior
unsecured debt issued by property REITs, real estate related asset backed securities and agency residential mortgage backed securities.
Newcastle also invests in loans, including real estate related loans, commercial mortgage loans, residential mortgage loans and manufactured
housing loans. Newcastle determines at acquisition whether loans will be assembled into pools based on common risk characteristics (credit
quality, loan type, and date of origination); loans assembled into pools are accounted for as if each pool were a single loan. Loans receivable
are presented in the consolidated balance sheet net of any unamortized discount (or gross of any unamortized premium) and an allowance for
loan losses. Discounts or premiums are accreted into interest income on an effective yield or “interest” method, based upon a comparison of
actual collections and expected collections, through the expected maturity date of the security or loan. For loans acquired at a discount for
credit quality, the difference between contractual cash flows and expected cash flows at acquisition is not accreted (nonaccretable difference).
Income is not accrued on non-performing securities or loans; cash received on such securities or loans is treated as income to the extent of
interest previously accrued. Interest income with respect to non-discounted securities or loans is recognized on an accrual basis. Deferred
fees and costs, if any, are recognized as interest income over the terms of the securities or loans using the interest method. Upon settlement of
securities and loans, the excess (or deficiency) of net proceeds over the net carrying value of the security or loan is recognized as a gain
(or loss) in the period of settlement.
Impairment of Securities and Loans—Newcastle periodically evaluates securities and loans for impairment. Securities and loans are
considered to be impaired, for financial reporting purposes, when it is probable that Newcastle will be unable to collect all principal or interest
when due according to the contractual terms of the original agreements, or, for securities or loans purchased at a discount for credit quality,
when Newcastle determines that it is probable that it will be unable to collect as anticipated. For loans purchased at a discount for credit qual-
ity, if Newcastle determines that it is probable that it will collect more than previously anticipated, the yield accrued on such loan or security
is adjusted upward, on a prospective basis. Upon determination of impairment, Newcastle establishes specific valuation allowances, through
provisions for losses, based on the estimated fair value of the underlying collateral using a discounted cash flow analysis. The allowance for
each security or loan is maintained at a level believed adequate by management to absorb probable losses, based on periodic reviews of actual
and expected losses. It is Newcastle’s policy to establish an allowance for uncollectible interest on performing securities or loans that are past
due more than 90 days or sooner when, in the judgment of management, the probability of collection of interest is deemed to be insufficient
to warrant further accrual. Upon such a determination, those loans are deemed to be non-performing. Actual losses may differ from
Newcastle’s estimates.
Rental and Escalation Income—Contractual minimum rental income is recognized on a straight-line basis over the terms of the related
operating leases. The excess of straight-line rents above contractual amounts was $1.4 million, $1.9 million and $1.4 million during 2004,
2003 and 2002, respectively. Expense recoveries are included in rental and escalation income.
p.38
Management Fee and Incentive Income from Affiliate—These income items relate to Holdings’ investment in Fund I which was not
transferred to Newcastle and is not part of our ongoing operations. For a further discussion of this income, see Note 3.
Expense Recognition
Interest Expense—Newcastle finances its investments using both fixed and floating rate debt, including securitizations, loans and
repurchase agreements, and other financing vehicles. Certain of this debt has been issued at discounts. Discounts are accreted into interest
expense on the interest method through the expected maturity date of the financing.
Deferred Costs and Interest Rate Cap Premiums—Deferred costs consist primarily of costs incurred in obtaining financing which are
amortized over the term of such financing using the interest method. Interest rate cap premiums, which are included in Derivative Assets,
are amortized as described below. During 2004, 2003 and 2002, approximately $4.0 million, $1.5 million and $1.4 million of such costs were
amortized into interest expense, respectively.
Derivatives and Hedging Activities—All derivatives are recognized as either assets or liabilities in the statement of financial position
and measured at fair value. Fair value adjustments affect either stockholders’ equity or net income depending on whether the derivative
instrument qualifies as a hedge for accounting purposes and, if so, the nature of the hedging activity. For those derivative instruments that are
designated and qualify as hedging instruments, Newcastle designates the hedging instrument, based upon the exposure being hedged, as
either a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign operation.
Derivative transactions are entered into by Newcastle solely for risk-management purposes, except for real estate securities portfolio
deposits as described in Note 4 and the total return swap described in Note 5. The decision of whether or not a given transaction/position (or
portion thereof) is hedged is made on a case-by-case basis, based on the risks involved and other factors as determined by senior management,
including restrictions imposed by the Code among others. In determining whether to hedge a risk, Newcastle may consider whether other
assets, liabilities, firm commitments and anticipated transactions already offset or reduce the risk. All transactions undertaken as hedges are
entered into with a view towards minimizing the potential for economic losses that could be incurred by Newcastle. Generally, all derivatives
entered into are intended to qualify as hedges under GAAP, unless specifically stated otherwise. To this end, terms of hedges are matched
closely to the terms of hedged items.
Description of the Risks Being Hedged
1)
Interest rate risk, existing positions—Newcastle generally hedges the aggregate risk of interest rate fluctuations with respect to its
borrowings, regardless of the form of such borrowings, which require payments based on a variable interest rate index. Newcastle generally
intends to hedge only the risk related to changes in the benchmark interest rate (LIBOR or a Treasury rate). In order to reduce such risks,
Newcastle may enter into swap agreements whereby Newcastle would receive floating rate payments in exchange for fixed rate payments,
effectively converting the borrowing to fixed rate. Newcastle may also enter into cap agreements whereby, in exchange for a premium,
Newcastle would be reimbursed for interest paid in excess of a certain cap rate.
Interest rate risk, anticipated transactions—Newcastle may hedge the aggregate risk of interest rate fluctuations with respect to
anticipated transactions, primarily anticipated borrowings. The primary risk involved in an anticipated borrowing is that interest rates
may increase between the date the transaction becomes probable and the date of consummation. Newcastle generally intends to hedge
only the risk related to changes in the benchmark interest rate (LIBOR or a Treasury rate). This is generally accomplished through the
use of interest rate swaps.
Foreign currency rate risk, net investments—Newcastle may hedge the aggregate risk of fluctuations in the exchange rate between a
foreign currency, in which Newcastle has made a net investment, and the U.S. dollar. In order to reduce this risk, Newcastle may maintain
a short position in the applicable foreign currency. The amount of the position would be equal to the anticipated net equity in the foreign
investment at a forward date, as denominated in the foreign currency. This effectively locks in the current exchange rate on Newcastle’s
net equity position for the period of such position. At December 31, 2004, no such derivative transactions were outstanding.
2)
3)
Cash Flow Hedges
Newcastle has employed interest rate swaps primarily in two ways: (i) to hedge its exposure to changes in market interest rates with
respect to its floating rate debt and (ii) to hedge anticipated financings. Interest on approximately $375.0 million and $1,990.9 million in
principal amount of Newcastle’s floating rate debt was designated as the hedged items to interest rate cap and swap agreements, respectively,
at December 31, 2004.
To qualify for cash flow hedge accounting, interest rate swaps and caps must meet certain criteria, including (1) the items to be hedged
expose Newcastle to interest rate risk, (2) the interest rate swaps or caps are highly effective in reducing Newcastle’s exposure to interest rate risk,
and (3) with respect to an anticipated transaction, such transaction is probable. Correlation and effectiveness are periodically assessed based
upon a comparison of the relative changes in the fair values or cash flows of the interest rate swaps and caps and the items being hedged.
Newcastle Investment Corp. and Subsidiaries
p.39
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
For derivative instruments that are designated and qualify as a cash flow hedge (i.e. hedging the exposure to variability in expected future
cash flows that is attributable to a particular risk), the effective portion of the gain or loss, and net payments received or made, on the derivative
instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during
which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in
the present value of future cash flows of the hedged item, if any, is recognized in current earnings during the period of change. Ineffectiveness
of approximately $0.1 million was recorded in 2004 to Gain on Settlement of Investments. No material ineffectiveness was recorded during
the years ended December 31, 2003 or 2002. Costs incurred in connection with the purchase of interest rate caps, treated as cash flow hedges,
are amortized into interest expense based on the estimated value of such cap for each period covered by such cap.
With respect to interest rate swaps which have been designated as hedges of anticipated financings, periodic net payments are recognized
currently as adjustments to interest expense; any gain or loss from fluctuations in the fair value of the interest rate swaps is recorded as a
deferred hedging gain or loss in accumulated other comprehensive income and treated as a component of the anticipated transaction. In the
event the anticipated refinancing failed to occur as expected, the deferred hedging credit or charge would be recognized currently in income.
Newcastle’s hedges of such refinancing were terminated upon the consummation of such refinancing. As of December 31, 2004 and 2003,
$(5.5 million) and $3.4 million, of such gains (losses) were deferred, net of amortization, respectively.
During 2004, Newcastle dedesignated four of its hedge derivatives, and redesignated all or a portion thereof as hedges. As a result of this
dedesignation, since the originally hedged items are still owned by Newcastle, the unrealized loss was recorded in OCI as a deferred hedging loss
and is being amortized over the life of the hedged item. As of December 31, 2004, $0.4 million of such loss was deferred, net of amortization.
Fair Value Hedges
At December 31, 2004, Newcastle owned one interest rate swap designated as a fair value hedge of a fixed rate investment with a notional
amount of $20.5 million. Any gain or loss, as well as net payments received or made on this derivative instrument, are recorded currently in
income, as is any gain or loss (including unrealized gains or losses) on the hedged item related to changes in interest rates.
With respect to interest rate swaps which were designated as hedges of the fair value of lease payments, periodic net payments and any
gain or loss from fluctuations in the fair value of the interest rate swaps were capitalized to accumulated other comprehensive income and are
being recognized over the term of the leases as adjustments to rental income. Newcastle’s hedge of such payments was terminated in 1999. As
of December 31, 2004 and 2003, $1.0 million and $1.4 million of such losses were deferred, net of amortization, respectively.
Classification
During the years ended December 31, 2004, 2003 and 2002, Newcastle recorded an aggregate of $12.3 million, $16.8 million and $(52.4) mil-
lion of net gain (loss) to other comprehensive income and an aggregate of $2.1 million, $4.8 million and $4.6 million of gain to earnings, as
an adjustment to interest expense, respectively, related to such hedges. Newcastle expects to reclassify approximately $1.7 million of net loss
on derivative instruments from accumulated other comprehensive income to earnings during the twelve months ending December 31, 2005
due to amortization of net deferred hedge losses.
Newcastle’s derivatives are recorded on its balance sheet as follows (excluding the real estate securities portfolio deposit, which is
reported separately):
Interest rate caps (A)
Interest rate swaps (A)
Total return swaps
Non-hedge derivatives (B)
2004
2003
$ 3,554
21,001
399
2,168
$ 8,294
14,194
—
3,024
Total derivative assets
$ 27,122
$ 25,512
Interest rate swaps (A)
Interest payable
Non-hedge derivatives (B)
$ 34,240
2,457
2,964
$ 43,075
2,829
3,771
Total derivative liabilities
$ 39,661
$ 49,675
(A) Treated as hedges.
(B) Interest rates swaps and caps.
