-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DYMx3/f+7/ERFOAPQKI/RYOULWNsx94JLoMvvShC5NJ8T7sluTiKvsPclkU9jrrH JF4ymo4Fj4SvVZj+lXl2gA== 0000950134-99-009972.txt : 19991115 0000950134-99-009972.hdr.sgml : 19991115 ACCESSION NUMBER: 0000950134-99-009972 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMRESCO CAPITAL TRUST CENTRAL INDEX KEY: 0001054337 STANDARD INDUSTRIAL CLASSIFICATION: ASSET-BACKED SECURITIES [6189] IRS NUMBER: 752744858 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-14029 FILM NUMBER: 99751215 BUSINESS ADDRESS: STREET 1: 700 NORTH PEARL STREET STREET 2: SUITE 2400 LB 342 CITY: DALLAS STATE: TX ZIP: 75201 BUSINESS PHONE: 2149537700 MAIL ADDRESS: STREET 1: 700 NORTH PEARL STREET STREET 2: SUITE 2400 LB 342 CITY: DALLAS STATE: TX ZIP: 75201 10-Q 1 FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 1999 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 1-14029 AMRESCO CAPITAL TRUST (Exact name of Registrant as specified in its charter) TEXAS 75-2744858 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 700 N. PEARL STREET, SUITE 2400, LB 342, DALLAS, TEXAS 75201-7424 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (214) 953-7700 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 10,015,111 shares of common stock, $.01 par value per share, as of November 1, 1999. 2 AMRESCO CAPITAL TRUST INDEX
Page No. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) Consolidated Balance Sheets - September 30, 1999 and December 31, 1998 ................................. 3 Consolidated Statements of Income - For the Three and Nine Months Ended September 30, 1999, the Three Months Ended September 30, 1998 and the Period from February 2, 1998 (Date of Initial Capitalization) through September 30, 1998............................................................................ 4 Consolidated Statement of Changes in Shareholders' Equity - For the Nine Months Ended September 30, 1999.................................................................................... 5 Consolidated Statements of Cash Flows - For the Nine Months Ended September 30, 1999 and the Period from February 2, 1998 (Date of Initial Capitalization) through September 30, 1998.............. 6 Notes to Consolidated Financial Statements.............................................................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............ 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................... 29 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K................................................................. 31 SIGNATURE ................................................................................................ 32
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AMRESCO CAPITAL TRUST CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
September 30, 1999 December 31, (unaudited) 1998 ------------ ------------ ASSETS Mortgage loans held for investment, net ........................................... $ 124,080 $ 96,976 Acquisition, development and construction loan arrangements accounted for as real estate or investments in joint ventures ........................................ 42,144 39,550 ------------ ------------ Total loan investments ............................................................ 166,224 136,526 Allowance for loan losses ......................................................... (2,690) (1,368) ------------ ------------ Total loan investments, net of allowance for losses ............................... 163,534 135,158 Commercial mortgage-backed securities - available for sale (at fair value) ........ 26,027 28,754 Real estate, net of accumulated depreciation of $572 and $56, respectively ........ 50,650 10,273 Investments in unconsolidated partnerships and subsidiary ......................... 11,773 3,271 Receivables and other assets ...................................................... 5,435 3,681 Cash and cash equivalents ......................................................... 3,794 9,789 ------------ ------------ TOTAL ASSETS ................................................................... $ 261,213 $ 190,926 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Accounts payable and other liabilities ............................................. $ 2,696 $ 941 Amounts due to affiliates .......................................................... 6,383 6,268 Repurchase agreement ............................................................... 10,701 -- Line of credit ..................................................................... 78,500 39,338 Non-recourse debt on real estate ................................................... 34,600 7,500 Dividends payable .................................................................. -- 4,002 ------------ ------------ TOTAL LIABILITIES .............................................................. 132,880 58,049 ------------ ------------ Minority interests ................................................................. 500 2,611 ------------ ------------ COMMITMENTS AND CONTINGENCIES (NOTE 3) SHAREHOLDERS' EQUITY: Preferred stock, $.01 par value, 49,650,000 shares authorized, no shares issued .... -- -- Series A junior participating preferred stock, $.01 par value, 350,000 shares authorized, no shares issued ................................................... -- -- Common stock, $.01 par value, 200,000,000 shares authorized, 10,015,111 and 10,006,111 shares issued and outstanding, respectively ......................... 100 100 Additional paid-in capital ......................................................... 140,998 140,941 Unearned stock compensation ........................................................ (359) (848) Accumulated other comprehensive income (loss) ...................................... (9,341) (6,475) Distributions in excess of accumulated earnings .................................... (3,565) (3,452) ------------ ------------ TOTAL SHAREHOLDERS' EQUITY ..................................................... 127,833 130,266 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY ..................................... $ 261,213 $ 190,926 ============ ============
See notes to consolidated financial statements 3 4 AMRESCO CAPITAL TRUST CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
Period from February 2, Three Months Ended Nine Months 1998 September 30, Ended through ----------------------- September 30, September 30, 1999 1998 1999 1998 ---------- ---------- ---------- ---------- Revenues: Interest income on mortgage loans ................................... $ 3,841 $ 1,188 $ 10,776 $ 1,328 Income from commercial mortgage-backed securities ................... 905 560 2,753 597 Operating income from real estate ................................... 1,416 91 2,593 108 Equity in earnings of unconsolidated subsidiary, partnerships and other real estate ventures ........................................ 63 326 197 486 Interest income from short-term investments ......................... 76 827 198 1,734 ---------- ---------- ---------- ---------- Total revenues .................................................... 6,301 2,992 16,517 4,253 ---------- ---------- ---------- ---------- Expenses: Interest expense .................................................... 1,769 1 3,427 1 Management fees ..................................................... 610 439 1,613 632 General and administrative .......................................... 338 755 1,120 953 Depreciation ........................................................ 408 21 705 24 Participating interest in mortgage loans ............................ 190 3 1,019 3 Provision for loan losses ........................................... 642 501 1,822 611 ---------- ---------- ---------- ---------- Total expenses .................................................... 3,957 1,720 9,706 2,224 ---------- ---------- ---------- ---------- Income before gains ................................................... 2,344 1,272 6,811 2,029 Gain associated with repayment of ADC loan arrangement ............. -- -- 584 -- ---------- ---------- ---------- ---------- Net income ............................................................ $ 2,344 $ 1,272 $ 7,395 $ 2,029 ========== ========== ========== ========== Earnings per common share: Basic .............................................................. $ 0.24 $ 0.12 $ 0.74 $ 0.34 ========== ========== ========== ========== Diluted ............................................................ $ 0.24 $ 0.12 $ 0.74 $ 0.34 ========== ========== ========== ========== Weighted average number of common shares outstanding: Basic .............................................................. 10,000 10,000 10,000 5,892 ========== ========== ========== ========== Diluted ............................................................ 10,016 10,006 10,011 5,896 ========== ========== ========== ==========
See notes to consolidated financial statements. 4 5 AMRESCO CAPITAL TRUST CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 (UNAUDITED; IN THOUSANDS, EXCEPT SHARE DATA)
Common Stock $.01 Par Value Accumulated Distributions ------------------- Additional Unearned Other in Excess of Total Number of Paid-in Stock Comprehensive Accumulated Shareholders' Shares Amount Capital Compensation Income (Loss) Earnings Equity ----------- ------ --------- ------------ ------------- ----------- ---------- Balance at January 1, 1999....... 10,006,111 $ 100 $ 140,941 $ (848) $ (6,475) $ (3,452) $ 130,266 Issuance of trust managers' restricted shares.............. 9,000 -- 91 (91) -- Issuance of warrants............. 400 400 Decrease in fair value of compensatory options .......... (434) 434 -- Amortization of unearned trust manager compensation........... 68 68 Amortization of compensatory options ....................... 78 78 Dividends declared ($0.75 per common share)....... (7,508) (7,508) Unrealized loss on securities available for sale............. (2,866) (2,866) Net income....................... 7,395 7,395 ----------- ------ --------- ------- --------- --------- ---------- Balance at September 30, 1999.... 10,015,111 $ 100 $ 140,998 $ (359) $ (9,341) $ (3,565) $ 127,833 =========== ====== ========= ======= ========= ========= ==========
See notes to consolidated financial statements. 5 6 AMRESCO CAPITAL TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED, IN THOUSANDS)
Period from February 2, Nine Months 1998 Ended through September 30, September 30, 1999 1998 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income .................................................................................... $ 7,395 $ 2,029 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses .................................................................. 1,822 611 Depreciation ............................................................................... 705 24 Gain associated with repayment of ADC loan arrangement ..................................... (584) -- Loss on sale of interest rate cap .......................................................... 5 -- Amortization of prepaid assets ............................................................. 176 104 Discount amortization on commercial mortgage-backed securities ............................. (231) (54) Amortization of compensatory stock options and unearned trust manager compensation ......... 146 285 Amortization of loan commitment fees ....................................................... (555) (74) Receipt of loan commitment fees ............................................................ 428 1,220 Increase in receivables and other assets ................................................... (1,020) (1,766) Increase in interest receivable related to commercial mortgage-backed securities ........... -- (377) Increase in accounts payable and other liabilities ......................................... 1,755 1,008 Increase in amounts due to affiliates ...................................................... 1,217 388 Equity in undistributed earnings of unconsolidated subsidiary, partnerships and other real estate ventures ......................................................................... (197) (486) Distributions from unconsolidated subsidiary, partnerships and other real estate venture ... 294 380 ------------ ------------ NET CASH PROVIDED BY OPERATING ACTIVITIES ............................................. 11,356 3,292 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of mortgage loans ................................................................. -- (25,807) Investments in mortgage loans ................................................................. (41,676) (55,607) Investments in ADC loan arrangements .......................................................... (22,482) (29,004) Sale of mortgage loan to affiliate ............................................................ 4,585 -- Principal collected on mortgage loans ......................................................... 8,385 -- Principal and interest collected on ADC loan arrangement ...................................... 11,513 -- Investments in real estate .................................................................... (40,894) -- Investments in unconsolidated partnerships and subsidiary ..................................... (2,374) (3,501) Distributions from unconsolidated partnerships and other real estate ventures ................. 26 133 Purchase of commercial mortgage-backed securities ............................................. -- (34,480) ------------ ------------ NET CASH USED IN INVESTING ACTIVITIES ................................................. (82,917) (148,266) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings under line of credit ................................................. 39,162 -- Proceeds from borrowings under repurchase agreement ........................................... 12,103 5,123 Repayment of borrowings under repurchase agreement ............................................ (1,402) -- Proceeds from financing provided by affiliate ................................................. 907 5,020 Proceeds from non-recourse debt on real estate ................................................ 27,100 -- Purchase of interest rate cap ................................................................. (110) -- Proceeds from sale of interest rate cap ....................................................... 30 -- Deferred financing costs associated with line of credit ....................................... (120) -- Deferred financing costs associated with non-recourse debt on real estate ..................... (594) -- Net proceeds from issuance of common stock .................................................... -- 139,717 Dividends paid to common shareholders ......................................................... (11,510) (1,001) ------------ ------------ NET CASH PROVIDED BY FINANCING ACTIVITIES ............................................. 65,566 148,859 ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ............................................. (5,995) 3,885 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ................................................... 9,789 -- ------------ ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD ......................................................... $ 3,794 $ 3,885 ============ ============ SUPPLEMENTAL INFORMATION: Interest paid, net of amount capitalized ...................................................... $ 2,783 $ -- ============ ============ Income taxes paid ............................................................................. $ 25 $ -- ============ ============ Minority interest contributions associated with ADC loan arrangements ......................... $ -- $ 2,611 ============ ============ Minority interest distribution associated with ADC loan arrangement ........................... $ 2,111 $ -- ============ ============ Receivables transferred in satisfaction of amounts due to affiliate ........................... $ 280 $ -- ============ ============ Amounts due to affiliate discharged in connection with sale of mortgage loan .................. $ 1,729 $ -- ============ ============ Issuance of warrants in connection with line of credit ........................................ $ 400 $ -- ============ ============
See notes to consolidated financial statements. 6 7 AMRESCO CAPITAL TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1999 (UNAUDITED) 1. ORGANIZATION AND RELATIONSHIPS AMRESCO Capital Trust (the "Company"), a real estate investment trust ("REIT"), was organized under the laws of the State of Texas. The Company was formed to take advantage of certain mid- to high-yield lending and investment opportunities in real estate related assets, including various types of commercial mortgage loans (including, among others, participating loans, mezzanine loans, acquisition loans, construction loans, rehabilitation loans and bridge loans), commercial mortgage-backed securities ("CMBS"), commercial real estate, equity investments in joint ventures and/or partnerships, and certain other real estate related assets. The Company was initially capitalized on February 2, 1998 and commenced operations on May 12, 1998, concurrent with the completion of its initial public offering ("IPO") of 9,000,000 common shares and private placement of 1,000,011 common shares. Pursuant to the terms of a Management Agreement dated as of May 12, 1998 and subject to the direction and oversight of the Board of Trust Managers, the Company's day-to-day operations are managed by AMREIT Managers, L.P. (the "Manager"), an affiliate of AMRESCO, INC. (together with its affiliated entities, the "AMRESCO Group"). For its services, the Manager is entitled to receive a base management fee equal to 1% per annum of the Company's Average Invested Non-Investment Grade Assets, as defined, and 0.5% per annum of the Company's Average Invested Investment Grade Assets, as defined. In addition to the base management fee, the Manager is entitled to receive incentive compensation in an amount equal to 25% of the dollar amount by which Funds From Operations (as defined by the National Association of Real Estate Investment Trusts), as adjusted, exceeds a certain threshold. The Manager is also entitled to receive reimbursement for its costs of providing certain services to the Company. The base management fee, reimbursable expenses and incentive fee, if any, are payable quarterly in arrears. During the three and nine months ended September 30, 1999, base management fees charged to the Company totaled $563,000 and $1,521,000, respectively. Reimbursable expenses charged to the Company during these periods totaled $66,000 and $170,000, respectively. During the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, base management fees charged to the Company totaled $298,000 and $421,000, respectively; reimbursable expenses charged to the Company during these periods totaled $80,000 and $96,000, respectively. Since its inception, no incentive fees have been charged to the Company. Immediately after the closing of the IPO, the Manager was granted options to purchase 1,000,011 common shares; 70% of the options are exercisable at an option price of $15.00 per share and the remaining 30% of the options are exercisable at an option price of $18.75 per share. During the three and nine months ended September 30, 1999, management fees included compensatory option charges totaling $47,000 and $92,000, respectively. During the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, management fees included compensatory option charges totaling $141,000 and $211,000, respectively. 2. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements. The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries and a majority-owned partnership. The Company accounts for its investment in AMREIT II, Inc., a taxable subsidiary, using the equity method of accounting, and thus reports its share of income or loss based on its ownership interest. The Company uses the equity method of accounting due to the non-voting nature of its ownership interest and because the Company is entitled to substantially all of the economic benefits of ownership of AMREIT II, Inc. The Company owns non-controlling interests in two partnerships; the Company accounts for these investments using the equity method of accounting and thus reports its share of income or loss based on its ownership interests. The accompanying financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1998 (the "10-K"). The notes to the financial statements included herein highlight significant changes to the notes included in the 10-K. 7 8 In the opinion of management, the accompanying consolidated financial statements include all adjustments (consisting of normal and recurring accruals) necessary for a fair presentation of the interim financial statements. Operating results for the periods presented are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the financial statements and revenues and expenses for the reporting period. Significant estimates include the valuation of commercial mortgage-backed securities, the allowance for loan losses and the determination of the fair value of certain share option awards and warrants. Actual results may differ from those estimates. Certain prior period amounts have been reclassified to conform with the current period's presentation. 3. LOAN INVESTMENTS During the three months ended September 30, 1999, the Company originated two loans. During the nine months ended September 30, 1999, four of the Company's loans were fully repaid, three loan originations were closed and one loan was sold to AMRESCO Commercial Finance, Inc. ("ACFI"), a member of the AMRESCO Group; additionally, one loan was reclassified, net of a $500,000 charge-off, to investment in unconsolidated subsidiary following the subsidiary's acquisition (through foreclosure on February 25, 1999) of the partnership interests of one of the Company's borrowers. As of September 30, 1999, the Company's loan investments are summarized as follows (dollars in thousands):
Date of Initial Scheduled Collateral Investment Maturity Location Property Type Position - ------------------------ ------------------- ---------------- -------------- --------------- May 12, 1998 March 31, 2001 Richardson, TX Office Second Lien June 1, 1998 June 1, 2001 Houston, TX Office First Lien June 12, 1998 June 30, 2000 Pearland, TX Apartment First Lien June 17, 1998 June 30, 2000 San Diego, CA R&D/Bio-Tech First Lien June 19, 1998 June 18, 2000 Houston, TX Office First Lien June 22, 1998 June 19, 2000 Wayland, MA Office First Lien July 1, 1998 July 1, 2001 Dallas, TX Office Ptrshp Interests July 2, 1998 June 30, 2000 Washington, D.C. Office First Lien July 10, 1998 July 31, 2000 Pasadena, TX Apartment First Lien September 1, 1998 February 28, 2001 Los Angeles, CA Mixed Use First Lien September 30, 1998 Various San Antonio, TX/ Residential Lots First Lien Sunnyvale, TX September 30, 1998 October 7, 1999 Ft. Worth, TX Apartment Ptrshp Interests September 30, 1998 December 31, 1999 Dallas, TX Medical Office First Lien September 30, 1998 September 22, 1999 Norwood, MA Industrial/Office First Lien October 1, 1998 December 31, 1999 Richardson, TX Office First Lien May 18, 1999 May 19, 2001 Irvine, CA Office First Lien July 29, 1999 July 28, 2001 Lexington, MA R&D/Bio-Tech First Lien August 19, 1999 August 15, 2001 San Diego, CA Medical Office First Lien
Amount Outstanding at Interest Interest Date of Initial Scheduled Commitment September 30, Pay Accrual Investment Maturity Amount 1999 Rate Rate - ------------------------ ------------------- ----------- --------------- -------- -------- May 12, 1998 March 31, 2001 $ 14,700 $ 13,368 10.0% 12.0% June 1, 1998 June 1, 2001 11,800 10,531 12.0% 12.0% June 12, 1998 June 30, 2000 12,827 12,291 10.0% 11.5% June 17, 1998 June 30, 2000 5,560 4,587 10.0% 13.5% June 19, 1998 June 18, 2000 24,000 20,281 12.0% 12.0% June 22, 1998 June 19, 2000 45,000 38,688 10.5% 10.5% July 1, 1998 July 1, 2001 10,068 7,197 10.0% 15.0% July 2, 1998 June 30, 2000 7,000 6,165 10.5% 10.5% July 10, 1998 July 31, 2000 3,350 2,993 10.0% 14.0% September 1, 1998 February 28, 2001 18,419 17,418 10.0% 12.0% September 30, 1998 Various 8,400 3,233 10.0% 14.0% September 30, 1998 October 7, 1999 2,650 2,649 10.5% 16.0% September 30, 1998 December 31, 1999 3,015 2,638 10.0% 13.0% September 30, 1998 September 22, 1999 8,765 8,335 10.0% 12.5% October 1, 1998 December 31, 1999 567 300 9.7% 15.0% May 18, 1999 May 19, 2001 15,260 12,924 10.0% 12.0% July 29, 1999 July 28, 2001 5,213 2,623 10.4% 13.4% August 19, 1999 August 15, 2001 5,745 3,415 10.4% 10.4% --------- ---------- $ 202,339 $ 169,636 ========= ==========
As more fully described in Note 13, the following loans were sold to ACFI on November 1, 1999 (dollars in thousands):
Amount Outstanding at Commitment September 30, Scheduled Amount 1999 Maturity ----------------- ---------------- ------------------- $ 2,650 $ 2,649 October 7, 1999 3,015 2,638 December 31, 1999 8,765 8,335 September 22, 1999 ------- -------- $14,430 $ 13,622 ======= ========
At September 30, 1999, amounts outstanding under construction loans, acquisition/rehabilitation loans, acquisition loans, land development loans and bridge loans totaled $48,589,000, $54,944,000, $54,235,000, $3,533,000 and $8,335,000, respectively. 8 9 Three of the 18 loan investments provide the Company with the opportunity for profit participation in excess of the contractual interest accrual rates. The loan investments are classified as follows (in thousands):
Loan Amount Balance Sheet Outstanding at Amount at September 30, 1999 September 30, 1999 ------------------ ------------------ Mortgage loans held for investment, net ............... $ 125,280 $ 124,080 Real estate, net ...................................... 37,159 35,897 Investment in real estate venture ..................... 7,197 6,247 ------------------ ------------------ Total ADC loan arrangements ........................ 44,356 42,144 ------------------ ------------------ Total loan investments ................................ $ 169,636 166,224 ================== Allowance for loan losses ............................. (2,690) ------------------ Total loan investments, net of allowance for losses ... $ 163,534 ==================
The differences between the outstanding loan amounts and the balance sheet amounts are due primarily to loan commitment fees, interest fundings, minority interests, capitalized interest and accumulated depreciation. ADC loan arrangements accounted for as real estate consisted of the following at September 30, 1999 (in thousands): Land ................................... $ 4,648 Buildings and improvements ............. 14,514 Construction in progress ............... 16,968 ------------ Total ............................... 36,130 Less: Accumulated depreciation ......... (233) ------------ $ 35,897 ============
On October 1, 1999, amounts classified as construction in progress were transferred to buildings and improvements. A summary of activity for mortgage loans and ADC loan arrangements accounted for as real estate or investments in joint ventures is as follows (in thousands): Balance at December 31, 1998 ........... $ 136,791 Investments in loans ................... 65,741 Collections of principal ............... (19,743) Cost of mortgage sold .................. (6,314) Foreclosure (partnership interests) .... (6,839) ------------ Balance at September 30, 1999 .......... $ 169,636 ============
The activity in the allowance for loan losses was as follows (in thousands): Balance at December 31, 1998 ........... $ 1,368 Provision for losses ................... 1,822 Charge-offs ............................ (500) Recoveries ............................. -- ------------ Balance at September 30, 1999 .......... $ 2,690 ============
As of September 30, 1999, the Company had outstanding commitments to fund approximately $32,703,000 under 18 loans, of which $808,000 was reimbursable by ACFI. The Company is obligated to fund these commitments to the extent that the borrowers are not in violation of any of the conditions established in the loan agreements. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee if amounts are repaid to the Company during certain prepayment lock-out periods. A portion of the commitments could expire without being drawn 9 10 upon and therefore the total commitment amounts do not necessarily represent future cash requirements. ACFI's reimbursement obligations were discharged in connection with the loan sale described in Note 13. 4. REAL ESTATE On April 30, 1999, the Company (through a majority-owned partnership) acquired interests in three newly constructed, grocery-anchored shopping centers in the Dallas/Fort Worth (Texas) area. These properties, which were acquired by subsidiary partnerships at an aggregate purchase price of $30.2 million, include an 86,516 square foot facility in Flower Mound, Texas, a 61,440 square foot facility in Fort Worth, Texas and an 85,611 square foot facility in Grapevine, Texas. Through the majority-owned partnership, the Company acquired an interest in an additional grocery-anchored shopping center on August 25, 1999. The newly constructed property, an 87,540 square foot facility in Richardson, Texas, was acquired by a subsidiary partnership at a purchase price of $10.7 million. In connection with these acquisitions, the subsidiary partnerships which hold title to these assets obtained non-recourse financing aggregating $19.5 million and $7.6 million, respectively, from an unaffiliated third party (Note 5). Immediately prior to the closings, the Company contributed $11.4 million and $3.4 million, respectively, of capital to the partnership. The proceeds from these contributions were used, in part, to fund the balance of the acquisition costs, to pay costs associated with the financing and to provide initial working capital to the title-holding partnerships. The majority-owned partnership owns, directly or indirectly, all of the equity interests in the title-holding subsidiary partnerships. Real estate, which is comprised entirely of amounts derived from the Company's partnership investment, consisted of the following at September 30, 1999 and December 31, 1998 (in thousands):
