UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2021
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____ to____
Commission file number: 001-35845
LUMENT FINANCE TRUST, INC.
(Exact name of registrant as specified in its charter)
| Maryland | 45-4966519 | |||||||
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |||||||
230 Park Avenue, 20th Floor, New York, New York | 10169 | |||||||
| (Address of principal executive offices) | (Zip code) | |||||||
Registrant’s Telephone Number, including area code (212) 317-5700
Securities Registered Pursuant to Section 12(b) of the Act:
| Title of Each Class: | Trading Symbol(s) | Name of Exchange on Which Registered: | ||||||||||||
| Common Stock, par value $0.01 per share | LFT | New York Stock Exchange | ||||||||||||
| 7.875% Series A Cumulative Redeemable Preferred Stock, par value $0.01 per share | LFTPrA | New York Stock Exchange | ||||||||||||
Securities Registered Pursuant to Section 12(g) of the Act: None.
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ or No ☒
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ☐ or No ☒
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ or No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ or No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act.
| Large accelerated filer ☐ | Accelerated filer ☐ | ||||
Non-accelerated filer ☒ | Smaller reporting company ☒ | ||||
Emerging growth company ☐ | |||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ or No ý
The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $74.0 million as of June 30, 2021 (the last business day of the registrant's most recently completed second fiscal quarter) based on the closing sale price on the New York Stock Exchange on that date.
As of March 14, 2022, there were 52,225,152 outstanding shares of common stock, $0.01 par value.
TABLE OF CONTENTS
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Cautionary Note Regarding Forward-Looking Statements
This Annual Report on Form 10-K contains certain forward-looking statements intended to qualify for the safe harbor contained in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act, as amended. Forward-looking statements are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial conditions, liquidity, results of operations, plans and objectives. In addition, our management may from time to time make oral forward-looking statements. You can identify forward-looking statements by use of words such as "believe," "expect," "anticipate," "estimate," "project," "plan," "continue," "intend," "should," "may," "will," "seek," "would," "could" or similar expressions or other comparable terms, or by discussions of strategy, plans or intentions.
These forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operation may vary materially from those expressed in our forward-looking statements. Factors that may cause actual results to vary from our forward-looking statements include, but are not limited to:
•the risks, uncertainties and factors set forth in Part I, Item 1A. "Risk Factors" in this Annual Report on Form 10-K;
•how widely utilized COVID-19 vaccines will be, whether they will be effective in preventing the spread of COVID-19 (including its variant strains), and their impact on the ultimate severity and duration of the COVID-19 pandemic;
•potential risks and uncertainties relating to the ultimate geographic spread of COVID-19;
•actions that may be taken by governmental authorities to contain COVID-19 and treat its impact;
•the potential negative impact of COVID-19 or other public health issues on our business and financial condition and the global economy in general;
•the general political, economic and competitive conditions in the markets in which we invest;
•the level and volatility of prevailing interest rates and credit spreads;
•adverse changes in the real estate and real estate capital markets;
•difficulty in obtaining financing or raising capital;
•reductions in the yield on our investments and an increase in the cost of our financing;
•defaults by borrowers in paying debt service on outstanding indebtedness;
•adverse legislative or regulatory developments;
•changes in our business, investment strategies or target assets;
•increased competition from entities engaged in mortgage lending or investing in our target assets;
•acts of God such as hurricanes, earthquakes, pandemics such as COVID-19 and other natural disasters, acts of war and/or terrorism and other events that may cause unanticipated and uninsured performance declines and/or losses to us or to the owners and operators of the real estate securing our investments;
•deterioration in the performance of the property securing our investments that may cause deterioration in the performance of our investments and, potentially, principal losses to us;
•difficulty in redeploying the proceeds from repayment of our existing investments;
•difficulty in successfully managing our growth, including integrating new assets into our existing systems;
•authoritative generally accepted accounting principles, or GAAP, or policy changes from such standard-setting bodies as the Financial Accounting Board, or FASB, the Securities Exchange Commission, or SEC, the Internal Revenue Service, or IRS, the New York Stock Exchange, or NYSE, or other authorities that we are subject to;
•the potential unavailability of the London Interbank Offered Rate ("LIBOR") after December 31, 2021; and
•our qualification as a real estate investment trust ("REIT") for U.S. federal income tax purposes under the Internal Revenue Code of 1986, as amended ("the Code"), and our exclusion from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act").
These and other risks, uncertainties and factors, including the risk factors described in Part 1, Item 1A - "Risk Factors" and Part 2, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Annual Report on Form 10-K, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All subsequent written and oral forward-looking statements that we make, or that are attributable to us, are expressly qualified in their entirety by this cautionary notice. Any forward-looking statement speaks only as of the date on which it is made. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
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PART I
ITEM 1. BUSINESS
References herein to "Lument Finance Trust," "Company," "LFT," "we," "us," or "our" refer to Lument Finance Trust, Inc., a Maryland corporation, and its subsidiaries unless the context specifically requires otherwise.
Our Company
We are a real estate investment trust ("REIT") focused on investing in, financing and managing a portfolio of commercial real estate ("CRE") debt investments. We primarily invest in transitional floating rate CRE mortgage loans with an emphasis on middle-market multifamily assets. We may also invest in other CRE-related investments including mezzanine loans, preferred equity, commercial mortgage-backed securities, fixed rate loans, construction loans and other CRE debt instruments.
We are externally managed by our manager, OREC Investment Management, LLC, doing business as Lument Investment Management (the "Manager" or "Lument IM") pursuant to the terms of our management agreement. Our Manager is a subsidiary of ORIX Real Estate Capital Holdings, LLC doing business as Lument ("Lument"). Lument is a subsidiary of ORIX Corporation USA ("ORIX USA"), a diversified financial company and a subsidiary of ORIX Corporation ("ORIX"). ORIX is a publicly traded, Tokyo-based international financial services company with assets in excess of $124 billion as of September 2021 and was ranked number 274 on Forbes 2021 Global 2000: World's Biggest Public Companies..
We are a Maryland corporation that was formed in March 2012 and commenced operations in May 2012. We have elected to be taxed as a REIT for U.S. federal income tax purposes. On December 28, 2020, we changed our name from "Hunt Companies Finance Trust, Inc." to "Lument Finance Trust, Inc." and our common stock began trading on the New York Stock Exchange ("NYSE") under the symbol "LFT." Previously, our common stock traded on the NYSE under the symbol "HCFT." Our Series Preferred Stock is traded on the NYSE under the symbol "LFTPrA."
The ORIX Transaction
On January 6, 2020, we announced the entry into a new external management agreement with Lument IM and the concurrent mutual termination of our management agreement with our prior manager, Hunt Investment Management, LLC ("HIM"). Lument IM is part of Lument, a nationally recognized leader in multifamily and seniors housing and healthcare finance. The terms of the new management agreement align with the terms of our prior management agreement with HIM in all material respects, including a cap on reimbursable expenses. Pursuant to the terms of the termination agreement between the Company and HIM, the termination of the management agreement did not trigger, and HIM was not paid, a termination fee by the us.
Our Manager and Lument
We are externally managed and advised by our Manager, a subsidiary of Lument. At December 31, 2021, Lument had over 600 employees located in over 30 offices throughout the United States. We have access to an extensive loan origination platform through our affiliation with Lument, which is a premier national mortgage originator and asset manager. Lument's origination teams employ a relationship-focused approach to lending opportunities and focus on speed and certainty of execution for its borrower clients, thereby strengthening Lument's reputation as a reliable counterparty and encouraging repeat business. Lument has originated over $70 billion of CRE mortgage transactions in its nearly 50 years of continuous operations (inclusive of predecessor companies).
Our Manager implements our business strategy, performs investment advisory services with respect to our assets, and is responsible for performing all of our day-to-day operations. Our Manager is an investment adviser registered with the Securities and Exchange Commission ("SEC") and is subject to the supervision and oversight of our board of directors and has only such functions and authority as our board of directors delegates to it. Pursuant to a management agreement between our Manager and us, our Manager is entitled to receive a base management fee, an incentive fee, and certain expense reimbursements.
Our Investment Strategy
We invest primarily in transitional floating rate CRE mortgage loans with an emphasis on middle-market multifamily assets. We may also invest in other CRE-related investments including mezzanine loans, preferred equity, commercial mortgage-backed securities, fixed rate loans, construction loans and other CRE debt instruments. We finance our current investments in transitional multifamily and other CRE loans primarily through match term non-recourse CRE collateralized loan obligations ("CLO"). We may utilize warehouse repurchase agreements or other forms of financing in the future. Our primary sources of income are net interest from our investment portfolio and non-interest income from our mortgage loan-related activities. Net interest income represents the interest we earn on investments less the expense of funding these investments.
Our investments typically have the following characteristics:
•Sponsors with experience in particular real estate sectors and geographic markets;
•Located in U.S. markets with multiple demand drivers, such as growth in employment and household formation;
•Fully funded principal balance greater than $5 million and generally less than $75 million;
•Loan to Value ratio up to 85% of as-is value and up to 75% of as-stabilized value;
•Floating rate loans historically tied to one-month U.S. denominated LIBOR, more recently to one-month term SOFR, and/or in the future, potentially other index replacement; and
•Three-year term with two one-year extension options.
We believe that our current investment strategy provides significant opportunities to achieve attractive risk-adjusted returns for our stockholders over time. However, to capitalize on the investment opportunities at different points in the economic and real estate investment cycle, we may modify or expand our investment strategy. We believe that the flexibility of our strategy, which is supported by the significant CRE experience of Lument's investment team, and the extensive resources of ORIX USA, will allow us to take advantage of changing market conditions to maximize risk-adjusted returns to our stockholders.
Our Target Assets
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Commercial Mortgage Loans. We intend to continue to focus on selectively acquiring first mortgage loans sourced by our Manager and its affiliates. These loans are secured by a first mortgage lien on a commercial property, may vary in duration, predominantly bear interest at a floating rate, may provide for regularly scheduled principal amortization and typically require a balloon payment of principal at maturity. These investments may encompass a whole commercial mortgage loan or may include a participation in a portion of a commercial mortgage loan.
Other Commercial Real-Estate-Related Debt Instruments. We also expect to opportunistically originate and selectively acquire other CRE-related debt instruments, subject to maintaining our qualification as a REIT for U.S. federal income tax purposes and our exclusion or exemption from regulation under the Investment Company Act, as amended (the 'Investment Company Act"), including, but not limited to, the following:
•Mezzanine Loans. These are loans made to the owner of a mortgage borrower and secured by a pledge of the equity interests in the mortgage borrower. These loans are subordinate to a first mortgage loan but senior to the borrower’s equity. These loans may be tranched into senior and junior mezzanine loans, with the junior mezzanine lenders secured by a pledge of the equity in the senior mezzanine borrower. Following a default on a mezzanine loan, and subject to the negotiated terms with the mortgage lender or other senior lenders, the mezzanine lender generally has the right to foreclose on its equity interest in the mortgage borrower and become the owner of the property, directly or indirectly, subject to the lien of the first mortgage loan and any debt senior to it, including any outstanding senior mezzanine debt. In addition, the mezzanine lender typically has additional rights relative to the more senior lenders, including the right to cure defaults under the mortgage loan and any senior mezzanine loan and purchase the mortgage loan and any senior mezzanine loan, in each case under certain circumstances following a default on the mortgage loan. Unlike a B Note holder, the mezzanine lender typically has the authority to administer its own loan, independent from the administration of the mortgage loan.
•Preferred Equity. These are investments subordinate to any mezzanine loan, but senior to the owners’ common equity. Preferred equity investments typically pay a dividend, rather than interest payments, and often provide for the accrual of such dividends if cash flow is insufficient to pay such amounts on a current basis. Preferred equity interests are not secured by the underlying real estate, but upon the occurrence of an issuer’s failure to make payments required by the terms of the preferred equity instrument or certain other specified events of default, the preferred equity holder typically has the right to effectuate a change of control with respect to the ownership of the property, which would include the ability of the preferred equity holder to sell the property to realize its investment. Preferred equity is generally subject to mandatory redemption by the issuer at the end of a specified term.
•Secured Real Estate Securities. These are securities, which may take the form of CMBS or CLOs that are collateralized by pools of CRE debt instruments, often first mortgage loans. The underlying loans are aggregated into a pool and sold as securities to investors. Under the pooling and servicing agreements that govern these pools, the loans are administered by a trustee and servicers, which act on behalf of all investors and distribute the underlying cash flows from the pools of debt instruments to the different classes of securities in accordance with their seniority and ratings.
•Miscellaneous Debt Instruments. This would encompass any other CRE-related debt instruments, if necessary, to maintain our qualification as a REIT for U.S. federal income tax purposes or our exclusion or exemption from regulation under the Investment Company Act.
The allocation of our capital among our target assets will depend on prevailing market conditions at the time we invest and may change over time in response to different prevailing market conditions. In the future, we may invest in assets other than our target assets or change our target assets, in each case subject to maintaining our qualification as a REIT for U.S. federal income tax purposes and our exclusion or exemption from regulation under the Investment Company Act.
Our Portfolio
Transitional Multifamily and Commercial Real Estate Loans
As of December 31, 2021, our mortgage loan investment portfolio consisted of 66 senior secured floating rate loans with an aggregate unpaid principal balance of $1.0 billion, collectively having a weighted average coupon of 3.9% and a weighted average term to maturity of 3.7 years. As of December 31, 2021, 66.2% of the loans in our mortgage loan investment portfolio benefit from a LIBOR floor, with a weighted average floor of 0.49%. As of December 31, 2021, 92.0% of the portfolio was supported by multifamily assets.
During 2021, the Company acquired $983.7 million in loans and realized $528.4 million of loan repayments. This activity resulted in net repayments of $455.3 million. The following table details the overall statistics of our loan portfolio as of December 31, 2021:
| Weighted Average | ||||||||||||||||||||||||||||||||||||||||||||
| Loan Type | Unpaid Principal Balance | Carrying Value | Loan Count | Floating Rate Loan % | Coupon(1) | Term (Years)(2) | LTV(3) | |||||||||||||||||||||||||||||||||||||
| December 31, 2021 | ||||||||||||||||||||||||||||||||||||||||||||
| Loans held-for-investment | ||||||||||||||||||||||||||||||||||||||||||||
Senior secured loans(4) | $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | 71.2 | % | ||||||||||||||||||||||||||||||||
| $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | 71.2 | % | |||||||||||||||||||||||||||||||||
(1) Weighted average coupon assumes applicable one-month LIBOR rate of 0.10% as of December 31, 2021, and is inclusive of weighted average LIBOR floors of 0.49%.
(2) Weighted average term assumes all extension options are exercised by the borrower; provided, however, that our loans may be repaid prior to such date.
(3) LTV as of the date the loan was originated and is calculated after giving effect to capex and earnout reserves, if applicable. LTV has not been updated for any subsequent draws or loan modifications and is not reflective of any changes in value which may have occurred subsequent to origination date.
(4) As of December 31, 2021, $974,025,294 of the outstanding senior secured loans were held in variable interest entities ("VIEs") and $27,800,000 of the outstanding senior secured loans were held outside VIEs.
The charts below present the geographic dispersion of our loan portfolio and the property types securing our loan portfolio as of December 31, 2021:
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MSRs
As of December 31, 2021, the Company retained the servicing rights associated with residential mortgage loans having an aggregate unpaid principal balance of approximately $91.7 million that we had previously transferred to three residential mortgage loan securitization trusts. The carrying value of these MSRs at December 31, 2021 was approximately $0.6 million. HIM, our prior external manager, ceased the aggregation of residential mortgage loans in 2016 and other than servicing our existing portfolio, we do not anticipate any residential loan activity going forward.
Our Financing Strategy
We use leverage to seek to increase potential returns to our stockholders. We may use of non-recourse CRE CLOs, secured revolving repurchase agreements, term loan facilities, warehouse facilities, asset-specific financing structures and other forms of leverage. As of December 31, 2021, our assets were financed with a match term, non-recourse CRE CLO and one senior corporate credit facility.
The goal of our leverage strategy is to ensure that, at all times, our leverage ratio is appropriate for the level of risk inherent in the investment portfolio and that each asset class has individual leverage targets that we believe are appropriate. We generally seek, to the extent possible, to match-fund and match-index our investments by minimizing the differences between the duration and indices of our investments and those of our liabilities. We also seek to minimize our exposure to mark-to-market risk.
While our organizational documents and our investment guidelines do not place any limits on the maximum amount of leverage that we may use, our financing facilities require us to maintain particular debt-to-equity leverage ratios. We may change our financing strategy and leverage without the consent of our stockholders.
Competition
We are engaged in a competitive business. In our investing activities, we compete for opportunities with a variety of institutional investors, including other REITs, specialty finance companies, public and private funds, commercial and investment banks, commercial finance and insurance companies and other financial institutions. Several other REITs and other investment vehicles have raised significant amounts of capital and may have investment objectives that overlap with ours, which may create additional competition for investment opportunities. Some competitors may have a lower cost of funds and broader access to funding sources, such as the U.S. Government, that are not available to us. Many of our competitors are not subject to the operating constraints associated with REIT compliance or maintenance of an exclusion from regulation under the Investment Company Act. We could face increased competition from banks due to future legislative developments, such as amendments to key provisions of the Dodd-Frank Act including, provisions setting forth capital and risk retention requirements. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of loans and investments and offer more attractive pricing or other terms than we would. Furthermore, competition for investments we target may lead to decreasing yields, which may further limit our ability to generate targeted returns.
We believe access to our Manager's professionals and their industry expertise and relationships provide us with competitive advantages in assessing risks and determining appropriate pricing for potential investments. We believe these relationships will enable us to compete effectively for attractive investment opportunities. However, we may not be able to achieve our business goals or expectations due to the competitive risks that we face.
Investment Guidelines
Under the management agreement with our Manager, our Manager will be required to manage our business in accordance with certain investment guidelines and policies that have been approved by our board of directors, including each of our independent directors. Under these investment guidelines and policies:
•We will not make an investment that would cause us to fail to qualify as a REIT for U.S. federal income tax purposes.
•We will not make an investment that would cause us to be regulated as an “investment company” under the Investment Company Act.
•We are permitted to invest residential mortgage-backed securities, multi-family mortgage-backed securities, commercial mortgage-backed securities, residential mortgage loans, multi-family mortgage loans, CRE mortgage loans, mortgage servicing rights and other mortgage or real estate-related investments.
•Our Manager may invest the net proceeds of any offerings of our securities in interest-bearing, short-term investments, including money market accounts or funds, that are consistent with our intention to qualify as a REIT for U.S. federal income tax purposes and maintain an exemption from registration under the Investment Company Act.
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These investment guidelines may be amended, restated, modified, supplemented or waived by our board of directors (which must include a majority of the independent directors of our board of directors) without the approval of our stockholders.
Environmental, Social and Governance
We are committed to responsibly managing risk and preserving value for our shareholders. We make capital allocation decisions with environmental, social and governance ("ESG") factors of our potential collateral and borrowers in mind, and incorporate diligence practices as part of our investment process to identify material ESG matters related to a given asset.
Our day-to-day operations are externally managed by our Manager, a subsidiary of ORIX USA. As such, much of the ESG initiatives undertaken by ORIX USA impact or apply to us. Key ESG initiatives we share with ORIX USA include considerations of ESG in the in the investment process, dedicated resources to ESG governance and oversight, industry engagement on ESG matters, corporate sustainability and environmental performance improvements at our office locations, and certain employee and community engagement and diversity, equity and inclusion ("DEI") programs.
Government Regulation
Our operations are subject, in certain instances, to supervision and regulation by U.S. and other governmental authorities, and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which among other things: (i) regulate credit-granting activities; (ii) establish maximum interest rates, finance charges and other charges; (iii) require disclosures to customers; (iv) govern secured transactions; and (v) set collections, foreclosure, repossession and claims-handling procedures and other trade practices. We are also required to comply with certain provisions of the Equal Credit Opportunity Act that are applicable to commercial loans. We intend to conduct our business so that neither we nor any of our subsidiaries are required to register as an investment company under the Investment Company Act.
In our judgment, existing statutes and regulations have not had a material adverse effect on our business. In recent years, legislators in the United States and in other countries have said that greater regulation of financial services firms is needed, particularly in areas such as risk management, leverage and disclosure. While we expect that additional new regulations in these areas may be adopted and existing ones may change in the future, it is not possible at this time to forecast the exact nature of any future legislation, regulations, judicial decisions, orders or interpretations, nor their impact upon our future business, financial condition, or results of operations or prospects.
Taxation of the Company
We elected to be taxed as a REIT commencing with our short taxable year ended December 31, 2012, and comply with the provisions of the Code with respect thereto. Accordingly, we are generally not subject to U.S. federal income tax on the REIT taxable income that we currently distribute to our stockholders so long as we maintain our qualification as a REIT. Our continued qualification as a REIT depends on our ability to meet, on a continuing basis, various complex requirements under the Code relating to, among other things, the source of our gross income, the composition and values of our assets, our distribution levels and the concentration of ownership of our capital stock. Even if we maintain our qualification as a REIT, we may be subject to some U.S. federal, state and local taxes on our income.
Taxable income generated by our taxable REIT subsidiary ("TRS"), is subject to regular corporate income tax. For the fiscal year 2021, our TRS did not generate taxable income.
Qualification as a REIT
Continued qualification as a REIT requires that we satisfy a variety of tests relating to our income, assets, distributions and ownership. The significant tests are summarized below.
Income Tests. In order to maintain our REIT qualification, we must satisfy two gross income requirements on an annual basis. First, at least 75% of our gross income for each taxable year, excluding gross income from sales of inventory or dealer property in "prohibited transactions" (as defined herein), discharge of indebtedness and certain hedging transactions, generally must be derived from investments relating to real property or mortgages on real property, including interest income derived from mortgage loans secured by real property (including certain types of mortgage-backed securities), rents from real property, dividends received from other REITs, and gains from the sale of designated real estate assets, as well as specified income from temporary investments. Second, at least 95% of our gross income in each taxable year, excluding gross income from "prohibited transactions", discharge of indebtedness and certain hedging transactions, must be derived from some combination of income that qualifies under the 75% gross income test described above, as well as other dividends, interest, and gain from the sale or disposition of stock or securities, which need not have any relation to real property. Income and gain from certain hedging transactions will be excluded from both the numerator and the denominator for purposes of both the 75% and 95% gross income tests.
Asset Tests. At the close of each calendar quarter, we must also satisfy five tests relating to the nature of our assets. First, at least 75% of the value of our total assets must be represented by some combination of designated real estate assets, cash, cash items, U.S. Government securities and, under some circumstances, stock or debt instruments purchased with new capital. Second, the value of any one issuer’s securities that we own may not exceed 5% of the value of our total assets. Third, we may not own more than 10% of any one issuer’s outstanding securities, as measured by either value (the "10% of value asset test") or voting power. The 5% and 10% asset tests do not apply to securities that qualify under the 75% asset test or to securities of a TRS and qualified REIT subsidiaries, and the 10% of value asset test does not apply to "straight debt" having specified characteristics and to certain other securities. Fourth, the aggregate value of all securities of TRSs that we hold may not exceed 20% of the value of our total assets. Fifth, not more than 25% of the value of our total assets may be represented by debt instruments of publicly offered REITs to the extent those debt instruments would not be real estate assets but for the inclusion of debt instruments of publicly offered REITs in the meaning of real estate assets.
Distribution Requirements. In order to maintain our REIT qualification, we are required to distribute dividends, other than capital gain dividends, to our stockholders in an amount at least equal to: (1) the sum of (a) 90% of our REIT taxable income computed without regard to our net capital gains and the deduction for dividends paid, and (b) 90% of our net income, if any, (after tax) from foreclosure property; minus (2) the sum of specified items of non-cash income that exceeds a certain percentage of our income.
Ownership. In order to maintain our REIT status, we must not be deemed to be closely held and must have more than 100 stockholders. The closely held prohibition requires that not more than 50% of the value of our outstanding shares be owned by five or fewer "individuals" (as defined for this purpose to
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include certain trusts and foundations) during the last half of our taxable year. The "more than 100 stockholders" rule requires that we have at least 100 stockholders for at least 335 days of a taxable year. Failure to satisfy either of these rules would cause us to fail to maintain our qualification for taxation as a REIT unless certain relief provisions are available.
Taxation of REIT Dividends
REIT dividends (other than capital gain dividends) received by non-corporate taxpayers may be eligible for a 20% deduction. This deduction is only applicable to investors of LFT that receive dividends and does not have any impact on us. Without further legislation, the deduction would sunset after 2025. Investors should consult their own tax advisors regarding the effect of this change on their effective tax rate with respect to REIT dividends.
Corporate Offices and Personnel
We were formed as a Maryland corporation in 2012. With effect from January 18, 2018, our corporate headquarters are located at 230 Park Avenue, 20th Floor, New York, NY 10169 and our telephone number is (212) 317-5700. We are externally managed by our Manager pursuant to the management agreement between us and our Manager. We have no employees. Our executive officers, all of whom were provided by our Manager, are employees of Lument.
As of March 13, 2020, our Manager and its affiliates implemented a work from home ("WFH") policy for employees in all locations. As of October 1, 2021, our Manager has begun reopening offices on a limited basis with certain staff returning to the office on a staggered partial schedule. Our Manager's highly experienced senior team and dedicated employees are fully operational during this ongoing disruption and are continuing to execute on all investment management, asset management, servicing, portfolio monitoring, financial reporting and related control activities. Our Manager's and affiliates' employees are in constant communication to ensure timely coordination and early identification of issues. We continue to engage in ongoing active dialogue with the borrowers in our commercial loan portfolio to understand what is taking place at the properties collateralizing our investments.
Access to our Periodic SEC Reports and Other Corporate Information
Our internet website address is www.lumentfinancetrust.com. We make available free of charge, through our website, our annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments thereto that we file pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. Our Code of Business Conduct and Ethics and Policy Against Insider Trading and our Corporate Governance Guidelines along with the charters of our Audit, Compensation and Nominating and Corporate Governance Committees are also available on our website. Information on our website is neither part of nor incorporated into this Annual Report on Form 10-K.
Website Disclosure
We use our website (www.lumentfinancetrust.com) as a channel of distribution of company information. The information we post through this channel may be deemed material. Accordingly, investors should monitor this channel, in addition to following our press releases, SEC filings, public conference calls, and webcasts. In addition you may automatically receive email alerts and other information about Lument Finance Trust, Inc. when you enroll your email address by visiting "Investor Relations & Email Alerts" section of our website at https://www.lumentfinancetrust.com/investor-relations/email-alerts/. The contents of our website and any alerts are not, however, a part of this report.
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ITEM 1A. RISK FACTORS
Set forth below are the risks that we believe are material to stockholders. You should carefully consider the following risk factors identified in or incorporated by reference into any other documents filed by us with the SEC in evaluating our company and our business. If any of the following risks occur, our business, financial condition, results of operations and our ability to make distributions to our stockholders could be adversely affected. In that case, the trading price of our stock could decline. The risk factors described below are not the only risks that may affect us. Additional risks and uncertainties not presently known to us also may adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
Summary Risk Factors
Our business is subject to a number of risks, including risks that may prevent us from achieving our business objectives or may adversely affect our business, financial condition, results of operations, cash flows, and prospects. These risks are discussed more fully below and include, but are not limited to, risks related to:
Risks Related to the Ongoing COVID-19 Pandemic
•The ongoing outbreak of COVID-19 could have an adverse impact on our financial condition and results of operations.
Risks Related to Our Investment Strategy and Our Businesses
•We may be unable to operate our business successfully or generate sufficient revenue to make or sustain distributions to our stockholders.
•We may change business policies without shareholder approval.
•Our floating-rate commercial mortgage loans are subject to various risks, such as interest rate risk, prepayment risk, real estate risk and credit risk.
•Transitional mortgage involve greater risk than conventional mortgage loans.
•Certain actions by the U.S. Federal Reserve could cause a change in the expected level of interest rates, which could adversely affect our business, financial conditions, results of operations and our ability to make distributions to our stockholders.
•If we are unable to implement and maintain effective internal controls over financial reporting in the future, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock may be negatively affected.
•An increase in interest rates may cause a decrease in the volume of certain of our target assets, which could adversely affect our ability to acquire assets that satisfy our investment objectives and to generate income and make distributions to our stockholders.
•Increases in interest rates typically adversely affect the value of certain of our investments and cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders.
•Changes to the method of determining LIBOR or the selection of a replacement for LIBOR may affect the value of the financial obligations to he held or issued by us that are linked to LIBOR and could affect our results of operations and financial results.
•We may invest or spend the net proceeds for our equity or debt offerings in ways with which our investors may not agree and in ways that may not earn a profit.
•Changes in laws and regulations governing our operations, changes in the interpretation thereof or newly enacted laws or regulations and any failure by us to comply with these laws or regulations, could require changes in certain of business practices, negatively impact our operations, cash flow or financial condition, impose additional costs on us, subject us to increased competition or otherwise adversely affect our business.
Risks Related to Financing and Hedging
•Our strategy involves leverage, which may amplify losses and there is no specific limit on the amount of leverage we may use.
•We may incur significant additional debt in the future, which will subject us to increased risk of loss and may reduce cash available for distributions to our stockholders.
•There can be no assurance that our Manager will be able to prevent mismatches in the maturities of our assets and liabilities.
•Lenders generally require us to enter into restrictive covenants relating to our operations.
•An increase in our borrowing costs relative to the interest that we receive on investments in our mortgage related investments may adversely affect our profitability and cash available for distributions to our stockholders.
•We have utilized and may utilize in the future non-recourse securitizations to finance our loans and investments, which may expose us to risks that could result in losses.
•Our loans and investments may be subject to fluctuations in interest rates that may not be adequately protected, or protected at all, by our hedging strategies.
Risks Associated with Our Relationship with Our Manager
•Our board of directors has approved very broad investment guidelines for our Manager and will not approve each investment and financing decision made by our Manager.
•We are dependent on our Manager and its key personnel for our success.
•There are conflicts of interest in our relationship with ORIX, including with our Manager and in the allocation of investment opportunities to ORIX affiliates and us, which could result in decisions that are not in the best interests of our stockholders.
Risks Related to Our Securities
•An increase in interest rates may have an adverse effect on the market price of our stock and our abilities to make distributions to stockholders.
•We have not established a minimum distribution payment level on our common stock and we cannot assure you of our ability to make distributions in the future, or that our board of directors will not reduce distributions in the future regardless of such ability.
•Future offerings of debt or equity securities that rank senior to our common stock may adversely the market price of our common stock.
Risks Related to Our Organization and Structure
•Maintenance of our exclusion from the Investment Company Act will impose limits on our business.
•Because of their significant ownership of our common stock, OREC Investment Holdings, LLC, an affiliate of our Manager, and Hunt Investors (as described herein) have the ability to influence the outcome of matters that require a vote of stockholders, including change of control.
•Stockholders have limited control over changes in our policies and procedures.
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•Ownership limitations may restrict change of control or business combination opportunities in which our stockholders might receive a premium for their shares.
Tax Risks
•If we failed to qualify as a REIT, we would be taxed at corporate rates and would not be able to take certain deductions when computing our taxable income.
•If we failed to qualify as a REIT, we may default on our current financing facilities and be required to liquidate our assets, and we may face delays or inabilities to procure future financing.
•Complying with REIT requirements may cause us to forgo otherwise attractive opportunities and may require us to dispose of our target assets sooner than originally anticipated.
•Qualifying as a REIT involves highly technical and complex provisions of the Code.
Risks Related to the Ongoing COVID-19 Pandemic
The ongoing outbreak of COVID-19 could have an adverse impact on our financial performance and results of operations.
As the COVID-19 pandemic has evolved from its emergence in early 2020, so has its global impact. Many countries have re-instituted, or strongly encouraged, varying levels of quarantines and restrictions on travel and in some cases have at times limited operations of certain businesses and taken other restrictive measures designed to help slow the spread of COVID-19 and its variants. Governments and businesses have also instituted vaccine mandates and testing requirements for employees. While vaccine availability and uptake has increased, the longer-term macro-economic effects on global supply chains, inflation, labor shortages and wage increases continue to impact many industries. Moreover, with the potential for new strains of COVID-19 to emerge, governments and businesses may re-impose aggressive measures to help slow its spread in the future. For this reason, among others, as the COVID-19 pandemic continues, the potential global impacts are uncertain and difficult to assess.
The outbreak of COVID-19 may have a material adverse impact on our financial condition, liquidity, results of operations and the market price of our common stock, among other things. We expect these impacts are likely to continue to some extent as the outbreak persists and potentially even longer. Although our business has been or could be impacted by COVID-19, we currently believe the following to be among the most material to us:
•COVID-19 could have a significant long-term impact on the broader economy and the CRE market generally, which would continue to negatively impact the value of the assets collateralizing our loans. Our portfolio includes loan that are collateralized by retail and other asset classes that are particularly negatively impacted by supply and labor issues. While we believe the principal amount of our loans are protected by the underlying value of the collateral securing the loans, deterioration in the performance of the properties securing our investments may cause deterioration in the performance of our investments and, potentially, principal losses to us.
•We are actively engaged in discussions with our borrowers to monitor their ability to pay principal and interest..
•Economic and market conditions may limit our ability to redeploy proceeds from payment of our existing investments in commercial mortgage loans with similar spreads which may reduce future interest income.
•Inflation, Interest rates and credit spreads have been significantly impacted since the outbreak of COVID-19.
The immediately preceding outcomes are those we consider to be most material as a result of the pandemic. We have also experienced and may experience other negative impacts to our business that could exacerbate other risks described herein, including:
•lack of liquidity in certain of our assets;
•risks associated with loans to properties in transition or construction;
•impairment of our investments and harm to our operation form a prolonged economic slowdown, a lengthy or severs recession or declining real estate values;
•the concentration of our loans and investments in terms of geography, asset types and sponsors;
•losses resulting from foreclosing on certain of the loans we acquire;
•our corporate debt;
•risks associated with non-recourse securitizations which we use to finance our assets;
•borrower and counterparty risks;
•operational impacts on ourselves and our third-party advisors, service providers, vendors and counterparties, including operating partners, property managers, other independent third-party appraisal firms that provide appraisals of properties collateralizing our loans, our lenders and other providers of financing, and legal and diligence professional that we rely on for acquiring our investments;
•limitation on our ability to ensure business continuity in the event our, or our third-party advisors' and service providers', continuity of operations plan is not effective or improperly implemented or deployed during a disruption;
•the availability of key personnel of the Manager and our service providers as they face changes circumstances and potential illness during the pandemic; and
•other risks described herein.
The ongoing fluidity of this situation precludes any prediction as to the ultimate adverse impact of COVID-19 on economic and market conditions, and, as a result, presents material uncertainty and risk with respect to us and the performance of our investments. The full extent of the impact and effects of COVID-19 will depend on future developments, including, among other factors, the duration and spread of the virus and its variants, availability, acceptance and effectiveness of vaccines along with related travel advisories, quarantines and restrictions, the recovery time of disrupted supply chains and industries, the impact of labor market interruptions, the impact of government interventions, and uncertainty with respect to the duration of the global economic slowdown. COVID-19 and the current financial, economic and capital markets environment and future developments in these and other areas present uncertainty and risk with respect to our performance, results of operations and ability to pay distributions.
Risks Related to Our Investment Strategies and Our Businesses
We may not be able to operate our businesses successfully or generate sufficient revenue to make or sustain distributions to our stockholders.
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We cannot assure you that we will be able to operate our businesses successfully or implement our operating policies and strategies. Our Manager may not be able to successfully execute our investment and financing strategies as described in this Annual Report on Form 10-K, which could result in a loss of some or all of your investment. Our results of operations depend on several factors, including our Manager's ability to execute on our investment and financing strategies, the availability of opportunities for the acquisition of target assets, the level and volatility of interest rates, the availability of adequate short and long-term financing, conditions in the financial markets and economic conditions. Our revenues will depend, in large part, on our Manager's ability to execute on our investment and financing strategies, and our ability to acquire assets at favorable spreads over our borrowing costs. If our Manager is unable to execute on our investment and financing strategies, or we are unable to acquire assets that generate favorable spreads, our results of operations may be adversely affected, which could adversely affect our ability to make or sustain distributions to our stockholders.
If we fail to develop, enhance and implement strategies to adapt to changing conditions in the mortgage industry and capital markets, our business, financial condition, results of operations and our ability to make distributions to our stockholders may be adversely affected.
The manner in which we compete and the products for which we compete are affected by changing conditions, which can take the form of trends or sudden changes in our industry, regulatory environment, changes in the role of GSEs, changes in the role of credit rating agencies or their rating criteria or process, or the U.S. economy more generally. If we do not effectively respond to these changes, or if our strategies to respond to these changes are not successful, our business, financial condition, results of operations and our ability to make distributions to our stockholders may be adversely affected.
We may not realize gains or income from our assets.
We seek to generate current income and attractive risk-adjusted returns for our stockholders. However, the assets that we acquire may not appreciate in value and, in fact, may decline in value, and the assets that we acquire may experience defaults of interest and/or principal payments. Accordingly, we may not be able to realize gains or income from our assets. Any income that we do realize may not be sufficient to offset other losses that we experience.
We may change our target assets, investment or financing strategies and other operational policies without stockholder consent, which may adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
We may change any of our strategies, policies or procedures with respect to investments, acquisitions, growth, operations, indebtedness, capitalization, distributions, financing strategy and leverage at any time without the consent of our stockholders, which could result in an investment portfolio with a different, and possibly greater, risk profile. A change in our target assets, investment strategy or guidelines, financing strategy or other operational policies may increase our exposure to interest rate risk, default risk and real estate market fluctuations. Furthermore, a change in our asset allocation could result in our making investments in asset categories different from those described in this Annual Report on Form 10-K. In addition, our charter provides that our board of directors may revoke or otherwise terminate our REIT election, without approval of our stockholders, if it determines that it is no longer in our best interests to maintain our REIT qualification. These changes could adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
Our portfolio of assets may be concentrated in terms of credit risk.
Although as a general policy we seek to acquire and hold a diverse portfolio of assets, we are not required to observe specific diversification criteria, except as may be set forth in the investment guidelines adopted by our board of directors. Therefore, our asset portfolio may at times be concentrated in certain property types that are subject to higher risk of foreclosure or secured by properties concentrated in a limited number of geographic locations. To the extent that our portfolio is concentrated in any one region or type of security, downturns relating generally to such region or type of security may result in defaults on a number of our assets within a short time period, which could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our portfolio may contain other concentrations of risk, and we may fail to identify, detect or hedge against those risks, resulting in large or unexpected losses. Lack of diversification can increase the correlation of non-performance and foreclosure risks among our investments.
The impact of any future terrorist attacks, the occurrence of a natural disaster, a significant climate change, health concerns regarding pandemic diseases (such as the continued outbreak of novel coronavirus) or changes in laws and regulations expose us to certain risks.
Terrorist attacks, the anticipation of any such attacks, and the consequences of any military or other response by the United States and its allies may have an adverse impact on the U.S. financial markets and the economy in general. We cannot predict the severity of the effect that any such future events would have on the U.S. financial markets, the economy or our business. Any future terrorist attacks could adversely affect the credit quality of some of our loans and investments. Some of our loans and investments will be more susceptible to such adverse effects than others, particularly those secured by properties in major cities or properties that are prominent landmarks or public attractions. We may suffer losses as a result of the adverse impact of any future terrorist attacks and these losses may adversely impact our results of operations.