With respect to interest rate swaps and caps that have not been designated as hedges, any net payments under, or fluctuations in the fair
value of, such swaps and caps has been recognized currently in income.
p.40
Newcastle’s derivative financial instruments contain credit risk to the extent that its bank counterparties may be unable to meet the terms
of the agreements. Newcastle minimizes such risk by limiting its counterparties to highly rated major financial institutions with good credit
ratings. In addition, the potential risk of loss with any one party resulting from this type of credit risk is monitored. Management does not
expect any material losses as a result of default by other parties. Newcastle does not require collateral.
Management Fees and Incentive Compensation to Affiliate—These represent amounts due to the Manager pursuant to the Management
Agreement as well as amounts due to the Manager related to Holdings’ investment in Fund I, which were passed through Holdings’ income
statement on a gross basis through the date of the commencement of our operations. For further information on the Management Agreement,
see Note 10. For further information the Fund I related expenses, see Note 3.
Balance Sheet Measurement
Investment in Real Estate Securities—Newcastle has classified its investments in securities as available for sale. Securities available for
sale are carried at market value with the net unrealized gains or losses reported as a separate component of accumulated other comprehensive
income. At disposition, the net realized gain or loss is determined on the basis of the cost of the specific investments and is included in earnings.
Unrealized losses on securities are charged to earnings if they reflect a decline in value that is other than temporary. A decline in value is
considered other than temporary if either (a) it is deemed probable that Newcastle will be unable to collect all amounts anticipated to be
collected at acquisition, or (b) Newcastle does not have the ability and intent to hold such investment until a forecasted market price recovery.
Investment in Loans—Loans receivable are presented net of any unamortized discount (or gross of any unamortized premium) and an
allowance for loan losses.
Investment in Operating Real Estate—Operating real estate is recorded at cost less accumulated depreciation. Depreciation is computed
on a straight-line basis. Buildings are depreciated over 40 years. Major improvements are capitalized and depreciated over their estimated
useful lives. Fees and costs incurred in the successful negotiation of leases are deferred and amortized on a straight-line basis over the terms
of the respective leases. Expenditures for repairs and maintenance are expensed as incurred. Newcastle adopted SFAS No. 144 “Accounting
for the Impairment or Disposal of Long-Lived Assets” in 2002. Pursuant to such pronouncement, Newcastle reviews its real estate assets for
impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.
No material impairment was recorded during 2004, 2003 or 2002. SFAS No. 144 also specifies that long-lived assets to be disposed of by
sale, which meet certain criteria, should be reclassified to Real Estate Held for Sale and measured at the lower of its carrying amount or fair
value less costs of sale. As of December 31, 2004 and 2003, Newcastle had one and five properties classified as Real Estate Held for Sale,
respectively (Note 6). The results of operations for such an asset, assuming such asset qualifies as a “component of an entity” as defined in
SFAS No. 144, are retroactively reclassified to Income (Loss) from Discontinued Operations for all periods presented.
Foreign Currency Investments—Assets and liabilities relating to foreign investments are translated using exchange rates as of the end of
each reporting period. The results of Newcastle’s foreign operations are translated at the weighted average exchange rate for each reporting
period. Translation adjustments are included as a component of accumulated other comprehensive income.
Foreign exchange contracts may, from time to time, be used to hedge Newcastle’s net foreign investments. Gains and losses on foreign
exchange contracts which qualify as hedges of net foreign investments as well as changes in the market value of these instruments are
included in accumulated other comprehensive income. Upon sale or liquidation of a foreign investment, the related amount in accumulated
other comprehensive income is reclassified to transaction gain or loss in the period of such liquidation.
Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional
currency, except those transactions which qualify as a hedge, are included currently in income.
Cash and Cash Equivalents and Restricted Cash—Newcastle considers all highly liquid short-term investments with maturities of 90
days or less when purchased to be cash equivalents. Substantially all amounts on deposit with major financial institutions exceed insured
limits. Restricted cash consisted of:
Derivative margin accounts
Restricted property operating accounts
Trustee accounts
Bond sinking funds
Held in CBO structures (Note 8) pending reinvestment
Reserve accounts
December 31,
2004
2003
$20,763
549
9,652
207
44,719
2,084
$ 2,339
604
8,105
—
56,971
2,084
$77,974
$ 70,103
Newcastle Investment Corp. and Subsidiaries
p.41
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
Stock Options—Newcastle accounts for stock options granted in accordance with SFAS No. 123, “Accounting for Stock-Based
Compensation” as revised in December 2004 and amended by EITF Issue No. 96-18 “Accounting for Equity Instruments That Are Issued
to Other Than Employees for Acquiring, or in Conjunction with Selling, Loans or Services.” The fair value of the options issued as compen-
sation to the Manager for its successful efforts in raising capital for Newcastle in 2004, 2003 and 2002 was recorded as an increase in
stockholders’ equity with an offsetting reduction of capital proceeds received. Options granted to Newcastle’s directors were accounted for
using the intrinsic value method under APB Opinion No. 25, as permitted by SFAS No.123 prior to its revision. Since these options were fully
vested before such revision became effective, such revision did not affect Newcastle.
3 . I N F O R M AT I O N R EG A R D I N G B U S I N E S S S EG M E N T S
Newcastle conducts its business through three primary segments: real estate securities and real estate related loans, operating real estate
and residential mortgage loans. Details of Newcastle’s investments in such segments can be found in Notes 4, 5 and 6. Newcastle has retroac-
tively combined two business segments which were previously reported separately: real estate securities and real estate related loans.
Management no longer reviews disaggregated, discrete financial information on these two investment categories since, among other reasons,
they are cross-financed and share common credit risk characteristics.
Holdings conducted its business in three primary segments: real estate securities and real estate related loans, operating real estate and its
investment in Fund I. The real estate securities investments were retained by Newcastle. The operating real estate segment, which comprised three
portfolios of properties, was split as follows: the Bell Canada (Canadian) and LIV (Belgian) portfolios were retained by Newcastle while the
GSA (U.S.) portfolio was distributed to Holdings. The existing real estate related loans and Fund I investments were distributed to Holdings.
The unallocated portion consists primarily of interest on short-term investments, general and administrative expenses, management fees
and incentive compensation pursuant to the Management Agreement, and interest on Holdings’ credit facility.
Summary financial data on Newcastle’s segments is given below, together with a reconciliation to the same data for Newcastle as a whole
(including its predecessor, through the date of the commencement of Newcastle’s operations, as described in Notes 1 and 2):
December 31, 2004 and the Year Then Ended
Gross revenues
Operating expenses
Operating income (loss)
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries (A)
Income (loss) from continuing operations
Income (loss) from discontinued operations
Real Estate
Securities and
Real Estate
Related Loans
Operating
Real
Estate
Residential
Mortgage
Loans
Unallocated
Total
$ 225,236
(828)
224,408
(124,930)
—
3,767
103,245
—
$ 13,222
$ 19,135
(7,425)
5,797
(3,054)
(1,298)
6,190
7,635
4,018
(2,319)
16,816
(10,863)
—
—
5,953
—
$
553
(22,983)
$ 258,146
(33,555)
(22,430)
—
(6)
—
(22,436)
—
224,591
(138,847)
(1,304)
9,957
94,397
4,018
Net income (loss)
$ 103,245
$ 11,653
$ 5,953
$ (22,436)
$
98,415
Revenue derived from non-U.S. sources:
Canada
Belgium
Total assets
Long-lived assets outside the U.S.:
Canada
Belgium
(A) Net of income taxes on related taxable subsidiaries.
$
$
—
—
$ 13,203
$ 10,602
$
$
—
—
$ —
$ —
$
$
13,203
10,602
$ 4,136,203
$ 108,322
$ 658,643
$ 29,552
$ 4,932,720
$
$
—
—
$ 57,193
$ 12,376
$
$
—
—
$ —
$ —
$
$
57,193
12,376
p.42
December 31, 2003 and the Year Then Ended
Gross revenues
Operating expenses
Operating income (loss)
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries
Income (loss) from continuing operations
Income (loss) from discontinued operations
Real Estate
Securities and
Real Estate
Related Loans
Operating
Real Estate
Residential
Mortgage
Loans
$ 134,348
(821)
133,527
(70,192)
—
861
64,196
—
$ 16,234
$ 12,892
(7,931)
8,303
(2,730)
(1,194)
—
4,379
(2,659)
(1,506)
11,386
(6,162)
—
—
5,224
—
Unallocated
Total
$
580
(15,603)
$ 164,054
(25,861)
(15,023)
—
—
1
(15,022)
—
138,193
(79,084)
(1,194)
862
58,777
(2,659)
Net income (loss)
$
64,196
$ 1,720
$ 5,224
$ (15,022)
$
56,118
Revenue derived from non-U.S. sources:
Canada
Belgium
Total assets
Long-lived assets outside the U.S.:
Canada
Belgium
December 31, 2002 and the Year Then Ended (A)
Gross revenues
Operating expenses
Operating income (loss)
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries
Income (loss) from continuing operations
Income (loss) from discontinued operations
$
$
—
—
$ 16,940
$ 5,999
$
$
—
—
$ —
$ —
$
$
16,940
5,999
$ 2,756,262
$ 146,635
$ 587,831
$ 59,571
$ 3,550,299
$
$
—
—
$ 54,250
$ 78,149
$
$
—
—
$ —
$ —
$
$
54,250
78,149
Real Estate
Securities and
Real Estate
Related Loans
Operating
Real Estate
Residential
Mortgage
Loans
Fund I
Unallocated
Total
$
83,259
$ 13,116
$ 1,281
$ 3,287
(586)
(6,984)
(141)
(3,861)
$
432
(10,473)
$ 101,375
(22,045)
82,673
(40,805)
—
—
41,868
(499)
6,132
(2,576)
(1,130)
—
2,426
237
1,140
(658)
—
—
482
—
(574)
—
(329)
303
(600)
—
(10,041)
(2,336)
(101)
59
(12,419)
—
79,330
(46,375)
(1,560)
362
31,757
(262)
Net income (loss)
$
41,369
$ 2,663
$
482
$ (600)
$ (12,419)
$
31,495
Revenue derived from non-U.S. sources:
Canada
Belgium
Italy
Total assets
Long-lived assets outside the U.S.:
Canada
Belgium
$
$
$
—
$ 14,015
—
$ 5,402
180
$
—
$
$
$
—
$ —
$ —
— $ —
$ —
—
$ —
$ —
$
$
$
14,015
5,402
180
$ 1,138,767
$ 128,831
$ 259,381
$ —
$ 45,588
$ 1,572,567
$
$
—
$ 49,271
—
$ 67,852
$
$
—
$ —
$ —
—
$ —
$ —
$
$
49,271
67,852
(A) The Fund I segment and a portion of the Unallocated segment (through the date of the commencement of Newcastle’s operations in July 2002) and the discontinued
operations of the Operating Real Estate and Real Estate Securities and Real Estate Related Loans segments represent operations related to activities treated as distributed
to our predecessor.
Newcastle Investment Corp. and Subsidiaries
p.43
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
Unconsolidated Subsidiaries
Newcastle has two unconsolidated subsidiaries which it accounts for under the equity method. Holdings held two such investments,
neither of which were transferred to Newcastle; such investments are included in Newcastle’s financial statements through the date of the
commencement of Newcastle’s operations.