September 30, 1999 December 31, 1998 ------------------ ------------------ Land ................................... $ 14,385 $ 2,353 Buildings and improvements ............. 36,837 7,976 ------------------ ------------------ Total ............................... 51,222 10,329 Less: Accumulated depreciation ......... (572) (56) ------------------ ------------------ $ 50,650 $ 10,273 ================== ==================
In connection with the partnership's procurement of third party financing, the Company was required to post two irrevocable standby letters of credit totaling $1,084,000. The letters of credit, which were cancelled on May 4, 1999, were collateralized by certificates of deposit in a like amount; the certificates of deposit matured on August 31, 1999. Concurrent with the cancellation and as a replacement for a portion thereof related to the financing associated with the Richardson property, the Company posted an irrevocable standby letter of credit in the amount of $304,000. This letter of credit, which was cancelled on August 30, 1999, was collateralized by a $304,000 certificate of deposit that matured on September 30, 1999. 5. DEBT AND FINANCING FACILITIES Effective as of July 1, 1998, the Company (and certain of its subsidiaries) entered into a $400 million Interim Warehouse and Security Agreement (the "Line of Credit") with Prudential Securities Credit Corporation ("PSCC"). Subject to certain limitations, borrowings under the facility can be used to finance the Company's structured loan and equity real estate investments. Prior to the modifications discussed below, borrowings under the Line of Credit bore interest at rates ranging from LIBOR plus 1% per annum to LIBOR plus 2% per annum depending upon the type of asset, its loan-to-value ratio and the advance rate selected by the Company. Advance rates on eligible assets ranged from 50% to 95% depending upon the asset's characteristics. Effective as of May 4, 1999, the Company (and certain of its subsidiaries) entered into an Amended and Restated Interim Warehouse and Security Agreement (the "Amended Line of Credit") with PSCC; the agreement amended the Company's existing Line of Credit. The Amended Line of Credit includes the following modifications: (1) a reduction in the size of the committed facility from $400 million to $300 million; (2) the elimination of the requirement that assets financed with proceeds from the facility must be securitizable; (3) a reduction in the amount of capital the Company must fund with respect to construction and rehabilitation loans before PSCC is required to begin advancing funds; (4) an extension of the maturity date from July 1, 2000 to November 3, 2000; and (5) the modification to, and addition of, certain sublimits on specified types of loans and assets. Under the Amended Line of Credit, borrowings bear interest at LIBOR plus 1.25% per 10 11 annum to the extent such borrowings do not exceed the Company's Tangible Net Worth, as defined; borrowings in excess of the Company's Tangible Net Worth bear interest at LIBOR plus 3%. At September 30, 1999, the weighted average interest rate under this facility was 6.63% per annum. As compensation for entering into the Amended Line of Credit and extending the maturity date, the Company granted warrants to Prudential Securities Incorporated, an affiliate of PSCC, to purchase 250,002 common shares of beneficial interest at $9.83 per share. The exercise price represents the average closing market price of the Company's common shares for the ten-day period ending on May 3, 1999. The warrants were issued in lieu of a commitment fee or other cash compensation. The estimated fair value of the warrants, totaling $400,000, was measured at the grant date and is being amortized to interest expense over the 18-month term of the facility using the straight-line method. Borrowings under the facility are secured by a first lien security interest on all assets funded with proceeds from the Amended Line of Credit. The Amended Line of Credit contains several covenants; among others, the more significant covenants include the maintenance of a $100 million consolidated Tangible Net Worth, subject to adjustment in connection with any future equity offerings; maintenance of a Coverage Ratio, as defined, of not less than 1.4 to 1; and limitation of Total Indebtedness, as defined, to no more than 400% of shareholders' equity. On July 2, 1999, the Company terminated its existing $33.6 million (notional) interest rate cap agreement at a loss of $5,000. Concurrently, the Company entered into a new cap agreement to reduce the impact that rising interest rates would have on its floating rate indebtedness. The new agreement, which became effective on August 1, 1999, has a notional amount of $59.0 million. Until its expiration on November 1, 2000, the agreement entitles the Company to receive from the counterparty the amounts, if any, by which one month LIBOR exceeds 6.25%. The premium paid for this cap, totaling $110,000, is being amortized on a straight-line basis over the life of the agreement as an adjustment of interest incurred. Five consolidated title-holding partnerships are indebted under the terms of five non-recourse loan agreements with Jackson National Life Insurance Company. All five loans bear interest at 6.83% per annum. The interest rates on the first four loans were adjusted in connection with the placement of the fifth loan on August 25, 1999. Prior to that time, a $7.5 million loan bore interest at 7.28% per annum while three loans aggregating $19.5 million bore interest at 6.68% per annum. The loans require interest only payments through January 1, 2002; thereafter, interest and principal payments are due based upon 25-year amortization schedules. The loans, which mature on January 1, 2014, prohibit any prepayment of the outstanding principal prior to January 1, 2006. Thereafter, prepayment is permitted at any time, in whole or in part, upon payment of a yield maintenance premium of at least 1% of the then outstanding principal balance. Obligations under various financing arrangements were as follows at September 30, 1999 and December 31, 1998 (in thousands):
September 30, 1999 December 31, 1998 ------------------ ------------------ Repurchase agreement ................... $ 10,701 $ -- Line of credit ......................... 78,500 39,338 Non-recourse debt on real estate ....... 34,600 7,500 ------------------ ------------------ $ 123,801 $ 46,838 ================== ==================
Future scheduled principal repayments on debt and financing facilities at September 30, 1999 are as follows (in thousands): Remainder of 1999 ........................ $ -- 2000 ..................................... 89,201 2001 ..................................... -- 2002 ..................................... 499 2003 ..................................... 581 2004 and thereafter ...................... 33,520 ------------ $ 123,801 ============
11 12 6. STOCK-BASED COMPENSATION As of September 30, 1999, the estimated fair value of the options granted to the Manager and certain employees of the AMRESCO Group approximated $0.71 per share. The fair value of the options granted was estimated using the Cox-Ross-Rubinstein option pricing model with the following assumptions: risk free interest rates ranging from 5.97% to 6.17%; expected lives ranging from four to seven years; expected volatility of 35%; and dividend yield of 12%. During the three months ended June 30, 1999, compensation cost associated with these options was adjusted to reflect the decline in fair value (from March 31, 1999) of approximately $0.39 per share. During the three and nine months ended September 30, 1999, the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, management fees and general and administrative expenses included the following compensatory option charges (in thousands):
Period from February 2, Three Months Ended Nine Months 1998 September 30, Ended through --------------------- September 30, September 30, 1999 1998 1999 1998 -------- -------- -------- -------- Management fees ........................ $ 47 $ 141 $ 92 $ 211 General and administrative expenses .... 6 27 (14) 41 -------- -------- -------- -------- $ 53 $ 168 $ 78 $ 252 ======== ======== ======== ========
In lieu of cash compensation for their services and participation at regularly scheduled meetings of the Board of Trust Managers, the Company granted 2,250 restricted common shares to each of its four independent trust managers on May 11, 1999. The associated compensation cost is being recognized over the one-year service period. At September 30, 1999, 519,006 shares were available for grant in the form of restricted common shares or options to purchase common shares. 7. EARNINGS PER SHARE A reconciliation of the numerator and denominator used in computing basic earnings per share and diluted earnings per share for the three and nine months ended September 30, 1999, the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, is as follows (in thousands, except per share data):
Period from February 2, Three Months Ended Nine Months 1998 September 30, Ended through ----------------------------- September 30, September 30, 1999 1998 1999 1998 ------------ ------------ ------------ ------------ Net income available to common shareholders ........... $ 2,344 $ 1,272 $ 7,395 $ 2,029 ============ ============ ============ ============ Weighted average common shares outstanding ............ 10,000 10,000 10,000 5,892 ============ ============ ============ ============ Basic earnings per common share ....................... $ 0.24 $ 0.12 $ 0.74 $ 0.34 ============ ============ ============ ============ Weighted average common shares outstanding ............ 10,000 10,000 10,000 5,892 Effect of dilutive securities: Restricted shares ................................. 15 6 11 4 Net effect of assumed exercise of stock options ... 1 -- -- -- ------------ ------------ ------------ ------------ Adjusted weighted average shares outstanding .......... 10,016 10,006 10,011 5,896 ============ ============ ============ ============ Diluted earnings per common share ..................... $ 0.24 $ 0.12 $ 0.74 $ 0.34 ============ ============ ============ ============
12 13 Options and warrants to purchase 1,466,011 and 250,002 shares, respectively, of common stock were outstanding at September 30, 1999. For the three and nine months ended September 30, 1999, options related to 1,460,011 shares and the warrants were not included in the computation of diluted earnings per share because the exercise prices related thereto were greater than the average market price of the Company's common shares. The Company was initially capitalized on February 2, 1998 with the sale of 100 shares to AMRESCO, INC. The Company had no earnings prior to the commencement of its operations on May 12, 1998. No options or warrants were outstanding during the period from February 2, 1998 through May 11, 1998. When calculated for the period from May 12, 1998 (inception of operations) through September 30, 1998, the Company's basic and diluted earnings were $0.20 per common share. 8. LEASING ACTIVITIES As of September 30, 1999, the future minimum lease payments to be received by the Company (through a majority-owned partnership) under noncancellable operating leases, which expire on various dates through 2024, are as follows (in thousands): Remainder of 1999 ........................ $ 1,158 2000 ..................................... 4,613 2001 ..................................... 4,630 2002 ..................................... 4,657 2003 ..................................... 4,630 2004 and thereafter ...................... 71,979 ------------ $ 91,667 ============
Approximately 86% of the future minimum lease payments disclosed above are due from a regional grocer. 9. COMPREHENSIVE INCOME Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances except those resulting from investments by, and distributions to, its owners. Other comprehensive income includes unrealized gains and losses on marketable securities classified as available-for-sale. Comprehensive income during the three and nine months ended September 30, 1999, the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, is as follows (in thousands):
Period from February 2, Three Months Ended Nine Months 1998 September 30, Ended through ---------------------- September 30, September 30, 1999 1998 1999 1998 -------- -------- -------- -------- Net income ........................................... $ 2,344 $ 1,272 $ 7,395 $ 2,029 Unrealized losses on securities available for sale ... (45) (4,301) (2,866) (4,301) -------- -------- -------- -------- Comprehensive income (loss) .......................... $ 2,299 $ (3,029) $ 4,529 $ (2,272) ======== ======== ======== ========
The unrealized losses on securities available for sale had no impact on the Company's taxable income or cash flow. 10. SEGMENT INFORMATION The Company, as an investor in real estate related assets, operates in only one reportable segment. Within this segment, the Company makes asset allocation decisions based upon its diversification strategies and changes in market conditions. The Company does not have, nor does it rely upon, any major customers. All of the Company's investments are secured directly or indirectly by real estate properties located in the United States; accordingly, all of its revenues were derived from U.S. operations. 13 14 11. RECENTLY ISSUED ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in its balance sheet and that it measure those instruments at fair value. The accounting for changes in the fair value of a derivative (that is, gains and losses) is dependent upon the intended use of the derivative and the resulting designation. SFAS No. 133 generally provides for matching the timing of gain or loss recognition on the hedging instrument with the recognition of (1) the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk or (2) the earnings effect of the hedged forecasted transaction. In June 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities - - Deferral of the Effective Date of FASB Statement No. 133" ("SFAS No. 137"). SFAS No. 137 deferred the effective date of SFAS No. 133 such that it is now effective for all fiscal quarters of all fiscal years beginning after June 15, 2000, although earlier application is encouraged. The Company has not yet assessed the impact that SFAS No. 133 will have on its financial condition or results of operations. 12. MERGER WITH IMPAC COMMERCIAL HOLDINGS, INC. Effective as of August 4, 1999, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Impac Commercial Holdings, Inc. ("ICH"). Pursuant to the Merger Agreement, ICH will be merged with and into the Company, with the Company as the surviving entity (the "Merger"), and each outstanding share of common stock of ICH will be converted into 0.66094 of a common share of the Company. Also pursuant to this agreement, the holder of the outstanding shares of Series B 8.5% Cumulative Convertible Preferred Stock of ICH ("ICH Preferred Stock") will convert all of such shares into 1,683,635 shares of common stock of ICH or, if such conversion does not occur prior to the effective time of the Merger, all of the shares of ICH Preferred Stock will be converted into 1,112,782 common shares of the Company. The Merger will be accounted for under the purchase method of accounting. After the Merger, the Company will have approximately 16.7 million common shares outstanding. The parties anticipate that the Merger will be completed late in the fourth quarter of 1999. The transactions contemplated by the Merger Agreement are subject to approval by the shareholders of the Company and ICH. On September 8, 1999, AMRESCO, INC., AMREIT Managers, L.P., AMREIT Holdings, Inc. and MLM Holdings, Inc. (all of which are members of the AMRESCO Group) and FIC Management, Inc. (ICH's external manager) entered into a purchase agreement (the "Purchase Agreement"). Pursuant to the Purchase Agreement, FIC Management, Inc. (or one of its affiliates) agreed to acquire certain assets from the AMRESCO Group concurrent with and as a condition to the closing of the Merger. These assets include, among others, the Company's existing management agreement and 1,500,111 common shares of the Company (representing approximately 15% of the Company's outstanding common shares). 13. SUBSEQUENT EVENTS On October 21, 1999, the Company declared a dividend of $0.40 per share; the dividend is payable on November 15, 1999 to shareholders of record on October 31, 1999. On November 1, 1999, the Company sold three loans to ACFI. The proceeds from this transaction totaled $8,755,000. In connection with the sale, amounts due to ACFI were fully extinguished; at November 1, 1999 and September 30, 1999, amounts due to ACFI totaled $5,825,000 and $5,754,000, respectively. The sale was recorded as follows (dollars in thousands): Cash ................................... $ 8,755 Mortgage loans ......................... (13,622) Receivables and other assets ........... (958) Amounts due to affiliates .............. 5,825 ------------ Gain (loss) ............................ $ -- ============
14 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW AMRESCO Capital Trust (the "Company") is a real estate investment trust ("REIT") which was formed in early 1998 to take advantage of certain mid- to high-yield lending and investment opportunities in real estate related assets, including various types of commercial mortgage loans (including, among others, participating loans, mezzanine loans, acquisition loans, construction loans, rehabilitation loans and bridge loans), commercial mortgage-backed securities ("CMBS"), commercial real estate, equity investments in joint ventures and/or partnerships, and certain other real estate related assets. Subject to the direction and oversight of the Board of Trust Managers, the Company's day-to-day operations are managed by AMREIT Managers, L.P. (the "Manager"), an affiliate of AMRESCO, INC. (together with its affiliated entities, the "AMRESCO Group"). The Company commenced operations on May 12, 1998 concurrent with the completion of its initial public offering of 9,000,000 common shares and private placement of 1,000,011 common shares with AMREIT Holdings, Inc., a wholly-owned subsidiary of AMRESCO, INC. To date, the Company's investment activities have been focused in three primary areas: loan investments, CMBS and equity investments in real estate. The Company expects that its mid- to high-yield loan investments and, to a lesser extent, equity investments in real estate, will continue to comprise a substantial portion of its investment portfolio. Similarly, the Company expects to continue to have 15% to 20% of its invested capital (comprising equity and proceeds from its two credit facilities) allocated to CMBS. In general, the Company's investment activities were limited early in the year as the mortgage REIT market continued to be affected by the aftermath of the dislocation in the capital markets which occurred in mid to late 1998. Following the completion (in early May) of modifications to its line of credit facility, the Company's investment activities increased in the second and third quarters of 1999, albeit at a slower rate than was achieved in the second and third quarters of 1998. Currently, the Company does not expect to make any new investments prior to the completion of its anticipated merger with Impac Commercial Holdings, Inc. The merger is described below under the heading "Recent Developments". The Company's year-to-date investment activities are more fully described below under the heading "Results of Operations". The Company believes it has operated and it intends to continue to operate in a manner so as to continue to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"). As such, the Company has distributed and it intends to continue to distribute at least 95% of its REIT taxable income annually. The Company may experience high volatility in financial statement net income and tax basis income from quarter to quarter and year to year, primarily as a result of fluctuations in interest rates, borrowing costs, reinvestment opportunities, prepayment rates and favorable and unfavorable credit related events (e.g., profit participations or credit losses). Additionally, the Company's accounting for certain real estate loan arrangements as either real estate or joint venture investments may contribute to volatility in financial statement net income. The operating results of the Company will depend, in large part, upon the ability of the Company to manage its interest rate, prepayment and credit risks, while maintaining its status as a REIT. RECENT DEVELOPMENTS Effective as of August 4, 1999, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Impac Commercial Holdings, Inc. ("ICH"). Pursuant to the Merger Agreement, ICH will be merged with and into the Company, with the Company as the surviving entity (the "Merger"), and each outstanding share of common stock of ICH will be converted into 0.66094 of a common share of the Company. Also pursuant to the Merger Agreement, the holder of the outstanding shares of Series B 8.5% Cumulative Convertible Preferred Stock of ICH ("ICH Preferred Stock") will convert all of such shares into 1,683,635 shares of common stock of ICH or, if such conversion does not occur prior to the effective time of the Merger, all of the shares of ICH Preferred Stock will be converted into 1,112,782 common shares of the Company. After the Merger, the Company will have approximately 16.7 million common shares outstanding. The parties anticipate that the Merger will be completed late in the fourth quarter of 1999. The transactions contemplated by the Merger Agreement are subject to approval by the shareholders of the Company and ICH. On September 8, 1999, AMRESCO, INC., AMREIT Managers, L.P., AMREIT Holdings, Inc. and MLM Holdings, Inc. (all of which are members of the AMRESCO Group) and FIC Management, Inc. (ICH's external manager) entered into a purchase 15 16 agreement (the "Purchase Agreement"). Pursuant to the Purchase Agreement, FIC Management, Inc. (or one of its affiliates) agreed to acquire certain assets from the AMRESCO Group concurrent with and as a condition to the closing of the Merger. These assets include, among others, the Company's existing management agreement and 1,500,111 common shares of the Company (representing approximately 15% of the Company's outstanding common shares). RESULTS OF OPERATIONS The following discussion of results of operations should be read in conjunction with the consolidated financial statements and notes thereto included in "Item 1. Financial Statements". Under generally accepted accounting principles, net income for the three and nine months ended September 30, 1999 was $2,344,000 and $7,395,000, respectively, or $0.24 and $0.74 per common share, respectively. The Company's sources of revenue for the three and nine months ended September 30, 1999, totaling $6,301,000 and $16,517,000, respectively, are set forth below. o $4,282,000 and $11,442,000, respectively, from loan investments. As certain of the Company's loan investments are accounted for as either real estate or joint venture investments for financial reporting purposes, these revenues are included in the consolidated statement of income for the three and nine months ended September 30, 1999 as follows: interest income on mortgage loans - $3,841,000 and $10,776,000, respectively; and operating income from real estate - $441,000 and $666,000, respectively. The loan investments earn interest at accrual rates ranging from 10.4% to 16% per annum as of September 30, 1999. o $905,000 and $2,753,000, respectively, from investments in CMBS. o $975,000 and $1,927,000, respectively, of operating income from real estate owned by the Company (through a majority-owned partnership). o $63,000 and $197,000, respectively, of equity in earnings from its unconsolidated subsidiary, partnerships and other real estate ventures. o $76,000 and $198,000, respectively, of interest income from short-term investments. Additionally, the Company realized a gain of $584,000 during the three months ended March 31, 1999 in connection with the repayment of an ADC loan arrangement. The gain was comprised principally of interest income earned at the accrual rate over the life of the loan investment. No gains were realized during the three month periods ended June 30, 1999 or September 30, 1999. The Company incurred expenses of $3,957,000 and $9,706,000, respectively, during the three and nine months ended September 30, 1999. These expenses are set forth below. o $610,000 and $1,613,000, respectively, of management fees, including $563,000 and $1,521,000, respectively, of base management fees payable to the Manager pursuant to the Management Agreement and $47,000 and $92,000, respectively, of expense associated with compensatory options granted to the Manager. Costs associated with the compensatory options decreased during the three months ended June 30, 1999 primarily as a result of a decrease in the expected volatility of the Company's stock. No incentive fees were incurred during either period. o $338,000 and $1,120,000, respectively, of general and administrative costs, including $0 and $200,000, respectively, of resolution costs associated with a non-performing loan, $71,000 and $270,000, respectively, for professional services, $59,000 and $176,000, respectively, for directors and officers' insurance, $66,000 and $170,000, respectively, of reimbursable costs pursuant to the Management Agreement, $6,000 and $(14,000), respectively, related to compensatory options granted to certain members of the AMRESCO Group, $87,000 and $87,000, respectively, of dividend equivalent costs, $19,000 and $19,000, respectively, of fees paid to the Company's Independent Trust Managers for their participation at special meetings of the Board of Trust Managers and $23,000 and $68,000, respectively, related to restricted stock awards to the Company's Independent Trust Managers. Costs associated with the compensatory options decreased during the three months ended June 30, 1999 primarily as a result of a decrease in the expected volatility of the Company's stock. These categories do not represent all general and administrative expenses. 16 17 o $1,769,000 and $3,427,000, respectively, of interest expense (net of capitalized interest totaling $207,000 and $593,000, respectively) associated with the Company's credit facilities and five non-recourse loans secured by real estate. o $190,000 and $1,019,000, respectively, of participating interest associated with amounts due to an affiliate. o $408,000 and $705,000, respectively, of depreciation expense, including $275,000 and $516,000, respectively, related to five grocery-anchored shopping centers and $133,000 and $189,000, respectively, related to loan investments accounted for as real estate. o $642,000 and $1,822,000, respectively, of provision for loan losses. During the three months ended March 31, 1999, the Company charged-off $500,000 against an existing allowance for losses related to the non-performing loan referred to above. This loan is discussed further in this section of Management's Discussion and Analysis of Financial Condition and Results of Operations under the sub-heading "Loan Investments". The Company's policy is to distribute at least 95% of its REIT taxable income to shareholders each year; to that end, dividends are paid quarterly. Tax basis income differs from income reported for financial reporting purposes due primarily to differences in methods of accounting for ADC loan arrangements and stock-based compensation awards and the nondeductibility, for tax purposes, of the Company's loan loss reserve (for a discussion of ADC loan arrangements, see the notes to the consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 1998). As a result of these accounting differences, net income under generally accepted accounting principles is not necessarily an indicator of distributions to be made by the Company. The following dividends have been declared in 1999:
Dividend per Declaration Record Payment Common Date Date Date Share ---------------- ---------------- ----------------- ------- First Quarter April 22, 1999 April 30, 1999 May 17, 1999 $ 0.36 Second Quarter July 22, 1999 July 31, 1999 August 16, 1999 0.39 Third Quarter October 21, 1999 October 31, 1999 November 15, 1999 0.40 ------- $ 1.15 =======