Moreover, the enactment of the Terrorism Risk Insurance Act of 2002, or TRIA, requires insurers to make terrorism insurance available under their property and casualty insurance policies and provides federal compensation to insurers for insured losses. TRIA was scheduled to expire at the end of 2020 but was reauthorized, with some adjustments to its provisions, in December 2019 for seven years through December 31, 2027. However, this legislation does not regulate the pricing of such insurance and there is no assurance that this legislation will be extended beyond 2027. The absence of affordable insurance coverage may adversely affect the general real estate lending market, lending volume and the market’s overall liquidity and may reduce the number of suitable investment opportunities available to us and the pace at which we are able to make investments. If the properties that we invest in are unable to obtain affordable insurance coverage, the value of those investments could decline and in the event of an uninsured loss, we could lose all or a portion of our investment.
In addition, the occurrence of a natural disaster (such as an earthquake, tornado, hurricane, or a flood) or a significant adverse climate change may cause a sudden decrease in the value of real estate in the area or areas affected and would likely reduce the value of the properties securing debt instruments that we purchase. Because certain natural disasters are not typically covered by the standard hazard insurance policies maintained by borrowers, the affected borrowers may have to pay for any repairs themselves. Borrowers may decide not to repair their property or may stop paying their mortgages under those circumstances. This would likely cause defaults and credit loss severities to increase.
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The occurrence of unforeseen or catastrophic events, including the emergence of a pandemic, such as coronavirus, or other widespread health emergency (or concerns over the possibility of such emergency) could create economic and financial disruptions, and could lead to operational difficulties that could impair our ability to manage our business.
Lack of diversification in the number of assets we acquire would increase our dependence on relatively few individual assets.
Our management objectives and policies do not place a limit on the size of the amount of capital used to support, or the exposure to (by any other measure), any individual asset or any group of assets with similar characteristics or risks. In addition, because we are a small company, we may be unable to sufficiently deploy capital into a number of assets or asset groups. As a result, our portfolio may be concentrated in a small number of assets or may be otherwise undiversified, increasing the risk of loss and the magnitude of potential losses to us and our stockholders if one or more of these assets perform poorly.
Our floating-rate commercial mortgage loans are subject to various risks, such as interest rate risk, prepayment risk, real estate risk and credit risk.
Generally, our business model is such that rising interest rates will generally increase our net interest income, while declining rates will generally decrease our net interest income. Our net interest income currently benefits from in-the-money USD LIBOR floors in our loan portfolio, which benefit is expected to initially decrease as LIBOR increases. There can be no assurance that we will continue to utilize USD LIBOR floors. As of December 31, 2021, one-month USD LIBOR was 0.10%, as compared to 0.08% as of September 30, 2021. There can be no assurance of how our net income may be affected in future quarters, which will depend on, among other things, the interest rate environment and our-then-current portfolio. As of December 31, 2021, 100.0% of our loans by principal balance earned a floating rate of interest indexed to one-month USD LIBOR. The interest rates we pay under our current financing arrangements are floating rate. Accordingly, our interest expense will generally increase as interest rates increase and decrease as interest rates decline.
As discussed below under "Changes to the method of LIBOR or the selection of a replacement for LIBOR may affect the value of the financial obligations to be held or issued by us that are linked to LIBOR and could affect our results operations and financial results," one-month USD LIBOR will cease to be published after June 30, 2023. Loans originated by the Manager or its affiliates as of January 1, 2022 that have been acquired or any be acquired by us have been indexed to the 30-day tenor CME Term SOFR. With respect to loans originated prior to such date, all loans have index fallback language that, when USD LIBOR ceases to be published (a) follows the Alternative Reference Rate Committee ("ARRC") recommendation for replacement floating rate index (noting the ARRC already identifies SOFR as the recommended replacement index), or (b) allows Lender discretion to identify the appropriate replacement index, to the extent reasonably possible, calculated in substantially the same manner and upon the same economic basis as one-month USD LIBOR.
We are subject to prepayment risk associated with the terms of our CLOs. Due to the generally short-term nature of transitional floating-commercial mortgage loans, our CLOs include a reinvestment period during which principal repayments and prepayments on our commercial mortgage loans may be reinvested in similar assets, subject to meeting certain eligibility criteria. While the interest-rate spreads of our collateralized loan obligations are fixed until they are repaid, the terms, including spreads, of newly originated loans are subject to uncertainty based on a variety of factors, including market and competitive conditions. To the extent that such conditions result in lower spreads on the assets in which we reinvest, we may be subject to a reduction in interest income in the future. It is expected that in 2022 the U.S. Federal Reserve will raise benchmark overnight interest rates on multiple occasions. Any such increases would increase our borrowers interest payments and for certain borrowers may lead to defaults and losses to us. Such increases could also adversely affect CRE property values.
The market values of commercial mortgage assets are subject to volatility and may be adversely affected by real estate risks, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions; changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the value of the collateral and potential proceeds available to a borrower to repay the underlying loans, which could also cause us to suffer losses.
Our commercial mortgage loans and other investments are also subject to credit risk. The performance and value of our loans and other investments depend upon the sponsor's ability to operate properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal to us. To monitor this risk, the Manager's asset management team reviews our portfolio and maintains regular contact with borrowers, co-lenders and local market experts to monitor the performance of the underlying collateral, anticipate borrower, property and market issues and, to the extent necessary or appropriate, enforce our rights as lender.
Transitional mortgage loans involve greater risk than conventional mortgage loans.
The typical borrower in a transitional mortgage loan has usually identified an asset which the borrower believes is undervalued or that has been under-managed, or is undergoing a repositioning plan including a potential capital improvement. If the market in which the asset is located fails to perform according to the borrower's projections, or if the borrower fails to improve the quality of the asset's management and/or value of the asset, the borrower may not receive a sufficient return on the asset to satisfy the transitional mortgage loan, and we bear the risk that we may not recover some or all of our investment.
In addition, borrowers typically use the proceeds of a conventional mortgage to repay a transitional mortgage loan. Transitional mortgage loans therefore are subject to the risk of a borrower's inability to obtain permanent financing to repay the transitional mortgage loan. Risks of cost overruns and renovations of properties in transition may result in significant losses. The renovation, refurbishment or expansion of a property by a borrower involves risks of cost overruns and non-completion. Estimates of the costs of improvements to bring an acquired property up to the standards established for the market position intended for the property may prove inaccurate. Other risks may include rehabilitation costs exceeding original estimates, possibly making a project uneconomical, environmental risks, delays in legal and other approvals (e.g., for condominiums) and rehabilitation and subsequent leasing of the property not being completed on schedule. If such renovation is not completed in a timely manner, or if it costs more than expected, the borrower may experience a prolonged impairment of net operating income and may not be able to make payments on our investment on a timely basis or at all. In the event of any default under transitional mortgage loans that may be held by us, we bear the risk of loss of principal and non-payment of interest and fees to the extent of any deficiency between the value of the mortgage collateral and the principal amount and unpaid interest on the transitional loan. To the extent we suffer such losses with respect to these transitional mortgage loans, it could adversely affect our results of operations and financial condition.
Investments in non-conforming and non-investment grade rated CRE loans or securities involve increased risk of loss.
Certain CRE debt investments may not conform to conventional loan standards applied by traditional lenders and either will not be rated (as is typically the case for private loans) or will be rated as non-investment grade by the rating agencies. Private loans often are not rated by credit rating agencies. Non-
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investment grade ratings typically result from the overall leverage of the loans, the lack of a strong operating history for the properties underlying the loans, the borrowers’ credit history, the underlying properties’ cash flow or other factors. As a result, these investments should be expected to have a higher risk of default and loss than investment-grade rated assets. Any loss we incur may be significant and may adversely affect our results of operations and financial condition. There are no limits on the percentage of unrated or non-investment grade rated assets we may hold in our investment portfolio.
We may invest in transitional multifamily loans, CRE loans, CRE debt securities and other similar structured finance investments, which are secured by income producing properties. Such loans are typically made to single-asset entities, and the repayment of the loan is dependent principally on the net operating income from the performance and value of the underlying property. The volatility of income performance results and property values may adversely affect our transitional multifamily loans, CRE loans and CRE debt securities and similar structured finance investments.
Our transitional multifamily and CRE loans are secured by the underlying commercial property and, in each case are subject to risks of delinquency, foreclosure and loss. Transitional multifamily loans, CRE loans, CRE debt securities and other similar structured finance investments generally have a higher principal balance and the ability of a borrower to repay a loan secured by an income-producing property typically is dependent upon the successful operation of the property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expenses or limit rents that may be charged, any need to address environmental contamination at the property, changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real estate values and declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental and/or tax legislation, and acts of God, terrorism, social unrest and civil disturbances.
Multifamily and CRE property values and net operating income derived therefrom are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions; changes in tax laws; local real estate conditions; changes or continued weakness in specific industry segments; perceptions by prospective tenants, retailers and shoppers of the safety, convenience, services and attractiveness of the property; the willingness and ability of the property’s owner to provide capable management and adequate maintenance; construction quality, age and design; demographic factors; retroactive changes to building or similar codes; and increases in operating expenses (such as energy costs).
Declines in the borrowers’ net operating income and/or declines in property values of collateral securing transitional multifamily loans, CRE loans or CRE debt securities and other similar structured finance investments could result in defaults on such loans, declines in our book value from reduced earnings and/or reductions to the market value of the investment.
Our target assets may include CRE loans which are funded with interest reserves and borrowers may be unable to replenish such interest reserves once they run out.
We invest in transitional CRE and we expect that borrowers may be required to post reserves to cover interest and operating expenses until the property cash flows are projected to increase sufficiently to cover debt service costs. We may also require the borrower to replenish reserves if they become depleted due to underperformance or if the borrower wishes to exercise extension options under the loan. Revenues on the properties underlying any CRE loan investments may decrease in an economic downturn which would make it more difficult for borrowers to meet their payment obligations to us. Some borrowers may have difficulty servicing our debt and may not have sufficient capital to replenish reserves, which could have a significant impact on our operating results and cash flows.
We may not have control over certain of our loans and investments.
Our ability to manage our portfolio of loans and investments may be limited by the form in which they are made. In certain situations, we may:
•acquire investments subject to rights of senior classes, special servicers or collateral managers under intercreditor, servicing agreements or securitization documents;
•pledge our investments as collateral for financing arrangements;
•acquire only a minority and/or non-controlling participation in an underlying investment;
•co-invest with others through partnership, joint ventures or other entities, thereby acquiring non-controlling interests; or
•rely on independent third party management or servicing with respect to the management of an asset.
Therefore, we may not be able to exercise control over all aspects of our loans or investments. Such financial assets may involve risks not present in investments where senior creditors, junior creditors, servicers or third-party controlling investors are not involved. Our rights to control the process following a borrower default may be subject to the rights of senior or junior creditors or servicers whose interests may not be aligned with ours. A partner or co-venturer may have financial difficulties resulting in a negative impact on such asset, may have economic or business interests or goals that are inconsistent with ours, or may be in a position to take action contrary to our investment objectives.
Certain actions by the U.S. Federal Reserve could cause a change in the expected level of interest rates, which could adversely affect our business, financial condition, results of operations and our ability to make distributions.
On January 26, 2022, the Federal Reserve announced that it will end its monthly asset purchases, including its purchases of agency mortgage-backed securities, in March and signaled that it is likely to begin increasing the federal funds rate this year. This announcement indicates that the Federal Reserve will likely continue to reverse the policies it adopted in response to the macro-economic effects of the 2020 COVID-pandemic. In response to the COVID-pandemic, the Federal Reserve adopted a policy of quantitative easing whereby it purchased each month significant amounts of U.S. Treasury securities and agency mortgage-backed securities. The Federal Reserve also reduced the federal funds rate target to 0 to ¼ percent, established a series of emergency lending programs, reduced the discount rate and encouraged depository institutions to borrow from the discount window, and took regulatory actions to ease capital and liquidity requirements at depository institutions. The purpose of these actions was to stabilize financial markets and reduce both interest rates generally and the spread between long-term and short-term interest rates. The Federal Reserve’s balance sheet increased by more than $4.5 trillion to nearly $9 trillion, including $2.5 trillion in agency mortgage-backed securities. Due to the reduction in interest rates, prepayment speeds and mortgage refinancing activity increased. The Federal Reserve took similar actions during the 2008 financial crisis. The Federal Reserve has already terminated most of the emergency lending facilities established in 2020.
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The Federal Reserve’s shift in policy is likely to result in higher interest rates, including for agency mortgage-backed securities. The Federal Reserve has already begun to reduce its asset purchases and has stated that it intends to hold, in the longer run, primarily Treasury securities on its balance sheet. These actions may decrease spreads on interest rates, reducing our net interest income. They may also negatively impact our results as we have certain assets and liabilities that are sensitive to changes in interest rates. In addition, increases in interest rates may result in lower refinancing activity and therefore decrease the rate of prepayment on loans underlying our assets, which could have a material adverse effect on our result of operations.
There is still considerable uncertainty concerning the speed at which the Federal Reserve will continue to adjust rates. Changes in the federal funds rate as well as the other policies of the Federal Reserve affect interest rates, which have a significant impact on the demand for CRE loans. Such uncertainty and volatility often leads to asset price volatility, changes in interest rate spreads and increased hedging costs, which in turn could adversely affect our business, financial condition, results of operation and our ability to make distributions to our stockholders.
Changes in laws or regulations governing our operations, changes in the interpretation thereof or newly enacted laws or regulations and any failure by us to comply with these laws or regulations, could require changes to certain of our business practices, negatively impact our operations, cash flow or financial condition, impose additional costs on us, subject us to increased competition or otherwise adversely affect our business.
The laws and regulations governing our operations, as well as their interpretation, may change from time to time, and new laws and regulations may be enacted. Accordingly, any change in these laws or regulations, changes in their interpretation, or newly enacted laws or regulations and any failure by us to comply with these laws or regulations, could require changes to certain of our business practices, negatively impact our operations, cash flow or financial condition, impose additional costs on us or otherwise adversely affect our business. For example, from time to time the market for real estate debt transactions has been adversely affected by a decrease in the availability of senior and subordinated financing for transactions, in part in response to regulatory pressures on providers of financing to reduce or eliminate their exposure to such transactions. Furthermore, if regulatory capital requirements-whether under the Dodd-Frank Act, Basel III (i.e., the framework for a comprehensive set of capital and liquidity standards for internationally active banking organizations, which was adopted in June 2011 by the Basel Committee on Banking Supervision, an international body comprised of senior representatives of bank supervisory authorities and central banks from 27 countries, including the United States) or other regulatory action-are imposed on private lenders that provide us with funds, or were to be imposed on us, they or we may be required to limit, or increase the cost of, financing they provide to us or that we provide to others. Among other things, this could potentially increase our financing costs, reduce our ability to originate or acquire loans and reduce our liquidity or require us to sell assets at an inopportune time or price.
Various laws and regulations currently exist that restrict the investment activities of banks and certain other financial institutions but do not apply to us, which we believe creates opportunities for us to participate in certain investments that are not available to these more regulated institutions. Any deregulation of the financial industry, including by amending the Dodd-Frank Act, may decrease the restrictions on banks and other financial institutions and would create more competition for investment opportunities that were previously not available to the financial industry. For example, in 2018, a bill was signed into law that eased the regulation and oversight of certain banks under the Dodd-Frank Act.
There has been increasing commentary amongst regulators and intergovernmental institutions on the role of nonbank institutions in providing credit and, particularly, so-called “shadow banking,” a term generally taken to refer to credit intermediation involving entities and activities outside the regulated banking system. For example, in August 2013, the Financial Stability Board issued a policy framework for strengthening oversight and regulation of “shadow banking” entities. The report outlined initial steps to define the scope of the shadow banking system and proposed general governing principles for a monitoring and regulatory framework. A number of other regulators, such as the Federal Reserve, and international organizations, such as the International Organization of Securities Commissions, are studying the shadow banking system. At this time, it is too early to assess whether any rules or regulations will be proposed or to what extent any finalized rules or regulations will have on the nonbank lending market. If rules or regulations were to extend to us or our affiliates the regulatory and supervisory requirements, such as capital and liquidity standards, currently applicable to banks, then the regulatory and operating costs associated therewith could adversely impact the implementation of our investment strategy and our returns. In an extreme eventuality, it is possible that such regulations could render the continued operation of our company unviable.
In the United States, the process established by the Dodd-Frank Act for designation of systemically important nonbank firms has provided a means for ensuring that the perimeter of prudential regulation can be extended as appropriate to cover large shadow banking institutions. The Dodd-Frank Act established the Financial Stability Oversight Council (the “FSOC”), which is comprised of representatives of all the major U.S. financial regulators, to act as the financial system’s systemic risk regulator. The FSOC has the authority to review the activities of nonbank financial companies predominantly engaged in financial activities and designate those companies as “systematically important financial institutions” (“SIFIs”) for supervision by the Federal Reserve. Such designation is applicable to companies where material distress or failure could pose risk to the financial stability of the United States. On December 18, 2014, the FSOC released a notice seeking public comment on the potential risks posed by aspects of the asset management industry, including whether asset management products and activities may pose potential risks to the U.S. financial system in the areas of liquidity and redemptions, leverage, operational functions, and resolution, or in other areas. On April 18, 2016, the FSOC released an update on its multi-year review of asset management products and activities and created an interagency working group to assess potential risks associated with certain leveraged funds. On December 4, 2019, the FSOC issued final guidance regarding the FSOC’s procedures for designating nonbank financial companies as SIFIs. This guidance implemented a number of reforms to the FSOC’s prior SIFI designation approach by shifting from an “entity-based” approach to an “activities-based” approach whereby the FSOC will primarily focus on regulating activities that pose systematic risk to the financial stability of the United States, rather than designations of individual firms. Under the guidance, designation of a nonbank financial company as a SIFI would only occur if the FSOC determined that the expected benefits justify the expected costs of the designation. While the impact of this guidance cannot be known at this time, increased regulation of nonbank credit extension could negatively impact our operations, cash flows or financial condition, impose additional costs on us, intensify the regulatory supervision of us or otherwise adversely affect our business.
The U.K.’s exit from the E.U. could adversely affect us.
The United Kingdom left the E.U. on January 31, 2020. On May 1, 2021, the E.U.-U.K. Trade and Cooperation Agreement (the “TCA”) became effective. The TCA provides the United Kingdom and E.U. members with preferential access to each other’s markets, without tariffs or quotas on imported products between the jurisdictions, provided that certain rules of origin requirements are complied with. However, economic relations between the United Kingdom and the E.U. will now be on more restricted terms than existed prior to Brexit. The long-term effects of Brexit are expected to depend on, among other things, any agreements the U.K. has made, or makes to retain access to E.U. markets. Brexit could adversely affect European or worldwide economic or market conditions and could contribute to instability in global financial and real estate markets. In addition, Brexit could lead to legal uncertainty and potentially divergent national laws and regulations as the U.K. determines which E.U. laws to replace or replicate. Any of these effects of Brexit, and others we cannot anticipate, could adversely affect our business, business opportunities, results of operations, financial condition and cash flows. Likewise, similar actions taken by other European and other countries in which we operate could have a similar or even more profound impact.
Changes in laws or regulations governing the operations of borrowers could affect our returns with respect to those borrowers.
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Government counterparties or agencies may have the discretion to change or increase regulation of a borrower’s operations, or implement laws or regulations affecting a borrower’s operations, separate from any contractual rights it may have. A borrower could also be materially and adversely affected as a result of statutory or regulatory changes or judicial or administrative interpretations of existing laws and regulations that impose more comprehensive or stringent requirements on such company. Governments have considerable discretion in implementing regulations, for example, the possible imposition or increase of taxes on income earned by a borrower or gains recognized by us on our investment in such borrower, that could impact a borrower’s business as well as our return on our investment with respect to such borrower. Changes in government rules, regulations and fiscal policies, including increases in property taxes, changes in zoning laws and increasing costs to comply with environmental law could increase operating expenses for our borrowers. Likewise, changes in rent control or rent stabilization laws or other residential landlord/tenant laws could result in lower revenue growth or significant unanticipated expenditures for our borrowers. These initiatives and any other future enactments of rent control or rent stabilization laws or other laws regulating multifamily housing may reduce our borrowers’ rental revenues or increase their operating costs. Such laws and regulations may limit our borrowers’ ability to charge market rents, increase rents, evict tenants or recover increases in their operating costs, which may, in turn, impact our return on our investment with respect to such borrowers.
The impacts of climate-related initiatives at the U.S. federal and state levels remain uncertain at this time but could result in increased operating costs for us and our borrowers.
Government authorities and various interest groups are promoting laws and regulations that could limit greenhouse gas (“GHG”) emissions due to concerns over contributions to climate change. The United States Environmental Protection Agency, (“EPA”) has moved to regulate GHG emissions using its existing authority under the Clean Air Act. Moreover, certain state and regional programs are being implemented to require reductions in GHG emissions. Any additional taxation or regulation of energy use, including as a result of (i) the regulations that EPA has proposed or may propose in the future, (ii) state programs and regulations, or (iii) renewed GHG legislative efforts by future Congresses, could result in increased operating costs for us or our borrowers. Any such increased costs could impact the financial condition of our borrowers and their ability to meet their loan obligations to us.
We may be subject to lender liability claims, and if we are held liable under such claims, we could be subject to losses.
In recent years, a number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed "lender liability." Generally, lender liability is founded on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty owed to the borrower or its other creditors or stockholders. We cannot assure prospective investors that such claims will not arise or that we will not be subject to significant liability if a claim of this type did arise.
Our investments in commercial mortgage backed securities, CLOs and other similar structured finance investments, as well as those we structure, sponsor or arrange, pose additional risks, including the risks of the securitization process and the risk that the special servicer, ORIX Real Estate Capital, LLC ("OREC"), an affiliate of our Manager, may take actions that could adversely affect our interests.
We have invested in, and may from time to time invest in, commercial mortgage-backed securities, including in the most subordinated classes of such commercial mortgage-backed securities, CLOs and other similar securities, which may be subordinated classes of securities in a structure of securities secured by a pool of mortgages or loans. Accordingly, such securities may be the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal, with only a nominal amount of equity or other debt securities junior to such positions. The estimated fair values of such subordinated interests tend to be much more sensitive to adverse economic downturns and underlying borrower developments than more senior securities. A projection of an economic downturn, for example, could cause a decline in the price of lower credit quality commercial mortgage-backed securities or CLOs because the ability of borrowers to make principal and interest payments on the mortgages or loans underlying such securities may be impaired.
Interests such as commercial mortgage-backed securities, CLOs and similar structured finance investments generally are not actively traded and are relatively illiquid investments. Volatility in commercial mortgage-backed securities and CLO trading markets may cause the value of these investments to decline. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as a result, less collateral value is available to satisfy interest and principal payments and any other fees in connection with the trust or other conduit arrangement for such securities, we may incur significant losses.
With respect to the commercial mortgage-backed securities and CLOs in which we have invested and may invest in the future, overall control over the special servicing of the related underlying mortgage loans will be exercised by OREC or another special servicer or collateral manager designated by a "directing certificate holder" or a "controlling class representative," which is appointed by the holders of the most subordinated class of commercial mortgage-backed securities in such series. Unless we acquire the subordinate classes of existing series of commercial mortgage-backed securities and CLOs, we will not have the right to appoint the directing certificate holder. In connection with the servicing of the specially serviced mortgage loans, the related special servicer may, at the direction of the directing certificate holder, take actions with respect to the specially serviced mortgage loans that could adversely affect our interests.
If the loans that we originate or acquire do not comply with applicable laws, we may be subject to penalties, which could materially and adversely affect us.
Loans that we may originate or acquire may be directly or indirectly subject to U.S. federal, state or local governmental laws. Real estate lenders and borrowers may be responsible for compliance with a wide range of laws intended to protect the public interest, including, without limitation, the Truth in Lending, Equal Credit Opportunity, Fair Housing and American with Disabilities Acts and local zoning laws (including, but not limited to, zoning laws that allow permitted non-conforming uses). If we or any other person fails to comply with such laws in relation to a loan that we have originated or acquired, legal penalties may be imposed, which could materially and adversely affect us. Additionally, jurisdictions with "one action," "security first" and/or "antideficiency rules" may limit our ability to foreclose on a real property or to realize on obligations secured by a real property. In the future, new laws may be enacted or imposed by U.S. federal, state or local governmental entities, and such laws could have a material adverse effect on us.
If we are unable to implement and maintain effective internal controls over financial reporting in the future, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock may be negatively affected.
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As a public company, we are required to maintain internal controls over financial reporting and to report any material weaknesses in such internal controls. In addition, we are required to furnish a report by management on the effectiveness of our internal controls over financial reporting, pursuant to Section 404 of the Sarbanes-Oxley Act. Once we are no longer a smaller reporting company, our independent registered public accounting firm will be required to formally attest to the effectiveness of our internal controls over financial reporting on an annual basis. The process of designing, implementing and testing the internal controls over financial reporting required to comply with this obligation is time consuming, costly and complicated. If we identify a material weakness in our internal controls over financial reporting, if we are unable to comply with the requirements of Section 404 of the Sarbanes-Oxley Act in a timely manner or to asset that our internal controls over financial reporting is effective or if, once we are no longer a smaller reporting company, our independent registered public accounting firm is unable to express an opinion as to the effectiveness of our internal controls over financial reporting, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock could be negatively affected. We could also become subject to investigations by the stock exchange on which our securities are listed, the SEC or other regulatory authorities, which could require additional financial and management resources.
We depend on our accounting services provider for assistance with the preparation of our financial statements, access to appropriate accounting technology and assistance with portfolio valuation.
Pursuant to our agreement with SS&C Technologies (SS&C"), SS&C currently maintains our general ledger and all related accounting records, reconciles all broker and custodial statements we routinely receive, provides us with monthly portfolio, cash and position reports, assists us with portfolio valuations, prepares draft quarterly financial statements for our review and provides us with access to data and technology services to facilitate the preparation of our annual financial statements. If our agreement with SS&C were to be terminated and no suitable replacement can be timely engaged, we may not be able to timely and accurately prepare our financial statements.
We may be required to make servicing advances and may be exposed to a risk of loss if such advances become non-recoverable and such advances and risk could adversely affect our liquidity or cash flow.
In connection with securitization transactions wherein Five Oaks Acquisition Corp. ("FOAC") sold mortgage loans to the securitization trust and holds the MSRs with respect to those mortgage loans, FOAC entered into sub-servicing agreements with one or more sub-servicers. Pursuant to the terms of the sub-servicing agreements, FOAC is required to refund or to fund any servicing advances that are obligated to be made by the sub-servicers. FOAC is therefore exposed to the potential loss of any servicing advance that becomes non-recoverable. Such advances and exposure going forward could adversely affect our liquidity or cash flow during a financial period.
We operate in a highly competitive market for investment opportunities and competition may limit our ability to acquire desirable investments in assets we target and could also affect the pricing of these securities.
We are engaged in a competitive business. In our investing activities, we compete for opportunities with a variety of institutional investors, including other REITs, specialty finance companies, public and private funds (including other funds managed by Lument IM and its affiliates), commercial and investment banks, commercial finance and insurance companies and other financial institutions. Several other REITs and other investment vehicles have raised significant amounts of capital, and may have investment objectives that overlap with ours, which may create additional competition for investment opportunities. Some competitors may have a lower cost of funds and broader access to funding sources, such as the U.S. Government, that are not available to us. Many of our competitors are not subject to the operating constraints associated with REIT compliance or maintenance of an exclusion from regulation under the Investment Company Act. We could face increased competition from banks due to future legislative developments, such as amendments to key provisions of the Dodd-Frank Act, including, provisions setting forth capital and risk retention requirements. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of loans and investments and offer more attractive pricing or other terms than we would. Furthermore, competition for investments we target may lead to decreasing yields, which may further limit our ability to generate targeted returns. We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Also, as a result of this competition, desirable investments in these assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment objectives.
A prolonged economic recession and declining real estate values could impair our assets and harm our operations.
The risks associated with our business are more severe during economic recessions and are compounded by declining real estate values. The transitional multifamily and other CRE loans in which we may invest will be particularly sensitive to these risks. Declining real estate values will likely reduce the level of new mortgage loan originations since borrowers often use appreciation in the value of their existing properties to support the purchase of additional properties. Borrowers will also be less able to pay principal and interest on loans underlying the securities in which we invest if the value of residential real estate weakens further. Further, declining real estate values significantly increase the likelihood that we will incur losses on the transitional multifamily and other CRE loans in the event of default because the value of collateral on the mortgages underlying such securities may be insufficient to cover the outstanding principal amount of the loan. Any sustained period of increased payment delinquencies, foreclosures or losses could have an adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.
The lack of liquidity in our investments may adversely affect our business.
We acquire assets that are not liquid or publicly traded. A lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets. In addition, mortgage-related assets generally experience periods of illiquidity. Further, validating third-party pricing for illiquid assets may be more subjective than for liquid assets. Any illiquidity of our investments may make it difficult for us to sell such investments if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. Further, we may face other restrictions on our ability to liquidate an investment in a business entity to the extent that we or our Manager has or could be attributed with material, non-public information regarding such business entity. If we are unable to sell our assets at favorable prices or at all, it could adversely affect our business, financial condition and results of operations and our ability to make distributions to our stockholders. Assets that are illiquid are more difficult to finance, and to the extent that we use leverage to finance assets that become illiquid, we may lose that leverage or have it reduced. Assets tend to become less liquid during times of financial stress, which is often the time that liquidity is most needed. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
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Our investment in CRE debt securities and other similar structured finance investments may be subject to losses.
We may acquire CRE debt securities and other similar structured finance investments. In general, losses on a mortgaged property securing a mortgage loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit, if any, then by the holder of a mezzanine loan or B-Note, if any, then by the "first loss" subordinated security holder and then by the holder of a higher-rated security. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit, mezzanine loans or B-Notes, and any classes of securities junior to those in which we invest, we will not be able to recover all of our investment in the securities we purchase. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline, less collateral is available to satisfy interest and principal payments due on the related CRE debt securities and other similar structured finance investments. The prices of lower credit quality securities are generally less sensitive to interest rate changes than more highly rated investments, but more sensitive to adverse economic downturns or individual issuer developments.
To the extent that due diligence is conducted on potential assets, such due diligence may not reveal all of the risks associated with such assets and may not reveal other weaknesses in such assets, which could lead to losses.
Before acquiring certain assets, such as transitional multifamily and other CRE loans or other mortgage-related assets, our Manager conducts (either directly or using third parties) due diligence. Such due diligence may include (1) an assessment of the strengths and weaknesses of the asset’s credit profile, (2) a review of all or merely a subset of the documentation related to the asset, or (3) other reviews that we or our Manager may deem appropriate to conduct. There can be no assurance that we or our Manager will conduct any specific level of due diligence, or that, among other things, the due diligence process will uncover all relevant facts and potential liabilities or that any purchase will be successful, which could result in losses on these assets, which, in turn, could adversely affect our financial condition and results of operations.
Our Manager utilizes analytical models and data in connection with the valuation of certain of our assets, and any incorrect, misleading or incomplete information used in connection therewith would subject us to potential risks.
Given the complexity of certain of our target assets, our Manager may rely heavily on analytical models and information and data supplied by third parties. Models and data are used to value potential target assets, potential credit risks and reserves and also in connection with hedging our acquisitions. Many of the models are based on historical trends. These trends may not be indicative of future results. Furthermore, the assumptions underlying the models may prove to be inaccurate, causing the models to also be incorrect. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, our Manager may be induced to buy for us certain target assets at prices that are too high, to sell certain other assets at prices that are too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.
Any credit ratings assigned to our investments will be subject to ongoing evaluations and revisions and we cannot assure you that those ratings will not be downgraded.
Some of our investments may be rated by Moody’s Investors Service, Fitch Ratings, Standard & Poor’s, Kroll Bond Rating Agency, DBRS, Inc., Egan Jones, or other rating agencies. Any credit ratings on our investments are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating agencies assign a lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our investments in the future, the value of these investments could significantly decline, which would adversely affect the value of our investment portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt service obligations to us.
Our real estate investments are subject to risks particular to real property. These risks may result in a reduction or elimination of, or return from, a loan secured by a particular property.
Real estate investments are subject to various risks, including:
•adverse changes in national and local economic and market conditions;
•changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;
•costs of remediation and liabilities associated with environmental conditions such as indoor mold;
•the potential for uninsured or under-insured property losses;
•acts of God, including earthquakes, floods and other natural disasters, which may result in uninsured losses;
•acts of war or terrorism, including the consequences of terrorist attacks; and
•social unrest and civil disturbances.
In the event any of these or similar events occurs, we may not realize our anticipated return on our investments and we may incur a loss on these investments. The ability of a borrower to repay these loans or other financial assets is dependent upon the income or assets of these borrowers.
We may be exposed to environmental liabilities with respect to properties to which we take title.
In the course of our business, we may take title to real estate, and, if we do take title, we could be subject to environmental liabilities with respect to these properties. In such a circumstance, we may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, results of operations and our ability to make distributions to our stockholders could be adversely affected.
The properties underlying our CRE loans may be subject to other unknown liabilities that could adversely affect the value of these properties, and as a result, our investments.
Properties underlying our commercial real estate loans may be subject to other unknown or unquantifiable liabilities that may adversely affect the value of our investments. Such defects or deficiencies may include title defects, title disputes, liens or other encumbrances on the mortgaged properties. The discovery
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of such unknown defects, deficiencies and liabilities could affect the ability of our borrowers to make payments to us or could affect our ability to foreclose and sell the underlying properties, which could adversely affect our results of operations and financial condition.
We may be affected by deficiencies in foreclosure practices of third parties, as well as related delays in the foreclosure process.
There continues to be uncertainty around the timing and ability of servicers to remove delinquent borrowers from their homes, so that they can liquidate the underlying properties and ultimately pass the liquidation proceeds through to owners of the mortgage loans. Given the magnitude of the housing crisis, and in response to the well-publicized failures of many servicers to follow proper foreclosure procedures (such as "robo-signing"), mortgage servicers are being held to much higher foreclosure-related documentation standards than they previously were. However, because many mortgages have been transferred and assigned multiple times (and by means of varying assignment procedures) throughout the origination, warehouse and securitization processes, mortgage servicers may have difficulty furnishing the requisite documentation to initiate or complete foreclosures. This leads to stalled or suspended foreclosure proceedings, and ultimately additional foreclosure-related costs. Foreclosure-related delays also tend to increase ultimate loan loss severities as a result of property deterioration, amplified legal and other costs, and other factors. Many factors delaying foreclosure, such as borrower lawsuits and judicial backlog and scrutiny, are outside of servicers’ control and have delayed, and will likely continue to delay, foreclosure processing in both judicial states (where foreclosures require court involvement) and non-judicial states.
We may find it necessary or desirable to foreclose on certain of the loans we acquire. Whether or not we have participated in the negotiation of the terms of any such loans, we cannot assure you as to the adequacy of the protection of the terms of the applicable loan, including the validity or enforceability of the loan and the maintenance of the anticipated priority and perfection of the applicable security interests. Furthermore, claims may be asserted by lenders or borrowers that might interfere with enforcement of our rights. Borrowers may resist foreclosure actions by asserting numerous claims, counterclaims and defenses against us, including, without limitation, lender liability claims and defenses, even when the assertions may have no basis in fact, in an effort to prolong the foreclosure action and seek to force the lender into a modification of the loan or a favorable buy-out of the borrower's position in the loan. In some states, foreclosure actions can take several years or more to litigate. A servicer’s failure to remove delinquent borrowers from their homes in a timely manner could increase our costs, adversely affect the value of the property and mortgage loans and have an adverse effect on our results of operations and business. In addition, foreclosure may create a negative public perception of the collateral property, resulting in a diminution of its value. Even if we are successful in foreclosing on a mortgage loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our investment. Any costs or delays involved in the foreclosure of the loan or a liquidation of the underlying property will reduce the net proceeds realized and, thus, increase the potential for loss.
Insurance on mortgage loans and real estate securities collateral may not cover all losses.
There are certain types of losses, generally of a catastrophic nature, such as earthquakes, floods, hurricanes, terrorism or acts of war, which may be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations and other factors, including terrorism or acts of war, also might result in insurance proceeds insufficient to repair or replace a property if it is damaged or destroyed. Under these circumstances, the insurance proceeds received with respect to a property relating to one of our investments might not be adequate to restore our economic position with respect to our investment. Any uninsured loss could result in the loss of cash flow from, and the asset value of, the affected property and the value of our investment related to such property.
The allocation of the net proceeds of any equity offering among our target assets, and the timing of the deployment of these proceeds is subject to, among other things, then prevailing market conditions and the availability of target assets.
Our allocation of the net proceeds from any equity offering among our target assets is subject to our investment guidelines and maintenance of our REIT qualification. Our Manager will make determinations as to the percentage of our equity that will be invested in each of our target assets and the timing of the deployment of the net proceeds of our equity offerings. These determinations will depend on then prevailing market conditions and may change over time in response to opportunities available in different interest rate, economic and credit environments. Until appropriate assets can be identified, our Manager may decide to use the net proceeds of our offerings to pay down our short-term debt or to invest the net proceeds in interest-bearing short-term investments, including funds, which are consistent with maintenance of our REIT qualification. These investments are expected to provide a lower net return than we seek to achieve from our target assets. Prior to the time we have fully used the net proceeds of our offerings to acquire our target assets, we may fund our monthly and/or quarterly distributions out of such net proceeds.
Real estate valuation is inherently subjective and uncertain.
The valuation of real estate and therefore the valuation of any collateral underlying our loans is inherently subjective due to, among other factors, the individual nature of each property, its location, the expected future rental revenues from that particular property and the valuation methodology adopted. As a result, the valuations of the real estate assets against which we will make or acquire loans are subject to a large degree of uncertainty and are made on the basis of assumptions and methodologies that may not prove to be accurate, particularly in periods of volatility, low transaction flow or restricted debt availability in the commercial or residential real estate markets.
An increase in interest rates may cause a decrease in the volume of certain of our target assets, which could adversely affect our ability to acquire assets that satisfy our investment objectives and to generate income and make distributions to our stockholders.
Rising interest rates generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans originated may affect the volume of transitional floating-rate multifamily and CRE loans and other mortgage related investments available to us, which could adversely affect our ability to acquire assets that satisfy our investment objectives. Rising interest rates may also cause our assets that were issued prior to an interest rate increase to provide yields that are below prevailing market interest rates. If rising interest rates cause us to be unable to acquire a sufficient volume of transitional floating-rate multifamily and CRE loans and other mortgage related investments with a yield that is above our borrowing cost, our ability to satisfy our investment objectives and to generate income and make distributions to our stockholders may be adversely affected.
The relationship between short-term and longer-term interest rates is often referred to as the "yield curve." Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because some of our future investments may bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income and the market value of our net assets. Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease our net income. It is also possible that short-term interest rates may
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exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses. Given the current state of the U.S. economy due to the ongoing COVID-19 pandemic, there can be no guarantee that the yield curve will not become and/or remain inverted.
Increases in interest rates typically adversely affect the value of certain of our investments and cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders.
We invest in transitional multifamily and other CRE loans, as well as other mortgage related investments. In a normal yield curve environment, an investment in the fixed-rate component of such assets will generally decline in value if future long-term interest rates increase. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect cash available for distribution to our stockholders.
A significant risk associated with our target assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates increased significantly, the market value of these investments would decline, and the duration and weighted average life of the investments would increase. We could realize a loss if the securities were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on any repurchase agreements we may enter into.