The following table summarizes the activity affecting the equity held by Newcastle in unconsolidated subsidiaries:
Operating Real
Estate Subsidiary
Real Estate
Loan Subsidiary
Balance at December 31, 2002
Contributions to unconsolidated subsidiaries
Distributions from unconsolidated subsidiaries
Equity in earnings of unconsolidated subsidiaries
Other
Balance at December 31, 2003
Contributions to unconsolidated subsidiaries
Distributions from unconsolidated subsidiaries
Equity in earnings of unconsolidated subsidiaries
Other
Balance at December 31, 2004
$ —
—
—
—
—
$ —
26,789
(17,709)
8,698
—
$ 17,778
$ —
30,827
(1,041)
861
(7)
$ 30,640
—
(10,955)
3,767
—
$ 23,452
Summarized financial information related to Newcastle’s unconsolidated subsidiaries, through the date of their distribution to Holdings,
as applicable, was as follows (in thousands):
Operating Real
Estate Subsidiary (A) (B)
Real Estate
Loan Subsidiary (A) (C)
December 31,
December 31,
2004
$ 89,222
(53,000)
(666)
$ 35,556
$ 17,778
2004
$ 25,011
(7,159)
(328)
$ 17,524
$ 8,698
2004
2003
$ 47,170
—
(266)
$ 61,628
—
(348)
$ 46,904
$ 61,280
$ 23,452
$ 30,640
Austin (D)
Fund I (A)
2004
2003
2002
2002
$ 7,852
(111)
(44)
$ 1,885
(152)
(10)
$ 585
(477)
(45)
$ 9,740
(4,470)
—
$ 7,697
$ 1,723
$ 63
$ 5,270
$ 3,767
$
862
$ 59
$ 303
Assets
Liabilities
Minority interest
Equity
Equity held by Newcastle
Revenues
Expenses
Minority interest
Net income (loss)
Newcastle’s equity in net income (loss)
(A) Except for Austin, the unconsolidated subsidiaries’ summary financial information is presented on a fair value basis, consistent with their internal basis of accounting.
Newcastle’s equity in net income excludes its predecessor’s incentive income with respect to Fund I.
(B) Included in the operating real estate segment.
(C) Included in the real estate securities and real estate related loans segment.
(D) Included in the unallocated segment.
p.44
Operating Real Estate Subsidiary
In March 2004 Newcastle 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 counter-
party under the leases. ACT guarantees the obligations of Tenant under the leases. Newcastle structured this transaction through a joint venture
in two limited liability companies with a private investment fund managed by an affiliate of its manager, pursuant to which such affiliate
co-invested on equal terms. In October 2004, the investment’s initial financing was refinanced with a nonrecourse term loan ($53.0 million
outstanding at December 31, 2004), 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.
This limited liability company is an investment company and therefore maintains its financial records on a fair value basis. Newcastle
has retained such accounting relative to its investment in such limited liability company, which is accounted for under the equity method
at fair value.
Real Estate Loan Subsidiary
In November 2003, Newcastle and a private investment fund managed by an affiliate of the Manager co-invested and each indirectly
own an approximately 38% interest in DBNC Peach Manager LLC, a limited liability company that has acquired a pool of franchise loans
collateralized by fee and leasehold interests and other assets from a third party financial institution. The Manager receives from this private
investment fund, in addition to management fees, incentive compensation if the fund’s aggregate investment returns exceed certain thresh-
olds. The remaining approximately 24% interest in the limited liability company is owned by the above-referenced third party financial
institution. Newcastle has no additional capital commitment to the limited liability company.
This limited liability company is an investment company and therefore maintains its financial records on a fair value basis. Newcastle
has retained such accounting relative to its investment in such limited liability company, which is accounted for under the equity method
at fair value.
Fund I
The managing member of Fund I was Fortress Fund MM LLC (the “Fund I Managing Member”), which was owned jointly, through
subsidiaries, by Holdings, approximately 94%, and the Manager, approximately 6%. A separate class of membership interests in the Fund I
Managing Member reflected the entitlement to the incentive return payable by Fund I, as described below, which was owned 50% by the
Manager and 50% by Holdings.
The Fund I Managing Member was entitled to receive an annual management fee of up to 1.5% of Fund I’s invested capital or total equity
commitments. Holdings was not charged management fees for its investment in Fund I. Pursuant to an agreement between the Fund I
Managing Member and the Manager, the Manager was entitled to 100% of the management fee paid by Fund I to the Fund I Managing
Member. Since the management fees paid to the Manager flowed through Holdings through its ownership of the Fund I Managing Member,
they were reflected as gross amounts in both Management Fee from Affiliate and Management Fee to Affiliate, although they had no effect
on net income.
The Fund I Managing Member was entitled to an incentive return (the “Incentive Return”) generally equal to 20% of Fund I’s returns, as
defined. Holdings recorded as incentive income the amount that would be due based on the fair value of the assets in Fund I exceeding the
required return at a specific point in time as if the management arrangement was terminated on that date. Based on this methodology,
Holdings’ incentive income in each reporting period reflected changes in the fair value of the assets in Fund I. As such, Holdings accrued
$27.5 million of Incentive Return through the date of the commencement of Newcastle’s operations. This amount was recorded in Incentive
Income from Affiliate. The Manager was entitled to 50% of this income which Holdings recorded as Incentive Compensation to Affiliate.
Newcastle Investment Corp. and Subsidiaries
p.45
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
Austin
In 1998, Holdings and Fortress Principal Investment Group LLC (“FPIG”), an affiliate of the Manager, formed Austin Holdings Corporation
(“Austin”). Holdings held non-voting preferred stock in Austin which represented a 95% economic ownership, and had a liquidation preference
over the common stockholders. FPIG was the holder of all of the common stock which represented 100% of the vote and 5% of the economic
ownership interest of Austin. Austin owned certain non-performing loans and foreclosed real estate as well as 100% of the common stock
of Ascend Residential Holdings, Inc. (“Ascend”). Ascend’s primary business was the acquisition, rehabilitation and sale of single-family
residential properties.
4 . R E A L E S TAT E S E C U R I T I E S
The following is a summary of Newcastle’s real estate securities at December 31, 2004 and 2003, all of which are classified as available
for sale and are therefore marked to market through other comprehensive income pursuant to SFAS No. 115 “Accounting for Certain
Investments in Debt and Equity Securities.”
December 31, 2004
Asset Type
CMBS—conduit
CMBS—large loan
CMBS—B-Note
Unsecured REIT debt
ABS—manufactured housing
ABS—home equity
ABS—franchise
Agency RMBS
Current
Face
Amount
Amortized
Cost
Basis
Gross Unrealized
Gains
Losses
Carrying
Value
Number
of
Securities
S&P
Equivalent
Rating
$ 1,024,762
583,758
173,587
735,402
221,803
298,934
77,825
199,182
$ 995,194
580,383
170,884
750,489
198,181
297,083
75,631
201,803
$ 54,506
9,781
2,614
38,433
5,328
3,072
2,493
—
$ (7,240)
(168)
(379)
(3,200)
(4,494)
(83)
(540)
(275)
$ 1,042,460
589,996
173,119
785,722
199,015
300,072
77,584
201,528
162
68
28
90
11
44
17
3
BBB–
BBB
BB+
BBB–
B
A–
BBB+
AAA
Weighted Average
Coupon Yield
6.17% 6.80%
5.16% 5.41%
6.31% 6.58%
6.51% 6.15%
7.10% 8.83%
4.16% 4.29%
7.13% 8.79%
4.69% 4.41%
Total/Average (A)
$ 3,315,253 $ 3,269,648 $ 116,227 $ (16,379) $ 3,369,496
423
BBB
5.89% 6.19%
(A) The total current face amount of fixed rate securities was $2,472.1 million, and of floating rate securities was $843.2 million.
Maturity
(Years)
7.53
2.35
6.12
7.34
5.67
4.06
5.25
3.35
5.76
Unrealized losses that are considered other than temporary are recognized currently in income. There were no such losses incurred during
the years ended December 31, 2004, 2003 or 2002. The unrealized losses on Newcastle’s securities are primarily the result of market factors,
rather than credit impairment, and Newcastle believes their carrying values are fully recoverable over their expected holding period. One of
the securities had an immaterial interest shortfall at December 31, 2004, which has subsequently been brought current; no other securities
are delinquent.
Securities in an Unrealized Loss Position
Less than twelve months
Twelve or more months
$ 866,660
$ 872,077
$
63,484
60,355
— $ (9,202)
—
(7,178)
$ 862,875
53,177
95
7
BBB+
BB–
5.45%
5.37%
6.37% 7.66%
6.47
5.92
Total
$ 930,144 $ 932,432 $
— $ (16,380) $ 916,052
102
BBB+
5.51% 5.52%
6.43
The unrealized losses on most of the securities in the “twelve or more months” category were primarily caused by changes in market
credit spreads. With respect to two of such securities, the unrealized losses were primarily caused by market perceptions of the credit quality
of such securities. None of the securities in this category are in default or delinquent and Newcastle has performed credit analyses in relation
to such securities which support its belief that the carrying values of such securities are fully recoverable over their expected holding period.
Although management expects to hold these securities until their recovery, there is no assurance that such securities will not be sold or at what
price they may be sold.
p.46
December 31, 2003
Asset Type
CMBS—Conduit
CMBS—Large Loan
CMBS—B-Note
Unsecured REIT Debt
ABS—Manufactured Housing
ABS—Home Equity
ABS—Franchise
Weighted Average
Current
Face
Amount
Amortized
Cost
Basis
Gross Unrealized
Gains
Losses
Carrying
Value
Number
of
Securities
S&P
Equivalent
Rating
Coupon
Yield
Maturity
(Years)
$ 830,471
374,208
57,653
532,008
243,938
74,867
60,393
$ 794,973
370,480
55,577
541,648
217,244
74,845
57,598
$ 39,308
2,064
1,141
44,301
3,402
785
2,383
$ (7,313)
(1,003)
(41)
(1,241)
(2,947)
—
(477)
$ 826,968
371,541
56,677
584,708
217,699
75,630
59,504
126
43
10
71
8
15
11
BBB–
BBB
BB+
BBB–
BBB+
A
A
6.39%
3.98%
6.37%
7.18%
7.07%
3.26%
7.13%
4.40%
7.05%
6.85%
8.98%
3.35%
8.60% 10.00%
7.64
2.65
7.06
7.28
6.11
4.88
5.95
Total/Average (A)
$ 2,173,538 $ 2,112,365 $ 93,384 $ (13,022)
$ 2,192,727
284
BBB
6.20%
6.71%
6.36
(A) The total current face amount of fixed rate securities was $1,531.6 million, and of floating rate securities was $457.5 million.
The following is a reconciliation of real estate securities:
Real Estate Securities
Current
Face Amount
Market
(Discount)/Premium
Loss
Allowance
Amortized
Cost Basis
Balance at December 31, 2002
Purchases
Collections of principal
Cost of securities sold
Accretion
Consolidation of ICH CMO (Note 6)
Balance at December 31, 2003
Purchases
Collections of principal
Cost of securities sold
Accretion
$ 1,025,680
1,476,600
(45,183)
(249,303)
—
(34,256)
$ 2,173,538
1,500,549
(181,008)
(177,826)
—
Balance at December 31, 2004
$ 3,315,253
$ (70,546)
(14,428)
(608)
6,846
5,710
11,853
$ (61,173)
4,084
—
4,677
6,807
$ (45,605)
$ —
—
—
—
—
—
$ —
—
—
—
—
$ 955,134
1,462,172
(45,791)
(242,457)
5,710
(22,403)
$ 2,112,365
1,504,633
(181,008)
(173,149)
6,807
$ —
$ 3,269,648
During 2004 and 2003, Newcastle recorded gross realized gains of approximately $20.0 million and $14.5 million, respectively, and
gross realized losses of approximately $0.0 million and $1.9 million, respectively, related to the sale of real estate securities.