For federal income tax purposes, all dividends declared to date should be treated as ordinary income to the Company's shareholders. The Company was initially capitalized through the sale of 100 common shares to AMRESCO, INC. on February 2, 1998 and it commenced operations on May 12, 1998 concurrent with the completion of its initial public offering of 9,000,000 common shares and private placement of 1,000,011 common shares with AMREIT Holdings, Inc., a wholly-owned subsidiary of AMRESCO, INC. At September 30, 1998, $149.0 million had been invested in structured finance arrangements and commercial mortgage-backed securities. As of September 30, 1998, the Company had advanced $111.1 million under 19 commercial mortgage loan commitments. During its initial 142-day period of operations, the Company, either directly or through its unconsolidated taxable subsidiary, acquired six commercial mortgage-backed securities at an aggregate purchase price of $37.9 million. The following comparisons are reflective of the fact that during the entire three and nine months ended September 30, 1999, the Company's net proceeds from the issuance of its common shares were fully invested and it (and its consolidated partnerships) had outstanding borrowings under several credit facilities. By contrast, during the three months ended September 30, 1998 and the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, the Company was actively investing the $139.7 million of net proceeds received from the issuance of its common shares; such proceeds were not fully invested until September 30, 1998. Additionally, the Company did not begin to borrow under its credit facilities until September 30, 1998. During the period from February 2, 1998 (date of initial capitalization) through September 30, 1998, the Company had operations for only 142 days (from May 12, 1998 through September 30, 1998); the Company had no income or expenses during the period from February 2, 1998 through May 11, 1998. 17 18 Three Months Ended September 30, 1999 Compared to Three Months Ended September 30, 1998 The Company's revenues increased 111%, from $2,992,000 to $6,301,000, due primarily to increases in interest income derived from mortgage loan investments, income from commercial mortgage-backed securities, and operating income from real estate; as of September 30, 1998, the Company had not made any equity investments in real estate. More specifically, the higher revenues were attributable to the following: o additional fundings (made after September 30, 1998) under commitments which were closed during the Company's initial 142-day period of operations; o certain loans which contributed to third quarter 1999 revenues were acquired on September 30, 1998 (as a result, such loans did not contribute significantly to the prior period's revenues); o acquisitions of real estate which occurred subsequent to September 30, 1998 (October 23, 1998, April 30, 1999 and August 25, 1999); o three of the six commercial mortgage-backed securities held by the Company were not acquired until September 1, 1998 (as a result, only one month of revenue was generated from these securities during the comparable period in 1998); and, o to a lesser extent, new loan originations in the fourth quarter of 1998 and the second and third quarters of 1999. During the three months ended September 30, 1999, the average book value of the Company's assets, excluding cash and cash equivalents, approximated $244 million. During the three months ended September 30, 1998, the average book value of the Company's assets, excluding cash and cash equivalents, approximated $100 million. Equity in earnings of unconsolidated subsidiary, partnerships and other real estate ventures declined by $263,000 from the comparable period in 1998. For the most part, this decline was attributable to the non-performing loan referred to above. This loan was performing until late in the fourth quarter of 1998. Prior to its reclassification (described below), this loan was accounted for as a joint venture investment for financial reporting purposes. Interest income on short-term investments declined by $751,000 from the comparable period in 1998 as the uninvested portion of the net proceeds received from the issuance of the Company's common shares were temporarily invested during such period in short-term investments. The Company's expenses increased 130%, from $1,720,000 to $3,957,000, due primarily to the fact that the Company incurred borrowing costs, including participating interest in mortgage loans, of $1,959,000 (net of amounts capitalized of $207,000) during the three months ended September 30, 1999; during the comparable period in 1998, the Company incurred only $4,000 of borrowing costs (including participating interest in mortgage loans) as it did not begin to leverage its assets until September 30, 1998. Additionally, base management fees increased by $265,000, from $298,000 to $563,000, as a result of the Company's larger asset base upon which the fee is calculated. The Company's loan loss provision increased by $141,000, from $501,000 to $642,000, as a result of significantly higher loan balances. Finally, depreciation expense increased by $387,000, from $21,000 to $408,000, primarily as a result of several real estate acquisitions which were closed in October 1998, April 1999 and August 1999. These higher costs were offset by a $417,000 decrease in general and administrative expenses. The reduction in general and administrative expenses was due primarily to the fact that the Company incurred approximately $400,000 of due diligence costs (in connection with an abandoned transaction) during the three months ended September 30, 1998. No such costs were incurred by the Company during the three months ended September 30, 1999. For the reasons cited above, income before gains and net income increased 84%, from $1,272,000 to $2,344,000. 18 19 Nine Months Ended September 30, 1999 Compared to Period from February 2, 1998 (Date of Initial Capitalization) through September 30, 1998 For the reasons described above, the Company's revenues increased by $12,264,000 (or 288%), from $4,253,000 to $16,517,000, and its expenses increased by $7,482,000 (or 336%), from $2,224,000 to $9,706,000. The changes in the component revenues and expenses were as follows (dollars in thousands):
Increase / (Decrease) ------------ Interest income on mortgage loans .......................... $ 9,448 Income from commercial mortgage-backed securities .......... 2,156 Operating income from real estate .......................... 2,485 Equity in earnings of unconsolidated subsidiary, partnerships and other real estate ventures ............ (289) Interest income from short-term investments ................ (1,536) ------------ Total revenues ......................................... $ 12,264 ============ Interest expense .......................................... $ 3,426 Management fees ........................................... 981 General and administrative ................................ 167 Depreciation .............................................. 681 Participating interest in mortgage loans .................. 1,016 Provision for loan losses ................................. 1,211 ------------ Total expenses ......................................... $ 7,482 ============
Income before gains increased 236%, from $2,029,000 to $6,811,000, and net income increased 264%, from $2,029,000 to $7,395,000. In addition to the factors cited above, net income increased partially as a result of a $584,000 gain realized in connection with the repayment of an ADC loan arrangement. Loan Investments During the three months ended September 30, 1999, the Company originated two first lien loans aggregating $11.0 million in commitments; the initial advances under these loans totaled approximately $5.9 million. During the nine months ended September 30, 1999, four of the Company's loans were fully repaid, three loan originations were closed and one loan was sold to AMRESCO Commercial Finance, Inc. ("ACFI"), a member of the AMRESCO Group; additionally, one loan was reclassified, net of a $500,000 charge-off, to investment in unconsolidated subsidiary following the subsidiary's acquisition (through foreclosure on February 25, 1999) of the partnership interests of one of the Company's borrowers. In connection with the loan sale, amounts due to ACFI were reduced by $2.0 million; as of September 30, 1999, amounts due to ACFI totaled $5.8 million. The proceeds from the four loan repayments and the loan sale totaled $22.3 million, including accrued interest, a profit participation and a prepayment fee aggregating $1.0 million. Principal collections on certain of the Company's other loan investments totaled $0.3 million and $3.0 million during the three and nine months ended September 30, 1999, respectively. During the three and nine months ended September 30, 1999, the Company advanced a total of $17.7 million and $65.7 million, respectively, under its loan commitments. Excluding the loan classified as an investment in unconsolidated subsidiary, the Company had 18 loans representing $202.3 million in aggregate commitments as of September 30, 1999; $169.6 million had been advanced under these facilities at September 30, 1999. A portion of the commitments may expire without being drawn upon and therefore the total commitment amounts do not necessarily represent future cash requirements. After giving effect to ACFI's economic interest (as described in the Company's Annual Report on Form 10-K for the year ended December 31, 1998), commitments and amounts outstanding totaled approximately $196.6 million and $164.7 million, respectively, at September 30, 1999. At September 30, 1999, ACFI's contingent obligation for additional advances which might have been 19 20 required to be made under certain of the Company's loans approximated $0.8 million. On November 1, 1999, the Company sold the following loans to ACFI:
Amount Outstanding at Commitment September 30, Scheduled Amount 1999 Maturity ----------------- ---------------- ---------------------- $ 2,650 $ 2,649 October 7, 1999 3,015 2,638 December 31, 1999 8,765 8,335 September 22, 1999 ------- ------- $14,430 $13,622 ======= =======
These investments were the last remaining loans subject to the ACFI economic interest. Comprised initially of five loans, one loan was sold to ACFI in January 1999 and the other was fully repaid by the borrower in May 1999. In connection with this most recent sale, amounts due to ACFI totaling $5.8 million were fully extinguished; additionally, ACFI's contingent reimbursement obligations were discharged. The proceeds from this transaction, which produced no gain or loss for the Company, totaled approximately $8.8 million. Following this sale, the Company has 15 loans representing $187.9 million in aggregate commitments; at September 30, 1999, $156.0 million had been advanced under these 15 facilities. Based upon the amounts outstanding under these facilities and after giving effect to the contractual right sold to ACFI, the Company's portfolio of commercial mortgage loans had a weighted average interest pay rate of 10.6% and a weighted average interest accrual rate of 11.8% as of September 30, 1999. Three of the 18 loans provide the Company with the opportunity for profit participation above the contractual accrual rate. The Company's loan investments as of September 30, 1999 are summarized as follows (dollars in thousands):
Date of Initial Scheduled Collateral Investment Maturity Location Property Type Position - --------------------- ---------------------- ------------------- ---------------- --------------- May 12, 1998 March 31, 2001 Richardson, TX Office Second Lien June 1, 1998 June 1, 2001 Houston, TX Office First Lien June 12, 1998 June 30, 2000 Pearland, TX Apartment First Lien June 17, 1998 June 30, 2000 San Diego, CA R&D/Bio-Tech First Lien June 19, 1998 June 18, 2000 Houston, TX Office First Lien June 22, 1998 June 19, 2000 Wayland, MA Office First Lien July 1, 1998 July 1, 2001 Dallas, TX Office Ptrshp Interests July 2, 1998 June 30, 2000 Washington, D.C. Office First Lien July 10, 1998 July 31, 2000 Pasadena, TX Apartment First Lien September 1, 1998 February 28, 2001 Los Angeles, CA Mixed Use First Lien September 30, 1998 Various San Antonio, TX/ Residential Lots First Lien Sunnyvale, TX September 30, 1998 October 7, 1999 Ft. Worth, TX Apartment Ptrshp Interests September 30, 1998 December 31, 1999 Dallas, TX Medical Office First Lien September 30, 1998 September 22, 1999 Norwood, MA Industrial/Office First Lien October 1, 1998 December 31, 1999 Richardson, TX Office First Lien May 18, 1999 May 19, 2001 Irvine, CA Office First Lien July 29, 1999 July 28, 2001 Lexington, MA R&D/Bio-Tech First Lien August 19, 1999 August 15, 2001 San Diego, CA Medical Office First Lien
Amount Outstanding at Interest Interest Date of Initial Scheduled Commitment September 30, Pay Accrual Investment Maturity Amount 1999(c) Rate Rate - --------------------- ---------------------- ------------ ------------- ------ -------- May 12, 1998 March 31, 2001 $14,700 $13,368 10.0% 12.0% June 1, 1998 June 1, 2001 11,800 10,531 12.0% 12.0% June 12, 1998 June 30, 2000 12,827 12,291(b) 10.0% 11.5% June 17, 1998 June 30, 2000 5,560 4,587(b) 10.0% 13.5% June 19, 1998 June 18, 2000 24,000 20,281(b) 12.0% 12.0% June 22, 1998 June 19, 2000 45,000 38,688 10.5% 10.5% July 1, 1998 July 1, 2001 10,068 7,197(a) 10.0% 15.0% July 2, 1998 June 30, 2000 7,000 6,165 10.5% 10.5% July 10, 1998 July 31, 2000 3,350 2,993 10.0% 14.0% September 1, 1998 February 28, 2001 18,419 17,418 10.0% 12.0% September 30, 1998 Various 8,400 3,233 10.0% 14.0% September 30, 1998 October 7, 1999 2,650 2,649 10.5% 16.0% September 30, 1998 December 31, 1999 3,015 2,638 10.0% 13.0% September 30, 1998 September 22, 1999 8,765 8,335 10.0% 12.5% October 1, 1998 December 31, 1999 567 300 9.7% 15.0% May 18, 1999 May 19, 2001 15,260 12,924 10.0% 12.0% July 29, 1999 July 28, 2001 5,213 2,623 10.4% 13.4% August 19, 1999 August 15, 2001 5,745 3,415 10.4% 10.4% -------- -------- 202,339 169,636 (5,765) (4,958) -------- -------- ACFI's Economic Interest $196,574(d) $164,678(d) ======== ========
(a) Accounted for as investment in joint venture for financial reporting purposes. (b) Accounted for as real estate for financial reporting purposes. (c) For all loan investments, payments of interest only are due monthly at the interest pay rate. All principal and all remaining accrued and unpaid interest are due at the scheduled maturities of the loans. (d) Amounts exclude the loan which was reclassified to investment in unconsolidated subsidiary during the three months ended March 31, 1999. 20 21 The Company provides financing through certain real estate loan arrangements that, because of their nature, qualify either as real estate or joint venture investments for financial reporting purposes (see notes [a] and [b] accompanying the table above). As of September 30, 1999, loan investments representing approximately $52,455,000 in aggregate commitments were accounted for as either real estate or joint venture interests; approximately $44,356,000 had been advanced to borrowers under the related agreements. For a discussion of these loan arrangements, see the Company's consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1998. A mezzanine (second lien) loan with an outstanding balance of $6,839,000 and a recorded investment of $6,659,000 was over 30 days past due as of December 31, 1998. The allowance for loan losses related to this investment totaled $500,000 at December 31, 1998. On February 25, 1999, an unconsolidated taxable subsidiary of the Company assumed control of the borrower (a partnership) through foreclosure of the partnership interests. In addition to the second lien mortgage, the property is encumbered by a $17 million first lien mortgage provided by an unaffiliated third party. The first lien mortgage, which matures on March 1, 2001, requires interest only payments throughout its term. To date, all interest payments have been made in accordance with the terms of the first lien mortgage. However, on March 11, 1999, the first lien lender notified the Company that it considered the first lien loan to be in default because of defaults under the Company's mezzanine loan. The first lien lender has not given the Company any notice of an intention to accelerate the balance of the first lien loan. During the first quarter of 1999, the Company charged-off $500,000 against the allowance for losses related to this investment which amount represented management's estimate at that time of the amount of the expected loss which could result upon a disposition of the collateral. If the Company incurs an actual loss on this investment, tax basis income would be reduced at the time the loss is realized. On September 21, 1999, a subsidiary of the Company entered into a non-binding letter agreement with a prospective investor who intends to make a substantial equity commitment to the project. Under the terms of the agreement, the Company would continue to have an interest in the project as an equity owner. If the proposed transaction is consummated, the Company currently believes that it will fully recover its original investment. At September 30, 1999, the Company's commercial mortgage loan commitments were geographically dispersed in three states and the District of Columbia: Texas (46%); Massachusetts (28%); California (23%); and Washington, D.C. (3%). The underlying collateral for these loans was comprised of the following property types: office (65%); mixed use (10%); multifamily (9%); R&D/Bio-Tech (6%); residential (4%); medical office (4%); and industrial (2%). Acquisition/rehabilitation loans, acquisition loans, construction loans, single-family lot development loans and bridge loans comprised 34%, 32%, 27%, 4% and 3% of the portfolio, respectively. All of the properties securing the Company's construction loans are now complete. Eighty-six percent of the portfolio is comprised of first lien loans while the balance of the portfolio (14%) is secured by second liens and/or partnership interests. The percentages reflected above are based upon committed loan amounts and give effect to ACFI's economic interest. Additionally, the percentages exclude the loan which was reclassified to investment in unconsolidated subsidiary during the first quarter of 1999. Until the loan investment portfolio becomes larger, geographic and product type concentrations are expected. The Company expects to see more diversification both geographically and by product type as the loan portfolio grows. Geographic and product type concentrations present additional risks, particularly if there is a deterioration in the general condition of the real estate market or in the sub-market in which the loan collateral is located, or if demand for a particular product type does not meet expectations due to adverse market conditions that are different from those projected by the Company. In an effort to reduce concentration risks, the Company is targeting transactions which will more broadly diversify its loan investment portfolio. Commercial Mortgage-backed Securities As of September 30, 1999, the Company holds five commercial mortgage-backed securities ("CMBS") which were acquired at an aggregate purchase price of $34.5 million. All of these securities were acquired on or before September 1, 1998. Due to an increase in comparable-term U.S. Treasury rates and increasing spreads in the CMBS market during the six months ended June 30, 1999, the value of the Company's CMBS holdings declined by $2,822,000. During the three months ended September 30, 1999, the value of the Company's CMBS holdings declined by $137,000 as an increase in comparable-term U.S. Treasury rates was largely offset by a decline in spreads for certain of its bonds. As a result, during the three and nine months ended September 30, 1999, the Company recorded an unrealized loss of $137,000 and $2,959,000, respectively, on its CMBS portfolio. Additionally, during the three and nine months ended September 30, 1999, the Company recorded an unrealized gain of $92,000 and $93,000, respectively, net of tax effects, related to one commercial mortgage-backed 21 22 security owned by its unconsolidated taxable subsidiary; the security held by this subsidiary has an investment rating of "B-". As these securities are classified as available for sale, the aggregate unrealized loss was reported as a component of accumulated other comprehensive income (loss) in shareholders' equity for financial reporting purposes. The cumulative unrealized losses (totaling $9.3 million) have had no impact on the Company's taxable income or cash flow. Management intends to retain these investments for the foreseeable future. Excluding the potential tax effects associated with the security held by the Company's unconsolidated taxable subsidiary, the weighted average unleveraged yield over the expected life of these investments is expected to approximate 11.4%. The Company's direct CMBS investments are summarized as follows (dollars in thousands):
Percentage of Security Aggregate Aggregate Total Based Rating Amortized Cost Fair Value on Fair Value ------------- ------------------ ----------------- ---------------- BB- $ 4,259 $ 3,341 13% B 19,608 15,746 60% B- 11,364 6,940 27% ------- ------- ---- $35,231 $26,027 100% ======= ======= ====
The Company's estimated returns on its CMBS investments are based upon a number of assumptions that are subject to certain business and economic risks and uncertainties including, but not limited to, the timing and magnitude of prepayments and credit losses on the underlying mortgage loans that may result from general and/or localized real estate market factors. These risks and uncertainties are in many ways similar to those affecting the Company's commercial mortgage loans. These risks and uncertainties may cause the actual yields to differ materially from expected yields. In February 1999, the Company contributed $0.7 million to a newly formed investment partnership with Olympus Real Estate Corporation. The partnership, which is 5% owned by the Company, acquired several classes of subordinated CMBS at an aggregate purchase price of $12.7 million. Currently, the Company does not expect to make any additional investments in the partnership. Equity Investments in Real Estate On March 2, 1999, the Company acquired a 49% limited partner interest in a partnership which owns a 116,000 square foot office building in Richardson, Texas. In connection with this acquisition, the Company contributed $1.4 million of capital to the partnership. The property is encumbered by a first lien mortgage with a current outstanding balance of approximately $13.8 million. The non-recourse mortgage loan, which is provided by an unaffiliated third party, bears interest at 6.75% per annum and requires interest and principal payments based upon a 25-year amortization schedule. The loan matures on March 5, 2019. On the tenth anniversary of the loan, the lender has the option, upon 60 days prior written notice, to increase the interest rate to the then current market rate. No prepayment of principal (other than scheduled amortization) is permitted during years 1-5 and years 11-15. The loan can be prepaid during years 6 and 16 upon payment of a penalty equal to 3% of the amount prepaid. Thereafter, the prepayment penalty decreases by 1% per year. In years 9, 10, 19 and 20 the loan can be prepaid without penalty. On April 30, 1999, the Company (through a majority-owned partnership) acquired interests in three newly constructed, grocery-anchored shopping centers in the Dallas/Fort Worth (Texas) area. These properties, which were acquired by subsidiary partnerships at an aggregate purchase price of $30.2 million, include an 86,516 square foot facility in Flower Mound, Texas, a 61,440 square foot facility in Fort Worth, Texas and an 85,611 square foot facility in Grapevine, Texas. Through the majority-owned partnership, the Company acquired an interest in an additional grocery-anchored shopping center on August 25, 1999. The newly constructed property, an 87,540 square foot facility in Richardson, Texas, was acquired by a subsidiary partnership at a purchase price of $10.7 million. In connection with these acquisitions, the subsidiary partnerships which hold title to these assets obtained non-recourse financing aggregating $19.5 million and $7.6 million, respectively, from an unaffiliated third party. Immediately prior to the closings, the Company contributed $11.4 million and $3.4 million, respectively, of capital to the partnership. The proceeds from these contributions were used, in part, to fund the balance of the acquisition costs, to pay costs associated with the financing and to provide initial working capital to the title-holding partnerships. With the transactions described above, the Company now owns interests in five grocery-anchored shopping centers in the Dallas/Fort Worth (Texas) area. The first center was acquired in October 1998. The Company holds a 99.5% interest in the majority-owned (or master) partnership. The master partnership owns, directly or indirectly, 100% of the equity 22 23 interests in each of the five title-holding subsidiary partnerships. To date, the Company has contributed a total of $18.2 million of capital to the partnerships. The five consolidated title-holding partnerships are indebted under the terms of five non-recourse loan agreements with Jackson National Life Insurance Company. All five loans, aggregating $34.6 million, bear interest at 6.83% per annum. The interest rates on the first four loans were adjusted in connection with the placement of the fifth loan on August 25, 1999. Prior to that time, a $7.5 million loan bore interest at 7.28% per annum and three loans aggregating $19.5 million bore interest at 6.68% per annum. The loans require interest only payments through January 1, 2002; thereafter, interest and principal payments are due based upon 25-year amortization schedules. The loans, which mature on January 1, 2014, prohibit any prepayment of the outstanding principal prior to January 1, 2006. Thereafter, prepayment is permitted at any time, in whole or in part, upon payment of a yield maintenance premium of at least 1% of the then outstanding principal balance. Ultimately, the Company expects to construct an additional 62,000 square feet of side-store space. This development is expected to occur at the four most recently acquired centers. It is currently anticipated that the development costs will be financed with an additional $1 million equity contribution from the Company and $3.8 million of third party financing proceeds. The Company's unconsolidated taxable subsidiary holds interests (indirectly) in a partnership which owns a 909,000 square foot mixed-use property in Columbus, Ohio. This investment is described above under the sub-heading "Loan Investments". LIQUIDITY AND CAPITAL RESOURCES The following discussion of liquidity and capital resources should be read in conjunction with the consolidated financial statements and notes thereto included in "Item 1. Financial Statements". The Company's ability to execute its business strategy, particularly the growth of its investment and loan portfolio, depends to a significant degree on its ability to obtain additional capital. The Company's principal demands for liquidity are cash for operations, including funds for its lending activities and other investments, interest expense associated with its indebtedness, debt repayments and distributions to its shareholders. In the near term, the Company's principal sources of liquidity are the funds available to it under its financing facilities described below. Effective as of July 1, 1998, the Company (and certain of its subsidiaries) entered into a $400 million credit facility (the "Line of Credit") with Prudential Securities Credit Corporation ("PSCC"). Subject to PSCC's approval on an asset by asset basis, borrowings under the facility can be used to finance the Company's structured loan and equity real estate investments. As a result of the dislocation in the capital markets in mid to late 1998, PSCC became more restrictive in the application of its approval rights with respect to financing for new investments sought by the Company; accordingly, very few new investments were consummated during the fourth quarter of 1998 and the first quarter of 1999. Prior to the modifications discussed below, borrowings under the Line of Credit bore interest at rates ranging from LIBOR plus 1% per annum to LIBOR plus 2% per annum. At December 31, 1998, $39,338,000 had been borrowed under the Line of Credit. To reduce the impact that rising interest rates would have on this floating rate indebtedness, the Company entered into an interest rate cap agreement which became effective on January 1, 1999; the agreement had a notional amount of $33,600,000 and was scheduled to expire on July 1, 2000. The agreement entitled the Company to receive from a counterparty the amounts, if any, by which one month LIBOR exceeded 6.0%. Prior to its termination (as described below), no payments were due from the counterparty as one month LIBOR had not exceeded 6.0%. On July 2, 1999, the agreement was terminated and replaced with an interest rate cap agreement which became effective on August 1, 1999. The new agreement, which was entered into to more closely match the then outstanding borrowings, has a notional amount of $59,000,000. Until its expiration on November 1, 2000, the agreement entitles the Company to receive from a counterparty the amounts, if any, by which one month LIBOR exceeds 6.25%. To date, one month LIBOR has not exceeded 6.25%. There are no margin requirements associated with interest rate caps and therefore there is no liquidity risk associated with this particular hedging instrument. 