Our business model is such that rising interest rates will generally increase our net interest income, while declining rates will generally decrease our net interest income. As of December 31, 2021, 100% of our loans by unpaid principal balance earned a floating rate of interest and were financed with liabilities that require interest payments based on floating rates, which resulted in an amount of net equity that is positively correlated to rising interest rates.
Market values of our investments may decline without any general increase in interest rates for a number of reasons, such as increases or expected increases in defaults, or increases or expected increases in voluntary prepayments for those investments that are subject to prepayment risk or widening of credit spreads.
In addition, in a period of rising interest rates, our operating results will depend in large part on the difference between the income from our assets and our financing costs. We anticipate that, in most cases, the income from such assets will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and market value of our assets.
Changes to the method of determining the LIBOR or the selection of a replacement for LIBOR may affect the value of the financial obligations to be held or issued by us that are linked to LIBOR and could affect our results of operations and financial results.
On July 27, 2017, and in a subsequent speech by its chief executive on July 12, 2018, the U.K. Financial Conduct Authority (the “FCA”), which regulates LIBOR, confirmed that it will no longer persuade or compel banks to submit rates for the calculation of the LIBOR benchmark after 2021. On March 5, 2021, ICE Benchmark Administration Limited, the LIBOR administrator, and the FCA issued an announcement on the future cessation and loss of representativeness of the LIBOR benchmarks. For one-month USD LIBOR, this will occur immediately after June 30, 2023. In addition, U.S. banking regulators have made clear that USD LIBOR originations are not permitted after December 31, 2021.
The Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions convened by the Federal Reserve, has recommended SOFR as a more robust reference rate alternative to USD LIBOR. The International Swaps and Derivatives Association, Inc. adopted fallback language for USD LIBOR-referencing derivatives contracts that provides for SOFR as the primary replacement rate in the event of a LIBOR cessation. SOFR is calculated based on overnight transactions under repurchase agreements, backed by Treasury securities. SOFR is observed on a daily basis and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate for specified tenors. Due to SOFR being a secured rate backed by government securities, it does not take into account bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. As a result, parties may seek to adjust spreads relative to such reference rate in underlying contractual arrangements.
We are unable to predict the effect of any changes to USD LIBOR or the establishment and success of any alternative reference rates, such as SOFR. Such changes, reforms or replacements relating to USD LIBOR could have an adverse impact on the market for or value of any USD LIBOR-linked securities, loans, derivatives or other financial instruments or extensions of credit held by or due to us or our funds. Furthermore, a significant number of our financing obligations are USD LIBOR-linked and may be negatively impacted by any changes to LIBOR and any replacement of USD LIBOR with SOFR in those obligations. As such, LIBOR-related changes could negatively affect our overall results of operations and financial condition.
We may invest in CMBS which are subordinate in right of payment to more senior securities.
Our investments may include subordinated tranches of CMBS, which are a subordinated class of security in a structure of securities collateralized by a pool of mortgage loans and, accordingly, is the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Additionally, estimated fair value of these subordinated interests tend to be more sensitive to changes in economic conditions than more senior securities. As a result, such subordinated interests generally are not actively traded and may not provide holders thereof with liquid investments.
Changes in prepayment rates may adversely affect our profitability.
Our business is primarily focused on investing in, financing and managing floating-rate mortgage loans secured by multifamily properties and other CRE assets. Generally, our mortgage loan borrowers may repay their loans prior to their stated maturities. Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. Prepayments can also occur when borrowers default on their mortgages and the mortgages are prepaid from the proceeds of a foreclosure sale of the property, or when borrowers sell the property and use the sale proceeds to prepay the mortgage. Prepayment rates may also be affected by conditions in the financial markets, general economic conditions and the relative interest rates on commercial mortgages, which could lead to an acceleration of the payment of the related principal. While we will seek to manage prepayment risk, in selecting our real estate investments we must balance prepayment risk against other risks, the potential returns of each investment and the cost of hedging our risks. Additionally, we are subject to prepayment risk associated with the terms of our CLOs. Due to the generally short-term nature of transitional floating-rate commercial mortgage loans, our CLOs include a reinvestment period during which principal repayments and prepayments on our commercial mortgage loans may be reinvested in similar assets, subject to meeting certain eligibility criteria. While the interest-rate spreads of our CLOs are fixed until they are repaid, the terms, including spreads, of newly originated loans are subject to uncertainty based on a variety of factors, including market and competitive conditions. To the
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extent that such conditions result in lower spreads on the assets in which we reinvest, we may be subject to a reduction in interest income in the future. No strategy can completely insulate us from prepayment or other such risks, and we may deliberately retain exposure to prepayment or other risks.
We are highly dependent on communications and information systems. Systems failures could significantly disrupt our operations, which may, in turn, negatively affect the market price of our equity securities and our ability to make distributions.
Our business is highly dependent on the communications and information systems of our Manager. Any failure or interruption of our Manager’s systems could have a material adverse effect on our operating results and negatively affect the market price of our equity securities and our ability to make distributions.
The occurrence of cyber-incidents, or a deficiency in our Manager's cybersecurity or in those of any of our third party service providers, could negatively impact our business by causing a disruption to our operations, a compromise of our confidential information or damage to our business relationships or reputation, all of which could negatively impact our business and results of operations.
A cyber-incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of our or our Manager's information resources or those of our third party service providers. A cyber-incident can be an intentional attack or an unintentional event and can include gaining unauthorized access to a system to disrupt operations, corrupt data or steal confidential information. The primary risks that could directly result from a cyber-incident include operational interruption and private data exposure. Our Manager has implemented processes, procedures and controls to help mitigate these risks, but these measures, as well as our increased awareness of the risk of a cyber-incident, do not guarantee that our business and results of operations will not be negatively impacted by such an incident.
Any downgrades, or perceived potential of downgrades, of the credit ratings of the U.S. Government, GSEs or certain European countries may adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
On August 5, 2011, Standard & Poor’s downgraded the U.S. Government’s credit rating for the first time in history, and on October 15, 2013, Fitch Ratings placed the ratings of all outstanding U.S. sovereign debt securities on Rating Watch Negative. Downgrades of the credit ratings of the U.S. Government, GSEs and certain European countries could create broader financial turmoil and uncertainty, which could weigh heavily on the global banking system. Therefore, any downgrades of the credit ratings of the U.S. Government, GSEs or certain European countries may adversely affect the value of our target assets and our business, financial condition, results of operations and our ability to make distributions to our stockholders.
Social, political, and economic instability, unrest, and other circumstances beyond our control could adversely affect our business operations.
Our business may be adversely affected by social, political, and economic instability, unrest, or disruption, including protests, demonstrations, strikes, riots, civil disturbance, disobedience, insurrection and looting in geographic regions where the properties securing our investments are located. Such events may result in property damage and destruction and in restrictions, curfews, or other governmental actions that could give rise to significant changes in regional and global economic conditions and cycles, which may adversely affect our financial condition and operations.
There have been demonstrations and protests, some of which involved violence, looting, arson and property destruction, in cities throughout the U.S., including Atlanta, Seattle, Los Angeles, Washington D.C., New York City, Minneapolis and Portland, as well as globally, including in Hong Kong. While protests have been peaceful in many locations, looting vandalism and fires have taken place in cities, which led to the imposition of mandatory curfews, and, in some locations, deployment of the U.S. National Guard. Governmental actions taken place to protect people and property, including curfews and restrictions on business operations, may disrupt operations, harm perceptions of personal well-being and increase the need for additional expenditures on security resources. The effect and duration of demonstrations, protests or other factors is uncertain, and we cannot assure there will not be further political or social unrest in the future or that there will not be other events that could lead to further social, political and economic instability. If such events or disruptions persist for a prolonged period of time, our overall business and results of operations may be adversely affected.
Any or all of the foregoing could have material adverse effect on our financial condition, results of operations and cash flows, or the market price of our common stock. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial , may also have potential to materially adversely affect our business, financial condition and results of operations.
Risks Related to Financing and Hedging
Our strategy involves leverage, which may amplify losses and there is no specific limit on the amount of leverage that we may use.
We leverage our portfolio investments in our target assets principally through borrowings under collateralized loan obligations. Our leverage (on both a GAAP and non-GAAP basis) currently ranges, and we expect that it will continue to range, between three and six times the amount of our stockholders’ equity. We will incur this leverage by borrowing against a substantial portion of the market or face value of our assets. Our leverage, which is fundamental to our investment strategy, creates significant risks.
To the extent that we incur leverage, we may incur substantial losses if our borrowing costs increase. Our borrowing costs may increase for any of the following, or other, reasons:
•short-term interest rates increase;
•the market value of our securities decreases;
•interest rate volatility increases;
•the availability of financing in the market decreases; or
•changes in advance rates.
Our return on our investments and cash available for distributions may be reduced if market conditions cause the cost of our financing to increase relative to the income that can be derived from the assets acquired, which could adversely affect the price of our equity securities. In addition, our debt service payments will reduce cash flow available for distributions to stockholders. In addition, if the cost of our financing increases, we may not be able to meet our debt service obligations. To the extent that we cannot meet our debt service obligations, we risk the loss of some or all of our assets to satisfy our debt obligations. To the extent we are compelled to liquidate qualified REIT assets to repay debts, our compliance with the REIT rules regarding our assets and our
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sources of income could be negatively affected, which would jeopardize our qualification as a REIT. Losing our REIT status would cause us to lose tax advantages applicable to REITs and would decrease our overall profitability and distributions to our stockholders.
We may incur significant additional debt in the future, which will subject us to increased risk of loss and may reduce cash available for distributions to our stockholders.
Subject to market conditions and availability, we may incur significant additional debt in the future. Although we are not required by our board of directors to maintain any particular assets-to-equity leverage ratio, the amount of leverage we may deploy for particular assets will depend upon our Manager’s assessment of the credit and other risks of those assets. Our board of directors may establish and change our leverage policy at any time without stockholder approval. Incurring debt could subject us to many risks that, if realized, would adversely affect us, including the risk that:
•our cash flow from operations may be insufficient to make required payments of principal and interest on the debt or we may fail to comply with all of the other covenants contained in the debt, which is likely to result in (1) acceleration of such debt (and any other debt containing a cross-default or cross-acceleration provision) that we may be unable to repay from internal funds or to refinance on favorable terms, or at all, (2) our inability to borrow unused amounts under our financing arrangements, even if we are current in payments on borrowings under those arrangements, and/or (3) the loss of some or all of our assets to foreclosure or sale;
•our debt may increase our vulnerability to adverse economic and industry conditions with no assurance that investment yields will increase with higher financing costs;
•we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, investments, stockholder distributions or other purposes; and
•we may not be able to refinance debt that matures prior to the investment it was used to finance on favorable terms or at all.
There can be no assurance that our Manager will be able to prevent mismatches in the maturities of our assets and liabilities.
Because we employ financial leverage in funding our portfolio, mismatches in the maturities of our assets and liabilities can create risk in the need to continually renew or otherwise refinance our liabilities. Our net interest margins will be dependent upon a positive spread between the returns on our asset portfolio and our overall cost of funding. Our Manager’s risk management tools include software and services licensed or purchased from third parties, in addition to proprietary systems and analytical methods developed internally. There can be no assurance that these tools and the other risk management techniques described above will protect us from asset/liability risks.
Lenders generally require us to enter into restrictive covenants relating to our operations.
When we obtain financing, lenders typically impose restrictions on us that would affect our ability to incur additional debt, our capability to make distributions to stockholders and our flexibility to determine our operating policies. Loan documents we execute may contain negative covenants that limit, among other things, our ability to repurchase stock, distribute more than a certain amount of our funds from operations and employ leverage beyond certain amounts.
Our inability to meet certain financial covenants related to our credit agreements could adversely affect our business, financial condition and results.
In connection with our credit and guaranty agreement, we are required to maintain certain financial covenants with respect to our net worth, asset values, loan portfolio composition, leverage ratios and debt service coverage levels. Compliance with these financial covenants will depend on market factors and the strength of our business and operating results. Various risks, uncertainties and events beyond our control could affect our ability to comply with our financial covenants. Failure to comply with our financial covenants could result in an event of default, termination of the credit facility and acceleration of all amounts owing under our credit facility and gives the counterparty the right to exercise certain other remedies under the credit agreement, unless we were able to negotiate a waiver. Any such waiver could be conditioned on an amendment to our credit facility and any related guaranty agreement on terms that may be unfavorable to us. If we are unable to negotiate a covenant waiver or replace or refinance our assets under a new credit facility on favorable terms or at all, our financial condition, results of operations and cash flows could be adversely affected.
We may enter into repurchase agreements, and our rights under such repurchase agreements may be subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of us or our counterparties under the repurchase agreements.
In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under Title 11 of the United States Code, as amended, or the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to take possession of and liquidate the assets that we have pledged under their repurchase agreements. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.
An increase in our borrowing costs relative to the interest that we receive on investments in our mortgage related investments may adversely affect our profitability and cash available for distribution to our stockholders.
As our financings mature, we will be required either to enter into new borrowings or to sell certain of our investments. An increase in short-term interest rates at the time that we seek to enter into new borrowings would reduce the spread between our returns on our assets and the cost of our borrowings. This would adversely affect our returns on our assets, which might reduce earnings and, in turn, cash available for distribution to our stockholders.
We have utilized and may utilize in the future non-recourse securitizations to finance our loans and investments, which may expose us to risks that could result in losses.
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We have utilized and may utilize in the future, non-recourse securitizations of our portfolio investment to generate cash for funding new loans and investments and other purposes. These transactions generally involve creating a special-purpose entity, contributing a pool of our assets to the entity, and selling interest in the entity on a non-recourse basis to purchasers (whom we would expect to be willing to accept a lower interest to invest in investment-grade loan pools). We would expect to retain all or a portion of the equity and potentially other tranches in the securitized pool of loans or investments. In addition, we have retained in the past and may in the future retain a pari passu participation in the securitized pool of loans.
Prior to any such financing, we may use short-term facilities to finance the acquisition of assets until a sufficient quantity of investments had been accumulated, at which time we would refinance these facilities through a securitization, such as a CMBS, or issuance of CLOs, or the private placement of loan participations or other long-term financing. As a result, we would be subject to the risk that we would not be able to acquire, during the period that our short-term facilities are available, a sufficient amount of eligible investment to maximize the efficiency of a CMBS, CLO or other private placement issuance. We also would be subject to the risk that we would not be able to obtain short-term credit facilities or would not be able to renew any short-term credit facilities after they expire should we find it necessary to extend our short-term credit facilities to allow more time to seek and acquire the necessary eligible investment for a long-term financing. The inability to consummate securitizations of our portfolio to finance our loans and investments on a long-term basis could require us to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price, which could adversely affect or performance and our ability to grow our business. Moreover, conditions in the capital markets, including volatility and disruption in the capital and credit markets, may not permit a non-recourse securitization at any particular time or may make the issuance of any such securitization less attractive to us even when we do have sufficient eligible assets. We may also suffer losses if the value of the mortgage loans we acquire declines prior to securitization. Declines in the value of a mortgage loan can be due to, among other things, changes in interest rates and changes in the credit quality of the loan. In addition, we may suffer a loss due to the incurrence of transaction costs related to executing these transactions. To the extent that we incur a loss executing or participating in future securitizations for the reasons described above or for other reasons, it could materially and adversely impact our business and financial condition. In addition, the inability to securitize our portfolio may hurt our performance and our ability to grow our business.
In addition, the securitization of our portfolio might magnify our exposure to losses because any equity interest or other subordinate interest we retain in the issuing entity would be subordinate to the notes issued to investors and we would, therefore, absorb all of the losses sustained with respect to a securitized pool of assets before the owners of the notes experience any losses. Moreover, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or Dodd-Frank Act, contains a risk retention requirement for all asset-backed securities, which requires both public and private securitizers to retain not less than 5% of the credit risk of the assets collateralizing any asset-backed issuance. Significant restrictions exist, and additional restrictions may be added in the future, regarding who may hold risk retention interest, the structure of the entities that hold risk retention interest and when and how such risk retention interests may be transferred. Therefore such risk retention interests will generally be illiquid. As result of the risk retention requirements, we have and may in the future be required to purchase and retain certain interests in a securitization into which we sell mortgage loans and/or when we act as an issuer, may be required to sell certain interests in a securitization at prices below levels that such interests have historically yielded and/or may be required to enter into certain arrangements related to risk retention that we have not historically been required to enter into. Accordingly, the risk retention rules may increase our potential liabilities and/or reduce our potential profits in connections with securitization of mortgage loans. It is likely, therefore, that these risk retentions rules will increase the administrative and operational cost of asset securitizations.
We may enter into hedging transactions that expose us to contingent liabilities in the future, which may adversely affect our financial results or cash available for distribution to stockholders.
We may engage in hedging transactions intended to hedge various risks to our portfolio, including the exposure to adverse changes in interest rates. Our hedging activity varies in scope based on, among other things, the level and volatility of interest rates, the type of assets held and other changing market conditions. Although these transactions are intended to reduce our exposure to various risks, hedging may fail to protect or could adversely affect us because, among other things:
•hedging can be expensive, particularly during periods of volatile or rapidly changing interest rates;
•available hedges may not correspond directly with the risks for which protection is sought;
•the duration of the hedge may not match the duration of the related liability;
•the amount of income that a REIT may earn from certain hedging transactions is limited by U.S. federal income tax provisions governing REITs;
•the credit quality of a hedging counterparty may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
•the hedging counterparty may default on its obligation to pay.
Subject to maintaining our qualification as a REIT, there are no current limitations on the hedging transactions that we may undertake. However, our Manager’s reliance on the CFTC’s December 7, 2012 no action letter relieving CPOs of mortgage REITs from the obligation to register with the CFTC as CPOs depends on the satisfaction of several conditions, including that we comply with additional limitations on our hedging activity. The letter limits the initial margin and premiums required to establish our Manager’s commodity interest positions to no more than 5% of the fair market value of our total assets and limits the net income derived annually from our commodity interest positions that are not qualifying hedging transactions to less than 5% of our gross income.
Therefore, our and our Manager’s reliance on this no action letter places additional restrictions on our hedging activity. Our hedging transactions could require us to fund large cash payments in certain circumstances (e.g., the early termination of the hedging instrument caused by an event of default or other early termination event or a demand by a counterparty that we make increased margin payments). Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to fund these obligations could adversely affect our financial condition. Further, hedging transactions, which are intended to limit losses, may actually result in losses, which would adversely affect our earnings and could in turn reduce cash available for distribution to stockholders.
Hedging instruments involve various kinds of risk because they are not always traded on regulated exchanges, guaranteed by an exchange or its clearinghouse or regulated by any U.S. or foreign governmental authorities. The CFTC is still in the process of proposing rules under the Dodd-Frank Act that may make our hedging more difficult or increase our costs. Furthermore, the enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty will most likely result in its default. Default by a hedging counterparty may result in the loss of unrealized profits and force us to cover our commitments, if any, at the then current market price. Although we generally seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
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Hedging against interest rate exposure may adversely affect our earnings, which could reduce our cash available for distribution to our stockholders, and such transactions may fail to protect us from the losses that they were designed to offset.
Subject to maintaining our qualification as a REIT and exemption from registration under the Investment Company Act, we may employ techniques that limit the adverse effects of rising interest rates on a portion of our short-term repurchase agreements and on a portion of the value of our assets. In general, our interest rate risk mitigation strategy depends on our view of our entire portfolio, consisting of assets, liabilities and derivative instruments, in light of prevailing market conditions. We could misjudge the condition of our portfolio or the market. Our interest rate risk mitigation activity varies in scope based on the level and volatility of interest rates and principal repayments, the type of securities held and other changing market conditions. Our actual interest rate risk mitigation decisions are determined in light of the facts and circumstances existing at the time and may differ from our currently anticipated strategy. These techniques may include purchasing or selling futures contracts, entering into interest rate swap, interest rate cap or interest rate floor agreements, swaptions, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements.
Because a mortgage borrower typically has no restrictions on when a loan may be paid off either partially or in full, there are no perfect interest rate risk mitigation strategies, and interest rate risk mitigation may fail to protect us from loss. Alternatively, we may fail to properly assess a risk to our portfolio or may fail to recognize a risk entirely leaving us exposed to losses without the benefit of any offsetting interest rate mitigation activities. The derivative instruments we select may not have the effect of reducing our interest rate risk. The nature and timing of interest rate risk mitigation transactions may influence the effectiveness of these strategies. Poorly designed strategies or improperly executed transactions could actually increase our risk and losses. In addition, interest rate risk mitigation activities could result in losses if the event against which we mitigate does not occur.
Our loans and investments may be subject to fluctuations in interest rates that may not be adequately protected, or protected at all, by our hedging strategies.
Our assets include loans with either floating interest rates or fixed interest rates. Floating rate loans earn interest at rates that adjust from time to time based upon an index (typically LIBOR). These floating rate loans are insulated from changes in value specifically due to changes in interest rates; however, the coupons they earn fluctuate based upon interest rates and, in a declining and/or low interest rate environment, these loans will earn lower rates of interest and this will impact our operating performance. For more information about our risks related to changes to, or the elimination of, LIBOR, see "Risk Factors—Risks Related to Our Investment Strategies and Our Businesses—Changes in the method for determining LIBOR or a replacement of LIBOR may affect the value of the financial obligations to be held or issued by us that are linked to LIBOR and could affect our results of operations or financial condition." Fixed interest rate loans, however, do not have adjusting interest rates and the relative value of the fixed cash flows from these loans will decrease as prevailing interest rates rise or increase as prevailing interest rates fall, causing potentially significant changes in value. We may employ various hedging strategies to limit the effects of changes in interest rates (and in some cases credit spreads), including engaging in interest rate swaps, caps, floors and other interest rate derivative products. We believe that no strategy can completely insulate us from the risks associated with interest rate changes and there is a risk that such strategies may provide no protection at all and potentially compound the impact of changes in interest rates. Hedging transactions involve certain additional risks such as counterparty risk, leverage risk, the legal enforceability of hedging contracts, the early repayment of hedged transactions and the risk that unanticipated and significant changes in interest rates may cause a significant loss of basis in the contract and a change in current period expense. We cannot make assurances that we will be able to enter into hedging transactions or that such hedging transactions will adequately protect us against the foregoing risks.
Accounting for derivatives under GAAP may be complicated. Any failure by us to meet the requirements for applying hedge accounting in accordance with GAAP could adversely affect our earnings. In particular, derivatives are required to be highly effective in offsetting changes in the value or cash flows of the hedged items (and appropriately designated and/or documented as such). If it is determined that a derivative is not highly effective at hedging the designated exposure, hedge accounting is discontinued and the changes in fair value of the instrument are included in our reported net income.
Risks Associated with Our Relationship with Our Manager
Our board of directors has approved very broad investment guidelines for our Manager and will not approve each investment and financing decision made by our Manager.
Our Manager is authorized to follow very broad investment guidelines. Our board of directors periodically reviews and updates our investment guidelines and also reviews our investment portfolio but does not generally review or approve specific investments. In addition, in conducting periodic reviews, our board of directors may rely primarily on information provided to them by our Manager. Furthermore, our Manager may use complex strategies, and transactions entered into by our Manager may be costly, difficult or impossible to unwind by the time they are reviewed by our board of directors. Our Manager will have great latitude within the broad parameters of our investment guidelines in determining the types and amounts of mortgage related investments it may decide are attractive investments for us, which could result in investment returns that are substantially below expectations or that result in losses, which would adversely affect our business operations and results. In addition, our Manager may invest up to $75 million in any investment on our behalf without restriction and generally without prior approval of our board of directors. Our Manager is generally permitted to invest our assets in its discretion, provided that such investments comply with our investment guidelines. Our Manager’s failure to generate attractive risk-adjusted returns on an investment which represents a significant dollar amount would adversely affect us. Further, decisions made and investments and financing arrangements entered into by our Manager may not fully reflect the best interests of our stockholders.
We are dependent on our Manager and its key personnel for our success.
We have no separate facilities and are completely reliant on our Manager. All of our officers are employees of an affiliate of our Manager. Our Manager has significant discretion as to the implementation of our investment and operating policies and strategies. Accordingly, we believe that our success will depend to a significant extent upon the efforts, experience, diligence, skill and network of business contacts of the officers and key personnel of our Manager. The officers and key personnel of our Manager evaluate, negotiate, close and monitor our investments; therefore, our success will depend on their continued service. The departure of any of the officers or key personnel of our Manager could have a material adverse effect on our performance. In addition, there can be no assurance that our Manager will remain our investment manager or that we will continue to have access to our Manager’s officers and professionals. The initial term of our management agreement with our Manager only extends until January 3, 2023, with automatic one-year renewals thereafter. If the management agreement is terminated and no suitable replacement is found to manage us, we may not be able to execute our business plan.
There are conflicts of interest in our relationship with ORIX, including with our Manager and in the allocation of investment opportunities to ORIX affiliates and us, which could result in decisions that are not in the best interests of our stockholders.
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We are subject to conflicts of interests arising out of our relationship with ORIX, including our Manager and its affiliates. In addition, we are managed by our Manager, an ORIX affiliate, and our executive officers are employees of an affiliate of our Manager or one or more of its affiliates. There is no guarantee that the policies and procedures adopted by us, the terms and conditions of the Management Agreement or the policies and procedures adopted by our Manager, ORIX and their respective affiliates, will enable us to identify, adequately address or mitigate all potential conflicts of interest. Some examples of conflicts of interest that may arise by virtue of our relationship with our Manager and ORIX includes:
•Allocation of Investment Opportunities. Certain conflicts of interest may arise from the fact that ORIX, its affiliates, and our Manager may provide investment management and other services both to us and to other persons or entities, whether or not the investment objectives or policies of such other person or entity are similar to those of ours, including without limitation, the sponsoring, closing and/or managing of any Lument IM fund.
•ORIX's Investment Advisory and Proprietary Activities. ORIX makes investments pursuant to an investment strategy that is similar to the investment strategy implemented by Lument IM with respect to LFT, on behalf of itself and its own investment vehicles. Further, certain affiliates of ORIX originate investment opportunities that may be suitable for LFT but which are allocated to other investment funds managed by an affiliate of ORIX. Therefore ORIX or an affiliate may originate opportunities that are suitable for LFT but are allocated to entities primarily owned by ORIX or its affiliates.
•In addition, we are expected, from time to time, to make an investment in, or a loan to, a company in which ORIX and its affiliates (each, an “Investing Party”) are also expected to invest, or already have invested, in a different part of the capital structure, which may mean that one investor’s interest in that company may have different rights, preferences and privileges than the company interests held by us. There may be instances where such a company may become insolvent or bankrupt and where an Investing Party’s interests in such company may otherwise conflict with the interests of other Investing Parties. To the extent that we hold securities or other financial interests (e.g., bank debt) in a company with rights, preferences and privileges that are different than interests held by an Investing Party in the same company, the Manager and its affiliates may be presented with decisions when and/or where our interests and the interests of the Investing Parties are in conflict. It is possible that our interest may be subordinated or otherwise adversely affected by virtue of other Investing Parties’ involvement and actions relating to such investment, in a bankruptcy proceeding or otherwise. In addition, we can be expected, from time to time, to hold an interest in the more senior portion of an issuer’s capital structure while another Investing Party holds a more junior security of that issuer. Because ORIX is the owner of the Manager, the Manager would experience a conflict of interest in making determinations regarding the senior securities we held, as decisions on behalf of such entity to enforce remedies or take other actions against the obligors under such senior securities or the related collateral could adversely impact the value of the more junior securities held by another Investing Party. In such situation, the Manager is incentivized to decline to enforce such remedies or take such actions on behalf of the senior securities we held in order to protect the value of the junior securities held by the other Investing Party, which could adversely affect the our returns. To address such conflicts, an Investing Party would generally not take a control position in one part of an issuer’s capital structure while another affiliated entity takes a control position in another part of the same issuer’s capital structure.
The incentive fee payable to our Manager under the management agreement is payable quarterly and is based on our core earnings and, therefore, may cause our Manager to select investments in more risky assets to increase its incentive compensation.
Our Manager is entitled to receive incentive compensation based upon our achievement of targeted levels of core earnings. In evaluating investments and other management strategies, the opportunity to earn incentive compensation based on core earnings may lead our Manager to place undue emphasis on the maximization of core earnings at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation. Investments with higher yield potential are generally riskier or more speculative. This could result in increased risk to the value of our investment portfolio.
Core earnings is not a measure calculated in accordance with accounting principles generally accepted in the United States of America ("GAAP") and is defined in our management agreement in this Annual Report on Form 10-K.
The management agreement with our Manager may be costly and difficult to terminate, including for our Manager’s poor performance.
The Management Agreement automatically renews for successive one year terms beginning January 3, 2023 and each January 3 thereafter, unless it is sooner terminated upon written notice delivered to the Company or Manager, as applicable, no later than 180 days prior to a renewal date either (i) by the Company upon the affirmative vote of at least two-thirds (2/3) of the independent directors of the Board or by a vote of at least two-thirds of the Company's outstanding shares of common stock, based upon a determination that (a) the Manager’s performance is unsatisfactory and materially detrimental to the Company or (b) the compensation payable to the Manager under the Management Agreement is not fair to the Company (provided that in the instance of (b), we shall not have the right to terminate the Management Agreement if the Manager agrees to continue to provide services under the Management Agreement at fees that at least two-thirds of the independent directors of the Board determine to be fair, provided further that in the instance of (b), the Manager will be afforded the opportunity to renegotiate its compensation prior to termination) or (ii) by the Manager. We may also terminate the Management Agreement at any time, including during the initial term, without the payment of any termination fee, with at least 30 days’ prior written notice from us "for cause" as described in the Management Agreement. In the event of a termination of the Manager other than a termination for cause, we are required to pay a termination fee to the Manager. The termination fee is equal to three times the sum of (a) the average annual Base Management Fee and (b) the average annual Incentive Compensation, in each case, earned by the Manager during the twenty-four month period immediately preceding the effective date of termination, calculated as of the end of the most recently completed fiscal quarter before the effective date of termination. Our Manager may terminate the Management Agreement upon written notice delivered no later than 180 days prior to a renewal date.
Our Manager’s liability is limited under the management agreement and we have agreed to indemnify our Manager and its affiliates against certain liabilities. As a result, we could experience poor performance or losses for which our Manager would not be liable.
Pursuant to the management agreement, our Manager does not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager maintains a contractual as opposed to a fiduciary relationship with us, although our officers who are also employees of an affiliate of our Manager will have a fiduciary duty to us under Maryland Law, as our officers. Under the terms of the management agreement, our Manager, its officers, members, managers, directors, personnel, trustees, partners, stockholders, equity holders, any person controlling or controlled by our Manager and any person providing sub-advisory services to our Manager will not be liable to us, our directors, our stockholders or any partners for acts or omissions performed in accordance with and pursuant to the management agreement, except because of acts or omissions constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the management agreement, as determined by a final non-appealable order of a court of competent jurisdiction. In addition, we have agreed to indemnify our Manager, its officers, stockholders, members, managers, directors, personnel, trustees, partners, stockholders, equity holders, any person controlling or controlled by our Manager and any person providing sub-advisory services to our Manager with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts or omissions of our Manager not constituting bad faith, willful misconduct, gross negligence or reckless disregard of
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duties, performed in good faith in accordance with and pursuant to the management agreement. As a result, we could experience poor performance or losses for which our Manager would not be liable.
Our Manager is subject to extensive regulation as an investment adviser, which could adversely affect its ability to manage our business.
Our Manager is an investment adviser registered with the SEC and is subject to regulation by various regulatory authorities that are charged with protecting the interests of its clients, including us. Our Manager could be subject to civil liability, criminal liability or sanction, including revocation or denial of its registration as an investment adviser, revocation of the licenses of its employees, censures, fines or temporary suspension or permanent bar from conducting business, if it is found to have violated any of laws or regulations applicable to it. Any such liability or sanction could adversely affect its ability to manage our business.
Employee litigation and unfavorable publicity could negatively affect our future business.
Employees may, from time to time, bring lawsuits against us or our Manager regarding injury, creation of a hostile work place, discrimination, wage and hour, sexual harassment and other employment issues. In recent years there has been an increase in the number of discrimination and harassment claims generally. Coupled with the expansion of social media platforms and similar devices that allow individuals access to a broad audience, these claims have had a significant negative impact on some businesses. Companies that have faced employment or harassment related lawsuits have had to terminate management or other key personnel and have suffered reputational harm that has negatively impacted their sales. If we were to face any employment related claims, our business could be negatively affected.
Risks Related to Our Securities
The market price and trading volume of our securities may vary substantially.
Our common stock is listed on the NYSE under the symbol "LFT." Stock markets, including the NYSE, have experienced significant price and volume fluctuations over the past several years. As a result, the market price of our securities has been and is likely to continue to be similarly volatile, and investors in our securities have experienced since the initial offering of our securities and may continue to experience a decrease in the value of their securities. Accordingly, no assurance can be given as to the ability of our stockholders to sell their securities or the price that our stockholders may obtain for their securities.
Some of the factors that negatively affect the market price of our securities include:
•changes in our dividend rates or frequency of payments thereof;
•actual or anticipated variations in our quarterly operating results;
•changes in our earnings estimates or publication of research reports about us or the real estate industry;
•changes in market valuations of similar companies;
•adverse market reaction to any increased indebtedness we incur in the future;
•additions to or departures of our Manager’s key personnel;
•actions by our stockholders;
•speculation in the press or investment community;
•trading prices of common and preferred equity securities issued by REITs and other similar companies;
•failure to satisfy REIT requirements;
•general economic and financial conditions;
•government action or regulation; and
•our issuance of additional preferred equity or debt securities.
Market factors unrelated to our performance could negatively impact the market price of our securities, and broad market fluctuations could also negatively impact the market price of our securities.
Market factors unrelated to our performance could negatively impact the market price of our securities. One of the factors that investors may consider in deciding whether to buy or sell our securities is our distribution rate as a percentage of our stock price relative to market interest rates. If market interest rates increase, prospective investors may demand a higher distribution rate or seek alternative investments paying higher distributions or interest. As a result, interest rate fluctuations and conditions in the capital markets can affect the market value of our securities. In addition, the stock market has experienced extreme price and volume fluctuations that have affected the market price of many companies in industries similar or related to ours and that have been unrelated to these companies’ operating performances. These broad market fluctuations could reduce the market price of our securities. Furthermore, our operating results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies with comparable market capitalizations, which could lead to a material decline in the market price of our securities.
The performance of our securities may be affected by the performance of our investments, which may be speculative and aggressive compared to other types of investments.
The investments we make in accordance with our investment objectives may result in a greater amount of risk as compared to alternative investment options, including relatively higher risk of volatility or loss of principal. Our investments may be speculative and aggressive, and therefore an investment in our securities may not be suitable for someone with lower risk tolerance.
One of the factors that investors may consider in deciding whether to buy or sell shares of our securities is our distribution rate as a percentage of the trading price of our securities relative to market interest rates and distribution rates of our competitors. If the market price of our securities is based primarily on the earnings and return that we derive from our investments and income with respect to our investments and our related distributions to stockholders, and not from the market value of the investments themselves, then interest rate fluctuations and capital market conditions are likely to adversely affect the market price of our securities. For instance, if market rates rise without an increase in our distribution rate, the market price of our securities could decrease as potential investors may require a higher distribution yield on our securities or seek other securities paying higher distributions or interest. In addition, rising interest rates would result in increased interest expense on our variable rate debt, thereby reducing cash flow and our ability to service our indebtedness and make distributions to our stockholders.
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An increase in interest rates may have an adverse effect on the market price of our stock and our ability to make distributions to our stockholders.
One of the factors that investors may consider in deciding whether to buy or sell shares of our stock is our dividend rate, or our future expected dividend rate, as a percentage of our common stock price, relative to market interest rates. If market interest rates increase, prospective investors may demand a higher dividend rate on our shares or seek alternative investments paying higher dividends or interest. As a result, interest rate fluctuations and capital market conditions can affect the market price of our stock independent of the effects such conditions may have on our portfolio.
We have not established a minimum distribution payment level on our common stock and we cannot assure you of our ability to make distributions in the future, or that our board of directors will not reduce distributions in the future regardless of such ability.
We intend to announce quarterly dividends in arrears on a quarterly basis to holders of our common stock. If substantially all of our taxable income has not been paid by the close of any calendar year, we intend to declare a special dividend to holders of our common stock prior to December 31st of the current year, to achieve this result.
We have not established a minimum distribution payment level on our common stock and our ability to make distributions may be adversely affected by the risk factors described in this Annual Report on Form 10-K. All distributions to our common stockholders will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. There can be no assurance of our ability to make distributions to our common stockholders, or that our board of directors will not determine to reduce such distributions, in the future. In addition, some of our distributions to our common stockholders may continue to include a return of capital.
Future offerings of debt or equity securities that rank senior to our common stock may adversely affect the market price of our common stock.
If we decide to issue additional equity securities or to issue debt in the future that rank senior to our common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Additionally, any convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common stock and may result in dilution to owners of our common stock. We and, indirectly, our stockholders, will bear the cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus holders of our common stock will bear the risk of our future offerings reducing the market price of our common stock and diluting the value of their stock holdings in us. Furthermore, the compensation payable to our Manager will increase as a result of future issuances of our equity securities even if the issuances are dilutive to existing stockholders.
Risks Related to Our Organization and Structure
Maintenance of our exclusion from the Investment Company Act will impose limits on our business; we have not sought formal guidance from the staff of the SEC as to our treatment of loans in securitization trusts and there can be no assurance that the staff will not adopt a contrary interpretation which could cause us to sell material amounts of our assets and to change our investment strategy.
We intend to conduct our operations so that neither we nor our subsidiaries are required to register as investment companies under the Investment Company Act. Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. We believe that we do not meet the definition of investment company under Section 3(a)(1)(A) of the Investment Company Act because we do not engage primarily, or hold ourselves out as being engaged primarily, in the business of investing, reinvesting or trading in securities. Rather, we are primarily engaged in a non-investment company businesses related to real estate.
Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis. Excluded from the term “investment securities,” among other things, are U.S. Government securities and securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. We intend to conduct our operations so that we do not come within the definition of an investment company under Section 3(a)(1)(C) of the Investment Company Act, or we otherwise qualify for an exclusion from the definition. We generally rely on guidance published by the SEC or its staff or on our own analyses to determine whether we fall outside of this definition, including, for example, whether a particular subsidiary is a “majority-owned subsidiary” or “wholly-owned subsidiary” (as those terms are defined in and interpreted under the Investment Company Act) for this purpose.
We hold our assets primarily through our direct or indirect subsidiaries, certain of which we believe are excluded from the definitions of investment company pursuant to Section 3(c)(5)(C) of the Investment Company Act. As interpreted by the SEC staff, this exception generally requires that at least 55% of the subsidiary’s total assets be comprised of certain qualifying real estate interests, and at least 80% of the subsidiary’s total assets be comprised of qualifying real estate interests and, as needed, certain real estate-related assets. We generally rely on guidance published by the SEC or its staff, or on our own analyses, to determine which assets are qualifying real estate assets and real estate-related assets.
Certain of our subsidiaries [may] seek to rely on Rule 3a-7 under the Investment Company Act. Rule 3a-7 under the Investment Company Act is available to certain structured financing vehicles that are engaged in the business of holding financial assets that, by their terms, convert into cash within a finite time period and that issue fixed income securities entitling holders to receive payments that depend primarily on the cash flows from these assets, provided that, among other things, the structured finance vehicle does not engage in certain portfolio management practices resembling those employed by management investment companies (e.g., mutual funds). Accordingly, each such subsidiary’s ability to acquire and dispose of assets is limited. As a result of this limitation as well as others imposed by the rule, these subsidiaries may suffer losses on their assets and we may in turn suffer losses.