The securities are encumbered by the CBO securitizations and by repurchase agreements (Note 8) at December 31, 2004.
Newcastle enters into short-term warehouse agreements with major investment banks for the right to purchase commercial mortgage backed
securities, unsecured REIT debt, real estate loans and asset backed securities for its real estate securities portfolios, prior to their being financed
with CBOs. These agreements are treated as non-hedge derivatives for accounting purposes and are therefore marked to market through current
income. If the related CBO is not consummated, except as a result of Newcastle’s gross negligence, willful misconduct or breach of contract,
Newcastle would be required to pay the Net Loss, if any, as defined, up to the related deposit, less any Excess Carry Amount, as defined,
earned on such deposit. Although Newcastle currently anticipates completing the most recent CBO in the near term, there is no assurance that
such CBO will be consummated or on what terms it will be consummated. The following table summarizes the agreements (in thousands):
December 31, 2004
Income (Loss) Recorded
Collateral
Accumulated (1)
Aggregate
Deposit
Fair Value
$224,928
$24,901
$25,411
Deal Status
Completed
Open
Total
2004
$2,604
510
$3,114
2003
$3,730
—
$3,730
2002
$652
—
$652
(1) Excludes $32.5 million of collateral accumulated on balance sheet and recorded in real estate securities.
Newcastle Investment Corp. and Subsidiaries
p.47
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
5 . R E A L E S TAT E R E L AT E D LOA N S A N D R E S I D E N T I A L M O R TG AG E LOA N S
The following is a summary of real estate related loans and residential mortgage loans. The loans contain various terms, including fixed
and floating rates, self-amortizing and interest only. They are generally subject to prepayment.
December 31, 2004
Loan Type
B-Notes
Mezzanine loans
Bank loans
Real estate loans
ICH CMO loans (A)
December 31,
2004
2003
2004
2003
Current Face Amount
Carrying Value (B)
Loan
Count
23
$132,777
4
80,000
3
146,909
2
29,555
205,147 243,809 202,674 241,334 123
$133,344
80,052
146,909
28,911
$ 61,591
—
99,859
—
$ 61,640
—
99,859
—
Weighted
Average
Yield
6.44%
5.25%
6.73%
16.55%
8.16%
Total real estate related loans
$594,388 $ 405,308 $591,890 $ 402,784 155
7.44%
Residential mortgage loan portfolio
$645,381
$ 578,330
$654,784
$ 586,237
1,653
3.71%
Weighted
Average
Maturity
(Years) (C)
Delinquent
Carrying
Amount
2.30
1.97
1.99
1.24
2.86
2.32
3.84
$ —
—
—
—
11,274
$ 11,274
$ 1,148
(A) In October 2003, pursuant to FIN No. 46, Newcastle consolidated an entity which holds a portfolio of commercial mortgage loans which has been securitized. This investment,
which is referred to as the ICH CMO, was previously treated as a non-consolidated residual interest in such securitization. Newcastle exercises no control over the management
or resolution of these assets and its residual investment in this entity was recorded at $2.9 million prior to its consolidation. The primary effect of the consolidation is the
requirement that Newcastle reflect the gross loan assets and gross bonds payable of this entity in its financial statements.
(B) The aggregate United States federal income tax basis for such assets at December 31, 2004 was approximately equal to their book basis.
(C) The weighted average maturity for the residential mortgage loan portfolio was calculated based on a constant prepayment rate (CPR) of 22.6%.
The following is a reconciliation of real estate related loans and residential mortgage loans.
Balance at December 31, 2002
Purchases/advances
Collections of principal
Cost of loans sold
Accretion
Loss allowance
Consolidation of ICH CMO
Balance at December 31, 2003
Purchases/advances
Collections of principal
Cost of loans sold
Accretion
Loss allowance
Balance at December 31, 2004
Real Estate Related Loans
Residential Mortgage Loans
Current
Face
Amount
Market
(Discount)/
Premium
Loss
Allowance
Carrying
Value
Current
Face
Amount
Market
(Discount)/
Premium
Loss
Allowance
Carrying
Value
$ 26,423
152,322
(20,513)
—
—
—
247,076
$ 405,308
281,340
(92,425)
—
165
—
$ 594,388
$ (6)
(84)
—
—
41
—
—
$ (49)
15
—
—
9
—
$ (25)
$ —
—
—
—
—
—
(2,475)
$ (2,475)
—
2
—
—
—
$ 26,417
152,238
(20,513)
—
41
—
244,601
$ 402,784
281,355
(92,423)
—
174
—
$ 254,201
524,502
(39,545)
(160,828)
—
—
—
$ 578,330
347,318
(154,660)
(125,607)
—
—
$ 3,997
8,116
—
(2,869)
(1,237)
—
—
$ 8,007
3,055
—
874
(2,533)
—
$ —
—
—
—
—
(100)
—
$ (100)
—
—
—
—
100
$ 258,198
532,618
(39,545)
(163,697)
(1,237)
(100)
—
$ 586,237
350,373
(154,660)
(124,733)
(2,533)
100
$ (2,473)
$ 591,890
$ 645,381
$ 9,403
$ —
$ 654,784
In November 2004, Newcastle entered into a total rate of return swap with a major investment bank, whereby Newcastle receives the sum
of all interest (at LIBOR + 2.25%), fees and any positive change in value amounts (the total return cash flows) from a referenced term loan
(to a retail mall REIT) with an initial notional amount of $107.0 million, and pays interest (at LIBOR + 0.50%) on such notional plus any
negative change in value amounts from such loan. This agreement is recorded in Derivative Assets and is treated as a non-hedge derivative for
accounting purposes and is therefore marked to market through income. Under the agreement, Newcastle was required to post an initial mar-
gin deposit equal to 17% of the notional amount and additional margin may be payable in the event of a decline in value of the referenced term
loan. Any margin on deposit, less any negative change in value payments, will be returned to Newcastle upon termination of the contract.
p.48
The average carrying amount of Newcastle’s real estate related loans was approximately $486.2 million and $113.6 million during 2004
and 2003, respectively, on which Newcastle earned approximately $36.7 million and $10.7 million of gross revenues, respectively.
The average carrying amount of Newcastle’s residential mortgage loans was approximately $637.4 million and $400.0 million during
2004 and 2003, respectively, on which Newcastle earned approximately $19.1 million and $12.9 million of gross revenues, respectively.
The residential mortgage loan portfolio is encumbered by repurchase agreements and a term loan (Note 8), the ICH CMO loans are
encumbered by the ICH CMO Bonds (Note 8) and the real estate related loans are encumbered by the CBO securitizations, term loans and
repurchase agreements (Note 8).
6 . O P E R AT I N G R E A L E S TAT E
The following is a reconciliation of operating real estate assets and accumulated depreciation:
Operating Real Estate
Balance at December 31, 2002
Improvements
Foreign currency translation
Depreciation
Transferred to Real Estate Held for Sale
Balance at December 31, 2003
Improvements
Foreign currency translation
Depreciation
Transferred to Real Estate Held for Sale
Gross
Accumulated
Depreciation
Net
$ 123,112
576
25,313
—
(34,671)
$ 114,330
148
8,899
—
(57,686)
$ (9,460)
—
(2,247)
(3,043)
3,415
$ (11,335)
—
(1,094)
(2,137)
6,068
$ 113,652
576
23,066
(3,043)
(31,256)
$ 102,995
148
7,805
(2,137)
(51,618)
Balance at December 31, 2004
$ 65,691
$ (8,498)
$ 57,193
Canadian properties
Belgian properties
Total
$ 65,691
—
$ (8,498)
—
$ 57,193
—
$ 65,691
$ (8,498)
$ 57,193
Real Estate Held for Sale
Balance at December 31, 2002
Sold
Transferred from Operating Real Estate
Mark to market
Balance at December 31, 2003
Improvements
Foreign currency translation
Sold
Transferred from Operating Real Estate
Balance at December 31, 2004
Canadian properties
Belgian properties
Total
$ 3,471
(3,471)
31,256
(1,852)
$ 29,404
73
(735)
(67,984)
51,618
$ 12,376
$
—
12,376
$ 12,376
All of Newcastle’s U.S. properties (the “GSA Portfolio”) were distributed to Holdings prior to the commencement of Newcastle’s
operations. Such properties were primarily leased to the General Services Administration of the U.S. Government. The GSA Portfolio was
financed by a securitization which was also distributed to Holdings.
Newcastle Investment Corp. and Subsidiaries
p.49
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
The Canadian properties are primarily leased to Bell Canada, a wholly-owned subsidiary of BCE, Inc. and are referred to as the “Bell
Canada Portfolio.” For 2004, 2003 and 2002, approximately 99%, 98% and 99% of Newcastle’s consolidated rental and escalation income
from continuing operations was attributable to Bell Canada. The Bell Canada leases expire in 2006 and 2007. The lease of the primary tenant
of one of these properties, the smallest property in the portfolio, expired in March 2004 and this building is now vacant; in January 2005, we
agreed to the terms for a sale of this property and received a nonrefundable deposit thereon. In March 2005, we agreed to the terms for a sale
of another of the Bell Canada properties and received a nonrefundable deposit thereon. Each Bell Canada lease contains one five-year lease
renewal option and provides for a significant payment due upon expiration of the lease. These terminal payments have been included in the
calculation of straight-line rental income assuming that each lease is renewed once. The Bell Canada leases also provide for the reimburse-
ment of substantially all operating expenses and property taxes plus an administrative fee. The Bell Canada Portfolio is encumbered by the
Bell Canada bonds (Note 8).
The Belgian properties are referred to as the “LIV Portfolio” and are leased to a variety of tenants. The leases on the Belgian properties
provide for annual increases in base rent based on the change in a Belgian index, as well as payment of increases in operating expenses and
real estate taxes over base year amounts.
The following is a schedule of the future minimum rental payments to be received under non-cancelable operating leases:
2005
2006
2007
2008
2009
Thereafter
$ 6,221
4,403
1,279
190
190
190
$12,473
In May 2002, Holdings sold one of its GSA Properties with a net basis of $33.0 million for a net purchase price of approximately
$34.1 million, at a gain of $1.1 million.
In May 2002, Newcastle sold a property in the LIV portfolio for gross proceeds of approximately $8.9 million, at a loss of
approximately $1.1 million.
In 2002, Newcastle entered into contracts to sell two commercial properties located in Canada for gross proceeds of approximately
$2.6 million, at a loss of approximately $1.6 million including the write off of accumulated other comprehensive income related to foreign
currency translation. The sales were completed in April 2003.
In June 2004, Newcastle consummated the sale of five properties in the LIV portfolio. These properties had been classified as held for
sale since December 2003. Newcastle recognized a $1.5 million loss on this sale in December 2003. In addition, Newcastle recognized a
$1.2 million loss in 2004, primarily related to the prepayment of the debt on such properties.
In December 2004, Newcastle sold two properties in the LIV portfolio at a gain of approximately $5.3 million, net of prepayment penalties
on the related debt.