23 24 Effective as of May 4, 1999, the Company (and certain of its subsidiaries) entered into an Amended and Restated Interim Warehouse and Security Agreement (the "Amended Line of Credit") with PSCC; the agreement amended the Company's existing line of credit. The Amended Line of Credit includes the following modifications: o a reduction in the size of the committed facility from $400 million to $300 million; o the elimination of the requirement that assets financed with proceeds from the facility must be securitizable; o a reduction in the amount of capital the Company must fund with respect to construction and rehabilitation loans before PSCC is required to begin advancing funds; o an extension of the maturity date from July 1, 2000 to November 3, 2000; and o the modification to, and addition of, sublimits on specified types of loans and assets, including: o a new $40 million sublimit on mezzanine loans and equity investments; and o a reduction in the sublimit on construction loans from $150 million to $115 million, with the addition of a new $50 million sublimit within this category for construction loans that are less than 70% pre-leased at the time the initial advance is to be made under the Amended Line of Credit with respect to a construction loan fitting this category. Under the Amended Line of Credit, borrowings bear interest at LIBOR plus 1.25% per annum to the extent such borrowings do not exceed the Company's Tangible Net Worth, as defined; borrowings in excess of the Company's Tangible Net Worth bear interest at LIBOR plus 3%. Borrowings are secured by a first lien security interest in all assets funded with proceeds from the Amended Line of Credit. At September 30, 1999, $78,500,000 had been borrowed under the Amended Line of Credit. All of these borrowings bear interest at LIBOR plus 1.25% per annum. The weighted average interest rate at September 30, 1999 was 6.63%. Effective as of July 1, 1998, the Company (and certain of its subsidiaries) entered into a $100 million Master Repurchase Agreement (the "Repurchase Agreement") with PSCC; subsequently, PSCC was replaced by Prudential-Bache International, Ltd. ("PBI"), an affiliate of PSCC, as lender. Borrowings under the Repurchase Agreement can be used to finance a portion of the Company's portfolio of mortgage-backed securities. The Repurchase Agreement provides that the Company may borrow a varying percentage of the market value of the purchased mortgage-backed securities, depending on the credit quality of such securities. Borrowings under the Repurchase Agreement bear interest at rates ranging from LIBOR plus 0.20% per annum to LIBOR plus 1.5% per annum depending upon the advance rate and the credit quality of the securities being financed. Borrowings under the facility are secured by an assignment to PBI of all mortgage-backed securities funded with proceeds from the Repurchase Agreement. The Repurchase Agreement matures on June 30, 2000. At September 30, 1999, $10,701,000 was outstanding under the Repurchase Agreement. At December 31, 1998, there were no outstanding borrowings under this facility. The weighted average interest rate at September 30, 1999 was 6.52%. Under the terms of the Amended Line of Credit and the Repurchase Agreement, PSCC and PBI, respectively, retain the right to mark the underlying collateral to market value. A reduction in the value of its pledged assets may require the Company to provide additional collateral or fund margin calls. From time to time, the Company may be required to provide such additional collateral or fund margin calls. The Company believes that the funds available under its two credit facilities will be sufficient to meet the Company's liquidity and capital requirements through the maturity date of the Amended Line of Credit. The Company believes that the Amended Line of Credit provides it with more flexibility, which in turn will allow it to utilize favorable financing terms in connection with the origination of investments. The Company, however, remains subject to capital constraints. In particular, the Company's ability to raise additional capital through the public equity and debt markets continues to be severely limited. Furthermore, the Company's ability to obtain additional secured debt beyond its existing credit facilities (or to replace its existing credit facilities) has not yet been fully explored. Currently, the Company does not expect to originate or acquire any new investments prior to the completion of its merger with ICH. 24 25 In the near term, the Company believes it will be constrained from accessing the public equity markets. In addition, new issues of long-term public unsecured debt would be difficult to obtain and, in any event, would likely not be available to the Company at a reasonable cost. Additional secured debt beyond the Company's Amended Line of Credit would also be difficult to obtain and may not be offered at a reasonable cost. Aside from limiting the Company's access to additional capital in the near term to fund growth, the Company has been relatively insulated from the effects of the dislocation in the capital markets. While the market value of the Company's CMBS holdings has declined, the Company invested in these bonds for the long term yields that they are expected to produce. Management believes that the fundamental value of the real estate mortgages underlying its bonds has been largely unaffected to date, although general economic conditions could adversely impact real estate values in the future. REIT STATUS Management believes that the Company is operated in a manner that will enable it to continue to qualify as a REIT for federal income tax purposes. As a REIT, the Company will not pay income taxes at the trust level on any taxable income which is distributed to its shareholders, although AMREIT II, Inc., its "Non-Qualified REIT Subsidiary", may be subject to tax at the corporate level. Qualification for treatment as a REIT requires the Company to meet certain criteria, including certain requirements regarding the nature of its ownership, assets, income and distributions of taxable income. The Company may, however, be subject to tax at normal corporate rates on any ordinary income or capital gains not distributed. YEAR 2000 ISSUE General Many of the world's computers, software programs and other equipment using microprocessors or embedded chips currently have date fields that use two digits rather than four digits to define the applicable year. These computers, programs and chips may be unable to properly interpret dates beyond the year 1999. For example, computer software that has date sensitive programming using a two-digit format may recognize a date using "00" as the year 1900 rather than the year 2000. This inability to properly process dates is commonly referred to as the "Year 2000 issue", the "Year 2000 problem" or the "Millennium Bug." These errors could potentially result in a system failure or miscalculation causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in similar normal business activities, which, in turn, could lead to disruptions in the Company's operations or performance. All of the Company's information technology infrastructure is provided by the Manager. The Manager's systems are supplied by AMRESCO, INC. The Company's assessments of the cost and timeliness of completion of Year 2000 modifications set forth below are based on representations made to the Company and the best estimates of the individuals within or engaged by AMRESCO, INC. charged with handling the Year 2000 issue. These estimates were derived using numerous assumptions relating to future events, including, without limitation, the continued availability of certain internal and external resources and third party readiness plans. Furthermore, as the AMRESCO, INC. Year 2000 initiative (described below) progresses, AMRESCO, INC., the Manager and the Company continue to revise estimates of the likely problems and costs associated with the Year 2000 issue and to adapt contingency plans. However, there can be no assurance that any estimate or assumption will prove to be accurate. The AMRESCO, INC. Year 2000 Initiative AMRESCO, INC. is conducting a comprehensive Year 2000 initiative with respect to its internal business-critical systems, including those upon which the Company depends. This initiative encompasses information technology ("IT") systems and applications, as well as non-IT systems and equipment with embedded technology, such as fax machines and telephone systems, which may be impacted by the Year 2000 issue. Business-critical systems encompass internal accounting systems, including general ledger, accounts payable and financial reporting applications; cash management systems; loan servicing systems; and decision support systems; as well as the underlying technology required to support the software. The initiative includes assessing, remediating or replacing, testing and upgrading the business-critical IT systems of AMRESCO, INC. with the assistance of a consulting firm that specializes in Year 2000 readiness. Based upon a review of the completed and planned stages of the initiative, and the testing done to date, AMRESCO, INC. does not anticipate any material difficulties in achieving Year 2000 readiness with respect to its internal business-critical systems used in connection with the operations of the Manager or the Company. The Company has received a written representation from AMRESCO, INC. that Year 2000 readiness was achieved by December 1998 with respect to all its internal business-critical systems used in connection with the operations of the Manager or the Company. 25 26 In addition to the internal IT systems and non-IT systems of AMRESCO, INC., the Company may be at risk from Year 2000 failures caused by or occurring to third parties. These third parties can be classified into two groups. The first group includes borrowers, significant business partners, lenders, vendors and other service providers with whom the Company, the Manager or AMRESCO, INC. has a direct contractual relationship. The second group, while encompassing certain members of the first group, is comprised of third parties providing services or functions to large segments of society, both domestically and internationally, such as airlines, utilities and national stock exchanges. As is the case with most other companies, the actions the Company, the Manager and AMRESCO, INC. can take to avoid any adverse effects from the failure of companies, particularly those in the second group, to become Year 2000 ready is extremely limited. However, AMRESCO, INC. has communicated with those companies that have significant business relationships with AMRESCO, INC., the Manager or the Company, particularly those in the first group, to determine their Year 2000 readiness status and the extent to which AMRESCO, INC., the Manager or the Company could be affected by any of their Year 2000 readiness issues. In connection with this process, AMRESCO, INC. has sought to obtain written representations and other independent confirmations of Year 2000 readiness from the third parties with whom AMRESCO, INC., the Manager or the Company has material contracts regarding the internal business-critical operations of the Company. AMRESCO, INC. and the Company have received written responses certifying Year 2000 readiness and/or have conducted testing from all but three of the vendors and other third parties providing goods and services supporting the internal business-critical functions identified in the initiative of the Company, the Manager and AMRESCO, INC. With respect to the three vendors who have not responded, alternative vendors have been identified or a contingency plan has been developed to address a business interruption arising from the Year 2000 issue. To date, eight of sixteen borrowers to which letters were sent have represented in writing that they are Year 2000 ready. Based on responses received and testing to date, it is not currently anticipated that AMRESCO, INC., the Manager or the Company will be materially affected by any third party Year 2000 readiness issues in connection with the operations of the Company or the Manager. For all business-critical systems interfaces used in connection with the operations of the Manager and the Company, AMRESCO, INC. advised the Company that readiness was achieved by December 31, 1998. Replacement providers believed to be compliant have been identified for significant third party providers that did not complete their Year 2000 initiatives. There can be no assurance that the systems of AMRESCO, INC. or those of third parties will not experience adverse effects after December 31, 1999. Furthermore, there can be no assurance that a failure to convert by another company, or a conversion that is not compatible with the systems of AMRESCO, INC. or those of other companies on which the systems of AMRESCO, INC. rely, would not have a material adverse effect on the Company. Under the terms of the Company's Management Agreement with the Manager, all of the costs associated with addressing the Company's Year 2000 issue are to be borne by the Manager. Therefore, the Company does not anticipate that it will incur any expenditures in connection with any modifications necessary to achieve Year 2000 readiness. Potential Risks In addition to the internal systems of AMRESCO, INC. and the systems and embedded technology of third parties with whom AMRESCO, INC., the Manager and the Company do business, there is a general uncertainty regarding the overall success of global remediation efforts relating to the Year 2000 issue, including those efforts of providers of services to large segments of society, as described above in the second group. Due to the interrelationships on a global scale that may be impacted by the Year 2000 issue, there could be short-term disruptions in the capital or real estate markets or longer-term disruptions that would affect the overall economy. 26 27 Due to the general uncertainty with respect to how this issue will affect businesses and governments, it is not possible to list all potential problems or risks associated with the Year 2000 issue. However, some examples of problems or risks to the Company that could result from the failure by third parties to adequately deal with the Year 2000 issue include: o in the case of lenders, the potential for liquidity stress due to disruptions in funding flows; o in the case of exchanges and clearing agents, the potential for funding disruptions and settlement failures; o in the case of counterparties, accounting and financial difficulties to those parties that may expose the Company to increased credit risk; and o in the case of vendors or providers, service failures or interruptions, such as failures of power, telecommunications and the embedded technology in building systems (such as HVAC, sprinkler and fire suppression, elevators, alarm monitoring and security, and building and parking garage access). With respect to the Company's loan portfolio, risks due to the potential failure of third parties to be ready to deal with the Year 2000 issue include: o potential borrower defaults resulting from increased expenses or legal claims related to failures of embedded technology in building systems, such as HVAC, sprinkler and fire suppression, elevators, alarm monitoring and security, and building and parking garage access; o potential reductions in collateral value due to failure of one or more of the building systems; o interruptions in cash flow due to borrowers being unable to obtain timely lease payments from tenants or incomplete or inaccurate accounting of rents; o potential borrower defaults resulting from computer failures of retail systems of major tenants in retail commercial real estate properties such as shopping malls and strip shopping centers; o construction delays resulting from contractors' failure to be Year 2000 ready and increased costs of construction associated with upgrading building systems to be Year 2000 compliant; and o delays in reaching projected occupancy levels due to construction delays, interruptions in service or other market factors. These risks are also applicable to the Company's portfolio of CMBS as these securities are dependent upon the pool of mortgage loans underlying them. If the investors in these types of securities demand higher returns in recognition of these potential risks, the market value of any CMBS portfolio of the Company also could be adversely affected. Additionally, the Company has made equity investments in a partnership that owns interests in five grocery-anchored shopping centers and in a partnership which owns a suburban office building. Furthermore, the Company's unconsolidated taxable subsidiary holds interests (indirectly) in a partnership which owns a mixed-use property. These operations will be subject to many of the risks set forth above. Although the Company intends to monitor Year 2000 readiness, there can be no guarantee that all building systems will be Year 2000 compliant. The Company believes that the risks most likely to affect the Company adversely relate to the failure of third parties, including its borrowers and sources of capital, to achieve Year 2000 readiness. If its borrowers' systems fail, the result could be a delay in making payments to the Company or the complete business failure of such borrowers. The failure, although believed to be unlikely, of the Company's sources of capital to achieve Year 2000 readiness could result in the Company being unable to obtain the funds necessary to continue its normal business operations. 27 28 Reasonably Likely Worst Case Scenario / Business Continuity / Disaster Recovery Plan The failure to correct a material Year 2000 problem could result in systems failures leading to a disruption in or failure of some normal business activities or operations. The most reasonably likely worst case scenario would involve a failure of the Manager's and the Company's accounting and management systems. In this case, the Company would temporarily convert its systems to a manual system. AMRESCO, INC. currently has a business continuity/disaster recovery plan that includes business resumption processes that do not rely on computer systems and the maintenance of hard copy files, where appropriate. The business continuity/disaster recovery plan is monitored and updated as potential Year 2000 readiness issues of AMRESCO, INC. and third parties are specifically identified. Due to the inability to predict all of the potential problems that may arise in connection with the Year 2000 issue, there can be no assurance that all contingencies will be adequately addressed by this contingency plan. FORWARD-LOOKING STATEMENTS Certain statements contained in this Form 10-Q are not based on historical facts and are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends that forward-looking statements be subject to such Act and any similar state or federal laws. Forward-looking statements, which are based on various assumptions, include statements regarding the intent, belief or current expectations of the Company, its Manager, and their respective Trustees or directors and officers, and may be identified by reference to a future period or periods or by use of forward-looking terminology such as "intends," "may," "could," "will," "believe," "expect," "anticipate," "plan," or similar terms or variations of those terms or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to risks, uncertainties and changes with respect to a variety of factors, including, but not limited to, changes in international, national, regional or local economic environments, changes in prevailing interest rates, credit and prepayment risks, basis and asset/liability risks, spread risk, event risk, conditions which may affect public securities and debt markets generally or the markets in which the Company operates, the Year 2000 issue, the availability of and costs associated with obtaining adequate and timely sources of liquidity, dependence on existing sources of funding, the size and liquidity of the secondary market for commercial mortgage-backed securities, geographic or product type concentrations of assets (temporary or otherwise), hedge mismatches with liabilities, other factors generally understood to affect the real estate acquisition, mortgage and leasing markets and securities investments, changes in federal income tax laws and regulations, and other risks described from time to time in the Company's SEC reports and filings, including its registration statement on Form S-11 and periodic reports on Form 10-Q, Form 8-K and Form 10-K. 28 29 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is a party to various financial instruments which are subject to market risk. These instruments include mortgage loan investments, investments in commercial mortgage-backed securities ("CMBS") and certain of the Company's borrowing facilities. The Company is also a party to an interest rate cap agreement which it entered into in order to mitigate the market risk exposure associated with its credit facilities. The Company's financial instruments involve, to varying degrees, elements of interest rate risk. Additionally, the Company's investment portfolio, which is comprised of both financial instruments (mortgage loans and CMBS) and equity investments in real estate, is subject to real estate market risk. The Company is a party to certain other financial instruments, including trade receivables and payables and amounts due to affiliates which, due to their short-term nature, are not subject to market risk. For a full discussion of market risk exposures, reference is made to Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" in the Company's Annual Report on Form 10-K for the year ended December 31, 1998. The market risk exposures described below are intended to supplement the disclosures included in the Company's Form 10-K. Commercial Mortgage-backed Securities The fair values of the Company's investments in non-investment grade CMBS are subject to both interest rate risk and spread risk. The non-investment grade, or subordinated classes, of CMBS typically include classes with credit ratings below investment grade "BBB". As the subordinated classes provide credit protection to the senior classes by absorbing losses from underlying mortgage loan defaults or foreclosures, they also carry more credit risk than the senior classes. Among other factors, the fair value of the Company's interests in CMBS is dependent upon, and is sensitive to changes in, comparable-term U.S. Treasury rates and the spreads over such U.S. Treasury rates in effect from time to time. Spreads over comparable-term U.S. Treasury rates, which are based upon supply and demand factors, typically vary across different classes of CMBS and are generally greater for each successively lower rated class of CMBS. Spreads are influenced by a number of factors including, but not limited to, investor expectations with respect to future economic conditions, interest rates and real estate market factors, all or any of which can impact the ability of borrowers to perform under the terms of the mortgage loans underlying CMBS. As a result, even in an environment characterized by relatively constant U.S. Treasury rates and low commercial mortgage default rates, the value of the Company's CMBS holdings can be adversely impacted simply by increasing spreads. This situation occurred during the latter half of 1998 and was the primary reason for the decline in the value of the Company's CMBS holdings. Notwithstanding this decline in value, the cash flows from the Company's CMBS were unaffected by this spread widening. As of September 30, 1999, the Company held five commercial mortgage-backed securities with credit ratings ranging from "BB-" to "B-". The weighted average duration of these bonds approximated 5.8 years as of that date. The estimated fair value of the Company's CMBS holdings was $26.0 million at September 30, 1999. All other things being equal, a 100 basis point increase or decrease in comparable-term U.S. Treasury rates (from those in effect as of September 30, 1999) would be expected to cause the value of the Company's CMBS to decline or increase, respectively, by approximately $1.5 million. Similarly, if comparable-term U.S. Treasury rates remained constant but spreads over such U.S. Treasury rates increased by 100 basis points (from those quoted as of September 30, 1999) for each of the classes of CMBS owned by the Company, the fair value of its securities portfolio would also be expected to decline by approximately $1.5 million. Conversely, a 100 basis point decline in spreads across all classes of CMBS (all other things being equal) would be expected to increase the value of the portfolio by a like amount. The Company's unconsolidated taxable subsidiary holds one commercial mortgage-backed security that has a credit rating of "B-". The estimated fair value of this bond and its duration at September 30, 1999 were $3.3 million and 2.5 years, respectively. All other things being equal, a 100 basis point increase or decrease in comparable-term U.S. Treasury rates (from those in effect as of September 30, 1999) would be expected to cause the value of this security to decline or increase, respectively, by approximately $82,000. Similarly, if comparable-term U.S. Treasury rates remained constant but spreads over such U.S. Treasury rates (for this security) increased or decreased by 100 basis points (from those quoted as of September 30, 1999), then the value of the bond would also be expected to decline or increase, respectively, by approximately $82,000. These amounts exclude the tax effects associated with reporting unrealized gains and losses. As these securities are classified as available for sale, unrealized gains and losses are excluded from earnings and reported as a component of accumulated other comprehensive income (loss) in shareholders' equity. In the absence of a sale or a 29 30 decline in fair value that is deemed to be other than temporary, the Company's earnings would not be impacted by the changes in fair value described above. Borrowing Facilities The Company is a party to two credit facilities, each of which bears interest at floating rates. Specifically, both facilities bear interest at varying spreads over one month LIBOR. One of the facilities can be used to finance the Company's structured loan and equity real estate investments (the "Amended Line of Credit") while the other facility can be used to finance the Company's CMBS (the "Repurchase Agreement"). As of September 30, 1999, amounts outstanding under the Amended Line of Credit and the Repurchase Agreement totaled $78.5 million and $10.7 million, respectively. To reduce the impact of changes in interest rates on these floating rate debt facilities, the Company purchased an interest rate cap agreement. As described below, this agreement reduces (but does not eliminate) the Company's risk of incurring higher interest costs due to rising interest rates. If the one-month LIBOR on September 30, 1999 increased by 100 basis points on that date (from 5.40% to 6.40%) and then remained constant at the higher rate for twelve consecutive months, the Company's interest costs on its outstanding borrowings ($89.2 million), in the absence of the interest rate cap agreement described below, would increase by approximately $892,000 for the twelve month period ending September 30, 2000. In order to reduce the impact that rising interest rates would have on this floating rate indebtedness, the Company entered into an interest rate cap agreement effective August 1, 1999. The cap agreement has a notional amount of $59.0 million. Until its expiration on November 1, 2000, the agreement entitles the Company to receive from the counterparty the amounts, if any, by which one-month LIBOR exceeds 6.25% multiplied by the notional amount. If the one-month LIBOR increased as described above, the Company would receive approximately $89,000 from the counterparty under the terms of the cap agreement. Under this scenario, earnings and cash flows for the twelve month period ending September 30, 2000 would be reduced by a net amount of approximately $803,000. Any further increase in one-month LIBOR would effect only that portion of the Company's indebtedness in excess of the cap agreement's notional amount ($30.2 million). As the Company paid an up-front, one-time premium of $110,000 for the cap, there is no liquidity risk to the Company associated with holding this derivative financial instrument. Conversely, a sustained 100 basis point reduction in the one-month LIBOR (if it occurred on September 30, 1999) would increase earnings and cash flows for the twelve month period ending September 30, 2000 by approximately $892,000. Under this scenario, no payments would be received from the counterparty under the cap agreement. The Company (through a majority-owned partnership) is indebted under the terms of five non-recourse loans aggregating $34.6 million. As the loans bear interest at a fixed rate, the Company's future earnings and cash flows would not be reduced in the event of rising interest rates. 30 31 PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits and Exhibit Index Exhibit No. 2.1 Agreement and Plan of Merger, dated as of August 4, 1999, by and between the Company and Impac Commercial Holdings, Inc. (filed as Exhibit 2.1 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999, which exhibit is incorporated herein by reference). 4.1 Rights Agreement, dated as of February 25, 1999, between the Company and The Bank of New York, as Rights Agent, which includes: as Exhibit A thereto, the Form of Statement of Designation of Series A Junior Participating Preferred Shares, par value $.01 per share, of the Company; as Exhibit B thereto, the Form of Right Certificate; and as Exhibit C thereto, the Summary of Rights to Purchase Preferred Shares (filed as Exhibit 1 to the Registrant's Current Report on Form 8-K dated February 25, 1999, which exhibit is incorporated herein by reference). 10.1 Amended and Restated Interim Warehouse and Security Agreement dated as of May 4, 1999, by and among Prudential Securities Credit Corporation and AMRESCO Capital Trust, AMREIT I, Inc., AMREIT II, Inc., ACT Equities, Inc. and ACT Holdings, Inc. (filed as Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, which exhibit is incorporated herein by reference). 10.2 Warrant Agreement dated as of May 4, 1999 between AMRESCO Capital Trust and Prudential Securities Incorporated (filed as Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, which exhibit is incorporated herein by reference). 10.3 Management Agreement, dated as of May 12, 1998, by and between AMRESCO Capital Trust and AMREIT Managers, L.P. 27 Financial Data Schedule. (b) Reports on Form 8-K. The following reports on Form 8-K were filed with respect to events occurring during the quarterly period for which this report is filed: (i) Form 8-K dated August 5, 1999 and filed with the Commission on August 9, 1999, reporting the announcement that AMRESCO Capital Trust and Impac Commercial Holdings, Inc. had entered into a merger agreement, under Item 5 of such form. 31 32 SIGNATURE Pursuant to the requirements 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. AMRESCO CAPITAL TRUST Registrant Date: November 12, 1999 By: /s/ Thomas R. Lewis II ---------------------- Thomas R. Lewis II Vice President and Controller (Chief Accounting Officer) 32 33 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Agreement and Plan of Merger, dated as of August 4, 1999, by and between the Company and Impac Commercial Holdings, Inc. (filed as Exhibit 2.1 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999, which exhibit is incorporated herein by reference). 4.1 Rights Agreement, dated as of February 25, 1999, between the Company and The Bank of New York, as Rights Agent, which includes: as Exhibit A thereto, the Form of Statement of Designation of Series A Junior Participating Preferred Shares, par value $.01 per share, of the Company; as Exhibit B thereto, the Form of Right Certificate; and as Exhibit C thereto, the Summary of Rights to Purchase Preferred Shares (filed as Exhibit 1 to the Registrant's Current Report on Form 8-K dated February 25, 1999, which exhibit is incorporated herein by reference). 10.1 Amended and Restated Interim Warehouse and Security Agreement dated as of May 4, 1999, by and among Prudential Securities Credit Corporation and AMRESCO Capital Trust, AMREIT I, Inc., AMREIT II, Inc., ACT Equities, Inc. and ACT Holdings, Inc. (filed as Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, which exhibit is incorporated herein by reference). 10.2 Warrant Agreement dated as of May 4, 1999 between AMRESCO Capital Trust and Prudential Securities Incorporated (filed as Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, which exhibit is incorporated herein by reference). 10.3 Management Agreement, dated as of May 12, 1998, by and between AMRESCO Capital Trust and AMREIT Managers, L.P. 27 Financial Data Schedule.