We and/or certain of our subsidiaries may seek to rely on the exclusion from the definition of investment company provided by Section 3(c)(6). As a general matter, this section excepts any company primarily engaged, directly or through majority-owned subsidiaries, in one or more other business excepted under the Investment Company Act (including Section 3(c)(5)(C)) or in one or more of such businesses together with an additional business or businesses other than investing, reinvesting, owning, holding, or trading in securities. Little interpretive guidance has been issued by the SEC or its staff with respect to Section 3(c)(6).
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SEC and staff no-action and other guidance under the Investment Company Act is based in large part on specific factual situations, some of which differ from the factual situations we and our subsidiaries face from time to time. As a result, we apply SEC or staff guidance that relates to other factual situations by analogy. A number of the staff no-action positions were issued more than twenty years ago. There may be no guidance from the SEC staff that applies directly to our factual situations. No assurance can be given that the SEC or its staff will concur with our analysis, conclusions or approach. In addition, the SEC or its staff may, in the future, issue further guidance that may require us and/or our subsidiaries to re-classify our assets; modify our organizational structure; acquire or sell assets; or make other changes for purposes of the Investment Company Act, any or all of which could materially and adversely affect us. For example, on August 31, 2011, the SEC issued a concept release and request for comments regarding the Section 3(c)(5)(C) exclusion (Release No. IC-29778) in which it solicited public comment on a wide range of issues relating to Section 3(c)(5)(C), including the nature of the assets that qualify for purposes of the exclusion and whether mortgage REITs should be regulated in a manner similar to registered investment companies.
Conducting our business so that we are not required to register under the Investment Company Act limits, among other things: the types of businesses in which we may engage through our subsidiaries; our organizational structure and business strategy; and the types of assets we and our subsidiaries originate, acquire or sell; and the timing of such originations, acquisitions and dispositions (including doing so when we would not otherwise choose to do so). We cannot assure you that we would be able to complete any such originations, acquisitions or on favorable terms, or at all. Any or all of the above could materially and adversely affect us.
Although we monitor our holdings and organizational structure for ongoing compliance with the above, there can be no assurance that we will be able to continue to avoid registration as an investment company, or that the laws and regulations governing, or regulatory guidance pertaining to, investment company status will not change in a manner that materially and adversely affects us. If the fair market value or income potential of our assets changes, we may need to increase or decrease our holdings of certain of our assets to maintain our exclusion from the Investment Company Act.
If it were established that we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the SEC, that we would be unable to enforce contracts with third parties, that third parties could seek to obtain rescission of transactions undertaken during the period for which it was established that we were an unregistered investment company. In addition, in this case, we would need to register as an investment company under the Investment Company Act, modify our operations, perhaps significantly, to seek to continue to avoid being require to register under the Investment Company Act, or seek some form of exemptive or other relief from the SEC or its staff. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to use borrowings), management, operations, transactions with affiliated persons (as defined in the Investment Company Act) and portfolio composition, including disclosure requirements and restrictions with respect to diversification and industry concentration and other matters. Compliance with the Investment Company Act would, accordingly, limit our ability to make certain investments and require us to significantly restructure our business strategy. Any of the foregoing results would have a material adverse effect on us.
Since we are not expected to be subject to the Investment Company Act and the rules and regulations promulgated thereunder, we will not be subject to its substantive provisions, and thus investors will not receive the protections that the Investment Company Act provides to investors in registered investment companies.
Our authorized but unissued shares of common and preferred stock may prevent a change in our control.
Our charter authorizes us to issue additional authorized but unissued shares of common or preferred stock. In addition, our board of directors may, without stockholder approval, amend our charter to increase the aggregate number of our shares of stock or the number of shares of stock of any class or series that we have authority to issue and classify or reclassify any unissued shares of common or preferred stock and set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board of directors may establish a series of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for our share class or of common stock or otherwise be in the best interest of our stockholders.
Ownership limitations may restrict change of control or business combination opportunities in which our stockholders might receive a premium for their shares.
In order for us to maintain our REIT qualification for each taxable year after December 31, 2012, during the last half of any taxable year no more than 50% in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals. "Individuals" for this purpose include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts. To assist us in maintaining our qualification as a REIT among other purposes and subject to certain exceptions, our charter generally prohibits any person from directly or indirectly owning more than 9.8% in value or in number of shares, whichever is more restrictive, of the outstanding shares of our common stock or more than 9.8% in value or in number of shares, whichever is more restrictive, of the outstanding shares of our capital stock. On February 17, 2022, in connection with the closing of our rights offering, in which we issued and sold an aggregate of 27,277,269 shares of our common stock, our board of directors adopted resolutions decreasing the common stock ownership limit and the aggregate stock ownership limit from 9.8% to 8.75% for all stockholders who are not excepted holders. The ownership limitations in our charter could have the effect of discouraging a takeover or other transaction in which holders of our equity securities might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests.
Our board of directors has granted exemptions to the aggregate stock ownership limit and the common stock ownership limit in our charter to (i) XL Bermuda Ltd, (ii) OREC Investment Holdings, LLC, an affiliate of our Manager, and (iii) James C. Hunt, a member of our board of directors and Hunt Company Equity Holdings, LLC.
Certain provisions of Maryland law may limit the ability of a third-party to acquire control of our company.
Certain provisions of the Maryland General Corporation Law ("MGCL") may have the effect of delaying, deferring or preventing a transaction or a change of control of our company that might involve a premium price for holders of our equity securities or otherwise be in their best interests.
Subject to certain limitations, provisions of the MGCL prohibit certain business combinations between us and an "interested stockholder" (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate of ours who beneficially owned 10% or more of the voting power of our then outstanding stock during the two-year period immediately prior to the date in question) or an affiliate of the interested stockholder for five years after the most recent date on which the stockholder became an interested stockholder. After the five-year period, business combinations between us and an interested stockholder or an affiliate of the interested stockholder must generally either provide a minimum price to our stockholders (as defined in the MGCL) in the form of cash or other consideration in the same form as previously paid by the interested stockholder or be recommended by our board of directors and approved by the affirmative vote of at least 80% of the votes entitled to be cast by holders of our outstanding
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shares of voting stock and at least two-thirds of the votes entitled to be cast by stockholders other than the interested stockholder and its affiliates and associates. These provisions of the MGCL relating to business combinations do not apply, however, to business combinations that are approved or exempted by our board of directors prior to the time that the interested stockholder becomes an interested stockholder. Pursuant to the statute, our board of directors has by resolution exempted business combinations between us and the XL Companies and certain affiliates thereof, the parent of which is AXA SA, between us and Hunt Investors and affiliates thereof and between us and OREC Investment Holdings and affiliates thereof.. Consequently, the five-year prohibition and the supermajority vote requirements will not apply to business combinations between us and the exempted parties. As a result, the exempted companies may be able to enter into business combinations with us that may not be in the best interest of our stockholders without compliance by us with the supermajority vote requirements and other provisions of the statute. However, our board of directors may repeal or modify these exemptions at any time in the future, in which case the applicable provisions of this statute will become applicable to business combinations between us and the previously exempted parties.
The "control share" provisions of the MGCL provide that holders of "control shares" of a Maryland corporation (defined as shares which, when aggregated with other shares controlled by the stockholder (except solely by virtue of a revocable proxy), entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a "control share acquisition" (defined as the direct or indirect acquisition of ownership or control of "control shares") have no voting rights with respect to such shares except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, our officers and our employees who are also our directors. Our bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of shares of our stock. There can be no assurance that this provision will not be amended or eliminated at any time in the future.
Additionally, Title 3, Subtitle 8 of the MGCL permits our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to elect to be subject to certain provisions relating to corporate governance that may have the effect of delaying, deferring or preventing a transaction or a change of control of our company that might involve a premium to the market price of our equity securities or otherwise be in our stockholders’ best interests. Those provisions are (i) a classified board; (ii) a two-thirds vote requirement for removing a director; (iii) a requirement that the number of directors be fixed only by vote of the directors; (iv) a requirement that a vacancy on the board be filled only by affirmative vote of a majority of the remaining directors in office and for the remainder of the full term of the class of directors in which the vacancy occurred; (v) and a majority requirement for the calling of a special meeting of stockholders. We are subject to all of those provisions except for a classified board, either by provisions of our charter and bylaws unrelated to Subtitle 8 or by reason of an election in our charter to be subject to certain provisions of Subtitle 8.
Stockholders have limited control over changes in our policies and operations.
Our board of directors determines our major policies, including with regard to financing, growth, debt capitalization, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders. Under our charter and the MGCL, our common stockholders generally have a right to vote only on the following matters:
•the election or removal of directors;
•the amendment of our charter, except that our board of directors may amend our charter without stockholder approval to:
◦change our name;
◦change the name or other designation or the par value of any class or series of stock and the aggregate par value of our stock;
◦increase or decrease the aggregate number of shares of stock that we have the authority to issue; and
◦increase or decrease the number of our shares of any class or series of stock that we have the authority to issue;
•our liquidation and dissolution; and
•our being a party to a merger, consolidation, sale or other disposition of all or substantially all of our assets or statutory share exchange.
All other matters are subject to the discretion of our board of directors.
Our charter contains provisions that make removal of our directors difficult, which could make it difficult for stockholders to effect changes in management.
Our charter provides that, subject to the rights of any class or series of preferred stock, a director may be removed only by the affirmative vote of at least two-thirds of all the votes entitled to be cast generally in the election of directors. Our charter and bylaws provide that vacancies generally may be filled only by a majority of the remaining directors in office, even if less than a quorum. These requirements make it more difficult to change management by removing and replacing directors and may prevent a change in control that is in the best interests of stockholders.
Our rights and stockholders’ rights to take action against directors and officers are limited, which could limit recourse in the event of actions not in the best interests of stockholders.
As permitted by Maryland law, our charter eliminates the liability of our directors and officers to us and our stockholders for money damages, except for liability resulting from:
•actual receipt of an improper benefit or profit in money, property or services; or
•a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.
In addition, our charter requires us, to the maximum extent permitted by Maryland law, to indemnify and, without requiring a preliminary determination of the ultimate entitlement to indemnification, pay or reimburse reasonable expenses in advance of final disposition of a proceeding to any individual who is a present or former director or officer and who is made or threatened to be made a party to the proceeding by reason of his or her service in that capacity or any individual who, while a director or officer and at our request, serves or has served as a director, officer, partner, trustee of another corporation, REIT, partnership, joint venture, trust, employee benefit plan or any other enterprise and who is made or threatened to be made a party to the proceeding by reason of his or her service in that capacity. Maryland law permits indemnification of our directors and officers in connection with a proceeding, unless it is established that (i) the act or omission of the individual was material to the proceeding and was committed in bad faith or was the result of active and deliberate dishonesty, or the individual actually received an improper personal benefit in money, property or services, or (ii) in the case of a criminal proceeding, the individual had reasonable cause to believe that the act or omission was unlawful. As part of these indemnification obligations, we may be obligated to fund the defense costs incurred by our directors and officers.
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We also are permitted to purchase and maintain insurance or provide similar protection on behalf of any directors, officers, employees and agents, including our Manager and its affiliates, against any liability asserted which was incurred in any such capacity with us or arising out of such status. This may result in us having to expend significant funds, which will reduce the available cash for distribution to our stockholders.
We have made, and in the future may make, distributions of offering proceeds, borrowings or the sale of assets to the extent that distributions exceed earnings or cash flow from our operations.
We have made, and in the future may make, distributions of offering proceeds, borrowings or the sale of assets to the extent that distributions exceed earnings or cash flow from our operations. Such distributions reduce the amount of cash we have available for investing and other purposes and could be dilutive to our financial results. In addition, funding our distributions from our net proceeds may constitute a return of capital to our investors, which would have the effect of reducing each stockholder’s basis in its shares of equity securities.
Because of their significant ownership of our common stock, OREC Investment Holdings, an affiliate of our Manager, and the Hunt Investors have the ability to influence the outcome of matters that require a vote of our stockholders, including a change of control.
OREC Investment Holdings and the Hunt Investors hold a significant interest in our outstanding common stock. As of March 1, 2022, OREC Investment Holdings owned 27.4% of our outstanding common stock and the Hunt Investors owned 12.1% of our outstanding common stock. In addition, James C. Hunt, one of the Hunt Investors, is a member of our board of directors. As a result, each of OREC Investment Holdings and the Hunt Investors has the ability to influence the outcome of matters that require a vote of our stockholders, including election of our board of directors and other corporate transactions, regardless of whether others believe that the transaction is in our best interests.
We are a "smaller reporting company” and we may avail ourselves of the reduced disclosure requirements, which may make the Company’s securities less attractive to investors.
As a "smaller reporting company," the Company has relied on exemptions from certain disclosure requirements that are applicable to other public companies. The Company may continue to rely on such exemptions for so long as the Company remains a "smaller reporting company." These exemptions include reduced financial disclosure and reduced disclosure obligations regarding executive compensation. We may continue to rely on such exemptions for so long as we remain a smaller reporting company under applicable SEC rules and regulations. The Company’s reliance on these exemptions may result in the public finding the Company’s securities to be less attractive and adversely impact the market price of the Company’s securities or the trading market thereof.
We are subject to financial reporting and other requirements for which our accounting, internal audit and other management systems and resources may not be adequately prepared.
We are subject to reporting and other obligations under the Exchange Act, including the requirements of Section 404 of the Sarbanes-Oxley Act. These reporting and other obligations may place significant demands on our management, administrative, operational, internal audit and accounting resources and cause us to incur significant expenses. We may need to upgrade our systems or create new systems, implement additional financial and management controls, reporting systems and procedures, expand or outsource our internal audit function and hire additional accounting, internal audit and finance staff. If we are unable to accomplish these objectives in a timely and effective fashion, our ability to comply with the financial reporting requirements and other rules that apply to reporting companies could be impaired. Any failure to maintain effective internal controls could have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders.
We are required to make critical accounting estimates and judgments, and our financial statements may be materially affected if our estimates or judgments prove to be inaccurate.
Financial statements prepared in accordance with GAAP require the use of estimates, judgments and assumptions that affect the reported amounts. Different estimates, judgments and assumptions reasonably could be used that would have a material effect on our financial statements, and changes in these estimates, judgments and assumptions are likely to occur from period to period in the future. Significant areas of accounting requiring the application of management’s judgment include, but are not limited to (1) determining the fair value of our investments, (2) assessing the adequacy of the allowance for loan losses or credit reserves and (3) appropriately consolidating VIEs for which we have determined we are the primary beneficiary. These estimates, judgments and assumptions are inherently uncertain, and, if they prove to be inaccurate, then we face the risk that charges to income will be required. In addition, because we have limited operating history in some of these areas and limited experience in making these estimates, judgments and assumptions, the risk of future charges to income may be greater than if we had more experience in these areas. Any such charges could significantly harm our business, financial condition, results of operations and our ability to make distributions to our stockholders. See "Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies" for a discussion of the accounting estimates, judgments and assumptions that we believe are the most critical to an understanding of our business, financial condition and results of operations.
Tax Risks
If we fail to remain qualified as a REIT, we will be subject to U.S. federal income tax as a regular corporation and could face a substantial tax liability, which would reduce the amount of cash available for distribution to our stockholders.
We elected to be taxed as a REIT commencing with our short taxable year ended December 31, 2012, and our subsidiary, Lument Commercial Mortgage Trust, Inc. elected to be taxed as a REIT commencing with its short taxable year ended December 31, 2018 and in each case to comply with the provisions of the Internal Revenue Code with respect thereto. Our and its continued qualification as a REIT will depend on our and its satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Our and its ability to satisfy the asset tests depends upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Further, there can be no assurance that the U.S. Internal Revenue Service, or the IRS, will not contend that our interests in subsidiaries or in securities of other issuers will not cause a violation of the REIT requirements.
If we were to fail to maintain our REIT qualification in any taxable year and were not able to qualify for, or fail to satisfy the requirements of certain statutory relief provisions, we would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and dividends paid to our stockholders would not be deductible by us in computing our taxable income. Any resulting corporate tax liability
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could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of our equity securities. Unless we were entitled to relief under certain Internal Revenue Code provisions, we also would be disqualified from re-electing to be taxed as a REIT for the four taxable years following the year in which we failed to qualify as a REIT.
Furthermore, any REIT in which we invest directly or indirectly, including Lument Commercial Mortgage Trust, Inc., the REIT through which we own our interests in our CLOs, is independently subject to, and must comply with, the same REIT requirements that we must satisfy in order to qualify as a REIT. If the subsidiary fails to qualify as a REIT and certain statutory relief provisions do not apply, then (a) the subsidiary REIT would become subject to U.S. federal income tax, (b) the subsidiary REIT will be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost, (c) our investment in the subsidiary REIT could cease to be a qualifying asset for purposes of the asset tests applicable to REITs and any dividend income or gains derived by us from such subsidiary REIT may cease to be treated as income that qualifies for purposes of the 75% gross income test, and (d) we may fail certain of the asset or income tests applicable to REITs, in which event we will fail to qualify as REIT unless we are able to avail ourselves of certain statutory relief provisions.
If we fail to remain qualified as REIT, we may default on our current financing facilities and be required to liquidate our assets, and we may face delays or inabilities to procure future financing.
Failure to maintain qualified as a REIT could result in an event of default under our credit facility and CLOs, and we may be required to liquidate all or substantially all of our assets, unless we were able to negotiate a waiver. Any such waiver could be conditioned on an amendment to our CLOs or credit facility and any related guaranty agreements on terms that may be unfavorable to us. If we are unable to negotiate a waiver or replace or refinance our assets under a new credit facility or CLO on favorable terms or at all, our financial conditions, results of operations and cash flows could be adversely affected.
Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.
The maximum tax rate applicable to income from "qualified dividends" payable to U.S. stockholders that are individuals, trusts and estates is 20%, exclusive of a 3.8% investment tax surcharge. Dividends payable by REITs, however, generally are not eligible for the reduced rates. Thus, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our equity securities. However, REIT dividends (other than capital gain dividends) received by non-corporate taxpayers may be eligible for a 20% deduction. This deduction is only applicable to investors of LFT that receive dividends and does not have any impact on us. Without further legislation, the deduction would sunset after 2025. Investors should consult their own tax advisors regarding the effect of this change on their effective tax rate with respect to REIT dividends.
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our REIT taxable income determined without regard to the deduction for dividends paid and excluding net capital gain and 90% of our net income, if any, (after tax) from foreclosure property, in order for us to maintain our REIT qualification. To the extent that we satisfy such distribution requirements but distribute less than 100% of our REIT taxable income we will be subject to U.S. federal income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under U.S. federal income tax laws. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code.
From time to time, differences in timing between our recognition of taxable income and our actual receipt of cash may occur. If we do not have other funds available in these situations we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt, make a taxable distribution of our shares as part of a distribution in which stockholders may elect to receive shares or (subject to certain limits) cash or use cash reserves, in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the REIT distribution requirement and to avoid the U.S. federal income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our equity. Thus, compliance with the REIT requirements may hinder our ability to grow, which could adversely affect the value of our equity securities.
Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.
Even if we remain qualified for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on certain types of income including as a result of a foreclosure, and state or local income, property and transfer taxes, such as mortgage recording taxes. Any of these taxes would decrease cash available for distribution to our stockholders.
Complying with REIT requirements may cause us to forgo otherwise attractive opportunities and may require us to dispose of our target assets sooner than originally anticipated.
To maintain our qualification as a REIT, we must satisfy five tests relating to the nature of our assets at the end of each calendar quarter. First, at least 75% of the value of our total assets must consist of cash, cash items, government securities and real estate assets, including certain mortgage loans and securities and debt instruments issued by publicly offered REITs. Second, we may not own more than 10% of any one issuer’s outstanding securities, as measured by either value or voting power. Third, no more than 5% of the value of our total assets can consist of the securities of any one issuer. Fourth, no more than 20% of our total assets can be represented by securities of one or more TRSs. Fifth, not more than 25% of our assets may consist of debt instruments issued by publicly offered REITs to the extent that such debt instruments constitute "real estate assets" for purposes of the 75% asset test described above only because of the express inclusion of "debt instruments issued by publicly offered REITs" in the definition. If we fail to comply with these requirements at the end of any calendar quarter, we will lose our REIT qualification unless we are able to qualify for certain statutory relief provisions, which may involve paying taxes and penalties. In order to comply with the asset tests, we may be required to liquidate from our investment portfolio otherwise attractive investments. These actions could have the effect of reducing our income and the amount available for distribution to our stockholders.
In addition to the asset tests set forth above, to maintain our REIT qualification, we must continually satisfy tests concerning, among other things, the sources of our income, the amounts we distribute to our stockholders and the ownership of our stock. We may be unable to pursue investments that would be otherwise advantageous to us in order to satisfy the income test, the asset tests, and the other REIT requirements. Thus, compliance with the REIT requirements
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may hinder our ability to make certain attractive investments. If we fail to comply with any of these other REIT requirements at the end of any fiscal year, we will lose our REIT qualification unless we are able to satisfy or qualify for certain statutory relief provisions which may involve paying taxes and penalties.
We may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.
We may continue to acquire mortgage-backed securities in the secondary market for less than their face amount. In addition, as a result of our ownership of certain mortgage-backed securities, we may be treated for tax purposes as holding certain debt instruments acquired in the secondary market for less than their face amount. The discount at which such securities or debt instruments are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally be treated as "market discount" for U.S. federal income tax purposes. Accrued market discount is generally reported as income when, and to the extent that, any payment of principal of the mortgage-backed security or debt instrument is made. If we collect less on the mortgage-backed security or debt instrument than our purchase price plus the market discount we had previously reported as income, we may not be able to benefit from any offsetting loss deductions.
In addition, as a result of our ownership of certain mortgage-backed securities, we may be treated for tax purposes as holding distressed debt investments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are "significant modifications" under applicable U.S. Treasury Department regulations, the modified debt may be considered to have been reissued to us at a gain in a debt-for-debt exchange with the borrower. In that event, we may be required to recognize taxable gain to the extent the principal amount of the modified debt exceeds our adjusted tax basis in the unmodified debt, even if the value of the debt or the payment expectations have not changed.
Moreover, some of the mortgage-backed securities that we acquire may have been issued with original issue discount. We will be required to report such original issue discount based on a constant yield method and will be taxed based on the assumption that all future projected payments due on such mortgage-backed securities will be made. If such mortgage-backed securities turn out not to be fully collectible, an offsetting loss deduction will become available only in the later year that lack of collectability is provable.
Finally, in the event that any debt instruments or mortgage-backed securities acquired by us are delinquent as to mandatory principal and interest payments, or in the event a borrower with respect to a particular debt instrument acquired by us encounters financial difficulty rendering it unable to pay stated interest as due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, we may be required to accrue interest income with respect to subordinate mortgage-backed securities at the stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while we would in general ultimately have an offsetting loss deduction available to us when such interest was determined to be uncollectable, the utility of that deduction could depend on our having taxable income in that later year or thereafter.
The "taxable mortgage pool" rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.
Securitizations by us or our subsidiaries could result in the creation of taxable mortgage pools for U.S. federal income tax purposes, resulting in "excess inclusion income." As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we generally would not be adversely affected by the characterization of the securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt U.S. stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the excess inclusion income. In the case of a stockholder that is a REIT, a regulated investment company, or RIC, common trust fund or other pass-through entity, our allocable share of our excess inclusion income could be considered excess inclusion income of such entity. In addition, to the extent that our stock is owned by tax-exempt "disqualified organizations," such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of any excess inclusion income. Because this tax generally would be imposed on us, all of our stockholders, including stockholders that are not disqualified organizations, generally would bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable mortgage pool. A RIC, or other pass-through entity owning our stock in record name will be subject to tax at the highest U.S. federal corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. Moreover, we could face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. Finally, if we were to fail to maintain our REIT qualification, any taxable mortgage pool securitizations would be treated as separate taxable corporations for U.S. federal income tax purposes that could not be included in any consolidated U.S. federal income tax return. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.
Liquidation of our assets may jeopardize our REIT qualification.
To maintain our qualification as a REIT, we must comply with requirements regarding our assets and our sources of income. If we liquidate our investments including to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.
Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.
The REIT provisions of the Internal Revenue Code substantially limit our ability to hedge our assets and liabilities. Under these provisions, any income from a hedging transaction we enter into to manage risk of interest rate changes with respect to borrowings made or to be made to acquire or carry real estate assets does not constitute "gross income" for purposes of the 75% or 95% gross income tests, if certain requirements are met. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both of the REIT gross income tests.
Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.
Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. In addition, our ability to satisfy the requirements to maintain our REIT qualification depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes. Thus,
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while we intend to continue to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, and the possibility of future changes in our circumstances, no assurance can be given that we will maintain our qualification for any particular year.
We may incur a significant tax liability as a result of selling assets that might be subject to the prohibited transactions tax if sold directly by us.
A REIT’s net income from "prohibited transactions" is subject to a 100% tax. In general, "prohibited transactions" are sales or other dispositions of assets held primarily for sale to customers in the ordinary course of business. There is a risk that certain loans that we are treating as owning for U.S. federal income tax purposes and certain property received upon foreclosure of these loans will be treated as held primarily for sale to customers in the ordinary course of business. Although we expect to avoid the prohibited transactions tax by contributing those assets to one of our TRSs and conducting the marketing and sale of those assets through that TRS, no assurance can be given that the IRS will respect the transaction by which those assets are contributed to our TRS. Even if those contribution transactions are respected, our TRS will be subject to U.S. federal, state and local corporate income tax and may incur a significant tax liability as a result of those sales.
We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of shares of our equity securities.
At any time, the U.S. federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be changed, possibly with retroactive effect. We cannot predict if or when any new U.S. federal income tax law, regulation or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective or whether any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.
Distributions to tax-exempt investors may be classified as unrelated business taxable income, or UBTI, as defined under Section 512(a) of the Internal Revenue Code.
Neither ordinary nor capital gain distributions with respect to our stock nor gain from the sale of stock should generally constitute UBTI to a tax-exempt investor. However, there are certain exceptions to this rule, including: (1) part of the income and gain recognized by certain qualified employee pension trusts with respect to our stock may be treated as UBTI if shares of our stock are predominantly held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as UBTI; (2) part of the income and gain recognized by a tax-exempt investor with respect to our stock would constitute UBTI if the investor incurs debt in order to acquire the stock; (3) part or all of the income or gain recognized with respect to our stock by social clubs, voluntary employee benefit associations, supplemental unemployment benefit trusts and qualified group legal services plans which are exempt from U.S. federal income taxation under the Internal Revenue Code may be treated as UBTI; and (4) to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a "taxable mortgage pool," or if we hold residual interests in a REMIC, a portion of the distributions paid to a tax-exempt stockholder that is allocable to excess inclusion income may be treated as UBTI.
The value of our assets represented by our TRS is required to be limited and a failure to comply with this and certain other rules governing transactions between a REIT and its TRSs would jeopardize our REIT qualification and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more TRSs. Other than certain activities relating to lodging and healthcare facilities, a TRS generally may engage in any business and may hold assets and earn income that would not be qualifying assets or income if held or earned directly by a REIT. No more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT, or by a TRS on behalf of its parent REIT, that are not conducted on an arm’s-length basis.
Our current TRS, and any future TRSs, will pay U.S. federal, state and local income tax on their respective taxable incomes, if any. We anticipate that the aggregate value of the securities of our TRS will be less than 20% of the value of our total assets (including our TRS securities). Furthermore, we intend to monitor the value of our investments in our TRS for the purpose of ensuring compliance with TRS-ownership limitations. In addition, we will review all our transactions with our TRS to ensure that they are entered into on arm’s-length terms to avoid incurring the 100% excise tax described above. There can be no assurance, however, that we will be able to continue to comply with the TRS-ownership limitation or to avoid application of the 100% excise tax discussed above.
Your investment has various U.S. federal income tax risks.
We urge you to consult your tax advisor concerning the effects of U.S. federal, state, local and foreign tax laws to you with regard to an investment in shares of our stock.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
We do not own any real estate or other physical properties. We maintain our corporate headquarters at 230 Park Avenue, 20th Floor, New York, NY 10169 in office space furnished to us by our Manager. We reimburse our Manager under the management agreement between us for lease and other related expenses incurred in furnishing us with our offices. We believe that our property is maintained in good condition and is suitable and adequate for our purposes.
ITEM 3. LEGAL PROCEEDINGS
As of the date of this filing, we are not party to any litigation or legal proceeding or, to the best of our knowledge, any threatened litigation or legal proceeding.
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ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
On March 14, 2022, the last reported sales price for our common stock on the New York Stock Exchange under symbol "LFT" was $3.03.
Holders
At December 31, 2021, there were 24,947,883 shares of our common stock outstanding. As of March 14, 2022, there were 16 registered holders. The number of beneficial stockholders is substantially greater than the number of holders of record as a large portion of our stock is held in "street name" through banks or broker dealers.
Dividends
Dividends on our common stock are paid on a quarterly basis.
All dividend distributions are made with the authorization of the board of directors at its discretion and depend on such items as our REIT taxable earnings, financial condition, maintenance of REIT status, and other factors that the board of directors may deem relevant from time to time.
The holders of our common stock share proportionally on a per share basis in all declared dividends on our common stock. We are required to distribute to our stockholders as dividends at least 90% of our REIT taxable income, computed without regard to our net capital gains and the deduction for dividends paid, and 90% of our net income, if any (after tax) from foreclosure property in order to maintain our qualification as a REIT. See Item 1A, "Risk Factors," and Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations," of this Annual Report on Form 10-K, for information regarding the sources of funds used for dividends and for a discussion of factors, if any, which may adversely affect our ability to pay dividends at the same level in 2021 and thereafter.
The following table presents cash dividends declared on our common stock from January 1, 2020 through December 31, 2021:
| Common Dividends Declared per Share | ||||||||||||||||||||
| Declaration Date | Amount | Record Date | Date of Payment | |||||||||||||||||
| March 12, 2020 | $ | 0.075 | March 31, 2020 | April 15, 2020 | ||||||||||||||||
| June 17, 2020 | $ | 0.075 | June 30, 2020 | July 15, 2020 | ||||||||||||||||
| September 17, 2020 | $ | 0.085 | September 30, 2020 | October 15, 2020 | ||||||||||||||||
| December 18, 2020 | $ | 0.090 | December 31, 2020 | January 15, 2021 | ||||||||||||||||
| December 21, 2020 | $ | 0.040 | December 31, 2020 | January 15, 2021 | ||||||||||||||||
| March 15, 2021 | $ | 0.090 | March 31, 2021 | April 15, 2021 | ||||||||||||||||
| June 15, 2021 | $ | 0.090 | June 30, 2021 | July 15, 2021 | ||||||||||||||||
| September 15, 2021 | $ | 0.090 | September 30, 2021 | October 15, 2021 | ||||||||||||||||
| December 15, 2021 | $ | 0.090 | December 31, 2021 | January 15, 2022 | ||||||||||||||||
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
On December 16, 2015, we announced a share repurchase program, pursuant to which our Board authorized us to repurchase up to $10 million of our common shares. Under this program, we have discretion to determine the dollar amount of common shares to be repurchased and the timing of any repurchases in compliance with applicable law and regulations. The program does not have an expiration date.
The Company did not purchase any common shares under the plan during the twelve months ended December 31, 2021.
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes included in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our current expectations, estimates, forecasts and projections.
Overview
We are a Maryland corporation that is focused on investing in, financing and managing a portfolio of commercial real estate ("CRE") debt investments.
In January 2020, we entered into a series of transactions with subsidiaries of ORIX Corporation USA ("ORIX USA"), a diversified financial company with the ability to provide investment capital and asset management services to clients in the corporate, real estate and municipal finance sectors. We entered into a new management agreement with OREC Investment Management, LLC doing business as Lument Investment Management (the "Manager" or "Lument IM"), while another affiliate of ORIX USA purchased an ownership stake of approximately 5.0% through a privately-placed stock issuance. The transactions are expected to enhance the scale of LFT and generate shareholder value through leveraging ORIX USA's expansive originations, asset management and servicing platform.
Lument IM is an affiliate of Lument, a nationally recognized leader in multifamily and seniors housing and care finance. The Company leverages Lument's broad platform and significant expertise when originating and underwriting investments.
We invest primarily in transitional floating rate CRE mortgage loans with an emphasis on middle market multifamily assets. We may also invest in other CRE-related investments including mezzanine loans, preferred equity, commercial mortgage-backed securities, fixed rate loans, construction loans and other CRE debt instruments. We finance our current investments in transitional multifamily and other CRE loans primarily through match term non-recourse CRE collateralized loan obligations ("CLOs"). We may utilize warehouse repurchase agreements or other forms of financing in the future. Our primary sources of income are net interest from our investment portfolio and non-interest income from our mortgage loan-related activities. Net interest income represents the interest income we earn on investments less the expense of funding these investments.
Our investments typically have the following characteristics:
•Sponsors with experience in particular real estate sectors and geographic markets;
•Located in U.S. markets with multiple demand drivers, such as growth in employment and household formation;
•Fully funded principal balance greater than $5 million and generally less than $75 million;
•Loan to Value ratio up to 85% of as-is value and up to 75% of as stabilized value;
•Floating rate loans historically tied to one-month U.S. denominated LIBOR, more recently to one-month term SOFR, and/or in the future potentially other index replacement;
•Three-year term with two one-year extension options.
We believe that our current investment strategy provides significant opportunities to achieve attractive risk-adjusted returns for our stockholders over time. However, to capitalize on the investment opportunities at different points in the economic and real estate investment cycle, we may modify or expand our investment strategy. We believe that the flexibility of our strategy, which is supported by significant CRE experience of Lument's investment team, and the extensive resources of ORIX USA, will allow us to take advantage of changing market conditions to maximize risk-adjusted returns to our stockholders.
We have elected to be taxed as a REIT and comply with the provisions of the Internal Revenue Code with respect thereto. Accordingly, we are generally not subject to federal income tax on our REIT taxable income that we currently distribute to our stockholders so long as we maintain our qualification as a REIT. Our continued qualification as a REIT depends on our ability to meet, on a continuing basis, various complex requirements under the Internal Revenue Code relating to, among other things, the source of our gross income, the composition and values of our assets, our distribution levels and the concentration of ownership of our capital stock. Even if we maintain our qualification as a REIT, we may become subject to some federal, state and local taxes on our income generated in our wholly owned taxable REIT subsidiary ("TRS"), Five Oaks Acquisition Corp. ("FOAC").
Recent Developments
As the COVID-19 pandemic has evolved from its emergence in early 2020, so has its global impact. Many countries have re-instituted, or strongly encouraged, varying levels of quarantines and restrictions on travel and in some cases have at times limited operations of certain businesses and taken other restrictive measures designed to help slow the spread of COVID-19 and its variants. Governments and businesses have also instituted vaccine mandates and testing requirements for employees. While vaccine availability and uptake has increased, the longer-term macro-economic effects on global supply chains, inflation, labor shortages and wage increases continue to impact many industries. Moreover, with the potential for new strains of COVID-19 to emerge, governments and businesses may re-impose aggressive measures to help slow its spread in the future. For this reason, among others, as the COVID-19 pandemic continues, the potential global impacts are uncertain and difficult to assess.
The effects of the COVID-19 pandemic did not significantly impact our operating results for the year ended December 31, 2021. However, the prolonged duration and impact of the COVID-19 pandemic could materially disrupt our business operations and negatively impact our business, financial performance and operating results for the year ending December 31, 2022 and potentially longer.
On February 22, 2022, the Company closed a transferable common stock rights offering. The Company issued and sold 27,277,269 shares of common stock for gross proceeds of approximately $83.5 million.
On February 22, 2022, the Company, together with its Credit Parties, entered into an amendment (the "Fourth Amendment") to the Credit and Guaranty Agreement. This amendment amends the maximum total net leverage financial covenant.
2021 Highlights
•Net income attributable to common stockholders of $7.4 million, or $0.30 per share of common stock, and Distributable Earnings of $9.7 million, or $0.39 per share of common stock, with common dividends declared of $9.0 million, or $0.36 per share of common stock. Distributable Earnings is a non-GAAP
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financial measure. For a definition of Distributable Earnings and a reconciliation of our Distributable Earnings to our net income attributable to common stockholders, see "Key Financial Measure and Indicators."
•Book value per share of common stock was $109.3 million, or $4.38 per share of common stock.
•Acquired sixty-four loans and acquired eighteen loan advances with an initial unpaid principal balance of $983.3 million with a weighted average interest rate of one month U.S. LIBOR plus 3.46% and a weighted average LIBOR floor of 0.46%.
•On April 21, 2021, the Company, together with its FOAC and Lument CMT Equity subsidiaries (together with the Company, the "Credit Parties"), entered into an amendment (the "Third Amendment") to the Credit and Guaranty Agreement dated January 15, 2019, as amended on February 13, 2019 and July 9, 2020 with Cortland Capital Market Services, LLC as the administrative agent and collateral agent (the "Administrative Agent") and the lenders party thereto. The Third Amendment amended the Credit and Guaranty Agreement to, among other things (i) provide the Company with an incremental secured term loan in the aggregate principal amount of $7.5 million ("Incremental Secured Term Loan"); (ii) extend the maturity of the Secured Term Loan from February 14, 2025 to February 14, 2026; (iii) amend certain asset concentration limits and (iv) amend certain financial covenants. Pursuant to the terms of the Amended Credit and Guaranty Agreement, borrowings under the Secured Term Loan bear interest at a fixed rate of 7.25% per annum, which is subject to step up by 0.25% per annum for the first four months after February 14, 2025, then by 0.375% per annum for the following four months and then by 0.50% for the last four months until maturity date. On May 5, 2021 the Third Amendment became effective. On August 23, 2021, we drew $7.5 million in incremental secured term loans as provided by the Third Amendment.
•On May 5, 2021, LFT issued 2,400,000 shared of 7.875% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") and received net proceeds, after underwriting discounts and commissions but before offering expenses payable by the Company, of $58.1 million. The Series A Preferred Stock is redeemable, at LFT's option, at a liquidation preference price of $25.00 per share plus accrued dividends commencing in May 2026. Dividends on the Series A Preferred Stock are payable quarterly in arrears.
•On June 14, 2021, the Company closed LFT CRE 2021-FL1, a collateralized loan obligation, totaling $1.0 billion of real estate related assets and cash, of which $833.75 million of investment-grade notes were issued to third party investors and $70 million of below investment-grade notes and $96.25 million equity interest in the portfolio were retained by us.
•In relation to the closing of LFT CRE 2021-FL1, on June 14, 2021, the Company unwound Hunt CRE 2017-FL1 and Hunt CRE 2018-FL2, redeeming $388.2 million of outstanding notes which were repaid primarily from refinancing the assets within Hunt CRE 2017-FL1 and Hunt CRE 2018-FL2.
The ORIX Transaction
On January 6, 2020, we announced the entry into a new external management agreement with Lument IM and the concurrent mutual termination of our management agreement with HIM. Lument IM is part of Lument, a nationally recognized leader in multifamily and seniors housing and healthcare finance. The terms of the new management agreement align with the terms of our prior management agreement with HIM in all material respects, including a cap on reimbursable expenses. Pursuant to the terms of the termination agreement between the Company and HIM, the termination of the management agreement did not trigger, and HIM was not paid, a termination fee by the Company.