In March 2004, Newcastle committed to a plan to sell one property in the LIV portfolio. Newcastle expects a sale of this property to be
completed by the first quarter of 2005. Accordingly, this property has been reclassified as Real Estate Held for Sale. Although Newcastle
currently anticipates completing this sale in the near term, there is no assurance that this sale will be completed or on what terms it will be
completed. This property is the last remaining property in the LIV portfolio.
Pursuant to SFAS No. 144, Newcastle has retroactively recorded the operations, including the gain or loss, of all sold or “held for sale”
properties in Income from Discontinued Operations for all periods presented.
Gross revenues from discontinued operations, which include those investments distributed to Holdings as discussed in Note 2, were
approximately $10.6 million, $6.7 million and $35.4 million in 2004, 2003 and 2002, respectively. Interest expense included in discontinued
operations was approximately $3.4 million, $4.0 million and $15.2 million in 2004, 2003 and 2002 respectively.
p.50
The following table sets forth certain information regarding the operating real estate portfolio:
Type of Property
Location
Costs
Capitalized
Subseq. to
Acq’n (A)
Initial
Cost (A)
December 31, 2004
Gross
Carrying
Amount
Accum.
Depr.
Net
Carrying
Value (B)
Encumb.
Occ. (C)
Off. Bldg.
Off. Bldg.
Industrial/Distribution
Etobicoke, ON
London, ON
Toronto, ON
$11,687
19,133
33,376
$ 866
400
229
$12,553
19,533
$10,736
16,653
33,605 3,801 29,804 22,513 100.0%
$10,623
9,286
—%
95.2%
$1,817
2,880
Net
Rentable
Sq. Ft. (C)
177,214
325,764
624,786
Acq’n
Date (C)
10/98
10/98
10/98
Year Built/
Renovated (C)
1972/1978
1980
1963/71/79
Subtotal—Canada
64,196 1,495
65,691 8,498 57,193 42,422 82.9% 1,127,764
Off. Bldg.
G. Bijgaarden, BEL
N/A N/A
12,376 N/A 12,376
— 84.0%
81,763
11/99
1994
Subtotal—Belgium (Held for Sale)
—
—
12,376
— 12,376
— 84.0%
81,763
Totals
$64,196 $ 1,495
$78,067 $8,498 $69,569 $42,422 83.0% 1,209,527
(A) Adjusted for changes in foreign currency exchange rates, which aggregated $4.7 million of gain and $10.4 million of gain between land, building and improvements in 2004
and 2003 respectively.
(B) The aggregate United States federal income tax basis for such assets at December 31, 2004 was approximately $71.8 million.
(C) Unaudited.
7. FA I R VA LU E O F F I N A N C I A L I N S T R U M E N T S
For certain of Newcastle’s financial instruments, fair values are not readily available since there are no active trading markets as characterized
by current exchanges between willing parties. Accordingly, fair values can only be derived or estimated for these instruments using various
valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks
involved. However, the determination of estimated future cash flows is inherently subjective and imprecise. It should be noted that minor
changes in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values, and that the fair
values reflected below are indicative of the interest rate, credit spread and currency rate environments as of December 31, 2004 and do not
take into consideration the effects of subsequent interest rate, credit spread or currency rate fluctuations.
The carrying values and estimated fair values of Newcastle’s financial instruments at December 31, 2004 and 2003 were as follows:
Assets:
Real estate securities, available for sale
Real estate securities portfolio deposit
Real estate related loans
Residential mortgage loans
Interest rate caps, treated as hedges (A)
Total return swap (A)
Liabilities:
CBO bonds payable
Other bonds payable
Notes payable
Repurchase agreements
Interest rate swaps, treated as hedges (B)
Non-hedge derivative obligations (C)
Carrying Value
December 31,
Principal Balance
or Notional Amount
Estimated Fair Value
December 31,
December 31,
2004
2003
2004
2004
2003
$3,369,496
25,411
591,890
654,784
3,554
399
2,656,510
222,266
652,000
490,620
13,239
796
$2,192,727
19,541
402,784
586,237
8,294
—
1,793,533
260,674
154,562
715,783
28,881
747
$3,315,253
See below
594,388
645,381
375,019
See below
2,681,395
222,729
652,000
490,620
2,011,418
See below
$3,369,496
25,411
600,528
654,784
3,554
399
2,720,704
227,510
652,000
490,620
13,239
796
$2,192,727
19,541
429,860
586,237
8,294
—
1,836,628
282,014
155,058
715,783
28,881
747
(A) Included in Derivative Assets. The longest cap maturity is October 2015. The total return swap matures in November 2008.
(B) Included in Derivative Assets or Liabilities, as applicable. The longest swap maturity is November 2018.
(C) Included in Derivative Assets or Liabilities, as applicable. The longest maturity is July 2038.
Newcastle Investment Corp. and Subsidiaries
p.51
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
The methodologies used and key assumptions made to estimate fair value are as follows:
Real Estate Securities, Available for Sale—The fair value of these securities is estimated by obtaining third party broker quotations, if
available and practicable, and counterparty quotations.
Real Estate Securities Portfolio Deposit—The fair value of this deposit, which is treated as a non-hedge derivative, is estimated by
obtaining third party broker quotations on the underlying securities, if available and practicable, and counterparty quotations, including a
counterparty quotation on the portion of the fair value resulting from the Excess Carry Amount, as defined, earned on such deposit. This
deposit is more fully described in Note 4.
Real Estate Related Loans—The fixed rate B-Notes were valued by obtaining counterparty quotations. The rest of the B-Notes as well
as the mezzanine loans, bank loans, and real estate loans, with one exception, bear floating rates of interest and Newcastle believes that, for
similar financial instruments with comparable credit risks, their effective rates approximate market rates. Accordingly, the carrying amounts
outstanding are believed to approximate fair value. The one fixed rate loan was purchased on December 29, 2004 and therefore its carrying
amount is believed to approximate fair value. The ICH CMO loans were valued by discounting expected future receipts by a rate calculated
based on current market conditions for comparable financial instruments, including market interest rates and credit spreads.
Residential Mortgage Loans—This portfolio of mortgage loans bears a floating rate of interest. Newcastle believes that, for similar
financial instruments with comparable credit risks, the effective rate on this portfolio approximates a market rate. Accordingly, the carrying
amount of this portfolio is believed to approximate fair value.
Interest Rate Cap and Swap Agreements, Total Return Swap and Non-Hedge Derivative Obligations—The fair value of these
agreements is estimated by obtaining counterparty quotations. The total return swap is more fully described in Note 5.
CBO Bonds Payable—These bonds were valued by discounting expected future payments by a rate calculated based on current market
conditions for comparable financial instruments, including market interest rates and credit spreads.
Other Bonds Payable—The Bell Canada bonds were valued, in U.S. dollars at the period end exchange rate, by discounting expected
future payments by a rate calculated by imputing a spread over a market index on the date of borrowing. The ICH CMO bonds were valued
by discounting expected future payments by a rate calculated based on current market conditions for comparable financial instruments,
including market interest rates and credit spreads.
Notes Payable—The LIV mortgage was valued, in U.S. dollars at the period end exchange rate, by discounting expected future payments
by a rate calculated by imputing a spread over a market index on the date of borrowing. It was repaid in December 2004. The real estate
related loan financings and residential mortgage loan financing bear floating rates of interest. Newcastle believes that, for similar financial
instruments with comparable credit risks, their effective rates approximate market rates. Accordingly, the carrying amounts outstanding are
believed to approximate fair value.
Repurchase Agreements—These agreements bear floating rates of interest and Newcastle believes that, for similar financial instruments
with comparable credit risks, the effective rates approximate market rates. Accordingly, the carrying amounts outstanding are believed to
approximate fair value.
p.52
8 . D E BT O B L I G AT I O N S
The following table presents certain information regarding Newcastle’s debt obligations and related hedges:
Current Face Amount
Carrying Value
December 31,
December 31,
Unhedged
Weighted
Average
Weighted
Average
Funding Maturity
Weighted
Average
Final
Stated
Face
Amount of Collateral
Floating
Carrying Maturity
2004
2003
2004
2003
Funding Cost Maturity Cost (1)
(Years) Rate Debt
Value
Collateral
Weighted
Average
Aggregate
Notional
Face
Amount of
Amount of
Currently
Floating
Effective
Rate
(Years) Collateral Hedges
Month
Issued
Debt Obligation/Collateral
CBO Bonds Payable
Real estate securities
and loans
July 1999
$ 436,895 $ 437,500 $ 432,893 $ 431,802
4.08% (2)
July 2038
4.85%
4.21
$ 341,895 $ 587,861
6.04
$
— $ 328,699
Real estate securities
and loans
Apr. 2002
444,000
444,000
440,427
439,832
3.67% (2)
Apr. 2037
6.18%
5.38
372,000
505,927
6.16
84,733
290,000
Real estate securities
and loans
Mar. 2003
472,000
472,000
467,905
467,325
3.68% (2)
Mar. 2038
4.45%
7.31
427,800
499,813
5.60
144,682
276,060
Real estate securities
and loans
Sept. 2003
460,000
460,000
455,115
454,574
3.28% (2)
Sept. 2038
4.32%
7.87
442,500
497,524
4.93
233,990
192,500
Real estate securities
and loans
Mar. 2004
414,000
—
410,018
Real estate securities
and loans
Sept. 2004
454,500
—
450,152
—
—
3.31% (2)
3.16% (2)
Mar. 2039
3.85%
7.63
382,750
449,244
6.01
217,652
165,300
Sept. 2039
3.90%
8.20
442,500
499,867
6.46
252,886
189,373
2,681,395 1,813,500 2,656,510 1,793,533
4.59%
6.78
2,409,445 3,040,236
5.87
933,943 1,441,932
Other Bonds Payable
Bell Canada portfolio (4)
ICH CMO loans (5)
Notes Payable
LIV portfolio
Real estate related loan
Real estate related loan (6)
Residential
mortgage loans (7)
Repurchase Agreements (7)
Residential
mortgage loans (8)
ABS—manufactured
housing (9)
Agency RMBS (10)
Real estate securities
Real estate related loans (11)
Apr. 2002
(5)
42,885
42,866
42,422
42,168
179,844
218,506
179,844
218,506
7.02%
6.61% (2)
Apr. 2012
7.02%
Aug. 2030
6.61%
1.43
2.79
—
57,193
3,684
202,674
N/A
2.86
222,729
261,372
222,266
260,674
6.69%
2.53
3,684
259,867
Nov. 2002
Nov. 2003
Feb. 2004
—
67,523
40,000
74,562
80,000
—
—
74,562
N/A
(3)
67,523
40,000
80,000 LIBOR+1.50% Nov. 2006
— LIBOR+1.50% Feb. 2005
N/A
3.92%
4.26%
—
1.64
0.17
—
67,523
40,000
—
83,909
50,000
—
1.64
2.13
—
3,684
3,684
—
83,909
50,000
Nov. 2004
544,477
—
544,477
— LIBOR+0.15% Nov. 2007
2.46%
2.10
544,477
583,922
3.76
575,759
652,000
154,562
652,000
154,562
2.72%
1.93
652,000
717,831
3.40
709,668
Rolling
67,382
557,191
67,382
557,191 LIBOR+0.43% Mar. 2005
2.99%
0.25
67,382
70,862
4.49
69,622
—
—
—
—
—
—
—
—
—
Rolling
Rolling
Rolling
Rolling
103,738
195,754
67,471
138,992
—
19,600
103,738
195,754
67,471
138,992 LIBOR+0.64% Mar. 2005
— LIBOR+0.13% Jan. 2005
19,600 LIBOR+0.61% Oct. 2005
4.29%
3.81%
3.29%
56,275
—
56,275
— LIBOR+0.95% Oct. 2005
3.34%
0.17
0.08
0.22
0.69
103,738
195,754
67,471
146,309
201,528
91,771
56,275
73,500
5.11
3.35
3.73
1.87
—
—
32,609
73,500
95,700
195,409
21,295
—
490,620
715,783
490,620
715,783
3.67%
0.21
490,620
583,970
3.80
175,731
312,404
Total debt obligations
$ 4,046,744 $ 2,945,217 $ 4,021,396 $ 2,924,552
4.29%
4.97
$ 3,555,749 $ 4,601,904
$ 1,823,026 $ 1,754,336
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
Including the effect of applicable hedges.