EX-10.3 2 MANAGEMENT AGREEMENT 1 EXHIBIT 10.3 MANAGEMENT AGREEMENT THIS MANAGEMENT AGREEMENT (this "Agreement"), dated as of May 12, 1998, is by and between AMRESCO CAPITAL TRUST, a Texas real estate investment trust (the "Company"), and AMREIT MANAGERS, L.P., a Delaware limited partnership (the "Manager"). WHEREAS, the Company intends to invest in various types of real estate related assets and to qualify as a "real estate investment trust" under the Internal Revenue Code of 1986, as amended (the "Code"); and WHEREAS, the Company desires to retain the Manager to undertake, on the Company's behalf, the duties and responsibilities set forth in this Agreement, subject to the direction and oversight of the Board of Trust Managers of the Company (the "Board of Trust Managers"), on the terms and conditions set forth in this Agreement; and WHEREAS, the Manager desires to undertake, on the Company's behalf, the duties and responsibilities set forth in this Agreement, subject to the direction and oversight of the Board of Trust Managers, on the terms and conditions set forth in this Agreement. NOW THEREFORE, in consideration of the mutual agreements herein set forth, the parties hereto agree as follows: SECTION 1 Definitions. Capitalized terms used herein and not otherwise defined herein shall have the respective meanings assigned to them below: (a) "AMRESCO Group" means AMRESCO, Inc. together with its affiliated entities. (b) "Average Invested Investment Grade Assets" means, for any quarter, the average of the aggregate book value of the assets of the Company on a consolidated basis (as reflected on the Company's balance sheet) and of all of the Company's nonconsolidated taxable subsidiaries (but excluding the Company's investment in such subsidiaries), which either (i) have received an Investment Grade Rating from all Rating Agencies which have rated such asset or (ii) are unrated but are guaranteed by the U.S. government or any agency or instrumentality thereof, before reserves for depreciation or bad debts or other similar noncash reserves, computed by dividing (a) the sum of such values for each of the three months during such quarter (based on the book value of such assets as of the last day of each month) by (b) three. (c) "Average Invested Non-Investment Grade Assets" means, for any quarter, the average of the aggregate book value of the assets of the Company on a consolidated basis (as reflected on the Company's balance sheet) and of all of the Company's nonconsolidated taxable subsidiaries (but excluding the Company's investment in such subsidiaries), other than Average Invested Investment Grade 2 Assets, before reserves for depreciation or bad debts or other similar noncash reserves, computed by dividing (a) the sum of such values for each of the three months during such quarter (based on the book value of such assets as of the last day of each month) by (b) three. (d) "Chief Investment Officer" means the Chief Investment Officer of the Company. (e) "Closing Date" means the date of closing of the Company's initial public offering of its Common Shares. (f) "Common Shares" means the Company's common shares of beneficial interest, $.01 par value per share. (g) "Confidential Information" means all information of the Company not generally known in the Company's industry or in the financial markets which is obtained by the Manager from the Company or directly as a result of the performance by the Manager of its services to the Company pursuant to this Agreement. (h) "Exchange Act" means the Securities Exchange Act of 1934, as amended. (i) "Funds From Operations" or "FFO" means net income (computed in accordance with generally accepted accounting principles) excluding gains or losses from debt restructuring and sales of property, plus depreciation and amortization on real estate assets and after adjustments for unconsolidated partnerships and joint ventures. (j) "Governing Instruments" means (i) with respect to the Company, its Declaration of Trust and Bylaws, (ii) with respect to any Subsidiary which is a corporation, the articles or certificate of incorporation and bylaws of such corporation, (iii) with respect to any Subsidiary which is a partnership, the partnership agreement of such partnership and (iv) with respect to any Subsidiary which is a limited liability company the articles of organization and the regulations of such limited liability company, in each case, as the same may be amended from time to time. (k) "Guidelines" means the operating policies and general guidelines for the Company's investments, borrowings and operations, as approved by the Board of Trust Managers of the Company and in effect from time to time. The Guidelines, as initially approved by the Board of Trust Managers of the Company, are attached hereto as Exhibit "A.". MANAGEMENT AGREEMENT - PAGE 2 3 (l) "Investment Grade Rating" means a rating equal to or higher than (i) "BBB-" by Standard & Poor's Rating Services, a division of the McGraw-Hill Companies, (ii) "Baa3" by Moody's Investors Services, Inc., (iii) "2" by National Association of Insurance Commissioners, (iv) "BBB-" by Duff and Phelps Credit Rating Co. or (v) "BBB-" by Fitch IBCA, Inc. (m) "Master Servicing" means providing administrative and reporting services to securitized pools of MBS. (n) "MBS" means mortgage-backed securities (including commercial or multifamily mortgage backed securities and residential mortgage backed securities). (o) "Mezzanine Loan" means a commercial real estate loan the repayment of which is subordinated to a senior Mortgage Loan and which is secured either by a second lien mortgage or a pledge of the ownership interests of the borrower. Such loans can also take the form of a preferred equity investment in the borrower. (p) "Mortgage Loans" means, collectively, loans secured by real property and Mezzanine Loans. (q) "Nasdaq" means the Nasdaq National Market. (r) "Nonperforming Mortgage Loans" means Mortgage Loans for which the payment of principal and/or interest is more than 90 days delinquent. (s) "NYSE" means the New York Stock Exchange. (t) "REIT" means a real estate investment trust, as defined under Section 856 of the Code. (u) "REIT Provisions of the Code" means Sections 856 through 860 of the Code. (v) "Securities Act" means the Securities Act of 1933, as amended. (w) "Special Servicer" means an entity which services delinquent and/or defaulted Mortgage Loans, including the oversight and management of the resolution of such Mortgage Loans by modification, foreclosure, deed in lieu of foreclosure or otherwise. (x) "Special Servicing" means the oversight and management of the resolution of Mortgage Loans by workout or modification of loan provisions, foreclosure, deed in lieu of foreclosure or otherwise, and the control of decisions MANAGEMENT AGREEMENT - PAGE 3 4 with respect to the preservation of the collateral generally, including property management and maintenance decisions. (y) "Special Servicing Rights" means rights to control the oversight and management of the resolution of Mortgage Loans by workout or modification of loan provisions, foreclosure, deed in lieu of foreclosure or otherwise, and to control decisions with respect to the preservation of the collateral generally, including property management and maintenance decisions. (z) "Subperforming Mortgage Loans" means Mortgage Loans for which default is likely or imminent or for which the borrower is making payments in accordance with a forbearance plan. (aa) "Subsidiary" means any corporation, partnership, limited liability company or other entity formed and controlled by the Company. (bb) "Ten-Year U.S. Treasury Rate" means the arithmetic average of the weekly average yield to maturity for actively traded current coupon U.S. Treasury fixed interest rate securities (adjusted to a constant maturity of ten years) published by the Federal Reserve Board during a quarter, or, if such rate is not published by the Federal Reserve Board, any Federal Reserve Bank or agency or department of the federal government selected by the Company. If the Company determines in good faith that the Ten-Year U.S. Treasury Rate cannot be calculated as provided above, then the rate shall be the arithmetic average of the per annum average yields to maturities, based upon closing asked prices on each business day during a quarter, for each actively traded marketable U.S. Treasury fixed interest rate security with a final maturity date not less than eight nor more than twelve years from the date of the closing asked prices as chosen and quoted for each business day in each such quarter in New York City by at least three recognized dealers in U.S. government securities selected by the Company. (cc) "Trust Manager" means a member of the Board of Trust Managers. SECTION 2 Duties of the Manager. (a) Subject to the direction and oversight of the Board of Trust Managers and in accordance with the Governing Instruments, the Manager shall be responsible for the day-to-day operations of the Company and perform (or cause to be performed as permitted herein) services and activities relating to the assets and operations of the Company, including, without limitation, the following: (i) providing a complete program of investing and reinvesting the capital and assets of the Company in pursuit of its investment objectives and in accordance with the Guidelines and policies adopted by the Board of Trust Managers from time to time; MANAGEMENT AGREEMENT - PAGE 4 5 (ii) serving as the Company's consultant with respect to formulation of investment criteria and policies and preparation of the Guidelines by the Board of Trust Managers; (iii) assisting the Company in developing criteria for asset purchase commitments that are specifically tailored to the Company's investment objectives and making available to the Company its knowledge and experience with respect to Mortgage Loans, MBS, real estate and other real estate related assets; (iv) representing and making recommendations to the Company in connection with the origination of Mortgage Loans, the purchase of and commitment to purchase Mortgage Loans, MBS, real estate and other real estate related assets, the financing of Mortgage Loans, MBS, real estate and other real estate related assets, and the sale and commitment to sell Mortgage Loans, MBS, real estate and other real estate related assets (including, without limitation, the underwriting of Mortgage Loans, the accumulation of Mortgage Loans for securitization and arrangement for the issuance of MBS from pools of Mortgage Loans owned by the Company); (v) furnishing reports and statistical and economic research to the Company regarding market conditions in the areas in which the Company proposes to invest as well as the Company's activities and the services performed for the Company by the Manager; (vi) monitoring and providing to the Board of Trust Managers on an ongoing basis price information and other data, obtained from certain nationally recognized brokers or dealers identified by the Board of Trust Managers from time to time, and providing data and recommendations to the Board of Trust Managers in connection with the identification of such brokers or dealers; (vii) providing the executive and administrative personnel and office space and office and administrative services required in rendering services to the Company; (viii) monitoring the operating performance of the Company's investments and providing periodic reports with respect thereto to the Board of Trust Managers, including comparative information with respect to such operating performance and budgeted or projected operating results; (ix) administering the day-to-day operations of the Company and performing and supervising the performance of such other administrative functions necessary for the management of the Company and its assets as MANAGEMENT AGREEMENT - PAGE 5 6 may be agreed upon by the Manager and the Board of Trust Managers, including the collection of revenues and the payment of the Company's debts and obligations; (x) communicating on behalf of the Company with the holders of any equity or debt securities of the Company as required to satisfy the reporting and other requirements of any governmental bodies or agencies and to maintain effective relations with such holders; (xi) counseling the Company in connection with policy decisions made or to be made by the Board of Trust Managers, including, without limitation, policy decisions with respect to investments, leveraging of the Company's assets, management of the credit risk of the Company's assets, management of the interest rate risks of the Company's assets, including decisions with respect to hedging of the assets and compliance with certain legal requirements; (xii) advising the Company regarding its status as a REIT, consulting with legal counsel as appropriate regarding the application of the REIT Provisions of the Code to the proposed investments and operations of the Company and monitoring compliance by the Company with the REIT Provisions of the Code; (xiii) advising the Company regarding the status of its exemption from the Investment Company Act of 1940, as amended, consulting with legal counsel as appropriate regarding the nature of its proposed investments and the impact of such proposed investments on the Company's exemption from registration under such Act and monitoring the Company's continuing exemption from registration; (xiv) evaluating and recommending hedging strategies to the Board of Trust Managers and, upon approval by the Board of Trust Managers, engaging in hedging activities on behalf of the Company, consistent with the Company's status as a REIT and with the Guidelines; (xv) upon request by and in accordance with the directions of the Board of Trust Managers, investing or reinvesting any money of the Company, and advising the Company as to its capital structure and capital raising; (xvi) causing the Company to retain qualified accountants and/or legal counsel to assist in developing appropriate accounting procedures, compliance procedures and testing systems with respect to financial reporting obligations and compliance with the REIT Provisions of the Code and to conduct quarterly compliance reviews with respect thereto; MANAGEMENT AGREEMENT - PAGE 6 7 (xvii) causing the Company to qualify to do business in all applicable jurisdictions; (xviii) assisting the Company in complying with all federal, state and local regulatory requirements applicable to the Company in respect of its business activities, including, without limitation, preparing or causing to be prepared all financial statements required under applicable regulations and contractual undertakings and all reports and documents, if any, required under the Exchange Act; (xix) taking all necessary actions to enable the Company to make required federal, state and local tax filings and reports, including, without limitation, soliciting shareholders for required information to the extent provided by the REIT Provisions of the Code; (xx) handling and resolving all claims, disputes or controversies (including all litigation, arbitration, settlement or other proceedings or negotiation) in which the Company may be involved or to which the Company may be subject arising out of the Company's day-to-day operations, subject to such limitation or parameters as may be imposed from time to time by the Board of Trust Managers; (xxi) using commercially reasonable efforts to cause expenses incurred by or on behalf of the Company to be reasonable or customary and within any budgeted parameters or Guidelines set by the Board of Trust Managers from time to time; (xxii) performing such other services as may be required from time to time for management or other activities relating to the assets of the Company in furtherance of the Manager's obligations hereunder, as the Board of Trust Managers shall reasonably request or the Manager shall deem appropriate under the particular circumstances; and (xxiii) using commercially reasonable efforts to cause the Company to comply with all applicable laws. (b) The Manager will perform portfolio management services on behalf of the Company with respect to the Company's investments. Such services will include, but not be limited to, consulting the Company on purchase, sale and other opportunities, collection of information and submission of reports pertaining to the Company's assets, interest rates, and general economic conditions, periodic review and evaluation of the performance of the Company's portfolio of assets, acting as liaison between the Company and banking, mortgage banking, investment banking and other parties with respect to the purchase, financing and disposition of assets, MANAGEMENT AGREEMENT - PAGE 7 8 and other customary functions related to portfolio management. The Manager may enter into subcontracts with other parties, including AMRESCO, Inc. and its affiliates, to provide any such services to the Company. (c) The Manager will monitor and administer the loan servicing activities provided by servicers of the Company's Mortgage Loans, other than loans pooled to collateralize MBS or pledged to secure MBS. Such monitoring and administrative services will include, but not be limited to, the following activities: serving as the Company's consultant with respect to the servicing of loans; collection of information and submission of reports pertaining to the Mortgage Loan and the moneys remitted to the Manager or the Company by servicers; periodic review and evaluation of the performance of each servicer to determine its compliance with the terms and conditions of the servicing agreement and, if deemed appropriate, recommending to the Company the termination of such servicing agreement; acting as a liaison between servicers and the Company and working with servicers to the extent necessary to improve their servicing performance; review of and recommendations as to fire losses, easement problems and condemnation, delinquency and foreclosure procedures with regard to the Mortgage Loans; review of servicers' delinquency, foreclosing and other reports on Mortgage Loans; advising as to and supervising claims filed under any mortgage insurance policies; and enforcing the obligation of any servicer to repurchase Mortgage Loans from the Company. (d) The Manager will perform monitoring services on behalf of the Company with respect to loan servicing activities provided by third parties and with respect to the Company's portfolio of Special Servicing Rights. Such monitoring services will include, but not be limited to: negotiating Special Servicing agreements; acting as liaison between the servicers of the Mortgage Loans and the Company; review of servicer's delinquency, foreclosures and other reports on Mortgage Loans; supervising claims filed under any mortgage insurance policies; and enforcing the obligation of any servicer to repurchase Mortgage Loans. (e) The Manager agrees to use its commercially reasonable efforts at all times in performing services for the Company hereunder and in accordance with the Guidelines and policies of the Company in effect from time to time. SECTION 3. Obligations of the Manager and the Company. (a) The Manager shall use commercially reasonable efforts to determine, in good faith, whether each Mortgage Loan, MBS, real estate or other real estate asset proposed to be acquired by the Company conforms to the investment criteria and Guidelines of the Company approved from time to time by the Board of Trust Managers. MANAGEMENT AGREEMENT - PAGE 8 9 (b) The Manager shall require each seller or transferor of assets to the Company to make such representations and warranties regarding such assets as are customarily made in similar transactions and as may, in the judgment of the Manager, be necessary and/or appropriate. With respect to Mortgage Loans acquired by the Company, and to the extent consistent with prevailing industry practices, the Manager shall use commercially reasonable efforts to require the seller or transferor of any Mortgage Loan to the Company to agree to repurchase any such Mortgage Loan with respect to which there is fraud or misrepresentation. In addition, the Manager shall take all such other action as it deems reasonably necessary or appropriate with regard to the protection of the Company's investments. (c) The Manager shall refrain from any action which, in its sole judgment made in good faith, (i) would adversely affect the status of the Company as a REIT under the Code, (ii) would violate any law, rule or regulation of any governmental body or agency having jurisdiction over the Company which violation could have a material adverse effect on the Company, its business or assets or results of operations or (iii) would otherwise not be permitted by the Governing Instruments, the Guidelines, any operating policies adopted from time to time by the Company or any agreements of the Company which have previously been provided to the Manager. If the Manager is ordered to take any such action by the Board of Trust Managers, the Manager shall promptly notify the Board of Trust Managers of the Manager's judgment that such action would adversely affect such status or violate any such law, rule or regulation or the Governing Instruments, the Guidelines, the operating policies adopted from time to time by the Company or any agreements which have previously been provided to the Manager. (d) The Manager shall cause Deloitte & Touche LLP, or another independent accounting firm having the requisite expertise and reputation, to review the Company's assets and operations on a quarterly basis to determine whether the Company has complied with the REIT Provisions of the Code. The Manager shall cause such accounting firm to deliver to the Board of Trust Managers no later than March 31 of each year an annual report regarding compliance by the Company with the REIT Provisions of the Code for the preceding fiscal year. (e) The Manager shall prepare regular reports for the Board of Trust Managers that will review the Company's acquisitions of assets, portfolio composition and characteristics, credit quality and compliance with the Guidelines and the operating performance of such assets (including comparative information with respect to such operating performance and budgeted or projected operating results). (f) In purchasing assets for the Company, the Manager shall endeavor to obtain on behalf of the Company terms no less favorable than commercially reasonable terms. In assessing commercially reasonable terms for any transaction, MANAGEMENT AGREEMENT - PAGE 9 10 the Manager shall consider all factors which it, in good faith, deems relevant, including the breadth of the market in the asset, the price of the asset, the reasonableness of any broker commissions both for the specific transaction and on a continuing basis and the market terms determined in comparable arm's length transactions. (g) The Company agrees to take all actions reasonably required to permit the Manager to carry out its duties and obligations under this Agreement. The Company further agrees to make available to the Manager all materials reasonably requested by the Manager to enable the Manager to satisfy its obligations to deliver financial statements and other information or reports with respect to the Company. (h) The Manager agrees, at all times during which it is serving as Manager to the Company, to (i) maintain a tangible net worth of at least $250,000 and (ii) maintain "errors and omissions" insurance coverage (which may be provided by a policy or policies maintained through, and providing coverage for, other members of the AMRESCO Group) in an amount which is comparable to that customarily maintained by other managers or servicers of assets similar to those held by the Company. SECTION 4. Additional Activities of Manager. (a) Except as expressly provided below, this Agreement shall not prevent or restrict the Manager or any other member of the AMRESCO Group, or any of their respective officers, directors, partners, officers, stockholders, employees or Affiliates from engaging in other businesses or from rendering services of any kind to any other Person, including investment in, or advisory service to others investing in, any type of real estate related assets, including assets which meet the principal investment objectives of the Company; provided, however, that during the term of this Agreement, neither the Manager, nor any other member of the AMRESCO Group, nor any of their respective directors, partners, officers, employees or affiliates (while acting in such capacity only) will (i) sponsor, (ii) act as manager to or (iii) make any significant equity investment in, any other REIT with investment objectives substantially similar to those of the Company, without the prior approval of a majority of the Independent Trust Managers. (b) Directors, partners, officers, stockholders, employees and Affiliates of the Manager or any other member of the AMRESCO Group may serve as directors, partners, officers, stockholders, employees or signatories for the Company or any Subsidiary of the Company, to the extent permitted by their Governing Instruments, as from time to time amended, or by any resolutions duly adopted by the Board of Trust Managers pursuant to the Company's Governing Instruments. When executing documents or otherwise acting in such capacities for the Company, such persons shall use their respective titles in the Company. MANAGEMENT AGREEMENT - PAGE 10 11 (c) Nothing in this Agreement shall prevent the Manager or any other member of the AMRESCO Group from selling assets to, or engaging in any other transaction with, the Company; provided, that any such transactions must be effected in accordance with the Guidelines or shall otherwise be approved in advance by a majority of the Independent Trust Managers. SECTION 5. Bank Accounts. At the direction of the Board of Trust Managers, the Manager may establish and maintain one or more bank accounts in the name of the Company, and may collect and deposit into any such account or accounts, and disburse funds from any such account or accounts, under such terms and conditions as the Board of Trust Managers may approve. The Manager shall from time to time (or at any time upon the request of a majority of the Independent Trust Managers) render appropriate accounting of such collections and payments to the Board of Trust Managers and, upon request, to the auditors of the Company. SECTION 6. Records; Confidentiality. The Manager shall maintain appropriate books of accounts and records relating to the assets of the Company and the services performed hereunder, and such books of account and records shall be accessible for inspection by representatives of the Company at any time during normal business hours. Except in the ordinary course of business or as required by the Securities Act, the Exchange Act, NYSE, Nasdaq or any statute, rule, regulation, order or decree of any governmental entity, the Manager agrees not to disclose any Confidential Information to third parties who are not Affiliates of the Manager, except with the prior approval of a majority of Independent Trust Managers. SECTION 7. Compensation. (a) For services rendered under this Agreement, the Company shall pay to the Manager a base management fee calculated and payable quarterly in an amount equal to (i) 1% per annum of the Average Invested Non-Investment Grade Assets of the Company and (ii) 0.50% per annum of the Average Invested Investment Grade Assets of the Company. (b) In addition to the base management fee, the Manager shall be entitled to receive incentive compensation for each fiscal quarter in an amount equal to the product of (A) 25% of the dollar amount by which (1)(a) Funds From Operations (before the incentive fee) of the Company for such quarter per Common Share (based on the weighted average number of shares outstanding during such quarter) (b) plus gains (or minus losses) from debt restructuring and sales of property per Common Share (based on the weighted average number of shares outstanding during such quarter), exceed (2) an amount equal to (a) the weighted average of the price per Common Share at the initial offering and the prices per Common Share for any subsequent issuances of Common Shares by the Company, multiplied by (b) the Ten-Year U.S. Treasury Rate for the respective quarter plus MANAGEMENT AGREEMENT - PAGE 11 12 3.5% multiplied by (B) the weighted average number of Common Shares outstanding during such period. (c) The Manager shall compute the compensation payable under Sections 7(a) and 7(b) within 45 days after the end of each fiscal quarter. A copy of the computations made by the Manager to calculate its compensation shall thereafter promptly be delivered to the Board of Trust Managers and payment of the compensation earned under Sections 7(a) and 7(b) of this Agreement shown therein shall be due and payable within 60 days after the end of such fiscal quarter. SECTION 8. Expenses. (a) Without regard to the compensation received under this Agreement by the Manager and subject to Sections 8(b) and 8(c), the Manager shall bear the following expenses: (i) employment