Factors Impacting Our Operating Results
Market conditions. The results of our operations are and will continue to be affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, our target assets in the marketplace. Our net interest income, will vary primarily as a result of changes in market interest rates and prepayment speeds, and by the ability of the borrowers underlying our commercial mortgage loans to continue making payments in accordance with the contractual terms of their loans, which may be impacted by unanticipated credit events experienced by such borrowers, such as the ongoing COVID-19 pandemic. Interest rates vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty, and have most recently been impacted by the ongoing COVID-19 pandemic. Our operating results will also be affected by general U.S. real estate fundamentals and the overall U.S. economic environment, including the pace and degree of recovery from the ongoing COVID-19 pandemic. In particular, our strategy is influenced by the specific characteristics of the underlying real estate markets, including prepayment rates, credit market conditions and interest rate levels.
Changes in market interest rates. Generally, our business model is such that rising interest rates will generally increase our net interest income, while declining interest rates will decrease our net interest income. Substantially all of our investments and all of our collateralized loan obligations are indexed to 30-day LIBOR, and as a result we are less sensitive to variability in our net interest income resulting from interest rate changes. Our net interest income currently benefits from in-the-money LIBOR floors in our commercial loan portfolio, with a weighted average LIBOR floor of 0.49% as of December 31, 2021. As of December 31, 2021, 99.0% of the loans in our commercial loan portfolio benefitted from LIBOR floors, 66.2% of which had a LIBOR floor greater than the current spot LIBOR rate. When interest rates are below our average LIBOR floor, an increase in interest rates will decrease our net interest until such time as interest rates rise above our average LIBOR floor. While we expect low LIBOR rates to persist as the economy continues to recover from the current COVID-19 pandemic, no assurance can be made that our current portfolio profile will be maintained. Additionally, there can be no assurance that will continue to obtain LIBOR floors as current market conditions reflect transactions with lower or no floors. Similarly, net interest income is also impacted by the spread in our commercial loan portfolio. As of December 31, 2021, the weighted average spread of our commercial loan portfolio was 3.41%, but there is no assurance that these spreads will be maintained as market environments fluctuate. Current market conditions have reflected a tightening trend in commercial mortgage loan credit spreads. A decrease to the weighted average LIBOR floor and/or spread would result in a decrease to net interest income. Additionally, a simultaneous decrease in both weighted average LIBOR floor and portfolio spread would exacerbate the impact to net interest income.
In addition to the risk related to fluctuations in cash flows associated with movement in interest rates, there is also the risk of non-performance on floating rate assets. In the case of significant increase in interest rates, the additional debt service payments due from our borrowers may strain the operating cash flows of the real estate assets underlying our mortgages and/or impact their ability to be refinanced at such higher interest rates, potentially, contribute to non-performance or, in severe cases, default.
On November 30, 2020, the ICE Benchmark Administration ("IBA"), with the support of the United States Federal Reserve and United Kingdom's Financial Conduct Authority ("FCA"), announced plans to consult on ceasing publication of LIBOR on December 31, 2021 for only one week and two month LIBOR tenors, and on June 30, 2023 for all other LIBOR tenors. While this announcement extends the transition period to June 2023, the United States
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Federal Reserve concurrently issued a statements advising banks to stop new LIBOR issuance by the end of 2021. On March 5, 2021, the FCA confirmed that all LIBOR settings will either cease to be provided by any administrator or no longer be representative" (a) immediately after December 31, 2021, in the case of the one week and two month U.S, dollar settings; and (b) immediately after June 30, 2023, in the case of the remaining U.S. dollar settings. The ARRC, a committee convened by the Federal Reserve that includes major market participants, has proposed an alternative rate to replace U.S. Dollar LIBOR: the Secured Overnight Financing Rate ("SOFR"). On July 29, 2021 the RRC ratified term rates for the one-, three- and six-month tenors based on SOFR futures traded. This announcement is expected to expedite the transition from LIBOR to SOFR. The outcome of these reforms is uncertain and any changes on the methods by which LIBOR is determined or regulatory activity related to LIBOR's phase-out could cause LIBOR to preform differently than in the past.
As of December 31, 2021, 100% of our commercial loans by principal balance and 100% of our collateralized loan obligations bear interest related to one-month U.S. LIBOR. All of these arrangements provide procedures for determining an alternative base rate in the event that LIBOR is discontinued. Regardless, there can be no assurances as to what alternative base rates may be and whether such base rate will be more or less favorable than LIBOR and any other unforeseen impacts of the discontinuation of LIBOR. We are monitoring the developments with respect to the phasing out of LIBOR and are working with our lenders and borrowers to minimize the impact of any LIBOR transitions on our financial condition and results of operations, but can provide no assurances regarding the impact of the discontinuation of LIBOR.
Credit risk. Our commercial mortgage loans and other investments are also subject to credit risk. The performance and value of our loans and other investments depend upon the sponsor's ability to operate properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due to us. To monitor this risk, the Manager's asset management team reviews our portfolio and maintains regular contact with borrowers, co-lenders and local market experts to monitor the performance of the underlying collateral, anticipate borrower, property and market issues and, to the extent necessary or appropriate, enforce our rights as lender. The market values of commercial mortgage assets are subject to volatility and may be adversely affected by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions; changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the value of the collateral and potential proceeds available to a borrower to repay the underlying loans, which could also cause us to suffer losses. As of December 31, 2021, 100% of the commercial mortgage loans in our portfolio were current as to principal and interest. Additionally, we have reviewed the loans designated as High Risk for impairment. Impairment of these loans, which are collateral dependent, is measured by comparing the estimated fair value of the underlying collateral, less costs to sell, to the book value of the respective loan. As of December 31, 2021, the Company has not recognized any impairments on its loan portfolio. However, due to the continued widespread impact of the COVID-19 pandemic we consider there to be heightened credit risk associated with our commercial mortgage loan portfolio. Uncertainty about the severity and duration of the economic impact of the COVID-19 pandemic, as exacerbated by events related to virus strains, persist and potential exists for the credit risk of our portfolio to heighten further. We can provide no assurances that our borrowers will remain current as to principal and interest, or that we will not enter into forbearance agreements or loan modifications in order to protect the value of our commercial mortgage loan assets. Should that occur, it could have a material negative impact on our results of operations.
Liquidity and financing markets. Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to pay dividends, fund investments and repay borrowings and other general business needs. Our primary sources of liquidity have been proceeds of common or preferred stock issuance, net proceeds from corporate debt obligations, net cash provided by operating activities and other financing arrangements. We finance our commercial mortgage loans primarily with collateralized loan obligations, the maturities of which are matched to the maturities of the loans, and which are not subject to margin calls or additional collateralization requirements. However, to the extent that we seek to invest in additional commercial mortgage loans, outside of our CLO, we will in part be dependent on our ability to issue additional collateralized loan obligations, to secure alternative financing facilities or to raise additional common or preferred equity.
Prepayment speeds. Prepayment risk is the risk that principal will be repaid at a different rate than anticipated, causing the return on certain investments to be less than expected. As we receive prepayments of principal on our assets, any premiums paid on such assets are amortized against interest income. In general, an increase in prepayment rates accelerates the amortization of purchase premiums, thereby reducing the interest income earned on the assets. Conversely, discounts on such assets are accreted into interest income. In general, an increase in prepayment rates accelerates the accretion of purchase discounts, thereby increasing the interest earned on the assets. With the exception of nine loans acquired with an initial aggregate unpaid principal balance of $117.0 million with an aggregate purchase premium of $538,146 and aggregate purchase discount of $171,186, all of our commercial mortgage loans were acquired at par. As of December 31, 2021, our aggregate unamortized purchase premium was $80,397 and our aggregate unamortized purchase discount was $125,098, and accordingly we do not believe this to be a material risk for us at present. Additionally, we are subject to prepayment risk associated with the terms of our collateralized loan obligations. Due to the generally short-term nature of transitional floating-rate commercial mortgage loans, our CLOs include a reinvestment period during which principal repayments and prepayments on our commercial mortgage loans may be reinvested in similar assets, subject to meeting certain eligibility criteria. The reinvestment period for LFT 2021-FL1 remains in place through December 2023. While the interest rate spreads of our collateralized loan obligations are fixed until they are repaid, the terms, including spreads, of newly originated loans are subject to uncertainty based on a variety of factors, including market and competitive conditions, which remain uncertain and volatile in light of the COVID-19 pandemic. To the extent that such conditions result in lower spreads on the assets in which we reinvest, we may be subject to a reduction in interest income in the future. However, our loan agreements provide for prepayment penalties which are intended to offset any potential reduction in future interest income.
Changes in market value of our assets. We account for our commercial mortgage loans at amortized cost. As such, our earnings will generally not be directly impacted by changes in the market values of these loans. However, if a loan is considered to be impaired as the result of adverse credit performance, an allowance is recorded to reduce the carrying value through a charge to the provision for loan losses. Impairment is measured by comparing the estimated fair value of the underlying collateral, less costs to sell, to the book value of the respective loan. Provisions for loan losses will directly impact our earnings. Given the widespread impact of COVID-19 pandemic, we consider there to be a heightened credit risk associated with our commercial mortgage loan portfolio.
Governmental actions. Since 2008, when both Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government, there have been a number of proposals to reform the U.S. housing finance system in general, and Fannie Mae and Freddie Mac in particular. We anticipate debate on residential housing and mortgage reform to continue through 2022 and beyond, but a deep divide persists between factions in Congress and as such it remains unclear what shape any reform would take and what impact, if any, reform would have on mortgage REITs.
Managing Our Business Through COVID-19
As of March 13, 2020, our Manager and its affiliates, implemented a work from home, or WFH, policy for employees in all locations. As of October 1, 2021, our Manager has begun reopening offices on a limited basis with certain staff returning to the office on a staggered partial schedule. Our Manager's highly experienced senior team and dedicated employees are fully operational during this ongoing disruption and are continuing to execute on all investment
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management, asset management, servicing, portfolio monitoring, financial reporting and related control activities. Our Manager's and affiliates employees are in constant communication to ensure timely coordination and early identification of issues. We continue to engage in ongoing active dialogue with the borrowers in our commercial mortgage loan portfolio to understand what is taking place at the properties collateralizing our investments.
Considering the current economic environment caused by COVID-19 we are mindful of constraints on landlord enforcement rights and continue to monitor the impact of fiscal stimulus on our loan portfolio. From September 4, 2020 through August 26, 2021, when the Centers for Disease Control ("CDC") Agency Order was overturned by the U.S. Supreme Court, residential landlords and those with similar eviction rights could not evict "covered persons" for nonpayment of rent in any U.S. state or territory. Covered persons (a) use best efforts to obtain government assistance; (b) make less than $99,000 or $198,000 jointly; (c) have suffered loss of income or extraordinary medical expenses; (d) use the best efforts to make partial payments; and (e) have no other housing options. In the last month before the Supreme Court lifted the order, the moratorium added to the definition of "covered persons" to include (f) the individual resides in a U.S. county experiencing substantial or high rates of community transmission levels of SARS-COV-2 as defined by the CDC. As a result of the national restriction, multifamily apartment borrowers had less ability to address nonpayment of tenants, which in turn may have negatively impacted a property's cash flow coverage of the debt service of their loans. Additionally, due to COVID-19, there have been potential challenges facing third-party providers, such as appraisers, environmental and engineering consultants we rely on to make new investments which may make it more difficult to make these investments. Currently, despite the Supreme Court having lifted the CDC order, individual states and localities continue to maintain limited evictions restrictions. New York, Washington D.C., Massachusetts, Minnesota, Oregon and Nevada all have some form of limited or prohibited residential evictions while the tenant applies for rental assistance. California has local eviction moratoriums that may extend beyond that in difference municipalities, but not statewide.
Key Financial Measure and Indicators
As a real estate investment trust, we believe the key financial measures and indicators for our business are earnings per share, dividends declared, Distributable Earnings, and book value per share of common stock. For the three months ended December 31, 2021, we recorded earnings per share of $0.09, declared a quarterly common dividend of $0.09 per share, and reported $0.11 per share of Distributable Earnings. In addition, our book value per share was $4.38 per share. For the year ended December 31, 2021, we recorded earnings per share of $0.30, declared aggregate common dividends of $0.36 per share, and reported $0.39 per share of Distributable Earnings.
As further described below, Distributable Earnings is a measure that is not prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, which helps us to evaluate our performance excluding the effects of certain transactions and GAAP adjustments that we believe are not necessarily indicative of our current loan portfolio and operations. In addition, Distributable Earnings is a performance metric we consider when declaring our dividends.
Earnings Per Share and Dividends Declared
The following table sets forth the calculation of basic and diluted net income per share and dividends declared per share:
| Three Months Ended December 31, | Year Ended December 31, | |||||||||||||||||||
| 2021 | 2021 | 2020 | ||||||||||||||||||
Net income(1) | $ | 2,478,911 | $ | 7,414,722 | $ | 8,434,770 | ||||||||||||||
| Weighted-average shares outstanding, basic and diluted | 24,947,883 | 24,945,824 | 24,934,505 | |||||||||||||||||
| Net income per share, basic and diluted | $ | 0.10 | $ | 0.30 | $ | 0.34 | ||||||||||||||
| Dividends declared per share | $ | 0.09 | $ | 0.36 | $ | 0.37 | ||||||||||||||
(1) Represents net income attributable to Lument Finance Trust, Inc.
Distributable Earnings
Distributable Earnings is a non-GAAP financial measure, which we define as GAAP net income (loss) attributable to holders of common stock, or, without duplication, owners of our subsidiaries, computed in accordance with GAAP, including realized losses not otherwise included in GAAP net income (loss) and excluding (i) non-cash equity compensation, (ii) depreciation and amortization, (iii) any unrealized gains or losses or other similar non-cash items that are included in net income for that applicable reporting period, regardless of whether such items are included in other comprehensive income (loss) or net income (loss), and (iv) one-time events pursuant to changes in GAAP and certain material non-cash income or expense items after discussions with the Company's board of directors and approved by a majority of the Company's independent directors.
While Distributable Earnings excludes the impact of any unrealized provisions for credit losses, any loan losses are charged off and realized through Distributable Earnings when deemed non-recoverable. Non-recoverability is determined (i) upon the resolution of a loan (i.e. when the loan is repaid, fully or partially, or in the case of foreclosures, when the underlying asset is sold), or (ii) with respect to any amount due under any loan, when such amount is determined to be non-collectible.
We believe that Distributable Earnings provides meaningful information to consider in addition to our net income (loss) and cash flows from operating activities determined in accordance with GAAP. We believe Distributable Earnings is a useful financial metric for existing and potential future holders of our common stock as historically, over time, Distributable Earnings has been a strong indicator of our dividends per share. As a REIT, we generally must distribute annually at least 90% of our taxable income, subject to certain adjustments, and therefore we believe our dividends are one of the principal reasons stockholders may invest in our common stock. Refer to Note 16 to our consolidated financial statements for further discussion of our distribution requirements as a REIT. Furthermore, Distributable Earnings help us to evaluate our performance excluding the effects of certain transactions and GAAP adjustments that we believe are not necessarily indicative of our current loan portfolio and operations, and is a performance metric we consider when declaring our dividends.
Distributable Earnings does not represent net income (loss) or cash generated from operating activities and should not be considered as an alternative to GAAP net income (loss), or an indication of GAAP cash flows from operations, a measure of our liquidity, or an indication of funds available for our cash needs. In addition, our methodology for calculating Distributable Earnings may differ from the methodologies employed by other companies to calculate the
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same or similar performance measures, and accordingly, our reported Distributable Earnings may not be comparable to the Distributable Earnings reported by other companies.
The following table provides a reconciliation of Distributable Earnings to GAAP net income:
| Three Months Ended December 31, | Year Ended December 31, | |||||||||||||||||||
| 2021 | 2021 | 2020 | ||||||||||||||||||
Net income(1) | $ | 2,478,911 | $ | 7,414,722 | $ | 8,434,770 | ||||||||||||||
| Unrealized gain (loss) on mortgage servicing rights | 56,106 | 356,772 | 1,780,528 | |||||||||||||||||
| Purchase premium payoffs | — | 150,990 | — | |||||||||||||||||
| Loss on extinguishment of debt | — | 1,663,926 | — | |||||||||||||||||
| Recognized compensation expense related to restricted common stock | 4,741 | 15,608 | 20,292 | |||||||||||||||||
| Adjustment for (provision for) income taxes | 109,336 | 77,894 | (476,248) | |||||||||||||||||
| Distributable Earnings | $ | 2,649,094 | $ | 9,679,912 | $ | 9,759,342 | ||||||||||||||
| Weighted-average shares outstanding, basic and diluted | 24,947,883 | 24,945,824 | 24,934,505 | |||||||||||||||||
| Distributable Earnings per share, basic and diluted | $ | 0.11 | $ | 0.39 | $ | 0.39 | ||||||||||||||
(1) Represents net income attributable to common stockholders of Lument Finance Trust, Inc.
Book Value Per Share
The following table calculates our book value per share:
| December 31, 2021 | December 31, 2020 | |||||||||||||
| Total stockholders' equity | $ | 169,276,000 | $ | 113,703,152 | ||||||||||
| Less preferred stock (liquidation preference of $25.00 per share) | (60,000,000) | — | ||||||||||||
| Total common stockholders' equity | 109,276,000 | 113,703,152 | ||||||||||||
| Common stock outstanding | 24,947,883 | 24,943,383 | ||||||||||||
| Book value per share | $ | 4.38 | $ | 4.56 | ||||||||||
As of December 31, 2021, our common stockholders' equity was $109.3 million, and our book value per common share was $4.38 on a basic and fully diluted basis. Our equity decreased by $4.4 million compared to our stockholders’ equity as of December 31, 2020 primarily as a result of the $1.7 million loss on extinguishment of debt and $2.7 million of preferred offering costs related to the issuance of the Series A Preferred Stock.
Investment Portfolio
Commercial Mortgage Loans
As of December 31, 2021, we have determined that we are the primary beneficiary of LFT CRE 2021-FL1, Ltd. based on our obligation to absorb losses derived from ownership of our residual interests. Accordingly, the Company consolidated the assets, liabilities, income and expenses of the underlying issuing entities, collateralized loan obligations.
The following table details our loan activity by unpaid principal balance:
| Year Ended December 31, 2021 | ||||||||
| Balance at December 31, 2020 | $ | 547,345,334 | ||||||
| Purchases and advances | 983,694,326 | |||||||
| Proceeds from principal repayments | (528,802,705) | |||||||
| Accretion of purchase discount | $ | 46,088 | ||||||
| Amortization of purchase discount | $ | (457,749) | ||||||
| Balance at December 31, 2021 | $ | 1,001,825,294 | ||||||
The following table details overall statistics for our loan portfolio as of December 31, 2021 and December 31, 2020:
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| Weighted Average | ||||||||||||||||||||||||||||||||||||||||||||
| Loan Type | Unpaid Principal Balance | Carrying Value | Loan Count | Floating Rate Loan % | Coupon(1) | Term (Years)(2) | LTV(3) | |||||||||||||||||||||||||||||||||||||
| December 31, 2021 | ||||||||||||||||||||||||||||||||||||||||||||
| Loans held-for-investment | ||||||||||||||||||||||||||||||||||||||||||||
Senior secured loans(4) | $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | 71.2 | % | ||||||||||||||||||||||||||||||||
| $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | 71.2 | % | |||||||||||||||||||||||||||||||||
| Weighted Average | ||||||||||||||||||||||||||||||||||||||||||||
| Loan Type | Unpaid Principal Balance | Carrying Value | Loan Count | Floating Rate Loan % | Coupon(1) | Term (Years)(2) | LTV(3) | |||||||||||||||||||||||||||||||||||||
| December 31, 2020 | ||||||||||||||||||||||||||||||||||||||||||||
| Loans held-for-investment | $ | 547,345,334 | $ | 547,345,334 | 40 | 100.0 | % | 5.1 | % | 3.1 | 73.6 | % | ||||||||||||||||||||||||||||||||
| Senior secured loans(3) | $ | 547,345,334 | $ | 547,345,334 | 40 | 100.0 | % | 5.1 | % | 3.1 | 73.6 | % | ||||||||||||||||||||||||||||||||
(1) Weighted average coupon assumes applicable one-month LIBOR of 0.10% and 0.14% as of December 31, 2021 and December 31, 2020, respectively, and weighted average LIBOR floors of 0.49% and 1.64%, respectively.
(2) Weighted average term assumes all extension options are exercised by the borrower; provided, however, that our loans may be repaid prior to such date.
(3) LTV as of the date the loan was originated and is calculated after giving effect to capex and earnout reserves, if applicable. LTV has not been updated for any subsequent draws or loan modifications and is not reflective of any changes in value which may have occurred subsequent to origination date.
(4) As of December 31, 2021, $974,025,294 of the outstanding senior secured loans were held in VIEs and $27,800,000 of the outstanding senior secured loans were held outside VIEs. As of December 31, 2020, $531,363,401 of the outstanding senior secured loans were held in VIEs and $15,981,933 of the outstanding senior secured loans were held outside VIEs.
The table below sets forth additional information relating to the Company's portfolio as of December 31, 2021:
| Loan # | Form of Investment | Origination Date | Total Loan Commitment(1) | Current Principal Amount | Location | Property Type | Coupon | Max Remaining Term (Years) | LTV(2) | |||||||||||||||||||||||||||||||||||||||||||||||
| 1 | Senior secured | November 22, 2019 | 39,500,000 | 36,781,588 | Virginia Beach, VA | Multi-Family | 1mL + 2.8 | 3.0 | 77.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 2 | Senior secured | June 28, 2021 | 39,263,000 | 34,690,000 | Barrington, NJ | Multi-Family | 1mL + 3.1 | 4.6 | 78.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 3 | Senior secured | November 2, 2021 | 33,500,000 | 33,500,000 | Warner Robbins, GA | Multi-Family | 1mL + 3.0 | 2.9 | 51.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 4 | Senior secured | June 8, 2021 | 35,877,500 | 33,360,000 | Chattanooga, TN | Multi-Family | 1mL + 3.7 | 4.6 | 79.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 5 | Senior secured | June 8, 2021 | 32,500,000 | 30,576,666 | Miami, FL | Multi-Family | 1mL + 3.2 | 4.6 | 74.3 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 6 | Senior secured | June 30, 2021 | 32,250,000 | 28,650,000 | Porter, TX | Multi-Family | 1mL + 3.3 | 4.6 | 71.6 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 7 | Senior secured | February 25, 2021 | 28,000,000 | 28,000,000 | Sacramento, CA | Multi-Family | 1mL + 3.5 | 0.3 | 63.6 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 8 | Senior secured | May 20, 2021 | 33,000,000 | 27,803,800 | Marietta, GA | Multi-Family | 1mL + 3.1 | 4.5 | 77.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 9 | Senior secured | April 22, 2021 | 27,750,000 | 27,750,000 | Los Angeles, CA | Multi-Family | 1mL + 3.3 | 0.9 | 55.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 10 | Senior secured | December 10, 2019 | 37,046,136 | 27,411,724 | San Antonio, TX | Multi-Family | 1mL + 3.2 | 3.1 | 71.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 11 | Senior secured | June 7, 2021 | 29,400,000 | 26,400,000 | San Antonio, TX | Multi-Family | 1mL + 3.4 | 4.6 | 80.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 12 | Senior secured | December 16, 2021 | 25,000,000 | 25,000,000 | Daytona, FL | Multi-Family | 1mL + 3.1 | 5.1 | 71.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 13 | Senior secured | August 26, 2021 | 27,268,000 | 24,832,000 | Clarkston, GA | Multi-Family | 1mL + 3.5 | 4.7 | 79.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 14 | Senior secured | November 15, 2021 | 26,003,000 | 24,330,000 | El Paso, TX | Multi-Family | 1mL + 3.1 | 5.0 | 76.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 15 | Senior secured | October 18, 2021 | 28,250,000 | 23,348,000 | Cherry Hill, NJ | Multi-Family | 1mL + 3.0 | 4.9 | 72.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
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| 16 | Senior secured | August 26, 2021 | 23,370,000 | 21,957,240 | Union City, GA | Multi-Family | 1mL + 3.4 | 4.8 | 70.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 17 | Senior secured | November 16, 2021 | 21,975,000 | 20,960,000 | Dallas, TX | Multi-Family | 1mL + 3.2 | 5.0 | 73.5 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 18 | Senior secured | August 31, 2021 | 21,750,000 | 20,700,000 | Houston, TX | Multi-Family | 1mL + 3.3 | 4.8 | 74.2 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 19 | Senior secured | October 29, 2021 | 20,500,000 | 20,500,000 | Knoxville, TN | Multi-Family | 1mL + 3.8 | 4.9 | 70.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 20 | Senior secured | June 30, 2021 | 21,968,000 | 20,188,700 | Jacksonville, FL | Multi-Family | 1mL + 3.5 | 4.6 | 77.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 21 | Senior secured | October 13, 2017 | 20,000,000 | 19,648,818 | Seattle, WA | Self Storage | 1mL + 3.6 | 2.9 | 46.5 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 22 | Senior secured | November 5, 2021 | 20,965,000 | 19,200,000 | Orlando, FL | Multi-Family | 1mL + 3.0 | 4.9 | 78.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 23 | Senior secured | October 12, 2021 | 17,500,000 | 17,500,000 | Atlanta, GA | Multi-Family | 1mL + 3.2 | 2.8 | 42.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 24 | Senior secured | December 28, 2018 | 24,123,000 | 17,172,623 | Austin, TX | Retail | 1mL + 4.1 | 1.1 | 60.5 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 25 | Senior secured | July 8, 2021 | 17,000,000 | 17,000,000 | Knoxville, TN | Multi-Family | 1mL + 4.0 | 2.7 | 69.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 26 | Senior secured | September 30, 2021 | 17,583,000 | 16,663,000 | Hanahan, SC | Multi-Family | 1mL + 3.2 | 4.8 | 76.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 27 | Senior secured | April 12, 2021 | 17,000,000 | 15,000,000 | Cedar Park, TX | Multi-Family | 1mL + 3.8 | 4.4 | 66.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 28 | Senior secured | October 11, 2019 | 17,000,000 | 14,500,000 | Pompano Beach, FL | Self Storage | 1mL + 3.8 | 2.8 | 75.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 29 | Senior secured | February 28, 2018 | 14,550,000 | 14,230,100 | Portland, OR | Multi-Family | 1mL + 7.5 | 1.2 | 75.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 30 | Senior secured | November 3, 2021 | 13,870,000 | 13,720,000 | Louisville, KY | Multi-Family | 1mL + 3.4 | 4.9 | 75.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 31 | Senior secured | October 14, 2021 | 13,440,000 | 13,440,000 | Bridgeton, NJ | Multi-Family | 1mL + 3.3 | 1.4 | 70.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 32 | Senior secured | May 28, 2021 | 13,675,000 | 13,332,734 | Houston, TX | Multi-Family | 1mL + 3.4 | 2.5 | 73.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 33 | Senior secured | May 12, 2021 | 13,930,000 | 13,026,000 | Fort Worth, TX | Multi-Family | 1mL + 3.4 | 4.5 | 74.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 34 | Senior secured | August 16, 2021 | 15,886,000 | 12,750,000 | Columbus, OH | Multi-Family | 1mL + 3.7 | 4.8 | 75.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 35 | Senior secured | March 12, 2021 | 13,703,000 | 12,375,000 | Mesa, AZ | Multi-Family | 1mL + 3.6 | 4.3 | 75.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 36 | Senior secured | October 1, 2021 | 13,775,000 | 12,100,000 | East Nashville, TN | Multi-Family | 1mL + 3.4 | 4.8 | 79.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 37 | Senior secured | July 23, 2018 | 16,200,000 | 11,748,199 | Chicago, IL | Office | 1mL + 3.8 | 1.7 | 72.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 38 | Senior secured | October 28, 2021 | 12,250,000 | 11,202,535 | Tampa, FL | Multi-Family | 1mL + 3.0 | 4.9 | 75.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 39 | Senior secured | September 30, 2021 | 11,300,000 | 10,795,000 | Clearfield, UT | Multi-Family | 1mL + 3.2 | 4.8 | 68.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 40 | Senior secured | February 8, 2019 | 12,625,000 | 10,676,822 | Federal Way, WA | Self Storage | 1mL + 4.8 | 2.2 | 65.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 41 | Senior secured | April 23, 2021 | 11,600,000 | 10,497,000 | Tualatin, OR | Multi-Family | 1mL + 3.2 | 4.4 | 73.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 42 | Senior secured | March 26, 2021 | 9,623,000 | 9,623,000 | Alhambra, CA | Multi-Family | 1mL + 3.3 | 0.8 | 49.0 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 43 | Senior secured | October 21, 2021 | 11,500,000 | 9,100,000 | Madison, TN | Multi-Family | 1mL + 3.2 | 4.9 | 68.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 44 | Senior secured | November 13, 2019 | 9,310,000 | 8,620,367 | Holly Hill, FL | Multi-Family | 1mL + 2.9 | 1.0 | 77.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 45 | Senior secured | May 12, 2021 | 8,950,000 | 8,220,000 | Lakeland, FL | Multi-Family | 1mL + 3.4 | 4.5 | 76.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 46 | Senior secured | January 13, 2020 | 8,510,000 | 8,037,399 | Fort Lauderdale, FL | Multi-Family | 1mL + 3.2 | 3.2 | 78.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 47 | Senior secured | April 7, 2021 | 10,152,000 | 7,963,794 | Phoenix, AZ | Multi-Family | 1mL + 3.6 | 4.4 | 69.5 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 48 | Senior secured | October 29, 2021 | 9,000,000 | 7,934,000 | Riverside, MO | Multi-Family | 1mL + 3.4 | 4.9 | 76.6 | % | ||||||||||||||||||||||||||||||||||||||||||||||
38
| 49 | Senior secured | March 12, 2018 | 9,112,000 | 7,912,000 | Waco, TX | Multi-Family | 1mL + 4.8 | 1.3 | 72.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 50 | Senior secured | November 16, 2021 | 7,680,000 | 7,680,000 | Cape Coral, FL | Multi-Family | 1mL + 3.3 | 3.0 | 79.2 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 51 | Senior secured | October 27, 2021 | 9,300,000 | 7,624,400 | Ambler, PA | Multi-Family | 1mL + 3.3 | 4.9 | 79.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 52 | Senior secured | March 19, 2021 | 8,348,000 | 7,513,000 | Glendora, CA | Multi-Family | 1mL + 3.6 | 4.3 | 72.2 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 53 | Senior secured | September 28, 2021 | 8,125,000 | 7,286,000 | Chicago, IL | Multi-Family | 1mL + 3.7 | 4.8 | 75.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 54 | Senior secured | February 3, 2020 | 7,250,000 | 6,959,953 | Fort Worth, TX | Self Storage | 1mL + 3.8 | 3.3 | 63.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 55 | Senior secured | March 31, 2021 | 8,432,000 | 6,893,000 | Tucson, AZ | Multi-Family | 1mL + 3.6 | 4.3 | 72.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 56 | Senior secured | July 1, 2021 | 7,285,000 | 6,290,000 | Harker Heights, TX | Multi-Family | 1mL + 3.6 | 4.6 | 72.3 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 57 | Senior secured | August 28, 2019 | 6,250,000 | 6,054,427 | Austin, TX | Multi-Family | 1mL + 3.3 | 2.8 | 69.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 58 | Senior secured | May 21, 2021 | 7,172,000 | 5,994,000 | Youngtown, AZ | Multi-Family | 1mL + 3.7 | 4.5 | 71.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 59 | Senior secured | October 26, 2021 | 6,807,000 | 5,812,000 | Indianapolis, IN | Multi-Family | 1mL + 3.9 | 4.9 | 77.1 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 60 | Senior secured | June 10, 2019 | 6,000,000 | 5,295,605 | San Antonio, TX | Multi-Family | 1mL + 2.9 | 2.6 | 62.9 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 61 | Senior secured | April 30, 2021 | 5,472,000 | 5,285,500 | Daytona Beach, FL | Multi-Family | 1mL + 3.7 | 4.4 | 77.4 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 62 | Senior secured | July 14, 2021 | 6,048,000 | 5,248,000 | Birmingham, AL | Multi-Family | 1mL + 3.7 | 4.7 | 71.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 63 | Senior secured | November 19, 2021 | 6,453,000 | 5,040,000 | Huntsville, AL | Multi-Family | 1mL + 3.8 | 5.0 | 78.8 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 64 | Senior secured | December 29, 2020 | 4,920,000 | 4,920,000 | Fayetteville, NC | Multi-Family | 1mL + 4.0 | 0.6 | 70.3 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 65 | Senior secured | November 30, 2018 | 4,446,000 | 4,446,000 | Anderson, SC | Multi-Family | 1mL + 3.3 | 0.9 | 53.7 | % | ||||||||||||||||||||||||||||||||||||||||||||||
| 66 | Senior secured | December 28, 2021 | 2,800,000 | 2,800,000 | Houston, TX | Multi-Family | 1mL + 3.2 | 5.1 | 71.2 | % | ||||||||||||||||||||||||||||||||||||||||||||||
(1) See Note 11 Commitments and Contingencies to our consolidated financial statements for further discussion of unfunded commitments.
(2) LTV as of the date the loan was originated by a Hunt/ORIX affiliate and is calculated after giving effect to capex and earnout reserves, if applicable. LTV has not been updated for any subsequent draws or loan modifications and is not reflective of any changes in value which may have occurred subsequent to origination date.
Our loan portfolio is 100% performing with no loan impairments, loan defaults, or non-accrual loans as of December 31, 2021.
We maintain strong relationships with our borrowers and utilized those relationships to address potential impacts of the COVID-19 pandemic on loans secured by properties experiencing cash flow pressure. All of our loans are current with respect to principal and interest, however, some of our borrowers have expressed concern on delays in the implementation of business plans due to the prolonged impact of the COVID-19 pandemic. Accordingly, we will continue to engage in discussions with them to work towards the maximization of cash flows and values of our commercial mortgage loan assets should these difficulties arise.
We have not entered into any forbearance agreements or loan modifications to date. However, due to the widespread economic impact of the COVID-19 pandemic we consider there to be heightened credit risk associated with our commercial mortgage loan portfolio. As such, we can provide no assurances that our borrowers will remain current as to principal and interest, or that we will not enter into any forbearance agreements or loan modifications on order to protect the value of our commercial mortgage loan assets.
As discussed in Note 2 to our consolidated financial statements, our Manager performs a quarterly review of our loan portfolio, assesses the performance of each loan, and assigns a risk rating between "1" and "5," from less risk to greater risk. The weighted average risk rating of our total loan exposure was 2.3 and 3.1 as of December 31, 2021 and December 31, 2020, respectively. The decrease in risk ratings is primarily the result of commercial mortgage loans that paid off with a risk rating of "2" of $133.6 million, a risk rating of "3" of $276.1 million and a risk rating of "4" of $17.8 million, offset by purchases of commercial mortgage loans with a risk rating of "2" of $599.0 million, a risk rating of "3" of $283.0 million and a risk rating of '4" of $0.1 million during the year ended December 31, 2021. The following table presents the principal balance and net book value based on our internal risk ratings:
39
| December 31, 2021 | ||||||||||||||||||||
| Risk Rating | Number of Loans | Unpaid Principal Balance | Net Carrying Value | |||||||||||||||||
| 1 | — | $ | — | — | ||||||||||||||||
| 2 | 40 | 634,438,386 | 634,438,386 | |||||||||||||||||
| 3 | 23 | 342,350,405 | 342,305,705 | |||||||||||||||||
| 4 | 3 | 25,081,203 | 25,081,203 | |||||||||||||||||
| 5 | — | — | — | |||||||||||||||||
| 66 | 1,001,869,994 | 1,001,825,294 | ||||||||||||||||||
Collateralized Loan Obligations
We may seek to enhance returns on our commercial mortgage loan investments through securitizations, or CLOs, if available, as well as the utilization of warehouse or repurchase agreement financing. To the extent available, we intend to securitize the senior portion of some of our loans, while retaining the subordinate securities in our investment portfolio. The securitizations of this senior portion will be accounted for as either a "sale" or as a "financing." If they are accounted for as a sale, the loan will be removed from the balance sheet and if they are accounted for as a financing the loans will be classified as "commercial mortgage loans held-for-investment" in our consolidated balance sheets, depending on the structure of the securitization. As of December 31, 2021, the carrying amounts and outstanding principal balances of our collateralized loan obligations were $826.8 million and $833.8 million, respectively. See Note 4 to our consolidated financial statements included in this Annual Report on Form 10-K for additional terms and details of our CLOs.
FOAC and Changes to Our Residential Mortgage Loan Business
In June 2013, we established FOAC as a Taxable REIT Subsidiary, or TRS, to increase the range of our investments in mortgage-related assets. Until August 1, 2016, FOAC aggregated mortgage loans primarily for sale into securitization transactions, with the expectation that we would purchase the subordinated tranches issued by the related securitization trusts, and that these would represent high quality credit investments for our portfolio. Residential mortgage loans for which FOAC owns the MSRs continue to be directly serviced by two licensed sub-servicers since FOAC does not directly service any residential mortgage loans.
As noted above, we previously determined to cease the aggregation of prime jumbo loans for the foreseeable future, and therefore no longer maintain warehouse financing to acquire prime jumbo loans. We do not expect the previous changes to our mortgage loan business strategy to impact the existing MSRs that we own, nor the securitizations we have sponsored to date.
Pursuant to a Master Agreement dated June 15, 2016, as amended on August 29, 2016, January 30, 2017 and June 27, 2018, among MAXEX, LLC ("MAXEX"), MAXEX Clearing LLC, MAXEX's wholly-owned clearinghouse subsidiary and FOAC, FOAC provided seller eligibility review services under which it reviewed, approved and monitored sellers that sold loans via MAXEX Clearing LLC. To the extent that a seller approved by FOAC fails to honor its obligations to repurchase a loan based on an arbitration finding that it breached its representations and warranties, FOAC was obligated to backstop the seller's repurchase obligation. The term of such backstop guarantee was the earlier of the contractual maturity of the underlying mortgage and its repayment in full. However, the incidence of claims for breaches of representations and warranties over time is considered unlikely to occur more than five years from the sale of a mortgage. FOAC's obligations to provide such seller eligibility review and backstop guarantee services terminated on November 28, 2018. Pursuant to an Assumption Agreement dated December 31, 2018, among MAXEX Clearing LLC and FOAC, MAXEX Clearing LLC assumed all of FOAC's obligations under its backstop guarantees and agreed to indemnify and hold FOAC harmless against any losses, liabilities, costs, expenses and obligations under the backstop guarantee. FOAC paid MAXEX Clearing LLC, as the replacement backstop provider, a fee of $426,770 (the "Alternative Backstop Fee"). MAXEX Clearing LLC represented to FOAC in the Assumption Agreement that it (i) is rated at least "A" (or equivalent) by at least one nationally recognized statistical rating agency or (ii) has (a) adjusted tangible net worth of at least $20.0 million and (b) minimum available liquidity equal to the greater of (x) $5.0 million and (y) 0.1% multiplied by the scheduled unpaid principal balance of each outstanding loan covered by the backstop guarantees. MAXEX's chief financial officer is required to certify ongoing compliance by MAXEX Clearing LLC with the aforementioned criteria on a quarterly basis and if MAXEX Clearing LLC fails to satisfy such criteria, MAXEX Clearing LLC is required to deposit into an escrow account for FOAC's benefit an amount equal to the greater of (A) the unamortized Alternative Backstop Fee for each outstanding loan covered by the backstop guarantee and (B) the product of 0.01% multiplied by the scheduled unpaid principal balance of each outstanding loan covered by the backstop guarantees. See Notes 13 and 14 to our consolidated financial statements included in this Annual Report for a further description of MAXEX.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with GAAP, which requires the use of estimates and assumptions that involve the exercise of judgment and use of assumptions as to future uncertainties. Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to understanding our financial statements because they involve significant judgments and uncertainties that could affect our reported assets and liabilities, as well as our reported revenues and expenses. All of these estimates reflect our best judgments about current, and for some estimates, future economic and market conditions and their effects based on information available as of the date of the financial statements. If conditions change from those expected, it is possible that the judgments and estimates described below could change, which may result in a change in our interest income recognition, allowance for loan losses, future impairment of our investments, and valuation of our investment portfolio, among other effects. We believe that the following accounting policies are among the most important to the portrayal of our financial condition and results of operations and require the most difficult, subjective or complex judgments:
Commercial Mortgage Loans Held-for-Investment
Commercial mortgage loans held-for-investment represent floating-rate transitional loans and other commercial mortgage loans purchased by the Company. These loans include loans sold into securitizations that the Company consolidates. Commercial mortgage loans held-for-investment are intended to be held-to-maturity and, accordingly, are carried at their unpaid principal balances, adjusted for net unamortized loan fees and costs (in respect of originated loans), premiums and discounts (in respect of purchased loans) and impairment, if any.