Weighted average, including floating and fixed rate classes.
Repaid in December 2004.
Denominated in Canadian dollars.
See Note 5.
Maturity date extended in January 2005 from February 2005 to February 2006.
Subject to potential mandatory prepayments based on collateral value.
The counterparty on this repo is Bear Stearns Mortgage Capital Corporation.
The counterparty on these repos is Greenwich Capital Markets Inc.
The counterparty on this repo is Bank of America Securities LLC.
The counterparty on these repos is Deutsche Bank AG.
Certain of the debt obligations included above are obligations of consolidated subsidiaries of Newcastle which own the related collateral.
In some cases, such collateral is not available to other creditors of Newcastle.
Newcastle Investment Corp. and Subsidiaries
p.53
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
CBO Bonds Payable
In connection with the sale of two classes of CBO bonds, Newcastle entered into two interest rate swaps and three interest rate cap
agreements that do not qualify for hedge accounting. Changes in the values of these instruments have been recorded currently in income.
In November 2001, Newcastle sold the retained subordinated $17.5 million Class E Note from its first CBO to a third party. The Class E
Note bore interest at a fixed rate of 8.0% and had a stated maturity of June 2038. The sale of the Class E Note represented an issuance of debt
and was recorded as additional CBO Bonds Payable. In April 2002, a wholly-owned subsidiary of Newcastle repurchased the Class E Note.
The repurchase of the Class E Note represented a repayment of debt and was recorded as a reduction of CBO Bonds Payable. The Class E
Note is included in the collateral for Newcastle’s second CBO. The Class E Note is eliminated in consolidation.
One class of the CBO bonds, with a $395.0 million face amount, was issued subject to remarketing procedures and related agreements
whereby such bonds are remarketed and sold on a periodic basis. These bonds are fully insured by a third party with respect to the timely
payment of interest and principal thereon.
In July 2004, Newcastle refinanced $342.5 million of the AAA and AA bonds in its first CBO. $322.5 million of AAA bonds were
refinanced at LIBOR +0.30% from LIBOR +0.65% and $20.0 million of AA bonds were refinanced at LIBOR +0.50% from LIBOR +0.80%.
In connection with this transaction, Newcastle incurred approximately $1.5 million of costs, which are included in Gain on Settlement of
Investments, Net.
Other Bonds Payable
In connection with the Bell Canada securitization, Newcastle guaranteed certain payments under an interest rate swap to be entered
into in 2007, if the Bell Canada securitization is not fully repaid by such date. Newcastle believes the fair value of this guarantee is negligible
at December 31, 2004. A portion of the Bell Canada securitization has been repaid with proceeds from the sale of properties in the Bell
Canada portfolio.
In October 2003, Newcastle consolidated an entity which holds a portfolio of commercial mortgage loans which has been securitized. The
primary effect of the consolidation is the requirement that Newcastle reflect the gross loans assets (Note 5) and gross bonds payable of this
entity in its financial statements.
Notes Payable
The LIV mortgage was repaid in full during 2004 with proceeds from the sale of properties in the LIV portfolio.
Predecessor
Newcastle’s predecessor had two primary debt obligations which were distributed to it upon Newcastle’s formation, a securitization which
was secured by the GSA Portfolio (Note 6) and a credit facility. Interest on the securitization is included in discontinued operations through
the date of Newcastle’s formation; interest on the credit facility is included in interest expense through such date.
Maturity Table
Newcastle’s debt obligations (gross of $25.3 million of discounts at December 31, 2004) have contractual maturities as follows
(in millions):
2005
2006
2007
2008
2009
Thereafter
$ 535,870
62,273
544,477
—
—
2,904,124
$ 4,046,744
p.54
9. S TO C K O P T I O N P L A N
In June 2002, Newcastle (with the approval of the board of directors) adopted a nonqualified stock option and incentive award plan (the
“Newcastle Option Plan”) for officers, directors, consultants and advisors, including the Manager and its employees. The maximum available
for issuance is equal to 10% of the number of outstanding equity interests of Newcastle, subject to a maximum of 10,000,000 shares in the
aggregate over the term of the plan.
The non-employee directors have been, in accordance with the Newcastle Option Plan, automatically granted options to acquire an aggregate
of 16,000 shares of common stock, which vest over three years. The fair value of such options was not material at the date of grant.
Through December 31, 2004, for the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, the
Manager has been granted options representing the right to acquire 2,325,727 shares of common stock, with strike prices subject to adjustment
as necessary to preserve the value of such options in connection with the occurrence of certain events (including capital dividends and capital
distributions made by Newcastle). The Manager options represented an amount equal to 10% of the shares of common stock of Newcastle
sold in its public offerings and the value of such options was recorded as an increase in stockholders’ equity with an offsetting reduction of
capital proceeds received. The options granted to the Manager, which may be assigned by the Manager to its employees, were fully vested on
the date of grant and one thirtieth of the options become exercisable on the first day of each of the following thirty calendar months, or earlier
upon the occurrence of certain events, such as a change in control of Newcastle or the termination of the Management Agreement. The
options expire ten years from the date of issuance.
The following table summarizes our outstanding options at December 31, 2004:
Date of
Grant/Exercise
Various
October 2002
July 2003
December 2003
January 2004
May 2004
November 2004
Prior to 2004
2004
Recipient
Directors
Manager (B)
Manager (B)
Manager (B)
Manager (B)
Manager (B)
Manager (B
Exercised (B)
Exercised (B)
Outstanding
Number
of Options
Weighted Average
Exercise Price
Fair Value at
Grant Date (millions)
16,000
700,000
460,000
328,227
330,000
345,000
162,500
(2,500)
(107,500)
2,231,727
$15.69
$13.00
$20.35
$22.85
$26.30
$25.75
$31.40
$13.90
$13.29
$21.25
Not Material
$0.4 (A)
$0.8 (A)
$0.4 (A)
$0.6 (A)
$0.5 (A)
$0.5 (A)
(A) The fair value of the options was estimated by reference to a binomial option pricing model. Since the Newcastle Option Plan has characteristics significantly different from
those of traded options, and since the assumptions used in such model, particularly the volatility assumption, are subject to significant judgment and variability, the actual
value of the options could vary materially from management’s estimate. The assumptions used in such model were as follows:
Date of Grant
Volatility
Dividend
Yield
Expected
Life (Years)
Risk-Free
Rate
October 2002
July 2003
December 2003
January 2004
May 2004
November 2004
15%
15%
15%
15%
15%
18%
13.85%
9.83%
8.75%
7.60%
9.32%
7.64%
10
10
10
10
10
10
4.05%
3.63%
4.23%
4.23%
4.77%
4.21%
(B) The Manager assigned certain of its options to its employees as follows:
Year Assigned
Strike Price
2004
2003
Total Inception
to Date
$13.00
$20.35
$22.85
$26.30
$31.40
Total
267,750
192,050
147,702
136,950
67,438
1,750
1,150
—
—
—
811,890
2,900
269,500
193,200
147,702
136,950
67,438
814,790
107,000 of the exercised options were exercised by employees of the Manager subsequent to their assignment. 3,000 of the exercised options were exercised by directors.
Newcastle Investment Corp. and Subsidiaries
p.55
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
10 . M A N AG E M E N T AG R E E M E N T A N D R E L AT E D PA R T Y T R A N S AC T I O N S
Manager
Newcastle entered into the Management Agreement with the Manager in June 2002, which provided for an initial term of one year with
automatic one-year extensions, subject to certain termination rights. After the initial one-year term, the Manager’s performance is reviewed
annually and the Management Agreement may be terminated by Newcastle by payment of a termination fee, as defined in the Management
Agreement, equal to the amount of management fees earned by the Manager during the twelve consecutive calendar months immediately
preceding the termination, upon the affirmative vote of at least two-thirds of the independent directors, or by a majority vote of the holders of
common stock. Pursuant to the Management Agreement, the Manager, under the supervision of Newcastle’s board of directors, formulates
investment strategies, arranges for the acquisition of assets, arranges for financing, monitors the performance of Newcastle’s assets and
provides certain advisory, administrative and managerial services in connection with the operations of Newcastle. For performing these
services, Newcastle pays the Manager an annual management fee equal to 1.5% of the gross equity of Newcastle, as defined. Holdings’
management agreement with the Manager contained substantially the same terms.
The Management Agreement provides that Newcastle will reimburse the Manager for various expenses incurred by the Manager or its
officers, employees and agents on Newcastle’s behalf, including costs of legal, accounting, tax, auditing, administrative and other similar
services rendered for Newcastle by providers retained by the Manager or, if provided by the Manager’s employees, in amounts which are no
greater than those which would be payable to outside professionals or consultants engaged to perform such services pursuant to agreements
negotiated on an arm’s-length basis.
To provide an incentive for the Manager to enhance the value of the common stock, the Manager is entitled to receive 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) the Funds from Operations, as defined (before the Incentive Compensation) of Newcastle per share of common
stock (based on the weighted average number of shares of common stock outstanding) plus (b) gains (or losses) from debt restructuring and
from sales of property and other assets per share of common stock (based on the weighted average number of shares of common stock
outstanding), exceed (2) an amount equal to (a) the weighted average of the price per share of common stock in the IPO and the value
attributed to the net assets transferred to us by Holdings, and in any subsequent offerings by Newcastle (adjusted for prior capital dividends or
capital distributions) multiplied by (b) a simple interest rate of 10% per annum (divided by four to adjust for quarterly calculations) multiplied
by (B) the weighted average number of shares of common stock outstanding. An affiliate of the Manager was entitled to a similar incentive
return from Holdings.
Management fee
Expense reimbursement
Incentive compensation
Amounts Incurred (in millions)
2004
$ 10.1
$ 0.5
$ 8.0
2003
$6.0
$0.5
$6.2
2002
$4.3
$0.5
$3.5
At December 31, 2004, an affiliate of the Manager, and its principals, owned 2.3 million shares of Newcastle’s common stock and had
options to purchase an additional 1.5 million shares of Newcastle’s common stock (Note 9).
At December 31, 2004, Due To Affiliates is comprised of $8.0 million of incentive compensation payable and $1.0 million of management
fees and expense reimbursements payable to the Manager.