expenses of the personnel employed by the Manager (including, but not limited to, officers of the Company employed by the Manager) including, but not limited to, salaries, wages, payroll taxes and the cost of the employee benefit plans of such personnel; (ii) rent, telephone, utilities, office furniture, equipment, machinery, and other office expenses of the Manager and/or its Affiliates required for the Company's day-to-day operations, including costs associated with accounting, clerical, primary or Master Servicing (including all expenses customarily paid by primary loan servicers or Master Servicers in performing primary loan servicing or Master Servicing for third parties) and back-office services provided by the Manager or its affiliates; (iii) computer hardware and software costs (including costs associated with determining whether its systems are "Year 2000" compliant and with modifying or replacing source codes to bring its systems into "Year 2000" compliance), except for any such expenses that relate solely to the computer hardware or software used solely for the business and operations of the Company; and (iv) all premiums and other expenses required in connection with "errors and omissions" insurance policies covering officers and employees of the Manager. (b) The Company shall pay all of its expenses except those that are the responsibility of the Manager pursuant to Section 8(a) and without limiting the generality of the foregoing, it is specifically agreed that the following expenses actually incurred by or on behalf of the Company shall be paid by the Company and shall not be paid by the Manager or any other member of the AMRESCO Group: MANAGEMENT AGREEMENT - PAGE 12 13 (i) the cost of money borrowed by the Company, including interest, commitment fees and other charges; (ii) all taxes and license fees applicable to the Company, including interest and penalties thereon; (iii) legal, audit, accounting, underwriting, brokerage, listing, filing, rating agency, registration and other fees, printing, engraving and other expenses and taxes incurred in connection with the issuance, distribution, transfer, registration and stock exchange listing of any securities of the Company (including, without limitation, debt or equity securities, options or warrants to purchase debt or equity securities, convertible securities, etc.); (iv) fees and expenses paid to advisors and independent contractors, consultants, managers and other agents (including the Manager or any other member of the AMRESCO Group) engaged directly by the Company upon its written request or by the Manager at the Company's written request for the account of the Company; (v) due diligence costs and related costs (including legal fees, accounting and auditing fees, environmental and engineering reviews) associated with the acquisition or proposed acquisition or the disposition or proposed disposition of any of the Company's assets; provided that with respect to any proposed acquisition of assets, such asset(s) shall have been preliminarily approved in writing for investment by the Chief Investment Officer or the Board of Trust Managers, and further provided that any extraordinary costs (in excess of $500,000 with respect to any single transaction or asset) shall be required to be approved in advance by the Board of Trust Managers; (vi) other expenses connected with the acquisition, disposition, financing and ownership of the Company's assets, including, but not limited to, commitment fees, brokerage fees, guaranty fees, ad valorem taxes, costs of foreclosure, maintenance, repair and improvement of property and premiums for insurance on property owned by the Company; (vii) costs related to hedging transactions (including losses); (viii) the expenses of organizing, modifying or dissolving the Company; (ix) costs related to advertising and marketing of the Company's assets or services; MANAGEMENT AGREEMENT - PAGE 13 14 (x) expenses connected with payments of dividends or interest or distributions in any other form made or caused to be made by the Board of Trust Managers to holders of the securities of the Company; (xi) expenses connected with the structuring, issuance and administration of MBS by the Company, including, but not limited to, legal, audit, accounting, underwriting, listing, filing, rating agency and trustee's fees, insurance premiums and costs of required credit enhancements; (xii) all expenses of third parties connected with communications to holders of equity securities or debt securities issued by the Company and the other bookkeeping and clerical work necessary in maintaining relations with holders of such securities and in complying with the continuous reporting and other requirements of governmental bodies or agencies, including any costs of computer services in connection with this function, the cost of printing and mailing certificates for such securities and proxy solicitation materials and reports to holders of the Company's securities and reports to third parties required under any indenture to which the Company is a party; (xiii) custodian's, transfer agent's and registrar's fees and charges; (xiv) compensation, fees and expenses paid to the Independent Trust Managers, the cost of director and officer liability insurance and premiums for any errors and omissions insurance coverage maintained for the Company and its employees (solely in their capacity as employees of the Company and not in their capacity as employees of the Manager or any other member of the AMRESCO Group); (xv) legal, accounting, tax and auditing fees and expenses paid to third parties relating to the Company's operations; (xvi) legal, expert and other fees and expenses paid to third parties relating to any actions, proceedings, lawsuits, demands, causes of action and claims, whether actual or threatened, made by or against the Company, or which the Company is authorized or obligated to pay under applicable law or the Governing Instruments or by the Board of Trust Managers; (xvii) any judgment rendered against the Company, or against any Trust Manager, director or officer of the Company in his capacity as such for which the Company is required to indemnify such Trust Manager, director, or officer by any court or governmental agency, or settlement of pending or threatened litigation; provided that such settlement is approved or authorized by the Board of Trust Managers or is entered into by the Manager pursuant MANAGEMENT AGREEMENT - PAGE 14 15 to the discretionary authority granted to the Manager by the Board of Trust Managers; (xviii) expenses relating to any office or office facilities maintained solely for the use or benefit of the Company exclusive of the office of the Manager; (xix) expenses related to the accumulation and Special Servicing of Mortgage Loans; (xx) travel and related expenses of directors, officers and employees of the Manager or other members of the AMRESCO Group, and of Trust Managers, directors, officers and employees of the Company who are also directors, officers or employees of the Manager or other members of the AMRESCO Group, incurred in connection with attending meetings of the Board of Trust Managers or holders of securities of the Company or performing other business activities that relate to the Company, including, where applicable, a proportionate share of such expenses as reasonably determined by the Manager where such expenses were not incurred solely for the benefit of the Company; (xxi) costs associated with computer hardware and software, third party information services and office expenses that relate solely to the business activities of the Company (including the costs of bringing any systems into "Year 2000" compliance, if such systems relate solely to the business activities of the Company); (xxii) any extraordinary or non-recurring costs or charges incurred by the Company; and (xxiii) other expenses of the Company that are not expenses of the Manager under Section 8(a). (c) Any due diligence investigations, underwriting and other services typically performed by third-party consultants or service providers (including, without limitation, legal review and documentation) may be provided to the Company by the Manager or any other member of the AMRESCO Group if the Manager determines in good faith that (i) the requisite expertise is available through the Manager or the other members of the AMRESCO Group and that (ii) either (a) such services provided by the Manager or other members of the AMRESCO Group are superior in quality to those available from third parties or (b) costs savings or other efficiencies will arise from the use of such services. The Manager will, and will cause each other member of the AMRESCO Group to, document the time spent by its employees on such services on behalf of the Company and will be MANAGEMENT AGREEMENT - PAGE 15 16 entitled to reimbursement for the allocable portion of salary and benefits for such employees. (d) Notwithstanding the foregoing provisions of this Section 8, if the Company (or the Manager on behalf of the Company) incurs due diligence and related costs with respect to a proposed acquisition of one or more assets and all or any portion of such assets are not acquired by the Company but are instead acquired by a member of the AMRESCO Group, then AMRESCO or the appropriate member of the AMRESCO Group shall, within 30 days of its receipt of an itemized statement from the Manager reflecting the costs incurred by or on behalf of the Company, pay or reimburse the Company for all such costs (or the appropriate portion thereof allocable to the portion of the asset(s) acquired). SECTION 9. Calculations of Expenses. The Manager shall prepare a statement documenting the expenses of the Company and those incurred by the Manager on behalf of the Company during each quarter and shall deliver such statement to the Company within 45 days after the end of each quarter. Expenses incurred by the Manager on behalf of the Company shall be reimbursed quarterly to the Manager within 60 days after the end of each quarter. All expenses incurred by the Manager and submitted to the Company for reimbursement shall be reviewed by the Independent Trust Managers on a quarterly basis. SECTION 10. Limits of Manager Responsibility. The Manager assumes no responsibility under this Agreement other than to render the services called for hereunder in good faith and shall not be responsible for any action of the Board of Trust Managers in following or declining to follow any advice or recommendations of the Manager, including as set forth in Section 3(b). Neither the Manager, nor any other member of the AMRESCO Group will be liable to the Company, the Independent Trust Managers, the Company's shareholders or partners, any issuer of MBS or any other party for any acts or omissions by the Manager, any other member of the AMRESCO Group or any of their respective partners, directors, officers, stockholders or employees under or in connection with this Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties. The Company shall reimburse, indemnify and hold harmless the Manager and the members of the AMRESCO Group and their respective stockholders, directors, partners, officers and employees (collectively, the "Indemnified Parties") for, from and against any and all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever, (including attorneys' fees) in respect of or arising from any acts or omissions of the Manager, its stockholders, directors, partners, officers and employees made in good faith in the performance of the Manager's duties under this Agreement and not constituting bad faith, willful misconduct, gross negligence or reckless disregard of its duties. WITHOUT LIMITING ANY OTHER PROVISION OF THIS AGREEMENT, IT IS THE EXPRESS INTENTION OF THE COMPANY AND THE MANAGER THAT THE COMPANY'S OBLIGATION TO INDEMNIFY THE INDEMNIFIED PARTIES PURSUANT TO THIS SECTION 10 INCLUDES INDEMNIFICATION FOR EXPENSES, LOSSES, DAMAGES, LIABILITIES, MANAGEMENT AGREEMENT - PAGE 16 17 DEMANDS AND CHARGES AND CLAIMS OF ANY NATURE WHATSOEVER (INCLUDING ATTORNEYS' FEES) ARISING DIRECTLY OR INDIRECTLY FROM THE SOLE OR CONTRIBUTORY NEGLIGENCE OF ANY OF SUCH INDEMNIFIED PARTIES. SECTION 11. No Joint Venture. The Company and the Manager are not partners or joint venturers with each other and nothing herein shall be construed to make them such partners or joint venturers or impose any liability as such on either of them. SECTION 12. Term; Termination. (a) This Agreement shall commence on the date set forth above and shall continue in force until the second anniversary of such date, and thereafter, it shall be subject to successive one-year renewal periods upon the review and approval of the Independent Trust Managers. If the Independent Trust Managers do not resolve to renew or terminate this Agreement within at least 90 days prior to the end of the then-current period of this Agreement, this Agreement shall be automatically extended for a one-year period. The Manager shall have the right, following the initial term of this Agreement, to terminate this Agreement at any time upon not less than 180 days prior written notice. The Company shall have the right, following the initial term of this Agreement and subject to Section 12(b), to terminate this Agreement at any time upon not less than 90 days prior written notice. (b) In addition to such further liability or obligation of either party to the other provided in Sections 15 and 16, if this Agreement is terminated by the Company without cause (as "cause" is defined in Section 14) by delivery of a notice of non-renewal or termination pursuant to Section 12(a), the Company, in addition to its obligations under Section 15, shall pay the Manager a termination fee in an amount equal to the sum of the Manager's base management fee and incentive compensation earned pursuant to Sections 7(a) and 7(b) during the four calendar quarters immediately preceding such termination. Such termination fee shall be paid no later than 30 days following receipt of the accounting contemplated by Section 15(b). SECTION 13. Assignments. (a) Except as set forth in Section 13(b), this Agreement shall terminate automatically in the event of its assignment, in whole or in part, by the Manager, unless such assignment is consented to in writing by the Company with the consent of a majority of the Independent Trust Managers. Any such assignment approved by the Independent Trust Managers, in their sole discretion, shall bind the assignee hereunder in the same manner as the Manager is bound. In addition, the assignee shall execute and deliver to the Company an amendment to this Agreement naming such assignee as Manager. This Agreement shall not be assigned by the Company without the prior written consent of the Manager, except in the case of assignment by the Company to another REIT or other organization which (i) is a successor to MANAGEMENT AGREEMENT - PAGE 17 18 the Company (by merger, consolidation or otherwise by operation of law) or (ii) is the purchaser of all or substantially all of the assets of the Company, in which case such successor organization shall be bound hereunder and by the terms of such assignment in the same manner as the Company is bound hereunder. (b) Notwithstanding any provision of this Agreement, the Manager may subcontract any or assign all of its responsibilities under this Agreement to any of its qualified Affiliates, and the Company hereby consents to any such assignment and subcontracting; provided that no such subcontract or assignment shall relieve the Manager of its duties and obligations hereunder. The Manager agrees to send copies of any subcontract or assignment to the Company promptly following its agreement to the same. SECTION 14. Termination by the Company for Cause. This Agreement may be terminated by the Company for "cause" upon 60 days' prior written notice of termination from the Board of Trust Managers to the Manager, without payment of any termination fee, if any of the following events shall occur: (a) if a majority of the Independent Trust Managers shall determine that the Manager has breached any provision of this Agreement in any material respect and, within 30 days after receipt of written notice of such violation, the Manager shall not have cured such violation, provided that, if such breach is not capable of cure within such 30-day period, the Manager shall have failed to commence to cure such breach within such 30-day period and thereafter to diligently and in good faith prosecute the cure of such breach and further provided, that if such breach is not capable of cure within any period of time, a majority of the Independent Trust Managers shall have also determined that such breach may have a material adverse effect on the business, operations or financial condition of the Company; or (b) there is entered an order for relief or similar decree or order with respect to the Manager by a court having competent jurisdiction in an involuntary case under the federal bankruptcy laws as now or hereafter constituted or under any applicable federal or state bankruptcy, insolvency or other similar laws; or the Manager (i) ceases, or admits in writing its inability to pay its debts as they become due and payable, or makes a general assignment for the benefit of, or enters into any composition or arrangement with, creditors; (ii) applies for, or consents (by admission of material allegations of a petition or otherwise) to the appointment of a receiver, trustee, assignee, custodian, liquidator or sequestrator (or other similar official) of the Manager or of any substantial part of its properties or assets, or authorizes such an application or consent, or proceedings seeking such appointment are commenced without such authorization, consent or application against the Manager and continue undismissed for 30 days; (iii) authorizes or files a voluntary petition in bankruptcy, or applies for or consents (by admission of material allegations of a petition or otherwise) to the application of any bankruptcy, MANAGEMENT AGREEMENT - PAGE 18 19 reorganization, arrangement, readjustment of debt, insolvency, dissolution, liquidation or other similar law of any jurisdiction, or authorizes such application or consent, or proceedings to such end are instituted against the Manager without such authorization, application or consent and are approved as properly instituted and remain undismissed for 30 days or result in adjudication of bankruptcy or insolvency; or (iv) permits or suffers all or any substantial part of its properties or assets to be sequestered or attached by court order and the order remains undismissed for 30 days. If any of the events specified in this Section 14(b) shall occur, the Manager shall give prompt written notice thereof to the Board of Trust Managers. SECTION 15. Action Upon Termination. From and after the effective date of termination of this Agreement, the Manager shall not be entitled to compensation for further services hereunder, but shall be paid all compensation accruing to the date of termination and, if terminated for any reason other than for "cause" under Section 14, the applicable termination fee. Upon such termination, the Manager shall forthwith: (a) after deducting any accrued compensation, any applicable termination fee and reimbursement for its expenses permitted hereunder to which it is then entitled, promptly pay over to the Company all money collected and held for the account of the Company pursuant to this Agreement; (b) deliver to the Board of Trust Managers a full accounting, including a statement showing all payments collected by it, all expenses incurred by it and a statement of all money held by it, covering the period following the date of the last accounting furnished to the Board of Trust Managers with respect to the Company; and (c) deliver to the Board of Trust Managers all property, documents, records and reports of the Company or pertaining to the Company's assets or operations then in the custody of the Manager. SECTION 16. Release of Money or Other Property Upon Written Request. The Manager agrees that any money or other property of the Company held by the Manager under this Agreement shall be held by the Manager as custodian for the Company, and the Manager's records shall be appropriately marked clearly to reflect the ownership of such money or other property by the Company. Upon the receipt by the Manager of a written request signed by a duly authorized officer of the Company requesting the Manager to release to the Company any money or other property then held by the Manager for the account of the Company under this Agreement, the Manager shall release such money or other property to the Company within a reasonable period of time, but in no event later than 60 days following such request. Subject to Section 10, the Manager shall not be liable to the Company, the Independent Trust Managers, or the Company's shareholders or partners for any acts performed or omissions to act by the Company in connection with the money or other property released to the Company in accordance with this Section 16. The Company shall indemnify the Manager, its directors, officers, stockholders, partners MANAGEMENT AGREEMENT - PAGE 19 20 and employees against any and all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever, which arise in connection with the Manager's release of such money or other property to the Company upon written request of the Company in accordance with the terms of this Section 16. Indemnification pursuant to this provision shall be in addition to any right of the Manager to indemnification under Section 10. SECTION 17. Representations and Warranties. (a) The Company hereby represents and warrants to the Manager as follows: (i) The Company is duly organized and validly existing under the laws of the jurisdiction of its incorporation, has the power to own its assets and to transact the business in which it is now engaged and is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership or lease of property or the conduct of its business requires such qualification, except for failures to be so qualified, authorized or licensed that could not in the aggregate have a material adverse effect on the business operations, assets or financial condition of the Company. the Company does not do business under any fictitious business name. (ii) The Company has the power and authority to execute, deliver and perform this Agreement and all obligations required hereunder and has taken all necessary action to authorize this Agreement on the terms and conditions hereof and the execution, delivery and performance of this Agreement and all obligations required hereunder. No consent of any other person, including, without limitation, shareholders and creditors of the Company, and no license, permit, approval or authorization of, exemption by, notice or report to, or registration, filing or declaration with, any governmental authority is required by the Company in connection with this Agreement or the execution, delivery, performance, validity or enforceability of this Agreement and all obligations required hereunder. This Agreement has been, and each instrument or document required hereunder will be, executed and delivered by a duly authorized officer of the Company, and this Agreement constitutes, and each instrument or document required hereunder when executed and delivered hereunder will constitute, the legally valid and binding obligation of the Company enforceable against the Company in accordance with its terms. (iii) The execution, delivery and performance of this Agreement and the documents or instruments required hereunder will not violate any provision of any existing law or regulation binding on the Company, or any order, judgment, award or decree of any court, arbitrator or governmental MANAGEMENT AGREEMENT - PAGE 20 21 authority binding on the Company, or the Governing Instruments of the Company or of any mortgage, indenture, lease, contract or other agreement, instrument or undertaking to which the Company is a party or by which the Company or any of its assets may be bound, the violation of which would have a material adverse effect on the business operations, assets or financial condition of the Company, and will not result in, or require, the creation or imposition of any lien on any of its property, assets or revenues pursuant to the provisions of any such mortgage, indenture, lease, contract or other agreement, instrument or undertaking. (b) The Manager hereby represents and warrants to the Company as follows: (i) The Manager is duly organized, validly existing and in good standing under the laws of the jurisdiction of its formation, has the power to own its assets and to transact the business in which it is now engaged and is duly qualified to do business and is in good standing under the laws of each jurisdiction where its ownership or lease of property or the conduct of its business requires such qualification, except for failures to be so qualified, authorized or licensed that could not in the aggregate have a material adverse effect on the business operations, assets or financial condition of the Manager and its subsidiaries, taken as a whole. The Manager does not do business under any fictitious business name. (ii) The Manager has the power and authority to execute, deliver and perform this Agreement and all obligations required hereunder and has taken all necessary action to authorize this Agreement on the terms and conditions hereof and the execution, delivery and performance of this Agreement and all obligations required hereunder. No consent of any other person including, without limitation, partners and creditors of the Manager, and no license, permit, approval or authorization of, exemption by, notice or report to, or registration, filing or declaration with, any governmental authority is required by the Manager in connection with this Agreement or the execution, delivery, performance, validity or enforceability of this Agreement and all obligations required hereunder. This Agreement has been, and each instrument or document required hereunder will be, executed and delivered by a duly authorized agent of the Manager, and this Agreement constitutes, and each instrument or document required hereunder when executed and delivered hereunder will constitute, the legally valid and binding obligation of the Manager enforceable against the Manager in accordance with its terms. (iii) The execution, delivery and performance of this Agreement and the documents or instruments required hereunder, will not violate any provision of any existing law or regulation binding on the Manager, or any MANAGEMENT AGREEMENT - PAGE 21 22 order, judgment, award or decree of any court, arbitrator or governmental authority binding on the Manager, or the partnership agreement of the Manager or of any mortgage, indenture, lease, contract or other agreement, instrument or undertaking to which the Manager is a party or by which the Manager or any of its assets may be bound, the violation of which would have a material adverse effect on the business operations, assets or financial condition of the Manager and its subsidiaries, taken as a whole, and will not result in, or require, the creation or imposition of any lien on any of its property, assets or revenues pursuant to the provisions of any such mortgage, indenture, lease, contract or other agreement, instrument or undertaking. SECTION 18. Notices. Unless expressly provided otherwise herein, all notices, requests, demands and other communications required or permitted under this Agreement shall be in writing and shall be deemed to have been duly given, made and received when delivered against receipt or upon actual receipt of registered or certified mail, postage prepaid, return receipt requested, addressed as set forth below: (a) If to the Company: AMRESCO Capital Trust 700 North Pearl Street Suite 2400 Dallas, Texas 75201 Attention: President and General Counsel MANAGEMENT AGREEMENT - PAGE 22 23 (b) If to the Manager: AMREIT Managers, L.P. 700 North Pearl Street Suite 2400 Dallas, Texas 75201 Attention: President and General Counsel Either party may alter the address to which communications or copies are to be sent by giving notice of such change of address in conformity with the provisions of this Section 18 for the giving of notice. SECTION 19. Binding Nature of Agreement; Successors and Assigns. This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective heirs, personal representatives, successors and assigns as provided herein. SECTION 20. Entire Agreement. This Agreement contains the entire agreement and understanding among the parties hereto with respect to the subject matter hereof, and supersedes all prior and contemporaneous agreements, understandings, inducements and conditions, express or implied, oral or written, of any nature whatsoever with respect to the subject matter hereof. The express terms hereof control and supersede any course of performance and/or usage of the trade inconsistent with any of the terms hereof. SECTION 21. Amendment. This Agreement may not be modified or amended