Interest income is recognized as revenue using the effective interest method and is recorded on the accrual basis according to the terms of the underlying loan agreement. Any fees, costs, premiums and discounts associated with these loan investments are deferred and amortized over the term of the loan using the
40
effective interest method, or on a straight line basis when it approximates the effective interest method. Income accrual is generally suspended and loans are placed on non-accrual status on the earlier of the date at which payment has become 90 days past due or when full and timely collection of interest and principal is considered not probable. The Company may return a loan to accrual status when repayment of principal and interest is reasonably assured under the terms of the underlying loan agreement. As of December 31, 2021, the Company did not hold any loans placed in non-accrual status.
Quarterly, the Company assesses the risk factors of each loan classified as held-for-investment and assigns a risk rating based on a variety of factors, including, without limitation, debt-service coverage ratio ("DSCR"), loan-to-value ratio ("LTV"), property type, geographic and local market dynamics, physical condition, leasing and tenant profile, adherence to business plan and exit plan, maturity default risk and project sponsorship. The Company's loans are rated on a 5-point scale, from least risk to greatest risk, respectively, which ratings are described as follows:
1.Very Low Risk: exceeds expectations and is outperforming underwriting or it is very likely that the underlying loan can be refinanced easily in the period's prevailing capital market conditions
2.Low Risk: meeting or exceeding underwritten expectations
3.Moderate Risk: in-line with underwritten expectations or the sponsor may be in the early stages of executing the business plan and the loan structure appropriately mitigates additional risks
4.High Risk: potential risk of default, a loss may occur in the event of default
5.Default Risk: imminent risk of default, a loss is likely in the event of default
The Company evaluates each loan rated High Risk or above as to whether it is impaired on a quarterly basis. Impairment occurs when the Company determines that the facts and circumstances of the loan deem it probable that the Company will not be able to collect all amounts due in accordance with the contractual terms of the loan. If a loan is considered to be impaired, an allowance is recorded to reduce the carrying value of the loan through a charge to the provision for loan losses. Impairment of these loans, which are collateral dependent, is measured by comparing the estimated fair value of the underlying collateral, less costs to sell, to the book value of the respective loan. These valuations require significant judgments, which include assumptions regarding capitalization rates, leasing, creditworthiness of major tenants, occupancy rates, availability of financing, exit plan, actions of other lenders, and other factors deemed necessary by the Manager. Actual losses, if any, could ultimately differ from estimated losses.
In addition, the Company evaluates the entire portfolio to determine whether the portfolio has any impairment that requires a valuation allowance on the remainder of the loan portfolio. As of December 31, 2021, the Company has not recognized any impairments on its loans held-for-investment. We also assessed the remainder of the loan portfolio, considering the absence of delinquencies and current market conditions, and, as such has not recorded any allowance for loan losses.
See Note 2 to our consolidated financial statements for the complete listing of our significant accounting policies.
Capital Allocation
The following tables set forth our allocated capital by investment type at December 31, 2021 and December 31, 2020:
This information constitutes non-GAAP financial measures within the meaning of Item 10(e) of Regulation S-K, as promulgated by the SEC. We believe that this non-GAAP information enhances the ability of investors to better understand the capital necessary to support each income-earning asset category, and thus our ability to generate operating earnings. While we believe that the non-GAAP information included in this report provides supplemental information to assist investors in analyzing our portfolio, these measures are not in accordance with GAAP, and they should not be considered a substitute for, or superior to, our financial information calculated in accordance with GAAP.
| December 31, 2021 | ||||||||||||||||||||||||||
| Commercial Mortgage Loans | MSRs | Unrestricted Cash(1) | Total(2) | |||||||||||||||||||||||
| Market Value | 1,001,825,294 | 551,997 | 14,749,046 | 1,017,126,337 | ||||||||||||||||||||||
| Collateralized Loan Obligations | (826,782,543) | — | — | (826,782,543) | ||||||||||||||||||||||
Other(3) | 25,769,860 | — | (3,422,658) | 22,347,202 | ||||||||||||||||||||||
| Restricted Cash | 3,530,006 | — | — | 3,530,006 | ||||||||||||||||||||||
| Capital Allocated | 204,342,617 | 551,997 | 11,326,388 | 216,221,002 | ||||||||||||||||||||||
| % Capital | 94.5 | % | 0.3 | % | 5.2 | % | 100.0 | % | ||||||||||||||||||
| December 31, 2020 | ||||||||||||||||||||||||||
| Commercial Mortgage Loans | MSRs | Unrestricted Cash(1) | Total(2) | |||||||||||||||||||||||
| Market Value | $ | 547,345,334 | $ | 919,678 | $ | 11,375,960 | $ | 559,640,972 | ||||||||||||||||||
| Collateralized Loan Obligations | (463,060,090) | — | — | (463,060,090) | ||||||||||||||||||||||
Other(3) | 1,663,740 | — | (2,984,668) | (1,320,928) | ||||||||||||||||||||||
| Restricted Cash | 57,999,396 | — | — | 57,999,396 | ||||||||||||||||||||||
| Capital Allocated | $ | 143,948,380 | $ | 919,678 | $ | 8,391,292 | $ | 153,259,350 | ||||||||||||||||||
| % Capital | 93.9 | % | 0.6 | % | 5.5 | % | 100.0 | % | ||||||||||||||||||
1.Includes cash and cash equivalents.
2.Includes the carrying value of our Secured Term Loan.
3.Includes principal and interest receivable, prepaid and other assets, interest payable, dividends payable and accrued expenses and other liabilities.
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Results of Operations
As of December 31, 2021, we consolidated the assets and liabilities of one CRE CLO, LFT CRE 202-FL1, Ltd. Additionally, although the COVID-19 pandemic did not significantly impact our operating results for the year ended December 31, 2021, should the pandemic and resulting economic deterioration persist, we expect it may affect our business, financial condition, results of operations and cash flows going forward, including but not limited to, interest income credit losses and commercial mortgage loan reinvestment, in ways that may vary widely depending on the duration and magnitude of the COVID-19 pandemic and ensuing economic turmoil, as well as numerous other factors, many of which are outside of our control.
Further in May 2021, we issued 2,400,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock resulting in net proceeds (after underwriting discount and commission but before operating expenses) of $58.1 million. On August 23, 2021, the Incremental Secured Term Loan of $7.5 million provided for in the Third Amendment to the Credit and Guaranty Agreement was funded. We believe that Lument IM and its affiliates continue to identify attractive CRE lending opportunities, which we expect will allow us to deploy our capital base into assets that are consistent with our investment strategy. The deployment of these proceeds into our target assets took time and as such, and resulted in a temporary decline in net interest income. Additionally, as a result of the Series A Preferred Stock issuances, Stockholders' Equity as calculated per our management agreement will increase, resulting in increased management fees, changes to the core earnings hurdle over which incentive fees are due and payable to our Manager and increase the reimbursable expense cap.
The table below presents certain information from our Statement of Operations for the years ended December 31, 2021 and December 31, 2020:
Year Ended December 31, | ||||||||||||||
| 2021 | 2020 | |||||||||||||
| Revenues: | ||||||||||||||
| Interest income: | ||||||||||||||
| Commercial mortgage loans held-for-investment | 36,162,050 | 33,570,949 | ||||||||||||
| Cash and cash equivalents | 28,779 | 45,782 | ||||||||||||
| Interest expense: | ||||||||||||||
| Collateralized loan obligations | (12,178,545) | (12,047,300) | ||||||||||||
| Secured term loan | (3,333,536) | (3,138,917) | ||||||||||||
| Net interest income | 20,678,748 | 18,430,514 | ||||||||||||
| Other income: | ||||||||||||||
| Realized loss on mortgage servicing rights | (10,910) | — | ||||||||||||
| Change in unrealized (loss) on mortgage servicing rights | (356,772) | (1,780,528) | ||||||||||||
| Loss on extinguishment of debt | (1,663,926) | — | ||||||||||||
| Servicing income, net | 398,939 | 709,565 | ||||||||||||
| Other income | — | 2 | ||||||||||||
| Total other (loss) | (1,632,669) | (1,070,961) | ||||||||||||
| Expenses: | ||||||||||||||
| Management fee | 3,041,600 | 2,524,139 | ||||||||||||
| General and administrative expenses | 2,879,655 | 3,518,500 | ||||||||||||
| Operating expenses reimbursable to Manager | 2,038,130 | 1,644,886 | ||||||||||||
| Other operating expenses | 280,970 | 1,493,214 | ||||||||||||
| Compensation expense | 200,608 | 205,292 | ||||||||||||
| Total expenses | 8,440,963 | 9,386,031 | ||||||||||||
| Net income before provision for income taxes | 10,605,116 | 7,973,522 | ||||||||||||
| Benefit from income taxes | (77,894) | 476,248 | ||||||||||||
| Net income | 10,527,222 | 8,449,770 | ||||||||||||
| Dividends to preferred stockholders | (3,112,500) | (15,000) | ||||||||||||
| Net income attributable to common stockholders | $ | 7,414,722 | $ | 8,434,770 | ||||||||||
| Earnings per share: | ||||||||||||||
| Net income attributable to common stockholders (basic and diluted) | $ | 7,414,722 | $ | 8,434,770 | ||||||||||
| Weighted average number of shares of common stock outstanding | 24,945,824 | 24,934,505 | ||||||||||||
| Basic and diluted income per share | $ | 0.30 | $ | 0.34 | ||||||||||
| Dividends declared per share of common stock | $ | 0.36 | $ | 0.37 | ||||||||||
Net Income Summary
For the year ended December 31, 2021, our net income attributable to common stockholders was $7,414,722 or $0.30 basic and diluted net income per average share, compared with net income of $8,434,770 or $0.34 basic and diluted net loss per share, for the year ended December 31, 2020. The principal drivers of this net income variance were an increase in net interest income from $18,430,514 for the year ended December 31, 2020 to $20,678,748 for the year ended December 31, 2021, and a decrease in total expenses from $9,386,031 for the year ended December 31, 2020 to $8,440,963 for the year ended December 31, 2021, which was more than offset by an increase in total other loss from $1,070,961 for the year ended December 31, 2020 to a loss of
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$1,632,669 for the year ended December 31, 2021, and an increase in preferred dividends from $15,000 for the year ended December 31, 2020 to $3,112,500 for the year ended December 31, 2021.
Net Interest Income
For the years ended December 31, 2021 and December 31, 2020, our net interest income was $20,678,748 and $18,430,514, respectively. The increase was primarily due to (i) a $67.6 million increase in weighted-average principal balance of our CLO loan portfolio; (ii) a decrease in weighted-average LIBOR of 49bps for our CLO liabilities, and (iii) an increase in exit/extension fees of $3.2 million for our loan portfolio. This was offset by (i) a $156.2 million increase in weighted average principal balance of our CLO liabilities; (ii) a decrease of 54bps in weighted-average LIBOR floor on our CLO loan portfolio for the year-ended December 31, 2021 compared to the corresponding period in 2020 (iii) a 3bps decrease in weighted-average spread on the CLO loan portfolio for the year-ended December 31, 2021 compared to the corresponding period in 2020, and (iv) an increase of 4bps in weighted-average spread for our CLO liabilities for the year-ended December 31, 2021 compared to the corresponding period in 2020 .
Other (Loss)
For the year ended December 31, 2021, we incurred a loss of $1,632,669. This loss was driven by loss on extinguishment of debt of $1,663,926 resulting from the unwind of Hunt CRE 2018-FL2 and the impact of net unrealized losses on mortgage servicing rights of $356,772 caused by decreased unpaid principal balances, which more than offset net mortgage servicing income of $398,939.
For the year ended December 31, 2020, we incurred a loss of $1,070,961. This loss was primarily driven by the impact of net realized losses on mortgage servicing rights of $1,780,528 caused by a decrease in interest rates which increased prepayment speeds and decreased projected float income, which more than offset net mortgage servicing income of $709,565.
The year-over-year increase in other loss was primarily due to the change in loss on extinguishment of debt and unrealized loss on mortgage servicing rights as a result of higher prepayment speeds.
Expenses
We incurred management and incentive fees of $3,041,600 for the year ended December 31, 2021 representing amounts payable to our Manager under our management agreement. We also incurred operating expenses of $5,399,363, of which $2,038,130 was payable to our Manager and $3,361,233 was payable to third parties.
For the year ended December 31, 2020, we incurred management and incentive fees of $2,524,139 representing amounts payable to our Manager under our management agreement. We also incurred operating expenses of $6,861,892, of which $1,644,886 was payable to our Manager and $5,217,006 was payable to third parties.
The year-over-year decrease in expenses primarily reflects a decrease in accounting, audit and legal fees, CLO expense and discontinued deal costs, which more than offset increased insurance, management and incentive fees and expense reimbursement.
Impairment
We review each loan classified as held-for-investment for impairment on a quarterly basis. For the years ended December 31, 2021 and December 31, 2020, the Company has not recognized any impairments on its loans held-for-investment and therefore has not recorded any allowance for loan losses.
Income Tax (Benefit) Expense
For the year ended December 31, 2021 the Company recognized a provision for income taxes in the amount of $77,894 and for the year ended December 31, 2020, the Company recognized a benefit from income taxes in the amount of $476,248. The year-over-year increase in tax expense primarily reflects the change in gross deferred revenue at FOAC due to the change in unrealized loss on mortgage servicing rights.
Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to pay dividends, fund investments, comply with margin requirements, if any, and repay borrowings and other general business needs. Our primary sources of liquidity have been met with net proceeds of common or preferred stock issuance, net proceeds from debt offerings and net cash provided by operating activities. We have added to our liquidity position in May 2021 by issuing 2,400,000 shares of 7.875% Series a Cumulative Redeemable Preferred Stock resulting in net proceeds (after underwriting discount and commission but before operating expense) of $ 58.1 million. We finance our commercial mortgage loans primarily with match term collateralized loan obligations, which are not subject to margin calls or additional collateralization requirements. On June 14, 2021, we closed LFT CRE 2021-FL1 issuing eight tranches of CLO notes totaling $903.8 million. Of the total CLO notes issued $833.8 million were investment grade notes issued to third-party investors and $70 million were below investment-grade notes retained by us. On August 23, 2021, we drew an additional $7.5 million of our Secured Term Loan pursuant to the Third Amendment. Additionally, on February 22, 2022, the Company issued 27,277,269 shares of common stock resulting in gross proceeds of $83.5 million. As of December 31, 2021, our balance sheet included $47.8 million of a secured term loan and $833.8 million in collateralized loan financing, gross of discounts and debt issuance costs. Our secured term loan matures in January 2026 and our collateralized loan financing is term-matched and matures in 2039 or later. However, to the extent that we seek to invest in additional commercial mortgage loans, we will in part be dependent on our ability to issue additional collateralized loan obligations to secure alternative financing facilities or to raise additional common or preferred equity.
If we were required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we previously recorded our assets, particularly in a financial market that has been significantly disrupted and less liquid as a result of the ongoing COVID-19 pandemic. Assets that are illiquid are more difficult to finance, and to the extent that we use leverage to finance assets that become illiquid, we may lose that leverage or have it reduced if such leverage is, at least in part, dependent on the market value of our assets. Assets tend to become less liquid during times of financial stress, which is often the time that liquidity is most needed. As a result, our ability to sell assets or vary our portfolio in response to changes in economic and other conditions may be limited by liquidity constraints, which could adversely affect our results of operations and financial condition. We seek to limit our exposure to illiquidity risk to the extent possible, by ensuring that the collateralized loan obligations that we use to finance our commercial mortgage loans are not subject to margin calls or other limitations that are dependent on the market value of the related loan collateral.
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We intend to continue to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated investment requirements and unforeseen business needs but that also allows us to be substantially invested in our target assets. We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which would force us to liquidate assets into unfavorable market conditions and harm our operating results. As of December 31, 2021, we had unrestricted cash and cash equivalents of $14.7 million, compared to $11.4 million as of December 31, 2020.
As of December 31, 2021, we had $47.8 million in outstanding principal under our Senior Secured Term Loan, with a borrowing rate of 7.25%. As of December 31, 2021, the ratio of our recourse debt to our equity was 0.2:1.
As of December 31, 2021, we consolidated the assets and liabilities of LFT 2021-FL1, Ltd. The assets of the trust are restricted and can only be used to fulfill their respective obligations, and accordingly the obligations of the trust, which we classify as collateralized loan obligations, do not have any recourse to us as the consolidator of the trust. As of December 31, 2021, the carrying value of these non-recourse liabilities aggregated to $826.8 million. As of December 31, 2021, our total debt-to-equity ratio was 5.2:1 on a GAAP basis.
Cash Flows
The following table sets forth changes in cash, cash equivalents and restricted cash for the years ended December 31, 2021 and December 31, 2020:
| For the years ended December 31, 2021 | ||||||||||||||
| 2021 | 2020 | |||||||||||||
| Cash Flows From Operating Activities | 13,846,947 | 12,219,209 | ||||||||||||
| Cash Flows From Investing Activities | (477,291,621) | 87,915,086 | ||||||||||||
| Cash Flows From Financing Activities | 412,348,370 | (46,770,769) | ||||||||||||
| Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash | $ | (51,096,304) | $ | 53,363,526 | ||||||||||
During the year ended December 31, 2021, cash, cash equivalents and restricted cash decreased by $51.1 million and for the year ended December 31, 2020, cash, cash equivalents and restricted cash increased by $53.4 million.
Operating Activities
For the years ended December 31, 2021 and December 31, 2020, net cash provided by operating activities totaled $13.8 million and $12.2 million, respectively. For the year ended December 31, 2021, our cash flows from operating activities were primarily driven by $23.8 million of interest received from the junior retained notes and preferred shares of Hunt CRE 2017-FL1, Ltd., Hunt CRE 2018-FL2, Ltd. and LFT 2021-FL1, Ltd., the CRE CLOs that we consolidate, $0.6 million of interest received from our senior secured loans held outside the CRE CLOs we consolidate and $0.4 million of cash received from mortgage servicing rights exceeding cash interest expense paid on our Secured Term Loan of $3.1 million, management fees of $2.7 million, expense reimbursements of $1.7 million and other operating expenditures of $3.4 million. For the year ended December 31, 2020, our cash flows from operating activities were primarily driven by $22.1 million of interest received from the junior retained notes and preferred shares of Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd., the CRE CLOs we consolidate, $0.7 million of interest received from our senior secured loans held outside the CRE CLOs we consolidate and $0.7 million of cash received from mortgage servicing rights exceeding cash interest expense paid on our Secured Term Loan of $3.0 million, management fees of $2.3 million, expense reimbursement of $1.7 million and other operating expenditures of $4.5 million.
Investing Activities
For the year ended December 31, 2021, net cash used in investing activities totaled $477.3 million. This was a result of the cash used for the purchase and funding of commercial mortgage loans held for investment exceeding the principal repayment of commercial mortgage loans held for investment during the period. For the year ended December 31, 2020 net cash provided by investing activities totaled $87.9 million. This was a result of the cash received from principal repayments of commercial mortgage loans held-for-investment exceeding the purchase and funding of commercial mortgage loans held for investment for the year ended December 31, 2020.
Financing Activities
For the year ended December 31, 2021, net cash provided by financing activities totaled $412.3 million and primarily related to proceeds from issuance of our Series A Preferred Stock of $57.3 million, proceeds from issuance of collateralized loan obligations of $833.8 million and proceeds from our Secured Term Loan of $7.5 million which more than offset by payments of common and preferred dividends of $12.1 million, repayment of collateralized loan obligations of $465.3 million and payment of debt issuance costs of $8.7 million. For the year ended December 31, 2020, net cash used in financing activities totaled $46.8 million and primarily related to proceeds of issuing common stock of $5.7 million more than offset by payments of common and preferred dividends of $7.6 million and repayment of collateralized loan obligations of $44.9 million.
Forward-Looking Statements Regarding Liquidity
Based upon our current portfolio, leverage rate and available borrowing arrangements, we believe that the net proceeds of our prior equity sales, combined with cash flow from operations and available borrowing capacity will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements to fund our investment activities, pay fees under our management agreement, fund our distributions to stockholders and for other general corporate expenses.
Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to, amongst other things, obtaining additional debt financing and equity capital. We may increase our capital resources by obtaining long-term credit facilities, additional collateralized loan obligations or making additional public or private offerings of equity or debt securities, possibly including classes of preferred stock, common stock and senior or subordinated notes.
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To maintain our qualification as a REIT, we generally must distribute annually at least 90% of our "REIT taxable income" (determined without regard to the deduction for dividends paid and excluding net capital gain). These distribution requirements limit our ability to retain earnings and thereby replenish or increase capital for operations.
Off-Balance Sheet Arrangements
As of December 31, 2021, we did not maintain any relationships with unconsolidated financial partnerships, or special purpose or variable interest entities established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of December 31, 2021, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.
In connection with the provision of seller eligibility and backstop guarantee services provided to MAXEX, we previously accounted for the related non-contingent liability at its fair value on our consolidated balance sheet as a liability. As of December 31, 2021, pursuant to an Assumption Agreement dated December 31, 2018, among MAXEX Clearing LLC and FOAC, MAXEX Clearing LLC assumed all of FOAC's obligations under its backstop guarantees and agreed to indemnify and hold FOAC harmless against any losses, liabilities, costs, expenses and obligations under the backstop guarantees. See Note 11 for further information.
Distributions
We intend to continue to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its "REIT taxable income" (determined without regard to the deduction for dividends paid and excluding net capital gain) and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its "REIT taxable income." We have historically made regular monthly distributions, but with effect from the third quarter of 2018 we now make regular quarterly distributions, to our stockholders in an amount equal to all or substantially all of our taxable income. Although FOAC no longer aggregates and securitizes residential mortgages, it continues to generate taxable income from MSRs and other mortgage-related activities. This taxable income will be subject to regular corporate income taxes. We generally anticipate the retention of profits generated and taxed at FOAC. Before we make any distribution on our common stock, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and any debt service obligations on debt payable. If cash available for distribution to our stockholders is less than our taxable income, we could be required to sell assets or borrow funds to make cash distributions, or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.
If substantially all of our taxable income has not been paid by the close of any calendar year, we may declare a special dividend prior to the end of such calendar year, to achieve this result. On December 15, 2021, we announced that our board of directors had declared a cash dividend rate for the fourth quarter of 2021 of $0.09 per share of common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Not applicable
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Reports of Independent Registered Public Accounting Firm, the Company’s consolidated financial statements and notes to the Company’s consolidated financial statements appear in a separate section of this Form 10-K (beginning on Page F-2 following Part IV). The index to the Company’s consolidated financial statements appears on Page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management is responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e)) under the Securities Exchange Act of 1934, as amended, or Exchange Act, that are designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.
Under the supervision and with the participation of management, including our principal executive officer and principal financial officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to paragraph (b) of Exchange Act Rules 13a-15 or 15d-15 as of December 31, 2021. Based upon our evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures were effective as of December 31, 2021.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is also responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Exchange Act Rules 13a-15(f) and 15d-15(f) as a process designed by, or under the supervision of, our principal executive and principal financial officers and effected by our Board, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (GAAP) 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 our assets;
45
•provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
•provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Under the supervision of our Audit Committee and with the participation of management, including our principal executive officer and principal financial officer, we evaluated the effectiveness, as of December 31, 2021, of our internal control over financial reporting. In making this assessment, management used the criteria set forth in the "Internal Control-Integrated Framework" (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO Framework). Based on its evaluation under the COSO Framework, our management has concluded that our internal control over financial reporting was effective as of December 31, 2021.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 or 15d-15 that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
None.
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PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required to be furnished by this Item 10 will be set forth in the Company's definitive proxy statement for its 2022 Annual Meeting of Stockholders (the "2022 Proxy Statement"), which the Company expects to files within 120 days of the end of its fiscal year December 31, 2021. For the limited purpose of providing the information necessary to comply with this Item 10, the 2022 Proxy Statement is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required to be furnished by this Item 11 will be set forth in the 2022 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 11, the 2022 Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required to be furnished by this Item 12 will be set forth in the 2022 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 12, the 2022 Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required to be furnished by this Item 13 will be set forth in the 2022 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 13, the 2022 Proxy Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required to be furnished by this Item 14 will be set forth in the 2022 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 14, the 2022 Proxy Statement is incorporated herein by reference.
47
PART IV
Item 15. Exhibits, Financial Statements and Schedules
(a)Financial Statements.
| Page | |||||
| Financial Statements | |||||
| Reports of Independent Registered Public Accounting Firm | |||||
| Consolidated Balance Sheets | |||||
| Consolidated Statements of Operations | |||||
| Consolidated Statements of Stockholders’ Equity | |||||
| Consolidated Statements of Cash Flows | |||||
| Notes to Consolidated Financial Statements | |||||
(b)Exhibits.
The Exhibits listed in the Exhibit Index, which appear immediately following the signature pages, are incorporated herein by reference and are filed as part of this Annual Report on Form 10-K.
(c)Schedules.
Schedule IV - Mortgage Loan on Real Estate
Schedules other than the one listed above are omitted because they are not applicable or deemed not material.
48
EXHIBIT INDEX
| Exhibit | ||||||||
| No. | Document | |||||||
| 3.1 | ||||||||
| 3.2 | ||||||||
| 3.3 | ||||||||
| 3.4 | ||||||||
| 3.5 | ||||||||
| 4.1 | ||||||||
| 4.2 | ||||||||
| 4.3 | ||||||||
| 10.1 | ||||||||
| 10.2 | ||||||||
| 10.3† | ||||||||
| 10.4 | ||||||||
| 10.5 | ||||||||
| 10.6 | ||||||||
| 10.7 | ||||||||
| 10.8 | ||||||||
| 10.9 | Registration Rights Agreement, dated as of January 18, 2018, by and between Five Oaks Investment Corp. and Hunt Companies Equity Holdings, LLC (incorporated by reference to Exhibit 10.3 to the Registrant's Current Report on Form 8-K (File No. 001-35845), which was filed with the SEC on January 18, 2018). | |||||||
49
50
| 99.1 | ||||||||
| 101.INS | Inline XBRL Instance Document* | |||||||
| 101.SCH | XBRL Taxonomy Extension Schema Document* | |||||||
| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document* | |||||||
| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document* | |||||||
| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document* | |||||||
| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document* | |||||||
| 104 | Cover Page Interactive Data File - the cover page XBRL tags are embedded within the Inline XBRL document | |||||||
* Filed herewith.
** Furnished herewith.
†Management contract or compensatory plan or arrangement.
51
Item 16. Form 10-K Summary
None.
52
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| LUMENT FINANCE TRUST, INC. | |||||
| March 15, 2022 | /s/ James P. Flynn | ||||
| James P. Flynn | |||||
| Chief Executive Officer and Chairman of the Board (Principal Executive Officer) | |||||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| Signature | Title | Date | ||||||||||||
| /s/ James P. Flynn | Chief Executive Officer, Chairman of the Board | March 15, 2022 | ||||||||||||
| James P. Flynn | (Principal Executive Officer) | |||||||||||||
| /s/ James A. Briggs | Chief Financial Officer (Principal Financial Officer and | March 15, 2022 | ||||||||||||
| James A. Briggs | Principal Accounting Officer) | |||||||||||||
| /s/ James C. Hunt | Director | March 15, 2022 | ||||||||||||
| James C. Hunt | ||||||||||||||
| /s/ Neil A. Cummins | Director | March 15, 2022 | ||||||||||||
| Neil A. Cummins | ||||||||||||||
| /s/ William Houlihan | Director | March 15, 2022 | ||||||||||||
| William Houlihan | ||||||||||||||
| /s/ Walter C. Keenan | Director | |||||||||||||
| Walter C. Keenan | March 15, 2022 | |||||||||||||
53
Contents
| Page | |||||
| Financial Statements | |||||
Reports of Independent Registered Public Accounting Firm (KPMG LLP, New York, NY, PCAOB ID: 185) | |||||
F-1
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
Lument Finance Trust, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Lument Finance Trust, Inc. and subsidiaries (the Company) as of December 31, 2021 and 2020, the related consolidated statements of operations, changes in equity, and cash flows for the years then ended, and the related notes and financial statement schedule IV (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Assessment of the allowance for loan losses on commercial mortgage loans held-for-investment individually evaluated for impairment
As discussed in Notes 2 and 3 to the consolidated financial statements, the Company’s allowance for loan losses on commercial mortgage loans held-for-investment individually evaluated for impairment (individually evaluated ALL) totaled $0 as of December 31, 2021. Based on the facts and circumstances of the loan, the Company determines the loan is impaired when it is probable that the Company will not be able to collect all amounts due in accordance with the contractual terms of the loan. Impaired loans are individually evaluated based on the Company’s quarterly assessment of each loan and assignment of a risk rating which are based on a number of factors including debt service coverage, loan-to-value, property type, geographic and local market dynamics, physical condition, leasing and tenant profile, adherence to business plan and exit plan, maturity default risk and project sponsorship. The individually evaluated ALL is measured by comparing the estimated fair value of the underlying collateral, less costs to sell, to the book value of the respective impaired loan. The Company utilized an income capitalization approach in determining the estimated fair value of the underlying collateral for use when evaluating that a loan is impaired, including assumptions, such as capitalization rates, creditworthiness of major tenants, occupancy rates, availability of financing, and exit plan.
We identified the assessment of the individually evaluated ALL as a critical audit matter. A high degree of audit effort, including specialized skills and knowledge, and subjective and complex auditor judgment was involved in the assessment due to significant recognition and measurement uncertainty. Specifically, the assessment encompassed the recognition of impairment of commercial mortgage loans, which are sensitive to the risk rating model applied and significant assumptions such as debt-service coverage ratio, loan-to-value, property type, geographic and local market dynamics. The assessment also encompassed the evaluation of the measurement of the individually evaluated ALL, which was sensitive to the significant assumptions of capitalization rates, creditworthiness of major tenants, occupancy rates, availability of financing, and exit plan. These assumptions are based on current market data and had a significant effect on the recognition and estimation of the individually evaluated ALL.
The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the Company’s recognition and measurement of the individually evaluated ALL estimate, including controls over the:
•Risk rating process;
•Evaluation and recognition that a loan is impaired, including significant assumptions;
•Evaluation of significant assumptions used in the measurement of the fair value of the collateral.
We evaluated the Company’s process to develop the individually evaluated ALL estimate by performing the following:
•Tested certain sources of data, factors, and assumptions that the Company used, and considered the relevance and reliability of such data, factors, and assumptions
•Tested the identification of individually impaired loans through the Company's risk rating process for a selection of loans
F-2
•Evaluated the significant assumptions used in the risk rating model by comparing to independent sources on similar properties and
•Evaluated that the significant assumptions used in the fair value of collateral were representative of current market data by comparing to recent market activity on similar property transactions.
We involved our valuation professionals with specialized skills and knowledge, who assisted in testing the fair value of the collateral, including the evaluation of the significant assumptions and related underlying documentation, for a selection of loans by comparing the assumptions to evidence obtained from external sources and evaluating the assumptions in light of historical and market information.
We also assessed the sufficiency of the audit evidence obtained related to individually evaluated ALL estimate by evaluating the:
•cumulative results of the audit procedures
•qualitative aspects of the Company’s accounting practices
•potential bias in the accounting estimate
/s/ KPMG LLP
We have served as the Company's auditor since 2019.
New York, New York
March 15, 2022
F-3
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(1)Our consolidated balance sheets include assets and liabilities of consolidated variable interest entities ("VIEs") as the Company was the primary beneficiary of these VIEs. As of December 31, 2021 and December 31, 2020, assets of the consolidated VIEs totaled $1,003,896,995 and $591,318,506, respectively and the liabilities of consolidated VIEs totaled $827,390,435 and $463,411,967, respectively. See Note 4 for further discussion.
The accompanying notes are an integral part of these consolidated financial statements.
F-4
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
| Year Ended December 31, 2021 | Year Ended December 31, 2020 | ||||||||||
| Revenues: | |||||||||||
| Interest income: | |||||||||||
| Commercial mortgage loans held-for-investment | 36,162,050 | 33,570,949 | |||||||||
| Cash and cash equivalents | 28,779 | 45,782 | |||||||||
| Interest expense: | |||||||||||
| Collateralized loan obligations | (12,178,545) | (12,047,300) | |||||||||
| Secured term loan | (3,333,536) | (3,138,917) | |||||||||
| Net interest income | 20,678,748 | 18,430,514 | |||||||||
| Other income: | |||||||||||
| Realized loss on mortgage servicing rights | (10,910) | — | |||||||||
| Change in unrealized loss on mortgage servicing rights | (356,772) | (1,780,528) | |||||||||
| Loss on extinguishment of debt | (1,663,926) | — | |||||||||
| Servicing income, net | 398,939 | 709,565 | |||||||||
| Other income | — | 2 | |||||||||
| Total other (loss) | (1,632,669) | (1,070,961) | |||||||||
| Expenses: | |||||||||||
| Management and incentive fees | 3,041,600 | 2,524,139 | |||||||||
| General and administrative expenses | 2,879,655 | 3,518,500 | |||||||||
| Operating expenses reimbursable to Manager | 2,038,130 | 1,644,886 | |||||||||
| Other operating expenses | 280,970 | 1,493,214 | |||||||||
| Compensation expense | 200,608 | 205,292 | |||||||||
| Total expenses | 8,440,963 | 9,386,031 | |||||||||
| Net income before provision for income taxes | 10,605,116 | 7,973,522 | |||||||||
| (Provision for) benefit from income taxes | (77,894) | 476,248 | |||||||||
| Net income | 10,527,222 | 8,449,770 | |||||||||
| Dividends to preferred stockholders | (3,112,500) | (15,000) | |||||||||
| Net income attributable to common stockholders | $ | 7,414,722 | $ | 8,434,770 | |||||||
| Earnings per share: | |||||||||||
| Net income attributable to common stockholders (basic and diluted) | $ | 7,414,722 | $ | 8,434,770 | |||||||
| Weighted average number of shares of common stock outstanding | 24,945,824 | 24,934,505 | |||||||||
| Basic and diluted income per share | $ | 0.30 | $ | 0.34 | |||||||
| Dividends declared per weighted average share of common stock | $ | 0.36 | $ | 0.37 | |||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-5
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Equity
| Preferred Stock | Common Stock | Additional Paid in Capital | Cumulative Distributions to Stockholders | Accumulated Earnings | Total Stockholders' Equity | Noncontrolling interests | Total Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Shares | Value | Shares | Par Value | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance at January 1, 2020 | — | — | 23,692,164 | 236,877 | 228,135,116 | (122,236,981) | 2,410,200 | 108,545,212 | 99,500 | $ | 108,644,712 | |||||||||||||||||||||||||||||||||||||||||||||||||||
| Issuance of common stock | — | — | 1,251,219 | 12,512 | 5,749,848 | — | — | 5,762,360 | — | 5,762,360 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Cost of issuing common stock | — | — | — | — | (40,000) | — | — | (40,000) | — | (40,000) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Restricted stock compensation expense | — | — | — | — | 5,307 | — | — | 5,307 | — | 5,307 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | — | 8,449,770 | 8,449,770 | — | 8,449,770 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Common dividends declared | — | — | — | — | — | (9,103,997) | — | (9,103,997) | — | (9,103,997) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Preferred dividends declared | — | — | — | — | — | (15,000) | — | (15,000) | — | (15,000) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance at December 31, 2020 | — | $ | — | 24,943,383 | $ | 249,389 | $ | 233,850,271 | $ | (131,355,978) | $ | 10,859,970 | $ | 113,603,652 | $ | 99,500 | $ | 113,703,152 | ||||||||||||||||||||||||||||||||||||||||||||
| Balance at January 1, 2021 | — | $ | — | 24,943,383 | $ | 249,389 | $ | 233,850,271 | $ | (131,355,978) | $ | 10,859,970 | $ | 113,603,652 | $ | 99,500 | $ | 113,703,152 | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of common stock | — | — | 4,500 | 45 | 11,655 | — | — | 11,700 | — | 11,700 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Cost of issuing common stock | — | — | — | — | (32,085) | — | — | (32,085) | — | (32,085) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Issuance of preferred stock, net | 2,400,000 | 57,254,935 | — | — | — | — | — | 57,254,935 | — | 57,254,935 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Restricted stock compensation expense | — | — | — | — | 3,908 | — | — | 3,908 | — | 3,908 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | — | 10,527,222 | 10,527,222 | — | 10,527,222 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Common dividends declared | — | — | — | — | — | (8,980,832) | — | (8,980,832) | — | (8,980,832) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Preferred dividends declared | — | — | — | — | — | (3,112,500) | — | (3,112,500) | — | (3,112,500) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance at December 31, 2021 | 2,400,000 | $ | 57,254,935 | 24,947,883 | $ | 249,434 | $ | 233,833,749 | $ | (143,449,310) | $ | 21,387,192 | $ | 169,276,000 | $ | 99,500 | $ | 169,375,500 | ||||||||||||||||||||||||||||||||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-6
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
| Year Ended December 31, 2021 | Year Ended December 31, 2020 | ||||||||||
| Cash flows from operating activities: | |||||||||||
| Net income | $ | 10,527,222 | $ | 8,449,770 | |||||||
| Adjustments to reconcile net income to net cash provided by operating activities: | |||||||||||
| Accretion of commercial mortgage loans held-for-investment discounts | (46,088) | — | |||||||||
| Amortization of commercial mortgage loans held-for-investment premiums | 457,749 | — | |||||||||
| Accretion of collateralized loan obligations discounts, net | 207,767 | 1,137,156 | |||||||||
| Amortization of deferred offering costs | (32,085) | (40,000) | |||||||||
| Amortization of deferred financing costs | 1,953,465 | 1,029,899 | |||||||||
| Realized loss on mortgage servicing rights | 10,910 | — | |||||||||
| Loss on extinguishment of debt | 1,663,926 | — | |||||||||
| Unrealized loss on mortgage servicing rights | 356,772 | 1,780,528 | |||||||||
| Restricted stock compensation expense | 15,608 | 20,292 | |||||||||
| Net change in: | |||||||||||
| Accrued interest receivable | (1,962,135) | 326,737 | |||||||||
| Deferred offering costs | — | 40,000 | |||||||||
| Other assets | (55,464) | (286,607) | |||||||||
| Accrued interest payable | 271,119 | (372,190) | |||||||||
| Fees and expenses payable to Manager | 668,802 | 164,359 | |||||||||
| Other accounts payable and accrued expenses | (190,621) | (30,735) | |||||||||
| Net cash provided by operating activities | 13,846,947 | 12,219,209 | |||||||||
| Cash flows from investing activities: | |||||||||||
| Purchase of commercial mortgage loans held-for-investment | (983,694,326) | (57,601,572) | |||||||||
| Principal payments from commercial mortgage loans held-for-investment | 506,402,705 | 145,516,658 | |||||||||
| Net cash (used in) provided by investing activities | (477,291,621) | 87,915,086 | |||||||||
| Cash flows from financing activities: | |||||||||||
| Proceeds from issuance of common stock | — | 5,747,375 | |||||||||
| Net proceeds from issuance of preferred stock | 57,254,935 | — | |||||||||
| Dividends paid on common stock | (9,978,162) | (7,638,270) | |||||||||
| Dividends paid on preferred stock | (2,115,000) | (15,000) | |||||||||
| Proceeds from collateralized obligations | 833,750,000 | — | |||||||||
| Proceeds from secured term loan | 7,500,000 | — | |||||||||
| Payment of collateralized loan obligations | (465,316,126) | (44,864,874) | |||||||||
| Payment of deferred financing costs | (8,747,277) | — | |||||||||
| Net cash provided by (used in) financing activities | 412,348,370 | (46,770,769) | |||||||||
| Net (decrease) increase in cash, cash equivalents and restricted cash | (51,096,304) | 53,363,526 | |||||||||
| Cash, cash equivalents and restricted cash, beginning of period | 69,375,356 | 16,011,830 | |||||||||
| Cash, cash equivalents and restricted cash, end of period | $ | 18,279,052 | $ | 69,375,356 | |||||||
| Supplemental disclosure of cash flow information | |||||||||||
| Cash paid for interest | $ | 13,079,740 | $ | 13,386,816 | |||||||
| Cash paid for income taxes | $ | — | $ | 180,898 | |||||||
| Non-cash investing and financing activities information | |||||||||||
| Dividends declared but not paid at end of period | $ | 3,426,559 | $ | 3,242,650 | |||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-7
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 1 - ORGANIZATION AND BUSINESS OPERATIONS
Lument Finance Trust, Inc. (together with its consolidated subsidiaries, the "Company”), formerly Hunt Companies Finance Trust, Inc., is a Maryland corporation that focuses primarily on investing in, financing and managing a portfolio of commercial real estate ("CRE") debt investments. Effective January 3, 2020, the Company is externally managed by OREC Investment Management, LLC, doing business as Lument Investment Management (the "Manager" or "Lument IM"), who replaced the prior manager, Hunt Investment Management, LLC ("HIM"). On December 28, 2020, the Company changed its name from Hunt Companies Finance Trust, Inc. to Lument Finance Trust, Inc., and its common stock began trading on the NYSE under the symbol "LFT." Previously, the Company's common stock was listed on the NYSE under the symbol "HCFT."