Other Affiliates
In November 2003, Newcastle and a private investment fund managed by an affiliate of our manager co-invested and each indirectly own
an approximately 38% interest in a limited liability company (Note 3) that has acquired a pool of franchise loans from a third party financial
institution. Newcastle’s investment in this entity, reflected as an investment in an unconsolidated subsidiary on Newcastle’s consolidated
balance sheet, was approximately $23.5 million at December 31, 2004. The remaining approximately 24% interest in the limited liability
company is owned by the above-referenced third party financial institution.
In January 2004, Newcastle purchased from an underwriter $31.5 million face amount of B and BB rated real estate securities (Note 4)
of Global Signal Trust I, a special purpose vehicle established by Global Signal Inc. Two of Newcastle’s directors are the CEO and President
of Global Signal, Inc., respectively. A private equity fund managed by an affiliate of Newcastle’s manager owns a significant portion of
p.56
Global Signal Inc.’s common stock. Approximately $418.0 million of Global Signal Trust I securities were issued in 7 classes, rated AAA
though B, of which the B and BB classes constituted $73.0 million. The balance of the B and BB securities was sold on identical terms to a
private investment fund managed by an affiliate of our manager and to a large third party mutual fund complex. The proceeds of the offering
were utilized by Global Signal Inc. to repay an existing credit facility, to pay an extraordinary dividend of approximately $140 million to its
stockholders of which approximately $67 million was paid to the above-referenced private equity fund, and for general working capital
purposes. In December 2004, through its warehouse, Newcastle placed a deposit of approximately $2.6 million on $17.0 million of BB rated
securities of Global Signal Trust II, a special purpose vehicle established by Global Signal Inc. Pursuant to an underwritten 144A offering,
approximately $293.8 million of Global Signal Trust II securities were issued in 7 classes, rated AAA through BB–, of which the BB class
constituted approximately $35.4 million.
In March 2004, Newcastle and a private investment fund managed by an affiliate of Newcastle’s manager co-invested and each indirectly
own an approximately 49% interest in a limited liability company (Note 3) that has acquired, in a sale-leaseback transaction, a portfolio
of convenience and retail gas stores from a public company. The properties are subject to a number of master leases, the initial term of which
in each case is a minimum of 15 years. This investment was financed with nonrecourse debt at the limited liability company level and
Newcastle’s investment in this entity, reflected as an investment in an unconsolidated subsidiary on Newcastle’s consolidated balance sheet,
was approximately $17.8 million at December 31, 2004.
In December 2004, Newcastle and a private investment fund managed by an affiliate of Newcastle’s manager each made an initial
investment in a new real estate related loan (Note 5) with a maximum loan amount of $128 million, subject to being drawn down under
certain conditions. The loan is secured by a first mortgage on a large development project and related assets. Newcastle owns a 27.3% interest
in the loan and the private investment fund owns a 72.7% interest in the loan. Major decisions require the unanimous approval of holders of
interests in the loan while for other decisions, holders of interests in the loan vote based on their percentage interest therein. Newcastle and
our affiliated investment fund are each entitled to transfer all or any portion of their respective interests in the loan to third parties. Newcastle’s
investment in this loan was approximately $11.9 million at December 31, 2004.
In January 2005, Newcastle entered into a servicing agreement with a portfolio company of a private equity fund advised by an affiliate
of Newcastle’s manager for them to service a portfolio of manufactured housing loans (Note 5). As compensation under the servicing agree-
ment, the portfolio company will receive, on a monthly basis, a net servicing fee equal to 1.00% per annum on the unpaid principal balance
of the loans being serviced. Newcastle acquired a portfolio of such loans in January 2005 at a cost of $308.2 million.
In each instance described above, affiliates of Newcastle’s manager have an investment in the applicable affiliated fund and receive from
the fund, in addition to management fees, incentive compensation if the fund’s aggregate investment returns exceed certain thresholds.
11. C O M M I T M E N T S A N D C O N T I N G E N C I E S
Remarketing Agreements—One tranche of Newcastle’s CBO bonds (Note 8), with a $395.0 million face amount, was issued subject to
remarketing procedures and related agreements whereby such bonds are remarketed and sold on a periodic basis. These bonds are fully
insured by a third party with respect to the timely payment of interest and principal thereon, pursuant to a financial guaranty insurance policy
(“wrap”). Newcastle pays annual fees of 0.12% of the outstanding face amount of such bonds under this agreement.
In connection with the remarketing procedures described above, a backstop agreement has been created whereby a third party financial
institution is required to purchase such bonds at the end of any remarketing period if such bonds could not be resold in the market by the
remarketing agent. Newcastle pays an annual fee of 0.20% of the outstanding face amount of such bonds under this agreement.
In addition, the remarketing agent is paid an annual fee of 0.05% of the outstanding face amount of such bonds under the remarketing
agreement.
Real Estate Securities Portfolio Deposit—Newcastle has the option to purchase certain real estate securities from an investment bank.
To the extent that such securities decline in value, Newcastle must either purchase such securities or lose an amount equal to the lesser of such
decline or its deposit. See Note 4.
Guarantee of Swap Payments—In connection with the Bell Canada bonds (Note 8), Newcastle has guaranteed certain payments under
an interest rate swap to be entered into in 2007, if the Bell Canada bonds are not fully repaid by such date. Newcastle believes the fair value
of this guarantee is negligible at December 31, 2004.
Loan Commitment—With respect to one of its real estate related loans, Newcastle was committed to fund up to an additional $22.7 million
at December 31, 2004, subject to certain conditions to be met by the borrower.
Newcastle Investment Corp. and Subsidiaries
p.57
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
Stockholder Rights Agreement—Newcastle has adopted a stockholder rights agreement (the “Rights Agreement”). Pursuant to the terms
of the Rights Agreement, Newcastle will attach to each share of common stock one preferred stock purchase right (a “Right”). Each Right
entitles the registered holder to purchase from Newcastle a unit consisting of one one-hundredth of a share of Series A Junior Participation
Preferred Stock, par value $0.01 per share, at a purchase price of $70 per unit. Initially, the Rights are not exercisable and are attached to
and transfer and trade with the outstanding shares of common stock. The Rights will separate from the common stock and will become
exercisable upon the acquisition or tender offer to acquire a 15% beneficial ownership interest by an acquiring person, as defined. The effect
of the Rights Agreement will be to dilute the acquiring party’s beneficial interest. Until a Right is exercised, the holder thereof, as such, will
have no rights as a stockholder of Newcastle.
Litigation—Newcastle is, from time to time, a defendant in legal actions from transactions conducted in the ordinary course of business.
Management, after consultation with legal counsel, believes the ultimate liability arising from such actions which existed at December 31,
2004, if any, will not materially affect Newcastle’s consolidated results of operations or financial position.
Environmental Costs—As a commercial real estate owner, Newcastle is subject to potential environmental costs. At December 31, 2004,
management of Newcastle is not aware of any environmental concerns that would have a material adverse effect on Newcastle’s consolidated
financial position or results of operations.
Debt Covenants—Newcastle’s debt obligations contain various customary loan covenants. Such covenants do not, in management’s
opinion, materially restrict Newcastle’s investment strategy or ability to raise capital. Newcastle is in compliance with all of its loan covenants
at December 31, 2004.
12. I N C O M E TA X E S
Newcastle Investment Corp. is organized and conducts its operations to qualify as a REIT under the Code. A REIT will generally not
be subject to federal income tax on that portion of its income that it distributes to its stockholders if it distributes at least 90% of its REIT
taxable income to its stockholders by prescribed dates and complies with various other requirements. Newcastle has elected to treat NC Circle
Holdings II LLC as a taxable REIT subsidiary (“TRS”), effective February 27, 2004. NC Circle Holdings II LLC owns a portion of Newcastle’s
investment in a portfolio of convenience and retail gas stores as described in Note 3. To the extent that NC Circle Holdings II LLC generates
taxable income, Newcastle has provided for relevant income taxes based on a blended statutory rate of 40%. Newcastle accounts for income
taxes in accordance with the provisions of SFAS No. 109 “Accounting for Income Taxes.” Under SFAS No. 109, Newcastle accounts for income
taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
No such material differences have been recognized through December 31, 2004.
13 . S U B S E Q U E N T E V E N T S
In January 2005, NCT sold 3.3 million shares of its common stock in a public offering at a price to the public of $29.60 per share, for net
proceeds of approximately $96.6 million. For the purpose of compensating the Manager for its successful efforts in raising capital for
Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 330,000 shares of Newcastle’s common
stock at the public offering price, which were valued at approximately $1.1 million.
In January 2005, Newcastle’s Manager and certain of the Manager’s employees exercised approximately 0.6 million options for shares of
Newcastle’s common stock. In connection with this exercise, Newcastle received proceeds of approximately $8.9 million.
In January 2005, Newcastle agreed to the terms for a sale of the vacant property in the Bell Canada portfolio (Note 6). The terms include
a sales price of $14.3 million CAD ($11.9 million USD at December 31, 2004) and Newcastle has received a nonrefundable deposit thereon.
In March 2005, Newcastle agreed to the terms for a sale of the industrial/distribution property in the Bell Canada portfolio (Note 6). The
terms include a gross sale price of $47.6 million CAD ($39.6 million USD at December 31, 2004) and Newcastle has received a nonrefundable
deposit thereon.
p.58
In January 2005, Newcastle, through a consolidated subsidiary, acquired a portfolio of approximately 8,100 manufactured housing loans
for an aggregate purchase price of approximately $308.2 million. The loans, which were all current at the time of acquisition, are primarily fixed
rate with a weighted average coupon of approximately 9.00% and a weighted average remaining term of approximately 5.00 years. Newcastle’s
acquisition was initially funded with approximately $246.5 million of one-year debt provided by two investment banks which is subject to
adjustment based on the market value and performance of the related portfolio. The debt bears interest at LIBOR + 1.25%. Newcastle
obtained an interest rate swap in order to hedge its exposure to the risk of changes in market interest rates with respect to this debt.
14 . S U M M A R Y Q UA R T E R LY C O N S O L I DAT E D F I N A N C I A L I N F O R M AT I O N ( U N AU D I T E D )
The following is unaudited summary information on Newcastle’s quarterly operations. The distribution of investments, and related liabilities,
to Holdings and the commencement of Newcastle’s independent operations occurred at the beginning of the quarter ended September 30, 2002.
Therefore, periods prior to this quarter are not reflective of Newcastle’s ongoing operations nor are they comparable to subsequent quarters.
2004
Gross revenues
Operating expenses
Operating income
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries (A)
Income from continuing operations
Income (loss) from discontinued operations
Preferred dividends
Quarter Ended
March 31 (B)
June 30 (B)
September 30 (B)
December 31
Year Ended
December 31
$ 58,857
$ 63,326
(8,860)
(7,417)
$ 64,886
(8,952)
$ 71,077
(8,326)
$ 258,146
(33,555)
49,997
(28,926)
(333)
1,223
21,961
(110)
(1,523)
55,909
(33,148)
(306)
2,218
24,673
(1,498)
(1,524)
55,934
(34,152)
(319)
3,179
24,642
325
(1,523)
62,751
(42,621)
(346)
3,337
23,121
5,301
(1,524)
224,591
(138,847)
(1,304)
9,957
94,397
4,018
(6,094)
Income available for common stockholders
$ 20,328
$ 21,651
$ 23,444
$ 26,898
$ 92,321
Net income per share of common stock
Basic
Diluted
Income from continuing operations per share of common stock,
after preferred dividends and related accretion
Basic
Diluted
Income (loss) from discontinued operations per share of common stock
Basic
Diluted
Weighted average number of shares of common stock outstanding
Basic
Diluted
(A) Net of income taxes on related taxable subsidiaries.