other than by an agreement in writing signed by the Manager and the Company, provided that the amendment of any provision of this Agreement requiring consent or approval of any matter by a majority of the Independent Trust Managers may not be amended without the approval of a majority of the Independent Trust Managers. SECTION 22. CONTROLLING LAW. THIS AGREEMENT AND ALL QUESTIONS RELATING TO ITS VALIDITY, INTERPRETATION, PERFORMANCE AND ENFORCEMENT SHALL BE GOVERNED BY AND CONSTRUED, INTERPRETED AND ENFORCED IN ACCORDANCE WITH THE LAWS OF THE STATE OF TEXAS. SECTION 23. Indulgences, Not Waivers. Neither the failure nor any delay on the part of a party to exercise any right, remedy, power or privilege under this Agreement shall operate as a waiver thereof, nor shall any single or partial exercise of any right, remedy, power or privilege preclude any other or further exercise of the same or of any other right, remedy, power or privilege, nor shall any waiver of any right, remedy, power or privilege with respect to any occurrence be construed as a waiver of such right, remedy, power or privilege with respect to any other occurrence. No waiver shall be effective unless it is in writing and is signed by the party asserted to have granted such waiver. MANAGEMENT AGREEMENT - PAGE 23 24 SECTION 24. Titles Not to Affect Interpretation. The titles of paragraphs and subparagraphs contained in this Agreement are for convenience only, and they neither form a part of this Agreement nor are they to be used in the construction or interpretation hereof. SECTION 25. Execution in Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original as against any party whose signature appears thereon, and all of which shall together constitute one and the same instrument. This Agreement shall become binding when one or more counterparts hereof, individually or taken together, shall bear the signatures of all of the parties reflected hereon as the signatories. SECTION 26. Provisions Separable. The provisions of this Agreement are independent of and separable from each other, and no provision shall be affected or rendered invalid or unenforceable by virtue of the fact that for any reason any other or others of them may be invalid or unenforceable in whole or in part. SECTION 27. Attorneys' Fees. Should any action or other proceeding be necessary to enforce any of the provisions of this Agreement or the various transactions contemplated hereby, the prevailing party will be entitled to recover its actual reasonable attorneys' fees and expenses from the non-prevailing party. SECTION 28. Gender. Words used herein regardless of the number and gender specifically used, shall be deemed and construed to include any other number, singular or plural, and any other gender, masculine, feminine or neuter, as the context requires. MANAGEMENT AGREEMENT - PAGE 24 25 IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written above. "COMPANY" AMRESCO CAPITAL TRUST By: /s/ Michael L. McCoy ------------------------------ Name: Michael L. McCoy ------------------------------ Title: Senior Vice President ------------------------------ "MANAGER" AMREIT MANAGERS, L.P. By: AMREIT MANAGERS G.P., INC. its general partner By: /s/ Thomas J. Andrus ------------------------------ Name: Thomas J. Andrus ------------------------------ Title: Executive Vice President ------------------------------ MANAGEMENT AGREEMENT - PAGE 25 26 EXHIBIT "A" TO MANAGEMENT AGREEMENT AMRESCO CAPITAL TRUST OPERATING POLICIES PRELIMINARY STATEMENT I. INVESTMENT POLICIES II. CAPITAL AND LEVERAGE POLICIES III. CREDIT RISK MANAGEMENT POLICIES IV. FINANCIAL RISK MANAGEMENT POLICIES V. POLICIES REGARDING TRANSACTIONS WITH THE AMRESCO GROUP VI. REIT COMPLIANCE POLICIES VII. POLICY REGARDING INVESTMENT COMPANY ACT SCHEDULE I - DEFINITIONS EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 1 27 PRELIMINARY STATEMENT The following operating policies of AMRESCO Capital Trust (the "Company") are intended to be guidelines for the business and operations of the Company. Such policies are intended to be reviewed from time to time and may be changed from time to time by the Board of Trust Managers, in their sole discretion without shareholder approval. As used in these policies, the term "Company" means either AMRESCO Capital Trust, a Texas real estate investment trust ("AMCT") or AMCT collectively with its affiliates, as the context requires, the term "AMRESCO Group" means AMRESCO, INC. and its affiliated entities (other than the Manager) and the term "Manager" means AMREIT Managers, L.P., an affiliate of AMRESCO. Other capitalized terms used in these policies have the meanings set forth on Schedule I attached. SECTION 1. INVESTMENT POLICIES A. General 1. Principal Business Objective. The Company's principal business objective is to maximize shareholder value by producing cash flow for distribution to its shareholders through investment in mid- to high-yield real estate related assets which earn an attractive spread over the Company's cost of funds. The investment policies set forth below are intended to enable the Company to achieve its principal business objective. 2. Role of the Manager. The Manager is authorized in accordance with the terms of the Management Agreement to make all day-to-day investment decisions of the Company based on the policies and guidelines set forth below. The Manager should use all commercially reasonable efforts to determine, in good faith, whether each investment proposed to be made by the Company conforms to the policies and guidelines set forth below. All proposed investments shall be reviewed and approved by the Investment Committee prior to investment. 3. Review by the Board. The Board will review the investments of the Company on a quarterly basis to determine general compliance with the policies and guidelines set forth below. B. Investment Objectives 1. General. The Company will invest in those real estate related assets which it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering all material relevant factors. Initially the Company intends to invest in a diversified portfolio of commercial and multifamily Mortgage Loans (including, among others, Participating Loans, Mezzanine Loans, Construction Loans and Bridge Loans), MBS, and commercial real estate (including, but not limited to, Net Leased Real Estate, real estate acquired at foreclosure or by deed-in-lieu of foreclosure or other EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 2 28 underperforming or Distressed Real Estate). Investments in real estate may also take the form of equity investments in partnerships and joint ventures, but not in corporations in which more than 10% of the voting shares would be owned by the Company or which would represent more than 5% of the value of the Company's total consolidated assets (unless such corporation is a Qualified REIT Subsidiary), and shall otherwise be structured in compliance with the REIT Provisions of the Code. 2. Types of Investments. The Company shall invest principally in the following types of investments: (a) Mortgage Loans. The Company may invest in various types of commercial and multifamily Mortgage Loans, including without limitation Permanent Mortgage Loans, Participating Loans, Construction Loans, Mezzanine Loans, Bridge Loans or any combination thereof. The Company may not invest directly nor originate residential Mortgage Loans secured by single family (one-to-four unit) residential property. (i) Limits on Investments. The Manager's loan underwriters will be afforded flexibility and latitude with respect to the size of any single Mortgage Loan, but shall generally target loans ranging from $10 million to $40 million. However, without the prior approval of the Board, the Company's investment in any one Mortgage Loan may not exceed the greater of (A) $75 million in principal amount outstanding or (B) 10.0% of the Company's total consolidated assets. (ii) Coinvestment. The Company may invest in any Mortgage Loan alone or may coinvest with others. If the Company coinvests in any Mortgage Loan with any member of the AMRESCO Group, such investment must be made in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (iii) Concentration Limits. The Manager shall seek to achieve diversification in the Company's assets to avoid undue geographic, borrower, issuer, product type, industry and certain other types of concentrations. The Company may, in the future, in consultation with the Manager and the Investment Committee, establish specified limitations or parameters as to the foregoing concentrations. The Manager shall seek to invest, on the Company's behalf, primarily in Mortgage Loans secured by property located in the United States and in foreign countries in which the AMRESCO Group has previously conducted business. (iv) Sources of Loans. Mortgage Loans in which the Company invests may be either originated or purchased by the Company. Purchased loans may be purchased individually, through loan participations or syndications or in pools and may include Distressed Mortgage Loans. Loans purchased from any member of the AMRESCO Group must be EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 3 29 purchased in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (v) Pricing. In determining the rate at which an originated Mortgage Loan will bear interest, or the price at which a purchased Mortgage Loan will be acquired, the Manager should consider the following factors, in addition to the Company's targeted rate of return on such investment: market conditions, market interest rates, the availability of mortgage credit and other economic factors, the term of the Mortgage Loan, the liquidity of the Mortgage Loan, the limitations on the obligations of the borrower and/or seller with respect to the Mortgage Loan, the rate and timing of payments to be made with respect to the Mortgage Loan, the mortgaged property underlying the Mortgage Loan, the existence and quality of any credit enhancement related to such Mortgage Loan, the risk of adverse fluctuations in the market values of that mortgaged property as a result of economic events or governmental regulations, the historical performance and other attributes of the property manager responsible for managing the mortgaged property, relevant laws limiting actions that may be taken with respect to Mortgage Loans and limitations on recourse against the borrower following realization on the collateral through various means, risks of timing with respect to Mortgage Loan prepayments, risks associated with geographic concentration of mortgaged property, environmental risks, pending and threatened litigation, junior liens and other issues relating to title, a prior history of real estate mortgage and other contractual defaults by affiliated parties on similar and dissimilar obligations, and other factors deemed relevant by the Manager. (vi) Due Diligence. In considering whether to originate or acquire any Mortgage Loan, the Manager should perform certain due diligence tasks on behalf of the Company that reasonably may be expected to provide relevant and material information as to the value of such Mortgage Loan and whether the Company should originate or acquire that Mortgage Loan, including all such information described above as necessary to be considered in connection with the pricing of a Mortgage Loan or as may be required by any warehouse lender. (vii) Credit Risk Management. Each Mortgage Loan investment must be in accordance with the Company's credit risk management policies and underwriting criteria, including its policies or criteria, to the extent applicable, regarding loan-to-value ratios or loan-to-cost ratios, borrower and tenant credit quality, credit enhancement, collateral requirements, etc. (viii) Compliance With Other Policies. Each Mortgage Loan investment shall comply with Company policies, including, without limitation, EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 4 30 its policies regarding compliance with the REIT Provisions of the Code and exclusions from regulation under the Investment Company Act. (b) MBS. The Company may invest in all types of MBS, including, without limitation, all types of investment grade and non-investment grade CMBS and RMBS (except that the Company does not currently intend to invest in RMBS secured by lower credit quality Mortgage Loans known as "B," "C" and "D" Mortgage Loans). (i) Limits on Investments. Without the prior approval of the Board, the percentage of the Company's total consolidated assets which may be invested in MBS at any time may not exceed 40%. The Company may, in the future, in consultation with the Manager and Investment Committee, establish specified limitations or parameters on the percentage of the Company's total consolidated assets invested in MBS that may be related to any one issuer. (ii) Coinvestment. The Company may invest in any MBS alone or may coinvest with others. If the Company coinvests in any MBS with any member of the AMRESCO Group, such investment must be made in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (iii) Sources of MBS. MBS may be purchased by the Company from any source. MBS purchased from any member of the AMRESCO Group must be purchased in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (iv) Pricing. In determining the price at which to acquire any MBS, the Manager should consider, in addition to the Company's targeted rate of return on such investment, the following factors: (A) the quality of the underlying collateral pool, (B) the prepayment and default history of the underlying Mortgage Loans, (C) cash flow analyses under various prepayment and interest rate scenarios (including sensitivity analyses), (D) an analysis of various default scenarios and (E) prices paid for similar MBS by bona fide third parties or broker price opinions. Because there are so many characteristics to consider, each MBS should be analyzed individually, taking into consideration both objective data as well as subjective analysis. (v) Due Diligence. The Company shall, in consultation with the Manager, determine the scope of review to be performed before the Company acquires MBS, which will be designed to provide sufficient information regarding the MBS to enable the Company to make a decision regarding the acquisition and pricing of the MBS. The due diligence should include an analysis of the information described above as necessary to be EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 5 31 considered in connection with the pricing of MBS. With respect to CMBS, the Manager will use sampling and other appropriate analytical techniques to determine which Mortgage Loans will undergo a full-scope review or a more streamlined review process. Considerations that should influence the choice for scope of review should generally include size of the loan, debt service coverage ratio, loan-to-value ratio, maturity of the loan, lease rollover, property type and geographic location. A full-scope review may include, among other factors, a site inspection, tenant-by-tenant rent roll analysis, review of historical income and expenses for each property securing the Mortgage Loan, a review of major leases for each property (if available); recent appraisals (if available), engineering and environmental reports (if available), and the price paid for similar CMBS by unrelated third parties in arm's length purchases and sales (if available) or a review of broker price opinions (if the price paid by a bona fide third party for similar CMBS is not available and such price opinions are available). For those Mortgage Loans that are selected for the more streamlined review process, the Manager's evaluation may include a review of the property operating statements, summary loan level data, third party report and a review of prices paid for similar CMBS by bonafide third parties or broker price opinions, each as available. If the Manager's review of such information does not reveal any unusual or unexpected characteristics or factors, no further due diligence need be performed. (vi) Compliance With Other Policies. Each MBS investment must be in accordance with all Company policies, including, without limitation, its policies regarding compliance with the REIT Provisions of the Code and exclusion from regulation under the Investment Company Act and the Investment Advisors Act. (c) Real Estate. The Company intends to invest in various types of commercial real estate, including, but not limited to, Net Leased Real Estate, REO Properties and other Distressed Real Estate. (i) Coinvestment; Manner of Investment. The Company may invest in any real estate project alone or may coinvest with others. Investments may be made directly by the Company or through partnerships or other entities formed with other parties, including members of the AMRESCO Group. If the Company coinvests in any real estate project with any member of the AMRESCO Group, such investment must be made in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (ii) Concentration Limits. The Manager shall seek to avoid undue geographic and product type concentrations with respect to the Company's commercial real estate, when considered together with the Company's other invested assets. The Manager will seek to invest, on the EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 6 32 Company's behalf, primarily in commercial real estate located in the United States and in other foreign countries in which the AMRESCO Group has previously conducted business. (iii) Sources. Real estate may be purchased by the Company from any source. Real estate purchased from any member of the AMRESCO Group must be purchased in accordance with the Company's policies regarding transactions with members of the AMRESCO Group. (iv) Pricing. The Company's policy is to determine the fair market value of real estate utilizing those procedures that the Company and the Manager deem relevant for the specific real estate being evaluated, which procedures need not be the same for each property being evaluated. Information that may be examined in determining the fair market value of a property includes the following: (A) the Company's projected rate of return on such investment; (B) current and historical operating statements; (C) existing or new appraisals; (D) sales comparables; (E) industry statistics and reports regarding operating expenses; (F) existing leases and market rates for comparable leases; (G) deferred maintenance observed during site inspections or described in structural and engineering reports; and (H) correspondence and other documents and memoranda found in the files of the seller of that real estate or other relevant parties. The Manager is expected to develop projections of net operating income and cash flows taking into account lease rollovers, tenant improvement costs and leasing commissions. The Manager should compare its estimates of revenue and expenses to historical operating statements and estimates provided in appraisals and general industry and regional statistics. Market capitalization rates and discount rates should then be applied to the cash flow projections to estimate values. These values should then be compared to available appraisals and market sale comparables to determine recommended bid prices for each property. The amount offered by the Company generally should take into account projected holding periods, capital costs and projected profit expectations. (v) Due Diligence. The Manager should conduct an investigation and evaluation of all real estate proposed to be purchased. The Manager should include within its due diligence review and analysis of the real estate contemplated to be acquired a review of market studies for each geographic market in which the real estate proposed to be purchased is concentrated, including area economic data, employment trends, absorption rates and market rental rates. Such due diligence analyses generally also should include (A) site inspections of properties, (B) a review of all property files and documentation that are made available to the Company or the Manager, (C) a Phase I environmental assessment for each property, and (D) all other information necessary to determine a fair price for such property. The Manager's review should include, to the extent possible, EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 7 33 examinations of available legal documents, litigation files, correspondence, title reports, operating statements, appraisals, engineering reports and environmental reports, among other due diligence items. (vi) Credit Risk Management. Each real estate investment must be in accordance with the Company's credit risk management policies, including its policies regarding tenant credit quality. (vii) Compliance With Other Policies. Each real estate investment must be in accordance with all Company policies including without limitation its policies regarding compliance with the REIT Provisions of the Code and exclusion from regulation under the Investment Company Act. (d) Other Investments. The Company may also pursue a variety of complementary commercial real estate and finance-related businesses and investments in furtherance of its business objective. Such activities may include, but are not limited to, foreign real estate-related asset investments, equity interests or other investments in other REITs, registered investment companies, partnerships and other investment funds and real estate operating companies to the extent permitted by the REIT Provisions of the Code. Any such investments may be made by the Company in accordance with the operating policies of the Company upon approval of the Investment Committee. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 8 34 SECTION 2. CAPITAL AND LEVERAGE POLICIES A. General. The Company intends to increase its invested assets through the use of leverage in order to create yields commensurate with its investment objectives. The Company intends to utilize leverage in a manner that is prudent and consistent with maintaining an acceptable level of risk. B. Limitations on Indebtedness. The Company's Leverage Ratio (i.e., ratio of (i) indebtedness with respect to which the Company is the obligor to (ii) the Company's total outstanding equity) shall not exceed (at the time any debt is incurred) 3:1, without the prior approval of the Board of Trust Managers. C. Sources of Financing. The Company may utilize a variety of debt vehicles, including warehouse lending arrangements, reverse repurchase agreements, securitizations of mortgage loans or other secured or unsecured financing sources, as deemed appropriate by the Manager, considering the availability of financing sources and existing rates and market conditions at any given time. D. Securitizations. The Company may obtain secured financing through the securitization of all or any portion of its Mortgage Loans. Securitizations may be accomplished through the issuance of structured debt, with the Company retaining an equity interest in the collateral or through a "sale" of the underlying Mortgage Loans, if the Manager reasonably determines there are structural or other advantages to such form of securitization. Any securitizations conducted by the Company under which a "sale" of an interest in Mortgage Loans occurs shall be conducted, to the extent permitted by the REIT Provisions of the Code, through one or more taxable subsidiaries of the Company, unless otherwise approved by the Board of Trust Managers or the Company's investment or tax compliance officer. In addition, any such securitizations shall be structured, to the extent practicable, to minimize the attribution of any Excess Inclusion income to the Company's shareholders. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 9 35 SECTION 3. CREDIT RISK MANAGEMENT POLICIES A. General. The Company is expected to be exposed to various levels of credit and special hazard risks depending on the nature of its investments. The Company's policy is to manage such risk by originating or otherwise acquiring only those assets which satisfy the Company's underwriting criteria and credit quality standards and, through the activities of the Manager, by closely monitoring the quality and performance of its invested assets. B. Investment Committee. The Manager will establish one or more Investment Committees (an "Investment Committee") which will meet regularly to consider whether the Company should invest in specific Targeted Investments. Subject to the following conditions, the voting members of an Investment Committee may vary depending on the type of Targeted Investment under consideration. At least two-thirds of the members of the Investment Committee present and voting, must vote in favor of a particular Targeted Investment before the Targeted Investment may be purchased, acquired or originated by the Company. A quorum must be present for any meeting of the Investment Committee. A quorum shall consist of a minimum of four of the members of the Investment Committee and must include at least two of the following officers of the Company: the President, the Chief Investment Officer and the Chief Operating Officer. The Board of Trust Managers will monitor the Invested Portfolio and the credit risk associated therewith. C. Portfolio Review Program. The Manager shall implement a Portfolio Review Program to provide for periodic review of the Invested Portfolio so that potential credit problems can be recognized and addressed at the earliest opportunity. D. Underwriting Criteria and Credit Quality. The Company shall, from time to time, in consultation with the Manager and the Investment Committee, establish underwriting criteria and credit quality standards for the various types of assets in which the Company intends to invest. Such underwriting criteria shall include, without limitation, the following: 1. Loan to Value Ratios. The Company will typically not loan in excess of 90% of the "stabilized" value of the property or in excess of 100% of the cost of a property (which may include budgeted construction period interest in the case of a Construction Loan). 2. Return Requirements. In underwriting a Mortgage Loan, the Manager will model the economic return to the Company and the borrower to determine whether the loan is economically feasible. The Manager is not required to establish minimum debt service coverage ratios, but shall underwrite to a "market" debt service coverage ratio in evaluating the viability of refinancing of a loan. With respect to MBS, the Manager shall utilize bond models (including those of AMRESCO, Charter Research and dealers), as appropriate, to project potentials EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 10 36 for delinquency, prepayment and extension and to project losses and returns prior to pricing of transactions. 3. Concentrations of Credit. The Manager shall seek to diversify and balance the Company's portfolio to minimize risk and potential losses. To the extent applicable, the Manager shall monitor the Company's Mortgage Loan concentrations from the perspectives of (i) the size of any single loan, (ii) the total size of the transaction if the Company is in a subordinate loan position, (iii) the aggregate amount of loans to one borrower, (iv) geographic concentrations, (v) property type concentrations. The Company may, in the future (in consultation with the Investment Committee and the Manager), establish specified limitations or parameters as to the foregoing concentrations. With respect to the Company's MBS portfolio, the Manager shall employ the following risk control guidelines: (i) investments should be made in a manner intended to minimize overweighing of economic concentration as measured by the quotient of the weighted average loan distribution (compared to the U.S. as a whole) of the largest states divided by the size of the state's economy relative to the entire U.S. economy, (ii) no single property type shall represent more than 50% of the Company's entire MBS portfolio, (iii) distribution of loan sizes intended to result in favorable loss distributions (large loans must be individually analyzed and determined to be secure enough to protect the Company's position) and (iv) the establishment of a maximum percentage of the Company's MBS portfolio that may be represented by a single issuer. 4. Insurance Requirements. The Manager shall require that the borrower or owner, as applicable, maintain, at all times during the term of the loan or the investment, liability, hazard, rent loss, flood, earthquake and/or other insurance coverage as may be applicable, in such amounts and in accordance with the requirements established from time to time by the Manager. 5. Borrower or Tenant Credit Quality. The Manager shall review and analyze the credit history, net worth, liquidity, etc. of each borrower/guarantor or significant tenant, as applicable. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 11 37 SECTION 4. FINANCIAL RISK MANAGEMENT POLICY A. General. The objective of the Company's Financial Risk Management Policy is to ensure that business exposures to risk are identified, measured, and are managed in the most effective and efficient methods within established guidelines. It is the Company's policy to hedge as much of the interest rate risk as the Manager determines is in the best interest of the Company, given the cost of and risks involved with such hedges and the Company's desire not to jeopardize its status as a REIT. B. Financial Risk Management Committee. The Trust Managers will establish the Financial Risk Management Committee to assist it in establishing financial risk management, hedging and derivatives policies and to oversee and monitor the Company's management of risk and use of derivatives. The Committee will be composed initially of the Chairman of the Board of Company, Chief Executive Officer ("CEO"), Chief Operating Officer ("COO"), Chief Investment Officer ("CIO"), Chief Financial Officer ("CFO"), Treasurer and Chief Accounting Officer. At least 50% of the members of the Financial Risk Committee are required to constitute a quorum at any meeting of such Committee and at least two-thirds of those present and voting at any meeting is required for approval of any action. The Committee can also designate other persons to act as nonvoting members who serve in an advisory capacity. To assist the Committee in operating decisions and implementation of policy and procedures, it may establish a Financial Risk Steering Committee to handle operational issues. C. General Objectives for the Use of Derivatives. Derivative transactions or hedging activities are not to be undertaken for speculative purposes, but only to lessen risks associated with earnings, credit, interest rate, foreign currency, and other similar risks. Use of derivatives is not automatic, nor is it necessarily the only response to managing business risk. Derivative transactions should only be undertaken after the risks that have been identified are determined to exceed defined levels established by this Policy and are considered to be unavoidable because they are necessary or support normal business activities. The use of derivatives involves risks such as credit, liquidity, basis, settlement, legal and systemic. Derivatives should be used only to the extent that the Manager determines that the expected benefit of such use (after considering the cost of the derivative transactions) is considered to outweigh these risks. The Manager should avoid any incremental increase in the Company's overall market exposure from the use of derivatives. D. Specific Objectives for Use of Derivatives. Derivatives may be used to protect foreign activities, including foreign revenue sources, specific assets and liabilities denominated in foreign currencies, to hedge firm commitments and forecasted transactions that expose the Company to risk, and to protect against exchange rate movements between different currencies that impact revenue and profit expressed in U.S. Dollars. Derivatives may also be used to protect the value of the Company's investments in EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 12 38 Mortgage Loans and MBS and to hedge purchase commitments and forecasted transactions that expose the Company to risk and to protect against interest rate movements that negatively impact the value and/or intended execution of a transaction. E. Prohibitions on Use of Derivatives. 1. General. Derivatives shall not be used for trading, speculation, or any other purpose in which the objective is to generate profits. Derivative transactions are considered speculative if they are perceived (at the time such transaction is entered into) to increase risk, if their use has no relation to objectives specified by the Company's policy, or if their use is not intended and expected to manage business risks that have been identified. 2. Leverage. Derivative transactions are considered to be highly leveraged if they expose the Company to loss in excess of gains expected to be generated by positions and transactions they modify. Unless approved by the Board of Trust Managers, the Manager shall not utilize highly leveraged derivatives as they generally do not reduce risk. 3. Valuation. Unless otherwise approved by the Board of Trust Managers, the Manager shall avoid using any derivative for which a market quotation cannot be obtained or which cannot be valued reliably internally by the financial staff using valuation methodologies that have been approved for use by the Financial Risk Management Committee. 4. GAAP Accounting. Use of derivatives that do not qualify for hedge accounting or deferral accounting under generally accepted accounting principles shall not be utilized unless approval is obtained from the Financial Risk Management Committee. 5. Accounting Motivated Transactions. Derivative transactions that are primarily motivated by accounting implications and do not reduce economic or business risk exposure shall not be utilized. Derivative transactions are considered to be accounting motivated transactions if they result in the current recognition of revenue or current reduction of cost as a result of incurring a liability to be recognized in the future or taking a risk to be determined and settled in the future. Use of derivatives solely to manage earnings is prohibited. Derivative transactions are unauthorized if the intention of the transaction is to recognize a profit by closing out, modifying, terminating or offsetting the derivative instrument, even if the transaction would otherwise meet the requirements for use under this policy. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 13 39 F. Operating Limitations on Use of Derivatives. 1. Forecasted Transactions. Forecasted transactions that are not expected to occur within one year generally are not considered to be probable of occurring under this policy. The Manager shall not use derivatives to hedge such forecasted transactions unless specific written approval is obtained from the Financial Risk Management Committee. 2. Derivative Products and Strategies. Use of the following products and strategies requires specific approval for each transaction by the Financial Risk Management Committee: o Written options o Combination options involving the use of written options o Written options embedded in swaps and other derivatives o Selective hedging and partial hedging of exposures outside of preapproved parameters that have been identified o Frequent buying and selling or terminating derivatives used in risk management activities not specifically related to changing positions of the matched items 3. Types of Contracts Authorized for Use. The Company may use the following derivative instruments specifically approved by the Financial Risk Management Committee: Cash Market Derivatives o Treasury or Eurodollar securities o Futures contracts Treasury or Eurodollar securities o Purchased options on Treasury and Eurodollar features o MBS forward securities Mortgage Backed Securities ("MBS") - FNMA, GNMA, FHLMC, and Other Debt Securities o Futures contracts on MBS and other debt securities o Purchase options on MBS and other debt securities o MBS forward cash securities Interest Rate Derivatives o Interest rate swaps o Interest rate caps, floors and collars o Options on swaps Foreign Currency Derivatives o Currency forwards and futures EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 14 40 o Purchased currency options o Combination foreign currency options - where the notional amount and maturity date exactly match the underlying transaction being hedged and the cost of the purchased options is equal to or greater than the proceeds received on the option sold o Foreign currency derivatives - authorized for use by business units exposed to foreign currency risk to the extent identified by the risk identification and measurement process Use of any derivative not specifically identified above requires the written approval of the Financial Risk Management Committee. G. Counterparty Risk. The Company will only enter into derivative transactions with counterparties that have a current senior debt rating by either Standard & Poor's Rating Services, a division of McGraw-Hill Companies, or Moody's Investors Service, Inc. of A or better or the equivalent rating by other recognized rating agencies approved by the Financial Risk Management Committee. The Company will generally continue in a derivative transaction if the counterparty's credit rating is downgraded to BBB. Appropriate steps should be taken by the Manager to minimize risks if the counterparty's credit rating is downgraded below BBB. Such steps may include obtaining collateral or some other acceptable form of credit enhancement, or terminating the transactions, if practicable. The Manager shall notify the Financial Risk Management Committee of all credit downgrades. The Committee must approve the actions proposed to be taken with respect to a transaction where the counterparty's credit rating is downgraded below BBB. The Company will not enter into a new derivative transaction with a counterparty if the new transaction will result in credit exposure exceeding limits specified by the Financial Risk Management Committee. Such limits are currently set as follows: (Senior Debt Rating) o For counterparties rated AAA Unlimited o For counterparties rated AA Unlimited o For counterparties rated A 10% of the Company's Equity For purposes of this paragraph, "credit exposure" means the greater of the current net market value of all derivative transactions with the counterparty, or 5% of the total notional value of the derivatives with that counterparty. H. Authorized Brokers. The Manager is authorized, on behalf of the Company, to enter into derivative transactions with primary dealers and other financial institutions as follows: EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 15 41 o Any "primary" government security dealer as approved from time to time by the Federal Reserve Bank of New York. o Any commercial bank which is FDIC insured and maintains a commercial paper rating in the top two credit categories from a rating service of national prominence. o Any SEC-registered broker dealer that meets the voluntary capital requirements of the Federal Reserve Bank of New York. o Any federal agency or federally sponsored agency. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 16 42 SECTION 5. POLICIES REGARDING TRANSACTIONS WITH THE AMRESCO GROUP A. General. As a result of the Company's relationship with the AMRESCO Group (including, particularly, as a result of the Right of First Refusal and the Correspondent Agreement), the Company expects to benefit from the market reputation, expertise and relationships developed by the AMRESCO Group and the potential investment opportunities (including coinvestment opportunities) expected to be identified through the AMRESCO Group. It is the intention of the Company that the agreements and transactions, including the sale of or coinvestment in any asset, between the Company and the AMRESCO Group be fair to the Company and be on terms at least as favorable as those the Company could have obtained from unaffiliated third parties. Accordingly, the following procedures should be implemented to assist the Company in ascertaining that any transactions and agreements with the AMRESCO Group meet such standard. B. Acquisitions from Members of the AMRESCO Group. 1. The Company may acquire assets which meet its investment criteria and objectives (other than CMBS or RMBS issued in securitizations sponsored by members of the AMRESCO Group) from members of the AMRESCO Group, without prior approval from the Independent Trust Managers provided that: (a) the Chief Investment Officer reasonably determines in good faith that the price of the asset is no greater and the terms of the sale are no less favorable than that which would be available from third parties for similar investments; (b) the purchase price of any individual asset or pool of assets proposed to be purchased at any one time does not exceed the greater of $75 million or 10.0% of the Company's total consolidated assets, determined before the proposed acquisition; and (c) when possible, the price that the Company will pay for any asset acquired from the AMRESCO Group shall be determined by reference to the prices most recently paid to the AMRESCO Group for similar investments, adjusted for differences in the terms of such transactions and for changes in market conditions between the dates of the relevant transactions. If no previous sales of comparable investments have occurred, the Manager shall attempt to determine a market price for the asset by obtaining a broker's price opinion or an appraisal, if it can do so at a reasonable cost. 2. Assets which do not meet the criteria set forth above may be purchased from any member of the AMRESCO Group only with the prior approval of a majority of the Independent Trust Managers (or a majority of the Independent Trust Managers of any authorized Committee of the Board). EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 17 43 3. The Company may purchase CMBS or RMBS issued in securitizations sponsored by members of the AMRESCO Group only in a competitive bidding situation and upon prior approval of a majority of the Independent Trust Managers. C. Coinvestments with Members of The AMRESCO Group. 1. The Company may coinvest in any asset with any member of the AMRESCO Group, without prior approval from the Independent Trust Managers, provided that the terms of the Company's investment is substantially similar to the terms of the investment of the AMRESCO Group, except for such differences as may be attributable solely to the size of the investment. 2. Any potential coinvestments by the Company with any member of the AMRESCO Group which exceed $15 million (in the aggregate, during any calendar year) and which contemplate investment terms for the Company which are different than those proposed for any member of the AMRESCO Group will require the prior approval of a majority of the Independent Trust Managers (or a majority of the Independent Trust Managers of any authorized Committee of the Board). D. Expense Reimbursement and Allocation Matters. 1. Due diligence and underwriting expenses incurred by the Manager or any member of the AMRESCO Group may be charged to and reimbursed by the Company only after an asset has been preliminarily approved for investment by the Chief Investment Officer or other authorized officer of the Company. 2. The Manager may incur due diligence, underwriting and other costs and expenses on behalf of the Company, provided that, in the event costs and expenses with respect to any one transaction are expected to exceed $500,000, the incurrence of such costs and expenses must be approved, in advance, by the Board of Trust Managers (or a majority of the Independent Trust Managers of any authorized Committee of the Board). 3. In the event that any member of the AMRESCO Group purchases or otherwise invests in all or any portion of an asset with respect to which due diligence, underwriting or other costs of which have been charged to or reimbursed by the Company, the Company shall recover from the AMRESCO Group all or the applicable portion of such costs and expenses allocable to the investment by the AMRESCO Group. 4. To the extent any member of the AMRESCO Group (other than the Manager) provides services to the Company pursuant to the Management Agreement or otherwise for which it is entitled to receive payment or compensation, such payment or compensation shall be reasonable and no greater than amounts which are charged by third parties in arms-length transactions. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 18 44 E. Quarterly Review of Related Party Transactions. The Independent Trust Managers shall review, on a quarterly basis, all (i) acquisitions of assets by the Company from members of the AMRESCO Group made during the preceding calendar quarter (including the prices of and the terms of such acquisitions) which were not specifically approved for acquisition by the Independent Trust Managers, (ii) all coinvestments made with any member of the AMRESCO Group during the preceding calendar quarter, (iii) the reasonableness of the expenses paid to any member of the AMRESCO Group and (iv) the terms of all other transactions between the Company and any member of the AMRESCO Group. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 19 45 SECTION 6. REIT COMPLIANCE POLICIES A. General. It is the Company's intention to qualify as a REIT under the Code beginning with its taxable year ending on December 31, 1998. Accordingly, the Company shall conduct its business in accordance with the following procedures so as to meet the (i) organizational requirements, (ii) income tests, (iii) asset tests and (iv) annual distribution requirements applicable to REITs. B. Organizational Requirements. The Company shall enforce the "Excess Share" provisions of its Declaration of Trust prohibiting ownership of more than 9.8% of the Common Shares by any person, subject to the exceptions provided therein. In addition, on or before January 30th of each year, the Company shall send a letter demanding information regarding the amount of shares each such shareholder constructively owns (the "shareholder demand letters") (i) in the event the Company has 2,000 or more shareholders of record on any dividend record date, from each record holder of 5% or more of its shares, (ii) in the event the Company has less than 2,000 and more than 200 shareholders of record on any dividend record date, from each record holder of 1% or more of its shares and (iii) in the event the Company has 200 or less shareholders of record on any dividend record date, from each shareholder of record of one-half of 1% or more of its shares. C. Income Tests. At least 75% of the Company's gross income (excluding income from prohibited transactions) for each taxable year shall be derived directly or indirectly from investments relating to real property or mortgages on real property (including "rents from real property" and interest) or from certain types of temporary investments. In addition, at least 95% of the Company's gross income (excluding income from prohibited transactions) for each taxable year must be derived from such real property investments and from dividends, interest and gain from the sale or disposition of securities. 1. Acquisition of Assets. Prior to purchasing, originating or otherwise acquiring any asset (including, without limitation, any acquisition by foreclosure or deed-in-lieu of foreclosure), such asset will be reviewed and analyzed by the Company's investment compliance officer (and, to the extent the investment compliance officer or other executive officer of the Company determines necessary, by qualified REIT tax counsel) to ensure that the acquisition and ownership will not cause the Company to fail to qualify as a REIT for federal income tax purposes. To the extent that any proposed acquisition includes an equity investment in real estate or a Mortgage Loan or a pool of Mortgage Loans secured by real estate, the Company shall require the owner of the real estate or the borrower, as applicable, to complete a "checklist," make representations, and/or otherwise supply requisite information regarding the nature of the income from and the operation of the property to enable the Company's investment compliance officer (or REIT tax counsel, as applicable) to determine whether such proposed investment satisfies the income tests applicable to REITs. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 20 46 2. Other Income. Prior to entering into any transaction which may result in the receipt by the Company of income (whether through the sale or lease of assets, the provision of services, the entering into of a hedging transaction or otherwise), such transaction will be reviewed and analyzed by the Company's investment compliance officer (and, to the extent the investment or tax compliance officer or other executive officer of the Company determines necessary, by qualified REIT tax counsel) to ensure that the receipt of income from such transaction will not cause the Company to fail to qualify as a REIT for federal income tax purposes. If the investment compliance officer or qualified REIT tax counsel determines it to be appropriate, the Company may transfer certain nonqualifying activities to a taxable corporation from which it may receive dividends, to the extent permitted by the Code. D. Asset Tests. At least 75% of the value of the Company's total assets shall be represented by cash or cash items (including certain receivables), government securities, "real estate assets" (including loans secured by real estate interests) or, in certain cases, temporary investments as defined in or permitted by the Code. In addition to the foregoing requirement, the value of any one issuer's securities owned by the Company shall not exceed 5% of the value of the Company's total consolidated assets, and the Company shall not own more than 10% of any one issuer's outstanding voting securities (except for its interests in any qualified REIT subsidiary). Prior to any acquisition or disposition of the Company's assets, the investment compliance officer (or qualified REIT counsel, as applicable) shall review such proposed acquisition or disposition to determine that such acquisition or disposition will not cause the Company to fail to qualify as a REIT for federal income tax purposes as a result of the foregoing asset tests. E. Annual Distribution Requirements. The Company shall make quarterly distributions to its shareholders equal, on an annual basis, to at least 95% of the Company's REIT taxable income (computed without regard to the dividends paid deduction and any net capital gains). F. Review by Independent Accounting Firm. The Company shall cause its independent accounting firm to review, in connection with its quarterly review of the financial statements of the Company, the Company's compliance with the REIT Provisions of the Code. The Company shall cause its independent accounting firm to review, in connection with its annual audit of the financial statements of the Company, the Company's compliance with the REIT Provisions of the Code and, in connection therewith, to prepare and deliver, on an annual basis, a report of its findings with respect thereto to the Board. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 21 47 SECTION 7. POLICY REGARDING INVESTMENT COMPANY ACT A. General. The Company intends to be primarily engaged in the business of purchasing or otherwise acquiring "mortgages and other liens on and interests in real estate" and therefore to be excluded from regulation under the Investment Company Act. B. Percentage of Assets Constituting Interests in Real Estate. The Company shall maintain at least 55% of its assets directly in Mortgage Loans, MBS which represent all of the beneficial interest in the underlying pool of Mortgage Loans, direct equity investments in real estate and other qualifying liens on and interests in real estate. C. Collateral Rights. With respect to any proposed investment in any MBS which does not represent all of the beneficial interest in the underlying pool of Mortgage Loans, the Manager shall seek (where appropriate and feasible) to obtain the right to foreclose on the underlying property, to control the oversight and management of the resolution of the underlying Mortgage Loans by workout or modification of loan provisions, foreclosure, deed in lieu of foreclosure or otherwise and to control decisions with respect to the preservation of the collateral generally (collectively, the "Collateral Rights"). D. Maximum Percentage of Partial MBS Interests. Without the prior approval of the Board of Trust Managers (or any authorized Committee of the Board), the Company's aggregate investments in MBS shall not exceed, at the time of such investment, 40% of the Company's total consolidated assets. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 22 48 SCHEDULE I DEFINITIONS Capitalized terms used above have the meanings set forth below, unless the context indicates otherwise. "Board" means the Board of Trust Managers of AMCT. "Bridge Loan" means a Mortgage Loan used for temporary financing. "CMBS" means commercial or multifamily MBS. "Code" means the Internal Revenue Code of 1986, as amended. "Common Shares" means AMCT's common shares of beneficial interest, par value $.01 per share. "Construction Loan" means a Mortgage Loan the proceeds of which are to be used to finance the costs of construction or rehabilitation of real property. "Correspondent Agreement" means the nonexclusive Correspondent Agreement between Holliday Fenoglio Fowler and the Company. "Distressed Mortgage Loans" means Subperforming Mortgage Loans and Nonperforming Mortgage Loans. "Distressed Real Estate" means REO Properties and other underperforming or otherwise distressed real estate. "Investment Company Act" means the Investment Company Act of 1940, as amended. "Investment Committee" means the committee(s) maintained by the Manager (which committee(s) will include the President and the Chief Investment Officer of the Company) which must approve the purchase, acquisition or origination by the Company of any Targeted Investment. "Management Agreement" means the agreement by and between the Company and the Manager whereby the Manager agrees to perform certain services to the Company in exchange for certain compensation. "MBS" means mortgage-backed securities (including CMBS and RMBS). EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 23 49 "Mezzanine Loan" means a commercial real estate loan the repayment of which is subordinated to a senior Mortgage Loan and which is secured either by a second lien mortgage or a pledge of the ownership interests of the borrower. Such loans can also take the form of a direct equity investment in a partnership or joint venture. "Mortgage Collateral" means mortgage pass-through securities or pools of whole loans securing or backing a series of CMBS. "Mortgage Loans" means, collectively, loans secured by real property and Mezzanine Loans. "Net Leased Real Estate" means real estate that is net leased on a long-term basis (ten years or more) to tenants who are typically responsible for paying a majority of the costs of owning, operating, and maintaining the leased property during the term of the lease, in addition to the payment of a monthly rent to the landlord for the use and occupancy of the premises. "Nonperforming Mortgage Loans" means Mortgage Loans for which the payment of principal and/or interest is more than 90 days delinquent. "Participating Loan" means a Mortgage Loan that entitles the lender to the receipt of interest based on a percentage of the mortgaged property's revenues or cash flow, and/or any gain on sale of the property which Participating Loan may be a Mezzanine Loan, Construction Loan, Bridge Loan or other Mortgage Loan. "Permanent Mortgage Loans" means long-term senior Mortgage Loans. "Qualified REIT Subsidiary" means a corporation whose stock is entirely owned by the Company at all times during such corporation's existence. "REIT" means a real estate investment trust, as defined under Section 856 of the Code. "REIT Provisions of the Code" means Sections 856 through 860 of the Code. "REO Property" means real estate acquired at foreclosure (or by deed in lieu of foreclosure). "Residual Interests" means REMIC Residual Interests and non-REMIC Residual Interests collectively. "Right of First Refusal" means the right to be granted by AMRESCO to the Company with respect to Targeted Mortgage Loans and MBS, pursuant to which AMRESCO will agree not to permit any member of the AMRESCO Group to invest in (i) the first $100 million of Targeted Mortgage Loans which are identified by or to any member of the AMRESCO Group during any calendar quarter, or (ii) any MBS, other than MBS issued EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 24 50 in securitizations sponsored in whole or in part by any member of the AMRESCO Group, unless the Investment Committee shall have first determined, in each case, that the Company should not invest in such asset or assets, or should invest in only a portion of such asset or assets. "RMBS" means a series of one-to four-family residential MBS. "Subordinated Interests" means classes of MBS that are subordinated in right of payments of principal and interest to more senior classes. "Subperforming Mortgage Loans" means Mortgage Loans for which default is likely or imminent or for which the borrower is making payments in accordance with a forbearance plan. "Targeted Investments" means the various types of real estate related assets targeted to be invested in by the Company. "Targeted Mortgage Loans" means any Mortgage Loan which (i) meets the investment criteria and objectives of the Company and (ii) has been preliminarily reviewed and approved for further consideration by any member of the AMRESCO Group. EXHIBIT "A" TO MANAGEMENT AGREEMENT - PAGE 25 EX-27 3 FINANCIAL DATA SCHEDULE
5 1,000 3-MOS DEC-31-1999 JUL-01-1999 SEP-30-1999 3,794 26,027 5,435 0 0 0 86,547 805 261,213 2,696 0 0 0 100 127,733 261,213 0 6,301 0 0 1,546 642 1,769 2,344 0 2,344 0 0 0 2,344 0.24 0.24
-----END PRIVACY-ENHANCED MESSAGE-----