The Company was incorporated on March 28, 2012 and commenced operations on May 16, 2012. The Company began trading as a publicly traded company on March 22, 2013.
The Company has elected to be taxed as a real estate investment trust ("REIT") and to comply with Sections 856 through 859 of the Internal Revenue Code of 1986, as amended, (the "Code"). Accordingly, the Company generally will not be subject to U.S. federal income tax to the extent of its distributions to stockholders and as long as certain asset, income and share ownership tests are met.
On January 3, 2020, the Company and HIM entered into a termination agreement pursuant to which the Company and HIM agreed to mutually and immediately terminate that certain management agreement dated January 18, 2018. The Company simultaneously entered into a new management agreement with Lument IM. Pursuant to the terms of the termination agreement between the Company and HIM, the termination of the management agreement did not trigger, and HIM was not paid, a termination fee by the Company. See Note 9 for further discussion.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
These financial statements have been prepared in accordance with U.S. GAAP and are expressed in United States dollars.
The consolidated financial statements of the Company include the accounts of its subsidiaries.
Principles of Consolidation
The accompanying consolidated financial statements of the Company include the accounts of the Company and all subsidiaries which it controls (i) through voting or similar rights or (ii) by means other than voting rights if the Company is the primary beneficiary of a variable interest entity ("VIE"). Entities which the Company does not control and entities which are VIEs in which the Company is not the primary beneficiary are accounted for under the equity method or other appropriate GAAP. All significant intercompany transactions have been eliminated on consolidation.
VIEs
An entity is considered a VIE when any of the following applies: (1) the equity investors (if any) lack one or more essential characteristics of a controlling financial interest; (2) the equity investment at risk is not sufficient to finance that entity's activities without additional subordinated financial support; or (3) the equity investors have voting rights that are not proportionate to their economic interests and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest. The Company consolidates VIEs in which it is considered to be the primary beneficiary. The primary beneficiary is defined as the entity having both the following characteristics: (1) the power to direct activities that, when taken together, most significantly impact the VIE performance; and (2) the obligation to absorb losses and right to receive returns from the VIE that would be significant to the VIE.
The Company evaluates quarterly its junior retained notes and preferred shares of LFT CRE 2021-FL1, Ltd. for potential consolidation, and prior to their unwinding in the second quarter of 2021, Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. At December 31, 2021, the Company determined it was the primary beneficiary of LFT CRE 2021-FL1, Ltd. based on its obligation to absorb losses derived from ownership of its preferred shares, and prior to the second quarter of 2021 determined it was the primary beneficiary of Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. Accordingly, the Company consolidated the assets, liabilities, income and expenses of the underlying issuing entities. The Company's maximum exposure to loss from collateralized loan obligations ("CLO") was $166,250,000 and $124,046,671 at December 31, 2021 and December 31, 2020.
Use of Estimates
The financial statements have been prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires the Company to make a number of significant estimates. As of December 31, 2021, the novel coronavirus, or COVID-19, pandemic is ongoing. During 2020, the COVID-19 pandemic created disruption in global supply chains, increased rates of unemployment and adversely impacted many industries, including industries related to the collateral underlying certain of our loans. In 2021, the global economy has, with certain setbacks, begun reopening and wider distribution of vaccines will likely encourage greater economic activity. Nonetheless, the recovery could remain uneven, particularly given uncertainty with respect to the distribution and acceptance of the vaccines and their effectiveness with respect to new variants of the virus, including the Delta and Omicron variants which are believed to be more contagious than previous variants of the virus. We believe the estimates and assumptions underlying our consolidated financial statements are reasonable and supportable based on the information available as of December 31, 2021, however uncertainty over the ultimate impact of COVID-19 on the global economy generally, and our business in particular, makes any estimates and assumptions as of December 31, 2021 inherently less certain than they would be absent the current and potential impacts of COVID-19. Actual results could differ from its estimates and the differences may be material.
F-8
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Cash and Cash Equivalents and Restricted Cash
Cash and cash equivalents at time of purchase include cash held in bank accounts on an overnight basis and other short term deposit accounts with banks having maturities of 90 days or less at time of acquisition. The Company maintains its cash and cash equivalents in highly rated financial institutions, and at times these balances exceed insurable amounts.
Restricted cash includes cash held within LFT CRE 2021-FL1, Ltd. as of December 31, 2021 and Hunt CRE 2018-FL2, Ltd. as of December 31, 2020.
The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the consolidated balance sheets that sum to the total of the same amounts shown in the statement of cash flows.
| December 31, 2021 | December 31, 2020 | ||||||||||
| Cash and cash equivalents | $ | 14,749,046 | $ | 11,375,960 | |||||||
| Restricted cash CRE 2018-FL2, Ltd. | $ | — | $ | 57,999,396 | |||||||
| Restricted cash CRE 2021-FL1, Ltd. | $ | 3,530,006 | $ | — | |||||||
| Total cash, cash equivalents and restricted cash | $ | 18,279,052 | $ | 69,375,356 | |||||||
Deferred Offering Costs
Direct costs incurred to issue shares classified as equity, such as legal and accounting fees, are deducted from the related proceeds and the net amount recorded as stockholders’ equity. Accordingly, payments made by the Company in respect of such costs related to the issuance of shares are recorded as an asset in the accompanying consolidated balance sheets in the line item "Other assets", for subsequent deduction from the related proceeds upon closing of the offering. To the extent that certain costs, in particular legal fees, are known to have been accrued but have not yet been invoiced and paid, they are included in "Other accounts payable and accrued expenses" on the accompanying consolidated balance sheets.
Fair Value Measurements
The "Fair Value Measurements and Disclosures" Topic 820 of the FASB, or ASC 820, defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurement under GAAP. Specifically, the guidance defines fair value based on exit price, or the price that would be received upon the sale of an asset or the transfer of a liability in an orderly transaction between market participants at measurement date. ASC 820 specifies a hierarchy of valuation techniques based on the inputs used in measuring fair value.
Valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable market data from independent sources, while unobservable inputs reflect the Company's market assumptions. The three levels are defined as follows:
•Level 1 Inputs - Quoted prices for identical instruments in active markets
•Level 2 Inputs - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
•Level 3 Inputs - Instruments with primarily unobservable value drivers.
Pursuant to ASC 820 we disclose fair value information about financial instruments, which are not otherwise reported at fair value in our consolidated balance sheet, to the extent it is practicable to estimate fair value for those certain instruments.
The following methods and assumptions are used to estimate the fair value of each class of financial instrument, for which it is practicable to estimate that value:
•Cash and cash equivalents: The carrying amount of cash and cash equivalents approximates fair value.
•Restricted cash: The carrying amount of restricted cash approximates fair value.
•Commercial mortgage loans: The Company determines the fair value of commercial mortgage loans by utilizing a pricing model based on discounted cash flow methodologies using discount rates, which reflect current market interest rates that would be offered for loans with similar characteristics and credit quality. Additionally, the Company may record fair value adjustments on a non-recurring basis when it has determined it necessary to record a specific impairment reserve or charge-off against a loan and the Company measures such specific reserve or charge-off using the fair value of the loan's collateral. To determine the fair value of loan collateral, the Company employs the income
capitalization approach, appraised values, broker opinion of value, sale offers, letters of intention to purchase, or other valuation benchmarks,
as applicable, depending upon the nature of such collateral and other relevant market factors.
•Mortgage servicing rights: The Company determines the fair value of MSRs from a third-party pricing service on a recurring basis. The third-party pricing service uses common market pricing methods that include using discounted cash flow models to calculate present value, estimated net servicing income and observed market pricing for MSR purchase and sale transactions. The model considers contractually specified servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenue, costs to service and other economic factors.
•Collateralized loan obligations: The Company determines the fair value of collateralized loan obligations by utilizing a third-party pricing service. In determining the value of a particular investment, pricing service providers may use market spreads, inventory levels, trade and bid history, as well as market insight from clients, trading desks and global research platform.
•Secured term loan: The Company determines the fair value of its secured term loan based on a discounted cash flow methodology.
F-9
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Commercial Mortgage Loans Held-for-Investment
Commercial mortgage loans held-for-investment represent floating-rate transitional loans and other commercial mortgage loans purchased by the Company. These loans include loans sold into securitizations that the Company consolidates. Commercial mortgage loans held-for-investment are intended to be held-to-maturity and, accordingly, are carried at their unpaid principal balances, adjusted for net unamortized loan fees and costs (in respect of originated loans), premiums and discounts (in respect of purchased loans) and impairment, if any.
Interest income is recognized as revenue using the effective interest method and is recorded on the accrual basis according to the terms of the underlying loan agreement. Any fees, costs, premiums and discounts associated with these loan investments are deferred and amortized over the term of the loan using the
effective interest method, or on a straight line basis when it approximates the effective interest method. Income accrual is generally suspended and loans are placed on non-accrual status on the earlier of the date at which payment has become 90 days past due or when full and timely collection of interest and principal is considered not probable. The Company may return a loan to accrual status when repayment of principal and interest is reasonably assured under the terms of the underlying loan agreement. As of December 31, 2021, the Company did not hold any loans placed in non-accrual status.
Quarterly, the Company assesses the risk factors of each loan classified as held-for-investment and assigns a risk rating based on a variety of factors, including, without limitation, debt-service coverage ratio ("DSCR"), loan-to-value ratio ("LTV"), property type, geographic and local market dynamics, physical condition, leasing and tenant profile, adherence to business plan and exit plan, maturity default risk and project sponsorship. The Company's loans are rated on a 5-point scale, from least risk to greatest risk, respectively, which ratings are described as follows:
1.Very Low Risk: exceeds expectations and is outperforming underwriting or it is very likely that the underlying loan can be refinanced easily in the period's prevailing capital market conditions
2.Low Risk: meeting or exceeding underwritten expectations
3.Moderate Risk: consistent with underwritten expectations or the sponsor may be in the early stages of executing the business plan and the loan structure appropriately mitigates additional risks
4.High Risk: potential risk of default, a loss may occur in the event of default
5.Default Risk: imminent risk of default, a loss is likely in the event of default
The Company evaluates each loan rated High Risk or above as to whether it is impaired on a quarterly basis. Impaired loans are individually evaluated based on the Company's quarterly assessment of each loan and assignment of a risk rating. Impairment occurs when the Company determines that the facts and circumstances of the loan deem it probable that the Company will not be able to collect all amounts due in accordance with the contractual terms of the loan. If a loan is considered to be impaired, an allowance is recorded to reduce the carrying value of the loan through a charge to the provision for loan losses. Impairment of these loans, all of which are deemed collateral dependent, is measured by comparing the estimated fair value of the underlying collateral, less costs to sell, to the book value of the respective loan. These valuations require significant judgments, which include assumptions regarding capitalization rates, leasing, creditworthiness of major tenants, occupancy rates, availability of financing, exit plan, actions of other lenders, and other factors deemed necessary by the Manager. Actual losses, if any, could ultimately differ from estimated losses.
In addition, the Company evaluates the entire portfolio to determine whether the portfolio has any impairment that requires a valuation allowance on the remainder of the loan portfolio. As of December 31, 2021, the Company has not recognized any impairments on its loans held-for-investment. We also assessed the remainder of the portfolio, considering the absence of delinquencies and current market conditions, and, as such has not recorded any allowance for loan losses.
Mortgage Servicing Rights, at Fair Value
Mortgage servicing rights ("MSRs") are associated with residential mortgage loans that the Company historically purchased and subsequently sold or securitized. MSRs are held and managed at Five Oaks Acquisition Corp. ("FOAC"), the Company's taxable REIT subsidiary ("TRS"). As the owner of MSRs, the Company is entitled to receive a portion of the interest payments from the associated residential mortgage loan, and is obligated to service, directly or through a subservicer, the associated loan. MSRs are reported at fair value. Residential mortgage loans for which the Company owns the MSRs are directly serviced by two sub-servicers retained by the Company. The Company does not directly service any residential mortgage loans.
MSR income is recognized at the contractually agreed upon rate, net of the costs of sub-servicers retained by the Company. If a sub-servicer with which the Company contracts were to default, an evaluation of MSR assets for impairment would be undertaken at that time.
Collateralized Loan Obligations
Collateralized loan obligations represent third-party liabilities of LFT CRE 2021-FL1, Ltd. as of December 31, 2021 and Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. prior to their unwind date of June 14, 2021 (the "CLOs"). The CLOs are VIEs that the Company has determined it is the primary beneficiary of and accordingly are consolidated in the Company's financial statements, excluding liabilities of the CLOs acquired by the Company that are eliminated on consolidation. The third-party obligations of the CLOs do not have any recourse to the Company as the consolidator of the CLOs. CLOs are carried at their outstanding unpaid principal balances, net of any unamortized discounts or deferred financing costs. Any premiums, discounts or deferred financing costs associated with these liabilities are amortized to interest expense using the effective interest method over the expected average life of the related obligations, or on a straight line basis when it approximates the effective interest method. In the second quarter of 2020, $624,816 in costs related to a contemplated collateralized loan transaction, that were previously deferred as "other assets" in the consolidated balance sheets were expensed as "Other operating expenses" in the statements of operations as a result of abandoning the contemplated transaction due to the then current market environment, which had been impacted by the COVID-19 pandemic.
Secured Term Loan
The Company and certain of its subsidiaries are party to a $47.75 million credit and guaranty agreement with the lenders referred to therein and Cortland Capital Service LLC, as administrative agent and collateral agent for the lenders (the "Secured Term Loan"). The Secured Term Loan is carried at its unpaid
F-10
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
principal balance, net of deferred financing costs. Deferred financing costs of $1,405,133 associated with this liability are amortized to interest expense on a straight line basis when it approximates the effective interest method.
Common Stock
At December 31, 2021, and December 31, 2020, the Company was authorized to issue up to 450,000,000 shares of common stock, par value $0.01 per share. The Company had 24,947,883 and 24,943,383 shares of common stock issued and outstanding at December 31, 2021 and December 31, 2020, respectively.
Stock Repurchase Program
On December 15, 2015, the Company’s Board of Directors authorized a stock repurchase program ("Repurchase Program") to repurchase up to $10 million of the Company’s outstanding common stock. Subject to applicable securities laws, repurchase of common stock under the Repurchase Program may be made at times and in amounts as the Company deems appropriate, using available cash resources. Shares of common stock repurchased by the Company under the Repurchase Program, if any, will be canceled and, until reissued by the Company, will be deemed to be authorized but unissued shares of common stock. The Repurchase Program may be suspended or discontinued by the Company at any time and without prior notice.
Preferred Stock
At December 31, 2021 and December 31, 2020, the Company was authorized to issue up to 50,000,000 shares of preferred stock, par value $0.01 per share, with such designations, voting and other rights and preferences as may be determined from time to time by the Company's Board of Directors. On May 5, 2021, the Company issued 2,400,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock (Series A Preferred Stock"). The Company had 2,400,000 shares of preferred stock issued and outstanding at December 31, 2021 and no shares of preferred stock issued and outstanding at December 31, 2020. Our preferred stock is classified as permanent equity and carried at its liquidation preference less offering costs. See Note 12 for additional information related to our Series A Preferred Stock.
Income Taxes
The Company has elected to be taxed as a REIT under the Code for U.S. federal income tax purposes, commencing with the Company’s short taxable period ended December 31, 2012. A REIT is generally taxable as a U.S. C-Corporation; however, so long as the Company qualifies as a REIT it is entitled to a special deduction for dividends paid to stockholders not otherwise available to corporations. Accordingly, the Company generally will not be subject to U.S. federal income tax to the extent its distributions to stockholders equals, or exceeds, its REIT taxable income for the year. In addition, the Company must continue to meet certain REIT qualification requirements with respect to distributions, as well as certain asset, income and share ownership tests, in accordance with Sections 856 through 860 of the Code, as summarized below. In addition, the TRS is maintained to perform certain services and earn income for the Company that the Company is not permitted engage in as a REIT.
To maintain its qualification as a REIT, the Company must meet certain requirements, including but not limited to the following: (i) distribute at least 90% of its REIT taxable income to its stockholders; (ii) invest at least 75% of its assets in REIT qualifying assets, with additional restrictions with respect to asset concentration risk; and (iii) earn at least 95% of its gross income from qualifying sources of income, including at least 75% from qualifying real estate and real estate related sources. Regardless of the REIT election, the Company may also be subject to certain state, local and franchise taxes. Under certain circumstances, federal income and excise taxes may be due on its undistributed taxable income. If the Company were to fail to meet these requirements, it would be subject to U.S. federal income tax as a U.S. C-Corporation, which could have a material adverse impact on its results of operations and amounts available for distributions to its stockholders.
Certain activities of the Company are conducted through a TRS and therefore are taxed as a standalone U.S. C-Corporation. Accordingly, 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. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The TRS is not subject to a distribution requirement with respect to its REIT owner. The TRS may retain earnings annually, resulting in an increase in the consolidated book equity of the Company and without a corresponding distribution requirement by the REIT. If the TRS generates net income, and declares dividends to the Company, such dividends will be included in its taxable income and necessitate a distribution to its stockholders in accordance with the REIT distribution requirements.
The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with ASC 740, Income Taxes. The Company records these liabilities to the extent the Company deems them more likely than not to be incurred. The Company's accounting policy with respect to interest and penalties is to classify these amounts as other interest expense.
Earnings per Share
The Company calculates basic and diluted earnings per share by dividing net income attributable to common stockholders for the period by the weighted-average shares of the Company’s common stock outstanding for that period. Diluted earnings per share takes into account the effect of dilutive instruments, such as warrants, stock options, and unvested restricted stock, but use the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares outstanding. See Note 17 for details of the computation of basic and diluted earnings per share.
Stock-Based Compensation
The Company is required to recognize compensation costs relating to stock-based payment transactions in the consolidated financial statements. The Company accounts for share-based compensation issued to its Manager and non-management directors using the fair-value based methodology prescribed by
F-11
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
ASC 505, Equity ("ASC 505"), or ASC 718, Share-Based Payment ("ASC 718"), as appropriate. Compensation cost related to restricted common stock issued to the Manager is initially measured at estimated fair value at the grant date, and is remeasured on subsequent dates to the extent the awards are unvested. Additionally, the compensation cost related to restricted common stock issued to the non-management directors is measured at its estimated fair value at the grant date and amortized and expensed over the vesting period. See Note 13 for details of stock-based awards issuable under the Manager Equity Plan.
Comprehensive Income (Loss) Attributable to Common Stockholders
For the years ended December 31, 2021 and December 31, 2020, comprehensive income equaled net income; therefore, a separate statement of comprehensive income is not included in the accompanying consolidated financial statements.
Recently Issued and/or Adopted Accounting Standards
Credit Losses
In June 2016, the FASB issued ASU 2016-13, which is a comprehensive amendment of credit losses on financial instruments. Currently, GAAP requires an "incurred loss" methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred. The standard’s core principle is that an entity replaces the "incurred loss" impairment methodology in current GAAP with a methodology that reflects current expected credit losses and requires consideration of a broader range of reasonable and supportable information to support credit loss estimates. For public business entities that are SEC filers, the amendment in this update was effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
In November 2019, the FASB issued ASU 2019-10 which amended the effective dates for implementation of ASU 2016-13. ASU 2019-10 defers the effective date of ASU 2016-13 for SEC filers that are eligible to be smaller reporting companies, public business entities that are not SEC filers and all other companies, including not-for-profit companies and employee benefit plans for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is designated as a smaller reporting company and has deferred implementation of ASU 2016-13 pursuant to ASU 2019-10 and is continuing to assess the impact of this guidance.
In February 2020, the FASB issued ASU 2020-02, amending SEC paragraphs in the Codification to reflect the issuance of SEC Staff Accounting Bulletin ("SAB") No. 119 related to the new credit losses standard and revised effective date of the new leases standard. SAB No. 119 provides interpretive guidance on methodologies and supporting documentation for measuring credit losses, with a focus on the documentation the staff would normally expect registrants engaged in lending transactions to prepare and maintain to support estimates of current expected credit losses for loan transactions. This new guidance is effective for fiscal years beginning after December 15, 2022 for smaller reporting companies such as the Company. The Company is assessing the impact of this guidance.
Accounting for Income Taxes
In December 2019, the FASB issued ASU No. 2019-12, "Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes." This guidance eliminates certain exceptions to the general principles in Topic 740. This new guidance is effective for us on January 1, 2021, with early adoption permitted. The Company adopted ASU 2019-12 beginning with the first quarter of 2021, which had no impact on the Company's financial condition or results of operations.
Financial Instruments
In March 2020, the FASB issued ASU 2020-03 which makes improvements to financial instruments guidance, including the current expected credit losses (CECL) guidance in ASU 2016-13. Only Issue 1, of the 7 improvement issues applies to the Company, which is effective upon issuance, requires all entities to provide fair value option disclosures. MSRs are reported at fair value as a result of the fair value election, as discussed in Mortgage Servicing Rights, at Fair Value above.
Reference Rate Reform
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 828): Facilitation of the Effects of Reference Rate Reform on Financial Reporting." The standard was issued to ease the accounting effects of reform to the London Interbank Offered Rate ("LIBOR") and other reference rates. The standard provides optional expedients and exceptions for applying GAAP to debt instruments, leases, derivatives and other contracts affected by reference rate reform. ASU 2020-04 generally considers contract modifications related to reference rate reform to be an event that does not require contract remeasurement at the modification date nor a reassessment of a previous accounting determination. The standard is effective for all entities as of March 12, 2020 through December 31, 2022 and may be elected over time as reference rate reform activities occur. We have not adopted any of the optional expedients or exceptions through December 31, 2021, but will continue to evaluate the possible adoption of any such expedients or exceptions.
NOTE 3 - COMMERCIAL MORTGAGE LOANS HELD-FOR-INVESTMENT
The following tables summarize certain characteristics of the Company's investments in commercial mortgage loans as of December 31, 2021 and December 31, 2020:
F-12
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 3 – COMMERCIAL MORTGAGE LOANS HELD-FOR-INVESTMENT (Continued)
| Weighted Average | ||||||||||||||||||||||||||||||||||||||
| Loan Type | Unpaid Principal Balance | Carrying Value | Loan Count | Floating Rate Loan % | Coupon(1) | Term (Years)(2) | ||||||||||||||||||||||||||||||||
| December 31, 2021 | ||||||||||||||||||||||||||||||||||||||
| Loans held-for-investment | ||||||||||||||||||||||||||||||||||||||
Senior secured loans(3) | $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | ||||||||||||||||||||||||||||
| $ | 1,001,869,994 | $ | 1,001,825,294 | 66 | 100.0 | % | 3.9 | % | 3.7 | |||||||||||||||||||||||||||||
| Weighted Average | ||||||||||||||||||||||||||||||||||||||
| Loan Type | Unpaid Principal Balance | Carrying Value | Loan Count | Floating Rate Loan % | Coupon(1) | Term (Years)(2) | ||||||||||||||||||||||||||||||||
| December 31, 2020 | ||||||||||||||||||||||||||||||||||||||
| Loans held-for-investment | ||||||||||||||||||||||||||||||||||||||
Senior secured loans(3) | $ | 547,345,334 | $ | 547,345,334 | 40 | 100.0 | % | 5.1 | % | 3.1 | ||||||||||||||||||||||||||||
| $ | 547,345,334 | $ | 547,345,334 | 40 | 100.0 | % | 5.1 | % | 3.1 | |||||||||||||||||||||||||||||
(1) Weighted average coupon assumes applicable one-month LIBOR of 0.10% and 0.14% as of December 31, 2021 and December 31, 2020, respectively, inclusive of weighted average LIBOR floors of 0.49% and 1.64%, respectively.
(2) Weighted average term assumes all extension options are exercised by the borrower; provided, however, that our loans may be repaid prior to such date.
(3) As of December 31, 2021, $974,025,294 of the outstanding senior secured loans were held in VIEs and $27,800,000 of the outstanding senior secured loans were held outside of VIEs. As of December 31, 2020, $531,363,401 of the outstanding senior secured loans were held in VIEs and $15,981,933 of the outstanding senior secured loans were held outside of VIEs.
Activity: For the years ended December 31, 2021 and December 31, 2020, the loan portfolio activity was as follows:
| Commercial Mortgage Loans Held-for-Investment | ||||||||
| Balance at December 31, 2019 | $ | 635,260,420 | ||||||
| Purchases and advances | 57,601,572 | |||||||
| Principal payments | (145,516,658) | |||||||
| Balance at December 31, 2020 | $ | 547,345,334 | ||||||
| Purchases and advances | 983,694,326 | |||||||
| Principal repayments | (528,802,705) | |||||||
| Accretion of purchase discount | 46,088 | |||||||
| Amortization of purchase premium | (457,749) | |||||||
| Balance at December 31, 2021 | $ | 1,001,825,294 | ||||||
Loan Risk Ratings: As further described in Note 2, the Company evaluates the commercial mortgage loan portfolio on a quarterly basis and assigns a risk rating based on a variety of factors. The following table presents the principal balance and net book value of the loan portfolio based on the Company's internal risk ratings as of December 31, 2021 and December 31, 2020:
| December 31, 2021 | December 31, 2020 | |||||||||||||||||||||||||||||||||||||
| Risk Rating | Number of Loans | Unpaid Principal Balance | Net Carrying Value | Number of Loans | Unpaid Principal Balance | Net Carrying Value | ||||||||||||||||||||||||||||||||
| 1 | — | $ | — | — | — | $ | — | — | ||||||||||||||||||||||||||||||
| 2 | 40 | 634,438,386 | 634,438,386 | 14 | 168,401,366 | 168,401,366 | ||||||||||||||||||||||||||||||||
| 3 | 23 | 342,350,405 | 342,305,705 | 20 | 309,726,343 | 309,726,343 | ||||||||||||||||||||||||||||||||
| 4 | 3 | 25,081,203 | 25,081,203 | 6 | 69,217,625 | 69,217,625 | ||||||||||||||||||||||||||||||||
| 5 | — | — | — | — | — | — | ||||||||||||||||||||||||||||||||
| 66 | 1,001,869,994 | 1,001,825,294 | 40 | 547,345,334 | 547,345,334 | |||||||||||||||||||||||||||||||||
F-13
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 3 – COMMERCIAL MORTGAGE LOANS HELD-FOR-INVESTMENT (Continued)
As of December 31, 2021, the average risk rating of the commercial mortgage loan portfolio was 2.3 (Low Risk), weighted by investment carrying value, with 97.5% of commercial loans held-for-investment rated 3 (Moderate Risk) or better by the Company's Manager.
As of December 31, 2020, the average risk rating of the commercial mortgage loan portfolio was 3.1 (Moderate Risk), weighted by investment carrying value, with 84.4% of commercial loans held-for-investment rated 3 (Moderate Risk) or better by the Company's Manager.
The decrease in risk ratings is primarily the result of commercial mortgage loans that paid off with a risk rating of "2" of $133.6 million, a risk rating of "3" of $276.1 million and a risk rating of "4" of $17.8 million, offset by purchases of commercial mortgage loans with a risk rating of "2" of $599.0 million, a risk rating of "3" of $283.0 million and a risk rating of '4" of $0.1 million during the year ended December 31, 2021.
Concentration of Credit Risk: The following tables present the geographic and property types of collateral underlying the Company's commercial mortgage loans as a percentage of the loans' carrying value as of December 31, 2021 and December 31, 2020:
Loans Held-for-Investment
| December 31, 2021 | December 31, 2020 | |||||||||||||
| Geography | ||||||||||||||
| South | 46.2 | % | 36.5 | % | ||||||||||
| Southwest | 27.5 | 38.7 | ||||||||||||
| West | 13.9 | 1.8 | ||||||||||||
| Mid-Atlantic | 7.9 | 6.2 | ||||||||||||
| Midwest | 4.5 | 16.8 | ||||||||||||
| Total | 100.0 | % | 100.0 | % | ||||||||||
| December 31, 2021 | December 31, 2020 | |||||||||||||
| Collateral Property Type | ||||||||||||||
| Multifamily | 92.0 | % | 89.5 | % | ||||||||||
| Self-Storage | 5.2 | 0.8 | ||||||||||||
| Retail | 1.7 | 6.4 | ||||||||||||
| Office | 1.1 | 3.3 | ||||||||||||
| Total | 100.0 | % | 100.0 | % | ||||||||||
We did not have any impaired loans, nonaccrual loans, or loans in maturity default as of December 31, 2021 or December 31, 2020.
NOTE 4 – USE OF SPECIAL PURPOSE ENTITIES AND VARIABLE INTEREST ENTITIES
We account for CLO transactions on our consolidated balance sheet as financing facilities. Our CLOs are VIEs for which we are the primary beneficiary and are consolidated in our financial statements. The investment grade tranches are treated as secured financings, and are non-recourse to us. See Note 2 ("Summary of Significant Accounting Policies - Principles Consolidation - VIE") for further discussion.
On June 14, 2021, the Company completed a CRE CLO (LFT CRE 2021-FL1, Ltd."), issuing eight tranches of CLO notes through two newly-formed wholly-owned subsidiaries totaling $903.8 million. Of the total CLO notes issued $833.8 million were investment grade notes issued to third party investors and $70 million were below investment-grade notes retained by us. In addition, a $96.25 million equity interest in the portfolio was retained by us. The financing has an initial two-and-a-half year reinvestment period that allows principal proceeds of the loan obligations to be reinvested in qualifying replacement loan obligations, subject to the satisfaction of certain conditions set forth in the indenture. Thereafter, the outstanding debt balance will be reduced as loans are repaid. Initially, the proceeds of the issuance of the securities also included $330.3 million for the purpose of acquiring additional loan obligations for a period up to 180 days from the CLO closing date, resulting in the issuer owning loan obligations with a face value of $1.0 billion, representing leverage of 83%.
On June 14, 2021, the Company unwound Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. redeeming $388.2 million of outstanding notes which were repaid primarily from the refinancing of the remaining assets primarily within LFT 2021-FL1, Ltd., as well as cash held within Hunt CRE 2018-FL2, Ltd. and expensed $1.7 million of deferred financing costs into loss on extinguishment of debt on the consolidated statements of operations. As of this date, the Company no longer consolidates the asset and liabilities of Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd.
The CLO we consolidate is subject to collateralization and coverage tests that are customary for this type of securitization. As of December 31, 2021, and December 31, 2020 all such collateralization and coverage tests in the CLOs we consolidate were met. If the duration of the COVID-19 pandemic continues to prolong, its impact on our borrowers and their tenants could result in a sustained deterioration in a material amount of assets and may impact these tests.
The carrying values of the Company's total assets and liabilities related to LFT CRE 2021-FL1, Ltd. at December 31, 2021 and Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. at December 31, 2020 included the following VIE assets and liabilities:
F-14
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 4 – USE OF SPECIAL PURPOSE ENTITIES AND VARIABLE INTEREST ENTITIES (Continued)
| ASSETS | December 31, 2021 | December 31, 2020 | ||||||||||||
| Cash, cash equivalents and restricted cash | $ | 3,530,006 | $ | 57,999,396 | ||||||||||
| Accrued interest receivable | 3,941,695 | 1,955,709 | ||||||||||||
| Investment related receivable | 22,400,000 | — | ||||||||||||
| Loans held for investment | 974,025,294 | 531,363,401 | ||||||||||||
| Total Assets | $ | 1,003,896,995 | $ | 591,318,506 | ||||||||||
| LIABILITIES | ||||||||||||||
| Accrued interest payable | $ | 607,892 | $ | 351,877 | ||||||||||
Collateralized loan obligations(1) | 826,782,543 | 463,060,090 | ||||||||||||
| Total Liabilities | $ | 827,390,435 | $ | 463,411,967 | ||||||||||
| Equity | 176,506,560 | 127,906,539 | ||||||||||||
| Total liabilities and equity | $ | 1,003,896,995 | $ | 591,318,506 | ||||||||||
(1) The stated maturity of the collateral loan obligations per the terms of the underlying collateralized loan obligation agreement is June 14, 2039 for LFT CRE 2021-FL1, Ltd., August 15, 2034 for Hunt CRE 2017-FL1, Ltd. and August 15, 2028 for Hunt CRE 2018-FL2, Ltd.
The following tables present certain loan and borrowing characteristics of LFT CRE 2021-FL1, Ltd. as of December 31, 2021 and Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd.as of December 31, 2020:
| As of December 31, 2021 | ||||||||||||||||||||||||||||||||
| Collateralized Loan Obligations | Count | Principal Value | Carrying Value(1) | Wtd. Avg. Coupon | ||||||||||||||||||||||||||||
| Collateral (loan investments) | 64 | 974,069,994 | 974,025,294 | L + 3.42% | ||||||||||||||||||||||||||||
| Financings provided | 1 | 833,750,000 | 826,782,543 | L + 1.43% | ||||||||||||||||||||||||||||
| As of December 31, 2020 | ||||||||||||||||||||||||||
| Collateralized Loan Obligations | Count | Principal Value | Carrying Value(1) | Wtd. Avg. Coupon | ||||||||||||||||||||||
| Collateral (loan investments) | 40 | 531,363,401 | 531,363,401 | L + 3.50% | ||||||||||||||||||||||
| Financings provided | 2 | 465,316,126 | 463,060,090 | L + 1.44% | ||||||||||||||||||||||
(1) The carrying value for LFT CRE 2021-FL1, Ltd. is net of debt issuance costs of $6,967,457 for December 31, 2021, Hunt CRE 2017-FL1, Ltd. is net of discount of $207,767 for December 31, 2020, and the carrying value for Hunt CRE 2018-FL2, Ltd. is net of debt issuance costs of $2,048,269 for December 31, 2020.
The statement of operations related to LFT 2021-FL1, Ltd., Hunt CRE 2017-FL1, Ltd. and Hunt CRE 2018-FL2, Ltd. at December 31, 2021 and December 31, 2020 include the following income and expense items:
| Statements of Operations | December 31, 2021 | December 31, 2020 | ||||||||||||
| Interest income | $ | 35,506,459 | $ | 32,831,608 | ||||||||||
| Interest expense | 12,178,545 | 12,047,300 | ||||||||||||
| Net interest income | $ | 23,327,914 | $ | 20,784,308 | ||||||||||
| Less: | ||||||||||||||
| Loss on extinguishment of debt | $ | 1,663,926 | $ | — | ||||||||||
| General and administrative fees | 308,718 | 675,624 | ||||||||||||
| Net income | $ | 21,355,270 | $ | 20,108,684 | ||||||||||
NOTE 5 - RESTRICTED CASH
LFT CRE 2021-FL1, Ltd. is actively managed with an initial reinvestment period of 30 months that expires in December 2023. As loans payoff or mature, as applicable, during this reinvestment period, cash received is restricted and intended to be reinvested within LFT CRE 2021-FL1, Ltd. in accordance with the terms and conditions of its respective governing agreement.
NOTE 6 – SECURED TERM LOAN
F-15
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 6 – SECURED TERM LOAN (Continued)
On January 15, 2019, the Company, together with its FOAC and Hunt CMT Equity subsidiaries (together with the Company, the "Credit Parties"), entered into the Secured Term Loan, as amended on February 13, 2019 and July 9, 2020 and April 21, 2021 with the lenders party thereto and Cortland Capital Market
Services, LLC, as administrative agent (in such capacity, the "Agent"), providing for a term facility ("Credit Agreement") to be drawn in an aggregate principal amount of $40.25 million with a maturity of 6 years.
On February 14, 2019, the Company drew on the Secured Term Loan in the aggregate principal amount of $40.25 million generating net proceeds of $39.2 million. The outstanding balance of the Secured Term Loan in the table below is presented gross of deferred financing costs ($904,498 at December 31, 2021 and $693,802 at December 31, 2020). As of December 31, 2021 and December 31, 2020, the outstanding balance and total commitment under the Credit Agreement consisted of the following:
| December 31, 2021 | December 31, 2020 | |||||||||||||||||||||||||
| Outstanding Balance | Total Commitment | Outstanding Balance | Total Commitment | |||||||||||||||||||||||
| Secured Term Loan | $ | 47,750,000 | $ | 47,750,000 | $ | 40,250,000 | $ | 40,250,000 | ||||||||||||||||||
| Total | $ | 47,750,000 | $ | 47,750,000 | $ | 40,250,000 | $ | 40,250,000 | ||||||||||||||||||
The borrowings under the Secured Term Loan are joint and several obligations of the Credit Parties. In addition, the Credit Parties' obligations under the Secured Term Loan are secured by substantially all the assets of the Credit Parties through pledge and security documentation. Amounts advanced under the Secured Term Loan are subject to compliance with a borrowing base comprised of assets of the Credit Parties and certain of their subsidiaries, and include senior and subordinated CRE mortgage loans, preferred equity in CRE assets (directly or indirectly), CRE construction mortgage loans and certain types of equity interests (the "Eligible Assets"). Borrowings under the Secured Term Loan bear interest at a fixed rate of 7.25% for the six-year period following the initial draw-down, which is subject to step up by 0.25% for the first four months after the sixth anniversary of the borrowing of the Senior Secured Term Loan, then by 0.375% for the following four months, then by 0.50% for the last four months until maturity.