$
$
0.59
0.58
$
$
$
$
0.59
0.58
0.00
0.00
$
$
$
$
$
$
0.60
0.59
0.64
0.63
(0.04)
(0.04)
$
$
$
$
$
$
0.61
0.60
$
0.70
$
0.69
0.60
0.59
0.01
0.01
$
0.56
$
0.55
$
0.14
$
0.14
$
$
$
$
$
$
2.50
2.46
2.39
2.35
0.11
0.11
34,402
36,161
34,976
36,671
38,234
38,883
38,941
39,663
36,944
37,558
Newcastle Investment Corp. and Subsidiaries
p.59
notes to consolidated financial statements (continued)
December 31, 2004, 2003 and 2002
(dollars in tables in thousands, except per share data)
March 31 (B)
June 30 (B)
Quarter Ended
Year Ended
September 30 (B) December 31 December 31
2003
Gross revenues
Operating expenses
Operating income
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries
Income from continuing operations
Income (loss) from discontinued operations
Preferred dividends
$ 31,398
$ 38,678
(5,811)
(6,257)
$ 40,772
(6,171)
$ 53,206
(7,622)
$ 164,054
(25,861)
25,587
(13,896)
(281)
—
11,410
(307)
(203)
32,421
(18,892)
(297)
—
13,232
185
(1,524)
34,601
(19,244)
(301)
—
15,056
(350)
(1,523)
45,584
(27,052)
(315)
862
19,079
(2,187)
(1,523)
138,193
(79,084)
(1,194)
862
58,777
(2,659)
(4,773)
Income available for common stockholders
$ 10,900
$ 11,893
$ 13,183
$ 15,369
$ 51,345
Net income per share of common stock
Basic
Diluted
Income from continuing operations per share of common stock,
after preferred dividends and related accretion
Basic
Diluted
Income (loss) from discontinued operations per share of common stock
Basic
Diluted
Weighted average number of shares of common stock outstanding
Basic
Diluted
2002
Gross revenues
Operating expenses
Operating income
Interest expense
Depreciation and amortization
Equity in earnings of unconsolidated subsidiaries
Income from continuing operations
Income (loss) from discontinued operations
Preferred dividends and related accretion
Income available for common stockholders
Net income per share of common stock, basic and diluted
Income (loss) from continuing operations per share of common stock,
after preferred dividends and related accretion, basic and diluted
Income (loss) from discontinued operations per share of common stock,
basic and diluted
Weighted average number of shares of common stock outstanding
Basic
Diluted
$
$
0.46
0.46
$
$
0.48
0.48
$
(0.02)
$
(0.02)
$
$
$
$
$
$
0.51
0.50
0.50
0.49
0.01
0.01
$
$
$
$
$
$
0.48
0.48
$
0.53
$
0.52
0.49
0.49
(0.01)
(0.01)
$
0.61
$
0.60
$
(0.08)
$
(0.08)
$
$
$
$
$
$
1.98
1.96
2.08
2.06
(0.10)
(0.10)
23,489
23,489
23,620
23,679
27,340
27,620
29,197
29,563
25,898
26,141
March 31 (B)
June 30 (B)
Quarter Ended
Year Ended
September 30 (B) December 31 December 31
$ 8,817
$ 37,596
(366)
(12,338)
$ 26,286
(3,982)
$ 28,676
(5,359)
$ 101,375
(22,045)
8,451
(7,747)
(477)
(452)
(225)
1,096
(638)
25,258
(12,469)
(544)
814
13,059
329
(524)
22,304
(12,835)
(273)
—
9,196
(1,692)
—
23,317
(13,324)
(266)
—
9,727
5
—
79,330
(46,375)
(1,560)
362
31,757
(262)
(1,162)
$
$
233
$ 12,864
$ 7,504
$ 9,732
$ 30,333
0.01
$
0.78
$
0.46
$
0.43
$
1.68
$
(0.06)
$
0.76
$
0.56
$
0.43
$
1.69
$
0.07
$
0.02
$
(0.10)
$
0.00
$
(0.01)
16,489
16,489
16,489
16,489
16,489
16,489
22,804
22,843
18,080
18,090
(B) The Income Available for Common Stockholders shown agrees with Newcastle’s quarterly report(s) on Form 10-Q as filed with the Securities and Exchange Commission.
However, individual line items vary from such report(s) due to the operations of properties sold, or classified as held for sale, during subsequent periods being retroactively
reclassified to Income for Discontinued Operations for all periods presented (Note 5).
p.60
report of independent registered public accounting firm
The Board of Directors and Stockholders of
Newcastle Investment Corporation
We have audited the accompanying consolidated balance sheets of Newcastle Investment Corporation and subsidiaries (the “Company”)
as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity and redeemable preferred stock,
and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the
Company at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in
the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated
March 3, 2005 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
New York, NY
March 3, 2005
Newcastle Investment Corp. and Subsidiaries
p.61
report on internal control over financial reporting of
independent registered public accounting firm
The Board of Directors and Stockholders of
Newcastle Investment Corporation
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial
Reporting, that Newcastle Investment Corporation and subsidiaries (the “Company”) maintained effective internal control over financial
reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining
effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our
responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over
financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting,
evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of
records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of
management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of
December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in
all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of the Company as of December 31, 2004, and the related consolidated statements of income, stockholders’
equity and redeemable preferred stock, and cash flows for each of the three years in the period ended December 31, 2004 of the Company and
our report dated March 3, 2005 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
New York, NY
March 3, 2005
p.62
management’s report on internal control over financial reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Internal
control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a
process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the
Company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial report-
ing and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the
United States and includes those policies and procedures that:
• pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of
the Company;
• provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with
accounting principles generally accepted in the United States, and that receipts and expenditures of the Company are being made only in
accordance with authorizations of management and directors of the Company; and
• provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Projections of
any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. In making
this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
in “Internal Control—Integrated Framework.”
Based on our assessment, management concluded that, as of December 31, 2004, the Company’s internal control over financial reporting
is designed and operating effectively.
The Company’s independent auditors have issued an audit report on our assessment of the Company’s internal control over financial
reporting.
By: /s/ Wesley R. Edens
Wesley R. Edens
Chairman of the Board
By: /s/ Debra A. Hess
Debra A. Hess
Chief Financial Officer
Newcastle Investment Corp. and Subsidiaries
p.63
market for registrant’s common equity, related stockholder matters
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.
2004
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
2003
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
High
$33.89
$33.40
$31.74
$32.87
High
$16.83
$20.00
$23.24
$27.24
Low
$25.51
$24.51
$27.97
$29.84
Low
$15.46
$16.50
$19.00
$22.64
Last
Sale
$33.70
$29.95
$30.70
$31.78
Last
Sale
$16.73
$19.58
$22.99
$27.10
Distributions
Declared
$0.600
$0.600
$0.600
$0.625
Distributions
Declared
$0.450
$0.500
$0.500
$0.500
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 March 8, 2005, the closing sale price for our common stock, as reported on the NYSE, was $30.73. As of March 8, 2005, there were
approximately 77 record holders of our common stock. This figure does not reflect the beneficial ownership of shares held in nominee name.
p.64
corporate information
B OA R D O F D I R E C TO R S
C O R P O R AT E O F F I C E R S
C O R P O R AT E H E A D Q UA R T E R S
Wesley R. Edens
Chairman and Chief Executive Officer
Kenneth M. Riis
President
Jonathan Ashley
Chief Operating Officer
Lilly H. Donohue
Managing Director and Assistant Secretary
Debra A. Hess
Chief Financial Officer
Randal A. Nardone
Secretary
Erik P. Nygaard
Chief Information Officer
Wesley R. Edens
Principal
Fortress Investment Group LLC
David J. Grain
President
Global Signal Inc.
Stuart A. McFarland(1)
Managing Partner
FCCA
David K. McKown(1)
Senior Advisor
Eaton Vance Management
Peter M. Miller(1)
Managing Director
Dresdner Kleinwort Wasserstein
Securities LLC
(1)Member of Audit Committee,
Nominating and Corporate
Governance Committee and
Compensation Committee
Newcastle Investment Corp.
c/o Fortress Investment Group LLC
1251 Avenue of the Americas, 16th Floor
New York, NY 10020
(212) 798-6100
Legal Counsel
Skadden, Arps, Slate, Meagher & Flom LLP
Four Times Square
New York, NY 10036-6522
Independent Auditors
Ernst & Young LLP
Five Times Square
New York, NY 10036-6522
Stock Transfer Agent and Registrar
American Stock Transfer & Trust Company
59 Maiden Lane
New York, NY 10038
(800) 937-5449
Stock Exchange Listing
Newcastle Investment Corp.’s
common stock is listed on the
New York Stock Exchange (symbol: NCT)
Annual Meeting of Stockholders
May 17, 2005, 10:30 a.m. EST
The Four Seasons Hotel
Metropolitan Suite
57 East 57th Street
New York, NY 10022
Investor Information Services
Lilly H. Donohue
Director, Investor Relations
Newcastle Investment Corp.
c/o Fortress Investment Group LLC
1251 Avenue of the Americas, 16th Floor
New York, NY 10020
Tel: (212) 798-6118
Fax: (212) 798-6133
e-mail: ldonohue@fortressinv.com
Newcastle Investment Corp. web site
http://www.newcastleinv.com
Newcastle Investment Corp. submitted a timely CEO certification to the New York Stock Exchange (NYSE) in 2004 pursuant to NYSE Listed Company Manual Section 303A.12(a) stating that
its CEO was not aware of any violations of the NYSE corporate governance listing standards.
Newcastle Investment Corp. filed timely CEO and CFO certifications with the Securities and Exchange Commission pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 regarding
Newcastle’s annual report on Form 10-K for the year ended December 31, 2004. These certifications were filed as exhibits 31.1 and 31.2 to such Form 10-K.
Forward-Looking 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 and financing needs. Forward-looking statements are generally identifiable by use of forward-looking terminology such as “may,” “will,”
“should,” “potential,” “intend,” “expect,” “endeavor,” “seek,” “anticipate,” “estimate,” “overestimate,” “underestimate,” “believe,” “could,” “project,” “predict,” “continue” or other
similar words or expressions. Forward-looking statements are based on certain assumptions, discuss future expectations, describe future plans and strategies, contain projections of results of
operations or of financial condition or state other forward-looking information. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Although
we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set
forth in the forward-looking statements. These forward-looking statements involve risks, uncertainties and other factors that may cause our actual results in future periods to differ materially
from forecasted results. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in economic conditions generally and
the real estate and bond markets specifically, changes in the financing markets we access that affect our ability to finance our real estate securities portfolios in general or particular real estate
related assets, changes in interest rates and/or credit spreads and the success of our hedging strategy in relation to such changes, the availability and cost of capital for future investments, the
rate at which we can invest our cash in suitable investments and legislative/regulatory changes (including in respect of rules applicable to REITs).
April, 2005
NE WC A STLE IN V ESTM ENT COR P.
www.newcastleinv.com
>>