In response to the continued COVID-19 pandemic, on July 9, 2020, the Company entered into the Second Amendment to the Credit and Guaranty Agreement. This amendment provides the Company with additional flexibility to effectively manage any potential borrower distress related to COVID-19 that were not originally contemplated in loan documentation.
On April 21, 2021, the Company, together with its Credit Parties, entered into an amendment (the "Third Amendment") to the Credit and Guaranty Agreement. The amendment, among other things, (i) provides the Company with an incremental secured term loan in the aggregate principal amount of $7.5 million; (ii) extends the maturity date of the Secured Term Loan from February 14, 2025 to February 14, 2026; (iii) amends certain asset concentration limits and (iv) amends certain financial covenants. On May 5, 2021 the Third Amendment became effective. On August 23, 2021, the Company drew down the $7.5 million incremental secured term loan.
The Credit Agreement contains affirmative and negative covenants binding the Company and its subsidiaries that are customary for credit facilities of this type, including, but not limited to: minimum asset coverage ratio; minimum unencumbered assets ratio; maximum total net leverage ratio, minimum tangible net worth; and an interest charge coverage ratio. As of December 31, 2021 and December 31, 2020, we were in compliance with these covenants. If the duration of the COVID-19 pandemic continues to prolong, its impact on our borrowers and their tenants could result in a sustained deterioration in a material amount of assets and may impact these covenants.
The Credit Agreement contains events of default that are customary for facilities of this type, including, but not limited to, nonpayment of principal, interest, fees and other amounts when due, violation of covenants, cross default with material indebtedness, and change of control.
NOTE 7 - MSRs
As of December 31, 2021, the Company retained the servicing rights associated with an aggregate principal balance of $91,727,121 of residential mortgage loans that the Company had previously transferred to residential mortgage loan securitization trusts. The Company’s MSRs are held and managed at the Company’s TRS, and the Company employs two licensed sub-servicers to perform the related servicing activities.
The following table presents the Company’s MSR activity as of the years ended December 31, 2021 and December 31, 2020:
| December 31, 2021 | December 31, 2020 | ||||||||||
| Balance at beginning of year | $ | 919,678 | $ | 2,700,207 | |||||||
| Changes in fair value due to: | |||||||||||
| Realized loss | (10,910) | — | |||||||||
| Changes in valuation inputs or assumptions used in valuation model | 109,663 | (634,824) | |||||||||
Other changes to fair value(1) | (466,434) | (1,145,705) | |||||||||
| Balance at end of year | $ | 551,997 | $ | 919,678 | |||||||
Loans associated with MSRs(2) | $ | 91,727,121 | $ | 191,799,159 | |||||||
MSR values as percent of loans(3) | 0.60 | % | 0.48 | % | |||||||
(1)Amounts represent changes due to realization of expected cash flows and prepayment of principal of the underlying loan portfolio.
(2)Amounts represent the unpaid principal balance of loans associated with MSRs outstanding at December 31, 2021 and December 31, 2020, respectively.
F-16
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 7 – MSRs (Continued)
(3)Amounts represent the carrying value of MSRs at December 31, 2021 and December 31, 2020, respectively divided by the outstanding balance of the loans associated with these MSRs.
The following table presents the servicing income recorded on the Company’s consolidated statements of operations for the years ended December 31, 2021 and December 31, 2020:
| Year Ended December 31, 2021 | Year Ended December 31, 2020 | ||||||||||
| Servicing income, net | $ | 398,939 | $ | 709,565 | |||||||
| Income from MSRs, net | $ | 398,939 | $ | 709,565 | |||||||
NOTE 8 - FAIR VALUE
The following tables summarize the valuation of the Company’s assets and liabilities carried at fair value on a recurring basis within the fair value hierarchy levels as of December 31, 2021 and December 31, 2020:
| December 31, 2021 | |||||||||||||||||||||||
Quoted prices in active markets for identical assets Level 1 | Significant other observable inputs Level 2 | Unobservable inputs Level 3 | Balance as of December 31, 2021 | ||||||||||||||||||||
| Assets: | |||||||||||||||||||||||
| Mortgage servicing rights | $ | — | $ | — | $ | 551,997 | $ | 551,997 | |||||||||||||||
| Total | $ | — | $ | — | $ | 551,997 | $ | 551,997 | |||||||||||||||
| December 31, 2020 | |||||||||||||||||||||||
Quoted prices in active markets for identical assets Level 1 | Significant other observable inputs Level 2 | Unobservable inputs Level 3 | Balance as of December 31, 2020 | ||||||||||||||||||||
| Assets: | |||||||||||||||||||||||
| Mortgage servicing rights | $ | — | $ | — | $ | 919,678 | $ | 919,678 | |||||||||||||||
| Total | $ | — | $ | — | $ | 919,678 | $ | 919,678 | |||||||||||||||
As of December 31, 2021 and December 31, 2020, the Company had $551,997 and $919,678, respectively, in Level 3 assets. The Company’s Level 3 assets are comprised of MSRs. For more detail about Level 3 assets, also see Notes 2 and 8.
The following table provides quantitative information about the significant unobservable inputs used in the fair value measurement of the Company’s MSRs classified as Level 3 fair value assets at December 31, 2021 and December 31, 2020:
| As of December 31, 2021 | |||||||||||||||||
| Valuation Technique | Unobservable Input | Range | Weighted Average | ||||||||||||||
| Discounted cash flow | Constant prepayment rate | 10.8 - 29.7% | 19.1 | % | |||||||||||||
| Discount rate | 12.0 | % | 12.0 | % | |||||||||||||
| As of December 31, 2020 | |||||||||||||||||
| Valuation Technique | Unobservable Input | Range | Weighted Average | ||||||||||||||
| Discounted cash flow | Constant prepayment rate | 12.4 - 28.0% | 21.6 | % | |||||||||||||
| Discount rate | 12.0 | % | 12.0 | % | |||||||||||||
As discussed in Note 2, GAAP requires disclosure of fair value information about financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practicable to estimate that value. The following table details the carrying amount, face amount and fair value of the financial instruments described in Note 2:
F-17
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 8 – FAIR VALUE (Continued)
| December 31, 2021 | ||||||||||||||||||||
| Carrying Value | Face Amount | Fair Value | ||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Cash and cash equivalents | $ | 14,749,046 | $ | 14,749,046 | $ | 14,749,046 | ||||||||||||||
| Restricted cash | 3,530,006 | 3,530,006 | 3,530,006 | |||||||||||||||||
| Commercial mortgage loans held-for-investment | 1,001,825,294 | 1,001,869,994 | 1,001,473,884 | |||||||||||||||||
| Total | $ | 1,020,104,346 | $ | 1,020,149,046 | $ | 1,019,752,936 | ||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Collateralized loan obligations | $ | 826,782,543 | $ | 833,750,000 | $ | 834,425,625 | ||||||||||||||
| Secured term loan | 46,845,502 | 47,750,000 | 50,986,154 | |||||||||||||||||
| Total | $ | 873,628,045 | $ | 881,500,000 | $ | 885,411,779 | ||||||||||||||
| December 31, 2020 | ||||||||||||||||||||
| Carrying Value | Face Amount | Fair Value | ||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Cash and cash equivalents | $ | 11,375,960 | $ | 11,375,960 | $ | 11,375,960 | ||||||||||||||
| Restricted cash | 57,999,396 | 57,999,396 | 57,999,396 | |||||||||||||||||
| Commercial mortgage loans held-for-investment | 547,345,334 | 547,345,334 | 547,134,755 | |||||||||||||||||
| Total | $ | 616,720,690 | $ | 616,720,690 | $ | 616,510,111 | ||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Collateralized loan obligations | $ | 463,060,090 | $ | 465,316,126 | $ | 458,094,412 | ||||||||||||||
| Secured term loan | $ | 39,556,198 | $ | 40,250,000 | $ | 44,514,373 | ||||||||||||||
| Total | $ | 502,616,288 | $ | 505,566,126 | $ | 502,608,785 | ||||||||||||||
Estimates of cash and cash equivalents and restricted cash are measured using quoted prices, or Level 1 inputs. Estimates of the fair value of collateralized loan obligations are measured using observable, quoted market prices, in active markets, or Level 2 inputs. All other fair value significant estimates are measured using unobservable inputs, or Level 3 inputs. See Note 2 for further discussion regarding fair value measurement of certain of our assets and liabilities.
NOTE 9 - RELATED PARTY TRANSACTIONS
Management and Incentive Fee
The Company is externally managed and advised by the Manager and through January 3, 2020 by HIM, our prior manager. Pursuant to the terms of the prior management agreement in effect for the year ended December 31, 2019, the Company paid the prior manager a management fee equal to 1.5% of Stockholders' Equity per annum, calculated and payable quarterly (0.375% per quarter) in arrears. For purposes of calculating the management fee, the Company’s stockholders’ equity included the sum of the net proceeds from all issuances of the Company’s equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus the Company’s retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount that the Company paid for repurchases of the Company’s common stock since inception, and excluding any unrealized gains, losses or other items that did not affect realized net income (regardless of whether such items were included in other comprehensive income or loss, or in net income). This amount was adjusted to exclude one-time events pursuant to changes in GAAP and certain non-cash items after discussions between the manager and the Company’s independent directors and approval by a majority of the Company’s independent directors. To the extent an asset impairment reduced the Company’s retained earnings at the end of any completed calendar quarter, it would reduce the management fee for such quarter. The Company’s stockholders’ equity for the purposes of calculating the management fee could be greater than the amount of stockholders’ equity shown on the consolidated financial statements. Additionally, under the terms of the prior management agreement, starting in the first full calendar quarter following January 18, 2019, the Company was also required to pay the Manager a quarterly incentive fee equal to 20% of the excess of Core Earnings (as defined in the management agreement) over the product of (i) Stockholders' Equity as of the end of such fiscal quarter, and (ii) 8% per annum.
On January 3, 2020, the management agreement in effect for the year ended December 31, 2019 was terminated, and a new management agreement with the Manager became effective. Pursuant to the terms of the new management contract, the Company is required to pay the Manager an annual base management fee of 1.50% of Stockholders' Equity (as defined in the management agreement), payable quarterly (0.375% per quarter) in arrears. The definition of stockholders' equity in the new management agreement is materially unchanged from the definition in the prior management agreement. Additionally,
F-18
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 9 – RELATED PARTY TRANSACTIONS (Continued)
starting in the first full calendar quarter following January 3, 2020, the Company is also required to pay the Manager a quarterly incentive fee equal to 20% of the excess of Core Earnings (as defined in the management agreement) over the product of (i) the Stockholders' Equity as of the end of such fiscal; quarter, and (ii) 8% per annum.
For the year ended December 31, 2021, the Company incurred management fees of $2,909,368 (2020: $2,351,562), recorded as "Management and incentive fees" in the consolidated statement of operations, of which $796,000 (2020: $588,000) was accrued but had not been paid, included in "Fees and expenses payable to Manager" in the consolidated balance sheets.
For the year ended December 31, 2021, the Company incurred incentive fees of $132,232 (2020: $172,577), recorded as "Management and incentive fees" in the consolidated statement of operations, of which $132,232 (2020: $172,577) was accrued but had not yet been paid, included in "Fees and expenses payable to Manager" in the consolidated balance sheets.
Expense Reimbursement
Pursuant to the management agreement, the Company is required to reimburse the Manager for operating expenses related to the Company incurred by the Manager, including accounting, auditing and tax services, technology and office facilities, operations, compliance, legal and filing fees, and miscellaneous general and administrative costs, including the cost of non-investment management personnel of the Manager who spend all or a portion of their time managing the Company’s affairs. The Manager has agreed to certain limitations on manager expense reimbursement from the Company.
On March 18, 2019, the Company entered into a support agreement with the prior manager, pursuant to which, the prior manager agreed to reduce the reimbursement cap by 25% per annum (subject to such reduction not exceeding $568,000 per annum) until such time as the aggregate support provided thereunder equaled approximately $1.96 million. Pursuant to the terms of the new management agreement, the terms of the support agreement are unchanged.
For the year ended December 31, 2021, the Company incurred reimbursable expenses of $2,038,130 (2020: $1,644,886) recorded as "operating expenses reimbursable to Manager" in the consolidated statement of operations, of which $724,333 (2020: $395,763) was accrued but had not yet been paid, included in "fees and expenses payable to Manager" in the consolidated balance sheets. Per the management agreement, any exit fees waived by the Company as a result of permanent financing by the Manager or any of its affiliates shall result in a reduction to reimbursed expenses by an amount equal to 50% of the amount of any such waived exit fee. For the year ended December 31, 2021, the Company waived $302,952 of reimbursable expense and for the year ended December 31, 2020, the Company waived $118,786 of reimbursable expense.
Manager Equity Plan
The Company has in place a Manager Equity Plan under which the Company may compensate the Manager and the Company's independent directors or consultants, or officers whom it may employ in the future. In turn, the Manager, in its sole discretion, grants such awards to its directors, officers employees or consultants. The Company is able to issue under the Manager Equity Plan up to 3.0% of the total number of issued and outstanding shares of common stock (on a fully diluted basis) at the time of each award. Stock based compensation arrangements may include incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock, restricted stock units, unrestricted stock awards and other awards based on the Company's common stock.
The following table summarizes the activity related to restricted common stock for the years ended December 31, 2021 and 2020:
| Year Ended December 31, | |||||||||||||||||||||||
| 2021 | 2020 | ||||||||||||||||||||||
| Shares | Weighted Average Grant Date Fair Market Value | Shares | Weighted Average Grant Date Fair Market Value | ||||||||||||||||||||
| Outstanding Unvested Shares at Beginning of Period | 4,500 | $ | 2.60 | 4,500 | $ | 3.33 | |||||||||||||||||
| Granted | 4,500 | 4.18 | 4,500 | 2.60 | |||||||||||||||||||
| Vested | (4,500) | 2.60 | (4,500) | 3.33 | |||||||||||||||||||
| Outstanding Unvested Shares at End of Period | 4,500 | $ | 4.18 | 4,500 | $ | 2.60 | |||||||||||||||||
For the year ended December 31, 2021, the Company recognized compensation expense related to restricted common stock of $15,608 (2020: $20,292). The Company has unrecognized compensation expense of $8,555 as of December 31, 2021 (2020: $5,353) for unvested shares of restricted common stock. As of December 31, 2021, the weighted average period for which the unrecognized compensation expense will be recognized is 5.5 months.
OREC Structured Finance Co, LLC dba Lument Structured Finance
During the year ended December 31, 2021, (a) Hunt CRE 2018-FL2, Ltd. purchased nine loans with an aggregate unpaid principal balance of $102.7 million at par from OREC Structured Finance, LLC d/b/a Lument Structured Finance ("LSF"), an affiliate of our Manager; (b) Lument Commercial Mortgage Trust ("LCMT") purchased two loans with an aggregate unpaid principal balance of $21.2 million and twenty funded loan participations with an aggregate unpaid principal balance of $42.3 million at par from LSF and (c) LFT CRE 2021-FL1, Ltd. purchased forty-four loans with an aggregate unpaid principal balance of $700.1 million at par from LSF.
During the year ended December 31, 2020, (a) Hunt CRE 2017-FL1, Ltd. purchased two loans with an aggregate unpaid principal balance of $31.9 million at par from LSF; (b) Hunt CRE 2018-FL2, Ltd. purchased two loans with an aggregate unpaid principal balance of $14.4 million at par from LSF and (c) Hunt CRE 2017-FL1, Seller, LLC funded fifty-eight loan participations with an aggregate unpaid principal balance of $11.2 million at par from LSF.
F-19
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 9 – RELATED PARTY TRANSACTIONS (Continued)
OREC 2018-CRE1, Ltd.
During the year ended December 31, 2021, LFT CRE 2021-FL1, Ltd. purchased nine loans with an aggregate unpaid principal balance of $112.5 million at a premium of $0.35 million from OREC 2018-CRE1, Ltd., an affiliate of our Manager.
ORIX Real Estate Holdings, LLC
During the year ended December 31, 2021, LFT CRE 2021-FL1, Ltd. purchased eight loans with an aggregate unpaid principal balance of $4.6 million at a premium of $0.02 million from ORIX Real Estate Holdings, LLC, an affiliate of our Manager.
ORIX Real Estate Capital, LLC
ORIX Real Estate Capital, LLC d/b/a Lument Capital ("OREC"), an affiliate of our Manager, was appointed the servicer and special servicer with respect to mortgage assets for LFT CRE 2021-FL1, Ltd.
Lument IM
Lument IM was appointed as the collateral manager with respect to LFT CRE 2021-FL1. Ltd. Lument IM has agreed to waive all its entitlements to collateral management fees for so long as Lument IM or an affiliate is the collateral manager and also the manager of Lument Finance Trust, Inc.
Hunt Companies, Inc.
One of the Company's directors is also Chief Executive Officer and President of Hunt Companies, Inc. ("Hunt") and is a member of the Hunt Board of Directors, with which affiliates of the Manager have a commercial business relationship. The Manager's affiliates may from time to time sell commercial mortgage loans to Hunt or various of its subsidiaries and affiliates.
NOTE 10 - GUARANTEES
The Company, through FOAC, is party to customary and standard loan repurchase obligations in respect of residential mortgage loans that it has sold into securitizations or to third parties, to the extent it is determined that there has been a breach of standard seller representations and warranties in respect of such loans. To date, the Company has not been required to repurchase any loan due to a claim of breached seller reps and warranties.
In July 2016, the Company announced that it would no longer aggregate and securitize residential mortgage loans; however, the Company sought to capitalize on its infrastructure and knowledge to become the provider of seller eligibility review and backstop services to MAXEX. MAXEX’s wholly owned clearinghouse subsidiary, MAXEX Clearing LLC, formerly known as Central Clearing and Settlement LLC ("MAXEX Clearing LLC") functions as the central counterparty with which buyers and sellers transact, and acts as the buyer’s counterparty for each transaction. Pursuant to a Master Agreement dated June 15, 2016, as amended August 29, 2016, January 30, 2017 and June 27, 2018, among MAXEX, MAXEX Clearing LLC and FOAC (the "Master Agreement") FOAC provided seller eligibility review services under which it reviewed, approved and monitored sellers that sold loans via MAXEX Clearing LLC. Once approved, and having signed the standardized loan sale contract, the seller sold loan(s) to MAXEX Clearing LLC, and MAXEX Clearing LLC simultaneously sold loan(s) to the buyer on substantially the same terms including representations and warranties. The Master Agreement was terminated on November 28, 2018 (the "MAXEX Termination Date"). To the extent that a seller approved by FOAC prior to the MAXEX Termination Date failed to honor its obligations to repurchase a loan based on an arbitration finding that it breached its representations and warranties, FOAC was obligated to backstop the seller’s repurchase obligation. The term of the backstop guarantee is the earlier of the contractual maturity of the underlying mortgage, or its earlier repayment in full; however, the incidence of claims for breaches of representations and warranties over time is considered unlikely to occur more than five years from the sale of a mortgage. FOAC's obligation to provide further seller eligibility review and backstop guarantee services terminated on the MAXEX Termination Date. Pursuant to an Assumption Agreement dated December 31, 2018, among MAXEX Clearing LLC and FOAC, MAXEX Clearing LLC assumed all of FOAC's obligations under its backstop guarantees and agreed to indemnify and hold FOAC harmless against any losses, liabilities, costs, expenses and obligations under the backstop guarantee. FOAC paid MAXEX Clearing LLC, as the replacement backstop provider, a fee of $426,770 (the "Alternative Backstop Fee"). MAXEX Clearing LLC represented to FOAC in the Assumption Agreement that it (i) is rated at least "A" (or equivalent) by at least one nationally recognized statistical rating agency or (ii) has (a) adjusted tangible net worth of at least $20,000,000 and (b) minimum available liquidity equal to the greater of (x) $5,000,000 and (y) 0.1% multiplied by the scheduled unpaid principal balance of each outstanding loan covered by the backstop guarantees. MAXEX's chief financial officer is required to certify ongoing compliance by MAXEX Clearing LLC with the aforementioned criteria on a quarterly basis and if MAXEX Clearing LLC fails to satisfy such criteria, MAXEX Clearing LLC is required to deposit into an escrow account for FOAC's benefit an amount equal to the greater of (A) the unamortized Alternative Backstop Fee for each outstanding loan covered by the backstop guarantee and (B) the product of 0.01% multiplied by the scheduled unpaid principal balance of each outstanding loan covered by the backstop guarantees.
The maximum potential amount of future payments that the Company could be required to make under the outstanding backstop guarantees, which represents the outstanding balance of all underlying mortgage loans sold by approved sellers to MAXEX Clearing LLC, was estimated to be $348.0 million and $860.5 million as of December 31, 2021 and December 31, 2020, respectively, although the Company believes this amount is not indicative of the Company's actual potential losses. Amounts payable in excess of the outstanding principal balance of the related mortgage, for example any premium paid by the loan buyer or costs associated with collecting mortgage payments, are not currently estimable. Amounts that may become payable under the backstop guarantee are normally recoverable from the related seller, as well as from any payments received on (or from the sale of property securing) the mortgage loan repurchased and, as noted above, MAXEX Clearing LLC has assumed all of FOAC's obligations in respect of its backstop guarantees. Pursuant to the Master Agreement, FOAC is required to maintain minimum available liquidity equal to the greater of (i) $5.0 million or (ii) 0.10% of the aggregate unpaid principal balance of loans backstopped by FOAC, either directly or through a credit support agreement acceptable by MAXEX. As of December 31, 2021, the Company was not aware of any circumstances expected to lead to the triggering of a backstop guarantee obligation.
In addition, the Company enters into certain contracts that contain a variety of indemnification obligations, principally with the Manager, brokers and counterparties to repurchase agreements. The maximum potential future payment amount the Company could be required to pay under these indemnification
F-20
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 10 – GUARANTEES (Continued)
obligations is unlimited. The Company has not incurred any costs to defend lawsuits or settle claims related to the indemnification obligations. As a result, the estimated fair value of these agreements is minimal. Accordingly, the Company recorded no liabilities for these agreements as of December 31, 2021.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
Impact of COVID-19
As further discussed in Note 2, the full extent of the impact of COVID-19 on the global economy generally, and our business in particular, remains uncertain. As of December 31, 2021, no contingencies have been recorded on our balance sheet as a result of COVID-19, however as the global pandemic continues, it may have long-term impacts on our financial condition, results of operations and cash flows. Refer to Note 2 for further discussion of COVID-19.
Unfunded Commitments
As of December 31, 2021, LSF, an affiliate of the Manager, had $78.4 million of unfunded commitments related to loans held in LFT 2021-FL1, Ltd. These commitments are not reflected in the Company's consolidated balance sheets.
As of December 31, 2021, LSF, an affiliate of the Manager, had $4.7 million of unfunded commitments related to loans held in LCMT. These commitments are not reflected in the Company's consolidated balance sheets.
As of December 31, 2020, LSF, an affiliate of the Manager, had $5.6 million in funded commitments and $24.6 million of unfunded commitments related to loans held in Hunt CRE 2017-FL1, Ltd. that the Company could be required to purchase from LSF under the Future Funding Participation Transfer. These commitments are not reflected on the Company's consolidated balance sheets.
As of December 31, 2020, LSF, an affiliate of the Manager, had $25.8 million of unfunded commitments related to loans held in Hunt CRE 2018-FL2, Ltd. These commitments are not reflected on the Company's consolidated balance sheets.
Future loan fundings comprise funding for capital improvements, leasing costs, interest and carry costs, and fundings will vary depending on the progress of the business plan and cash flows at the mortgage assets. Therefore, the exact timing and amounts of such future loan fundings are uncertain and will depend on the current and future performance of the underlying mortgage assets. Due to the ongoing COVID-19 pandemic, the progress of capital improvements and leasing is anticipated to be slower than otherwise expected, and, as such the pace of future funding relating to these capital needs may be commensurately lower.
NOTE 12 – EQUITY
Common Stock
The Company has 450,000,000 authorized shares of common stock, par value $0.01 per share, with 24,947,883 and 24,943,383 shares issued and outstanding as of December 31, 2021 and December 31, 2020, respectively.
On January 3, 2020, the Company issued 1,246,719 shares of common stock to an affiliate of the Manager in a private placement at a purchase price of $4.61 per share resulting in aggregate net proceeds of $5.7 million.
Stock Repurchase Program
On December 15, 2015, the Company’s board of directors authorized a stock repurchase program (or the "Repurchase Program"), to repurchase up to $10 million of the Company’s outstanding common stock. Shares of the Company’s common stock may be purchased in the open market, including through block purchases, or through privately negotiated transactions, or pursuant to any trading plan that may be adopted in accordance with Rule 10b18(b)(1) of the Securities Exchange Act of 1934, as amended. The timing, manner, price and amount of any repurchases will be determined at the Company’s discretion and the program may be suspended, terminated or modified at any time for any reason. Among other factors, the Company intends to only consider repurchasing shares of the Company’s common stock when the purchase price is less than the Company’s estimate of the Company’s current net asset value per common share. Shares of common stock repurchased by the Company under the Repurchase Program, if any, will be canceled and, until reissued by the Company, will be deemed to be authorized but unissued shares of the Company’s common stock. Through December 31, 2021, the Company had repurchased 126,856 shares of common stock at a weighted average share price of $5.09. No share repurchases have been made since January 19, 2016. As of December 31, 2021, $9.4 million of common stock remained authorized for future share repurchase under the Repurchase Program.
Preferred Stock
At December 31, 2021 and December 31, 2020, the Company was authorized to issue up to 50,000,000 shares of preferred stock, par value $0.01 per share, with 2,400,000 shares of Series A Preferred Stock issued and outstanding as of December 31, 2021, and no shares of preferred stock issued and outstanding at December 31, 2020. Voting and other rights and preferences will be determined by the Company's Board of Directors upon issuance.
On May 5, 2021, LFT issued 2,400,000 shares of Series A Preferred Stock, and received net proceeds, after underwriting discounts and commissions but before offering expenses payable by the Company, of $58.1 million. The Series A Preferred Stock is redeemable, at LFT's option, at a liquidation preference price of $25.00 per share plus accrued dividends commencing on May 5, 2026. Dividends on Series A Preferred Stock are payable quarterly in arrears beginning on July 15, 2021.
Distributions to stockholders
For the 2021 taxable year to date, the Company has declared dividends to common stockholders totaling $8,980,832, or $0.36 per share. The following table presents cash dividends declared by the Company on its common stock for the year ended December 31, 2021:
F-21
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 12 – EQUITY (Continued)
| Declaration Date | Record Date | Payment Date | Dividend Amount | Cash Dividend Per Weighted Average Share | ||||||||||||||||||||||
| March 15, 2021 | March 31, 2021 | April 15, 2021 | $ | 2,244,904 | $ | 0.090 | ||||||||||||||||||||
| June 15, 2021 | June 30, 2021 | July 15, 2021 | $ | 2,245,309 | $ | 0.090 | ||||||||||||||||||||
| September 15, 2021 | September 30, 2021 | October 15, 2021 | $ | 2,245,310 | $ | 0.090 | ||||||||||||||||||||
| December 15, 2021 | December 31, 2021 | January 15, 2022 | $ | 2,245,309 | $ | 0.090 | ||||||||||||||||||||
The following table presents cash dividends declared by the Company on its Series A Preferred stock for the year ended December 31, 2021:
| Declaration Date | Record Date | Payment Date | Dividend Amount | Cash Dividend Per Weighted Average Share | ||||||||||||||||||||||
| June 15, 2021 | July 1, 2021 | July 15, 2021 | $ | 918,750 | $ | 0.38281 | ||||||||||||||||||||
| September 15, 2021 | October 1, 2021 | October 15, 2021 | $ | 1,181,250 | $ | 0.49219 | ||||||||||||||||||||
| December 15, 2021 | January 1, 2022 | January 15, 2022 | $ | 1,181,250 | $ | 0.49219 | ||||||||||||||||||||
Non-controlling interests
On November 29, 2018, Lument Commercial Mortgage Trust, Inc. ("LCMT"), formerly known as Hunt Commercial Mortgage Trust ("HCMT"), an indirect wholly-owned subsidiary of the Company that has elected to be taxed as a REIT issued 125 shares of Series A Preferred Shares ("LCMT Preferred Shares"). Net proceeds to LCMT were $99,500 representing $125,000 in equity raised, less $25,500 in expenses and is reflected as "Non-controlling interests" in the Company’s consolidated balance sheets. Dividends on the LCMT Preferred Shares are cumulative annually, in an amount equal to 12% of the initial purchase price plus any accrued unpaid dividends. The LCMT Preferred Shares are redeemable at any time by LCMT. The redemption price through December 31, 2020 was 1.1x the initial purchase price plus all accrued and unpaid dividends, and the initial purchase price plus all accrued and unpaid dividends thereafter. The holders of the LCMT Preferred Shares have limited voting rights, which do not entitle the holders to participate or otherwise direct the management of LCMT or the Company. The LCMT Preferred Shares are not convertible into or exchangeable for any other property or securities LCMT or the Company. Dividends on the LCMT Preferred Shares, which amounted to $15,000 for the year ended December 31, 2021 and $15,000 for the year ended December 31, 2020, are reflected in "Dividends to preferred stockholders" in the Company’s consolidated statements of operations.
NOTE 13 – EARNINGS PER SHARE
In accordance with ASC 260, outstanding instruments that contain rights to non-forfeitable dividends are considered participating securities. The Company is required to apply the two-class method or the treasury stock method of computing basic and diluted earnings per share when there are participating securities outstanding. The Company has determined that outstanding unvested restricted shares issued under the Manager Equity Plan are participating securities, and they are therefore included in the computation of basic and diluted earnings per share. The following tables provide additional disclosure regarding the computation for the years ended December 31, 2021 and December 31, 2020:
| Year Ended December 31, 2021 | Year Ended December 31, 2020 | ||||||||||||||||||||||
| Net income | $ | 10,527,222 | $ | 8,449,770 | |||||||||||||||||||
| Less dividends expense: | |||||||||||||||||||||||
| Common stock | $ | 8,980,832 | $ | 9,103,997 | |||||||||||||||||||
| Preferred stock | 3,112,500 | 15,000 | |||||||||||||||||||||
| 12,093,332 | 9,118,997 | ||||||||||||||||||||||
| Undistributed earnings (deficit) | $ | (1,566,110) | $ | (669,227) | |||||||||||||||||||
Unvested Share-Based Payment Awards | Common Stock | Unvested Share-Based Payment Awards | Common Stock | ||||||||||||||||||||
| Distributed earnings | $ | 0.36 | $ | 0.36 | $ | 0.37 | $ | 0.37 | |||||||||||||||
| Undistributed earnings (deficit) | $ | — | $ | (0.06) | — | (0.03) | |||||||||||||||||
| Total | $ | 0.36 | $ | 0.30 | $ | 0.37 | $ | 0.34 | |||||||||||||||
| For the years ended December 31, | ||||||||||||||
| 2021 | 2020 | |||||||||||||
| Basic weighted average shares of common stock outstanding | 24,941,324 | 24,930,079 | ||||||||||||
| Weighted average of non-vested restricted stock | 4,500 | 4,426 | ||||||||||||
| Diluted weighted average shares of common stock outstanding | 24,945,824 | 24,934,505 | ||||||||||||
NOTE 14 – SEGMENT REPORTING
F-22
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 14 – SEGMENT REPORTING (Continued)
The Company invests in a portfolio comprised of commercial mortgage loans and other mortgage-related investments and operates as a single reporting segment.
NOTE 15 - INCOME TAXES
The Company has elected to be treated as a REIT under federal income tax laws. As a REIT, the Company must generally distribute annually at least 90% of our taxable income, subject to certain adjustments and excluding any net capital gain, in order for U.S. federal income not to apply to our earnings that we distribute. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our net taxable income, we will be subject to U.S. federal income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less that a minimum amount specified under U.S. federal tax laws.
Certain activities of the Company that produce prohibited income are conducted through a TRS, FOAC, to protect REIT election and FOAC is therefore subject to tax as a U.S. C-Corporation. To maintain our REIT election, the Company must continue to meet certain ownership, asset and income requirements set forth in the Code. As further discussed below, the Company may be subject to non-income taxes on excess amounts of assets or income that cause a failure of any of the REIT testing requirements. As of December 31, 2021 and 2020, we were in compliance with all REIT requirements.
The following table presents our provision for income taxes:
| Year Ended December 31, | ||||||||||||||
| 2021 | 2020 | |||||||||||||
| Deferred tax (benefit) | $ | 77,894 | $ | (476,248) | ||||||||||
| Provision for income tax (benefit) | $ | 77,894 | $ | (476,248) | ||||||||||
The following is a reconciliation of our effective income tax rate as a percentage of pre-tax income to the U.S. federal statutory rate, for the years ended December 31, 2021 and 2020:
| Year Ended December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| U.S. federal statutory income tax | 21.0 | % | 21.0 | % | |||||||
| REIT income not subject to federal income tax | (21.4) | % | (24.6) | % | |||||||
| State and local income taxes, net of federal tax benefit | (0.2) | % | (1.6) | % | |||||||
| Return to provision | (0.1) | % | (0.8) | % | |||||||
| Effective income tax rate | (0.7) | % | (6.0) | % | |||||||
The differences between the Company's statutory rate and effective rate are largely determined by the amount of income subject to tax by the Company's TRS subsidiary. The Company expects that its future effective tax rate will be determined in a similar manner.
As of December 31, 2021 and 2020, the Company's net deferred tax assets were $1.3 million and $1.4 million, respectively, and are included in other assets in the Company's consolidated balance sheets. The Company believes it is more likely than not that the deferred tax assets will be realized in the future. Realization of the net deferred tax assets is dependent on our generation of sufficient taxable income in future years in appropriate tax jurisdictions to obtain benefit from the reversal of temporary difference. The amount of deferred tax assets considered realizable is subject to adjustment in future periods of future taxable income change.
The TRS has a deferred tax asset , comprised of the following:
| As of December 31, 2021 | As of December 31, 2020 | ||||||||||
| Accumulated net operating losses of TRS | $ | 985,917 | $ | 993,683 | |||||||
| Mortgage servicing rights | $ | 261,440 | $ | 319,048 | |||||||
| Capitalized transaction costs | $ | 93,903 | $ | 106,423 | |||||||
| Net non-current deferred tax asset | $ | 1,341,260 | $ | 1,419,154 | |||||||
At December 31, 2021, and 2020, the TRS had net operating loss carryforwards for federal income tax purposes of $3.2 million and $3.3 million, which are available to offset future taxable income and begin expiring in 2034.
As of December 31, 2021, the Company has concluded that there are no material uncertain tax positions requiring recognition in the Company's consolidated financial statements. As of December 31, 2021, tax years 2018 through 2021 remain subject to examination by taxing authorities.
REIT Qualification
During tax years 2020 and 2021 the Company passed all the requisite ownership, asset and income tests.
NOTE 16 - SUBSEQUENT EVENTS
F-23
LUMENT FINANCE TRUST, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2021
NOTE 16 – SUBSEQUENT EVENTS (Continued)
On February 22, 2022, the Company closed a transferable common stock rights offering. The Company issued and sold 27,277,269 shares of common stock. for gross proceeds of approximately $83.5 million
On February 22, 2022, the Company, together with its Credit Parties, entered into an amendment (the "Fourth Amendment") to the Credit and Guaranty Agreement. This amendment waives the step-down provisions of the maximum total net leverage financial covenant in connection with the February 2022 rights offering.
F-24
Schedule IV – Mortgage Loans on Real Estate
As of December 31, 2021
Type of Loan/Borrower Senior Mortgage Loans(1) | Description/Location | Interest(2) Payment Rates | Extended Maturity Date(3) | Periodic Payment Terms(4) | Prior Liens(5) | Unpaid Principal Balance | Carrying Amount of Loans | |||||||||||||||||||||||||||||||||||||
| Senior Loans in excess of 3% of the carrying amount of total loans | ||||||||||||||||||||||||||||||||||||||||||||
| Borrower A | Multifamily /VA | L+4.30% | 2024 | I/O | $ | — | $ | 36,781,588 | $ | 36,781,588 | ||||||||||||||||||||||||||||||||||
| Borrower B | Multifamily / NJ | L+4.05% | 2026 | I/O | — | 34,690,000 | 34,690,000 | |||||||||||||||||||||||||||||||||||||
| Borrower C | Multifamily / GA | L+3.25% | 2024 | I/O | — | 33,500,000 | 33,500,000 | |||||||||||||||||||||||||||||||||||||
| Borrower D | Multifamily / TN | L+3.65% | 2026 | I/O | — | 33,360,000 | 33,360,000 | |||||||||||||||||||||||||||||||||||||
| Borrower E | Multifamily /FL | L+2.75% | 2026 | I/O | — | 30,576,666 | 30,576,666 | |||||||||||||||||||||||||||||||||||||
| Senior Loans less than 3% of the carrying amount of total loans | ||||||||||||||||||||||||||||||||||||||||||||
| Senior Loan | Multifamily / Diversified | L+2.90% - 7.50% | 2022 - 2027 | I/O | $ | — | $ | 752,255,325 | $ | 752,272,465 | ||||||||||||||||||||||||||||||||||
| Senior Loan | Office / IL | L+3.75% | 2023 | I/O | — | 11,748,199 | 11,748,199 | |||||||||||||||||||||||||||||||||||||
| Senior Loan | Retail / TX | L+4.10% | 2023 | I/O | — | 17,172,623 | 17,172,623 | |||||||||||||||||||||||||||||||||||||
| Senior Loan | Self-Storage / Diversified | L+3.60% - 4.75% | 2024 - 2025 | I/O | — | 51,785,593 | 51,723,753 | |||||||||||||||||||||||||||||||||||||
| Total senior loans | $ | — | $ | 1,001,869,994 | $ | 1,001,825,294 | ||||||||||||||||||||||||||||||||||||||
(1)Includes senior mortgage loans and pari passu participations in senior mortgage loans.
(2)L = one-month LIBOR rate
(3)Extended maturity date assumes all extension options are exercised
(4)I/O = interest only
(5)Represents only third party liens
1.Reconciliation of Mortgage Loans on Real Estate
The following table reconciles activity regarding mortgage loans on real estate for the years ended:
| 2021 | 2020 | |||||||||||||
| Balance at January 1, | $ | 547,345,334 | $ | 635,260,420 | ||||||||||
| Additions during period: | ||||||||||||||
| Mortgage loans purchased | 983,694,326 | 57,601,572 | ||||||||||||
| Deductions during period | ||||||||||||||
| Mortgage loan repayments | (528,802,705) | (145,516,658) | ||||||||||||
| Accretion of purchase discount | $ | 46,088 | $ | — | ||||||||||
| Amortization of purchase premium | $ | (457,749) | $ | — | ||||||||||
| Balance at December 31, | $ | 1,001,825,294 | $ | 547,345,334 | ||||||||||
F-25
